[IMGCAP(1)]This fall the IRS will send out CP2100 and CP2100a Forms, or “B” Notices, to payers who filed incorrect or incomplete forms including those with incorrect name and Taxpayer Identification Number data.

Businesses should take note of this punitive measure used by the IRS to enforce proper reporting of revenue and to avoid the client ramifications of the backup withholding process.

Tax Gap Means More Backup Withholding is Inevitable
The IRS is very conscious of the $450 billion tax gap, the estimated amount of revenue it currently does not collect each year. More than 80 percent of that missing revenue is due to underreporting, and studies point to third-party reporting and withholding as a cure-all to that underreporting. These strategies have proven to work well for payroll tax collection, which has a one percent rate of underreporting.

With this in mind, the IRS will be putting a bigger focus on information reporting and the associated backup withholding. In 2006, the IRS issued 3.6 million “B” Notices requiring businesses to withhold income. By 2011, the IRS had sent 4.7 million notices. This year, it’s possible that the IRS will send more than 5 million “B” Notices to businesses across the U.S., an increase of 40 percent in just six years.

The IRS has also been increasing “B” Notice fines and penalties. As of fiscal year 2012, businesses that received a “B” Notice were fined $100, up from $50. It has also increased the maximum penalty for “B” Notices, up to $1.5 million from $250,000, and has removed the cap on penalties for repeatedly uncooperative businesses.

How the Backup Withholding Process Works
Internal Revenue Code section 3406 requires payers such as banks and corporations to deduct 28 percent of payments made to a payee for whom they have not filed accurate information returns and remit the collected amount to the IRS.

Unfortunately, the backup withholding process is a lengthy one. Upon receiving the first “B” Notice, the payer must send the payee a W-9 packet, soliciting corrected TIN information. The payer has 15 days to send the W-9 packet to the payee who in turn has 15 days after that to respond to the solicitation. Payers are required to withhold 28 percent of income if the TIN information is not corrected within 30 days of receiving the “B” Notice.

Once a “B” notice is received, the payer cannot simply call the payee and amend the 1099 information over the phone. The payee must complete the W-9 package and return it to the IRS before backup withholding can cease.

If a second “B” Notice is received for the same record within three years, the payee must go to their local Social Security Administration office to have his or her Social Security Number validated on an SSN printout. This printout must then be sent to the payer before they can stop backup withholding.

A payer reports withheld income on Form 945. It also must report withholding on the appropriate 1099 form. Backup withholding continues until the IRS notifies the payer to stop or until the payee shows written certification from the IRS that they are no longer subject to backup withholding.

1099-K Retribution Arrives, “B” Notices Will Follow
Many of the “B” Notices sent this year may be a result of the recent 1099-K legislation set out in Section 6050W of the 2008 Housing Association Tax Act. These information forms must be sent to businesses that received payment via credit card within the year.

Tax year 2011 was the first year for the 1099-K, and the IRS did not attach any punitive charges to noncompliance, giving time for businesses to set up their systems and get their houses in order. The IRS received around 9 million 1099-Ks, but this was 44 million fewer than the IRS predicted in its 2011 forecasts. Seemingly, not all merchants and processors of credit card information filed their 1099-Ks.

Historically, there’s usually a 40 percent noncompliance rate when 1099 regulation is enacted for new industries, and this sector may not be an exception. For example, a cursory glance through merchant forums on the likes of Amazon and eBay reveals much confusion and misinformation among professional online sellers that may lead to incorrectly or unfiled 1099-K forms.

For small business, withholding may significantly affect their bottom line. Losing 28 percent of their income would certainly disrupt cash flow. Avoiding this must be a priority for any merchant acquirer in order to ensure that long-term customer relations remains intact.

FATCA Will Exacerbate Withholding Woes
The 1099-K and the IRS’s focus on information reporting will increase the number of “B” Notices sent in 2013. In 2014 and beyond the backup withholding picture gets much more complicated, when regulations from the Foreign Account Tax Compliance Act begin to be implemented.

FATCA backup withholding adds layers of complexity to an already complicated process. Withholding rates and rules may differ between tax authorities where the person is a registered taxpayer, so how much and who you withhold on may be different for 50 different non-U.S. persons.

Be Prepared for the Process Now
Unfortunately for payers, “B” Notices may be inevitable. The good news is that there are processes that banks and corporations can follow now to minimize 2013 backup withholding headaches. The first is to do a thorough audit of all existing clients’ TINs, names and addresses. There are great real-time resources that can check large batches of TINs instantly with IRS records and highlight erroneous information.

The next step is to formulate a process of information retrieval and collection. This means a multipronged approach through various communication channels to minimize costs and maximize efficiency. It’s worth noting that this process can actually add value beyond regulatory compliance by cleaning up important client contact information that can also be used for marketing purposes.

The most important thing any business can do now is assess where they may be liable to withhold income and concentrate efforts on maximizing information collection now. The best advice may be to take tax information reporting and backup withholding as seriously as the IRS does.

Jeff Cronin is vice president of product strategy at Convey Compliance Systems.