When you receive income that's not subject to income tax withholding, the person or organization that's paying you will usually ask you to fill out a W-9 form. This form is an official request for a taxpayer identification number -- that is, a Social Security number or Employer Identification Number. This form is also used to declare whether you're what's called an exempt payee, someone who isn't subject to "backup withholding."
To understand what an exempt payee is, you first need to understand backup withholding. In certain circumstances, payers must withhold a certain amount for taxes, known as backup withholding, with that money to be paid to the IRS. Payments that could be subject to backup withholding include interest, dividends, patronage dividends, royalties, rent and nonemployee compensation. These payments require that a 1099 form to be sent to the IRS and the recipient. However, backup withholding is required only when the payee does not give the payer his name or taxpayer identification number; or the taxpayer ID number on the W-9 does not match IRS records; or if the taxpayer did not report all interest, dividend or other subject payments on his tax return; or if the taxpayer owes federal income tax.
Exempt Payee Defined
An exempt payee is a payee who is not subject to backup withholding even when backup withholding would normally be required. Exempt payees are outlined in the instructions provided by the IRS for completing the standard W-9 form, which is the form payers use to request your taxpayer identification number. In general, exempt payees include government agencies, charitable organizations, financial institutions, corporations and trusts. Individuals, including sole proprietors, generally are not exempt from backup withholding, and thus are not exempt payees.
Checking the Box
The W-9 has a box to check if you are an exempt payee. If you do not check that box, the payer will assume you are nonexempt and will withhold money for taxes if you fall into one of the categories where backup withholding is required. In other words, all payees are considered nonexempt unless they specifically claim exemption by checking the box.
Rules on paying state taxes will vary depending on the state of residence. Payees should check the rule for their particular state. You may want to seek the help of an accountant or tax professional to determine whether you are subject to backup withholding and whether you are considered exempt or nonexempt.