What is backup withholding?
The IRS has rules that require a payer to withhold federal income tax from payments not otherwise subject to withholding. You may be subject to backup withholding if you fail to provide a correct taxpayer identification number (TIN) when required. This usually happens when a payer does not have a W-9 on file for the payee.
Gas and oil producers, banks, and other businesses that make certain types of payments during the year must file a 1099 information return with the IRS and to you as the recipient. A 1099 form includes your name and TIN such as a social security number (SSN), employer identification number (EIN), or individual taxpayer identification number (ITIN). The 1099 will also report any amounts withheld under the backup withholding rules.
If you are subject to backup withholding, the payer must withhold at a flat 24% federal rate. You might think that this is a good thing because you are paying into your federal taxes, kind of like paying estimated taxes. But here is the problem, the IRS form you will receive at the end of the year will have your name, address, the amount you were paid, and the amount of backup withholding all on the 1099 form. What is missing is your social security number (SSN). This results in federal income taxes sent to the IRS on your behalf but not associated with your SSN.
Filing an income tax return with backup withholding payments may result in you receiving a letter from the IRS stating they can’t process your return and issue you a refund until you verify the withholding amounts reported on the return. The IRS can’t match the withholding claimed on the return to all of the withholding submitted to the IRS under your SSN because your SSN is missing. The one thing the old IRS computer systems seem to get right is SSN matching.
If you notice federal backup withholding on your royalty statement, payment advice, or check stub, contact the payer and send a completed W-9. We find the best way to do this is by sending an email to owner relations.
Do not confuse post-production deductions for ad valorem or severance taxes (sometimes referred to as owner taxes) on your royalty statement for backup withholding or income tax withheld. They are entirely two different things. You can deduct the post-production expenses against your royalty income. A producer typically will not withhold income taxes like your W-2 employer will unless you are subject to backup withholding. The exception to this is in Pennsylvania, which has a non-resident withholding law that requires gas and oil companies to withhold PA state income taxes on any payments to non-residents.
Each tax season we see dozens of royalty 1099s issued to mineral owners that have backup withholding in the federal income tax withheld box and the SSN is missing. We immediately have the mineral owner sign a W-9 and email it to owner relations to get the account updated. We also see the IRS notices which will need to be resolved through mail correspondence and will significantly delay any expected refund.