Introduction: Backup Withholding On Interest-Bearing Accounts

The backup withholding rules are a major concern to you at the time you open a deposit account. Remember that these rules apply only to interest-bearing accounts, but they apply to all interest-bearing accounts. (The Bank Secrecy Act, which we discuss in a separate section in this manual, has some tax-related account-opening requirements that apply to all accounts, whether they bear interest or not. See that section for details.)

The backup withholding rules are the result of provisions in the Interest and Dividend Tax Compliance Act of 1983 and the Tax Reform Act of 1986. The purpose of these laws was to enhance the ability of the Internal Revenue Service (IRS) to collect income tax due on interest income. The law and regulations created two devices for accomplishing this.

The first device was the requirement that “payors” (those who pay interest) exercise “due diligence” in obtaining the correct taxpayer identification number (TIN) of the “payee” (the person receiving the interest payment). The payor was then required to include the TIN it obtained from the payee on Form 1099, which the payor files annually with the IRS to report the amount of interest paid to the payee. (An individual’s TIN is his or her social security number; for other entities—corporations, etc.—the TIN is an employer identification number.)

The IRS uses the TIN on the 1099 to pull together the payee’s income tax return and all other 1099 forms filed by other payors relating to that payee. The IRS then compares the total interest reported on all the 1099 forms to the interest reported by the payee on the income tax return to see if the payee reported all interest income. Obviously, this system works only if the 1099 forms contain the correct payee TIN. The Internal Revenue Code provided that payors would be liable for a penalty if they failed to include the payee’s correct TIN on Form 1099, unless the payor exercised “due diligence” in obtaining the correct TIN.

The second device was the requirement that payors withhold portions of interest payments. This was known as “backup withholding.” The payor was required to withhold 20 percent of an interest payment to the payee’s account if any of the following four things occurred:

1. The payee did not supply his or her TIN in “the manner required,”
2. The IRS notified the payor that the payee had supplied an incorrect TIN,
3. The IRS notified the payor that the payee had underreported interest income, or
4. The payee did not certify that he or she is not subject to backup withholding due to underreporting interest income (this certification is not required for accounts established prior to January 1, 1984).

[26 USC 3406(a)(1)]

The 20 percent rate mentioned above was the original backup withholding rate. Effective January 1, 1993, Congress increased the rate to 31 percent, where it remained until June 7, 2001, when President Bush signed a bill that set the rate at 28 percent.

The payor remits to the IRS the amount the payor withholds and that amount is applied to the tax liability of the payee. You can see that backup withholding also contributes to the goal of enhancing the ability of the IRS to collect tax on interest income.

Exercising “due diligence” and “backup withholding” on interest payments in the proper circumstances were the basic obligations of the payor until 1989. In that year, the Omnibus Budget Reconciliation Act of 1989 (OBRA 1989, P.L. 101-239, Sec. 7711) deleted the “due diligence” standard from the tax code, and replaced it with the “reasonable cause” standard. This standard penalized a payor for failing to include the payee’s correct TIN on Form 1099 unless the failure was due to “…reasonable cause and is not due to willful neglect.” [26 USC 6721 – 6724] In February and December of 1991, the IRS issued regulations that went into great detail on what a payor must do to meet the “reasonable cause” standard. [26 CFR 301.6721-0 through 26 CFR 301.6724-1] OBRA 1989 did not change the requirement that payors backup withhold in the circumstances above.

The change from the “due diligence” standard to the “reasonable cause” standard created a number of complications.

First, the IRS rules had dictated numerous and complicated procedures that constituted “due diligence.” Payors had struggled mightily to learn and implement these procedures. The “reasonable cause” standard requires quite different procedures with which payors needed to become familiar. (This is tempered somewhat, as we will point out later, by the fact that the “reasonable cause” regulations provide a “safe harbor” for payors who meet the “due diligence” standard; in other words, payors are deemed to meet the “reasonable cause” standard if they meet the “due diligence” standard. This means payors need not learn the “reasonable cause” standard if they are content with continuing to meet the somewhat more stringent “due diligence” standard.)

Second, the original backup-withholding regulations dealt simultaneously with what a payor had to do to exercise due diligence and what a payor had to do to meet its separate obligation to backup withhold. To put it another way, the original backup-withholding regulations listed all sorts of procedures that payors should follow—some of these derived from the payor’s duty to exercise due diligence and some derived from the payor’s duty to backup withhold. The elimination of the “due diligence” standard, with the retention of the backup-withholding requirement, forces payors to review all those procedures and determine which a payor follows solely to satisfy the “due diligence” standard. Since “due diligence” no longer exists, payors no longer need to follow those procedures. Those payors now have the option of following the procedures necessary to satisfy the “reasonable cause” standard.

This section will focus on what you as a payor of reportable interest must do at the time of account opening with respect to all these rules—the backup withholding requirement, the “due diligence” standard, and the “reasonable cause” standard. In a later section we will deal with your ongoing duties after account opening. When we discuss an account-opening responsibility, we will try to make clear why you want to meet the responsibility—whether it is to meet your duty to backup withhold or to meet the “due diligence” or “reasonable cause” standards. With this approach, payors trying to shift from meeting the “due diligence” standard to meeting the “reasonable cause” standard should more easily be able to do so.