Tax-Exempt Bonds and Backup Withholding

June 22, 2009

Statements regarding backup withholding and reporting are common in official statements relating to tax-exempt bonds.  Such statements have also appeared in official statements relating to taxable bonds such as Build America Bonds.  This post provides a basic overview of what backup withholding (and reporting) means for purposes of tax-exempt and taxable bonds. Portions of the following description are taken from a McGuireWoods news letter posted here.

Section 6049 of the Code requires “payors” to file information returns with the IRS showing interest payments. These information returns are required to assist taxpayers and the IRS in determining a taxpayer’s correct tax liability. The returns are made on IRS Form 1099-INT.

Section 3406 of the Code subjects reportable interest to backup withholding, which means that a payor must institute a backup withholding on a payee who fails to properly certify (a) the payee’s federal TIN, (b) that the payee is not subject to backup withholding and (c) that the payee is a U.S. citizen.  Such certifications are usually made on IRS Form W-9.

In the past, interest on tax-exempt bonds, notes, installment-sale and lease-purchase agreements, capital leases and similar obligations issued or incurred by state or local governmental units (all tax-exempt) was not subject to reporting under Section 6049 of the Code and not subject to backup withholding under Section 3406 of the Code. In other words, such tax-exempt obligations were exempt from reporting and withholding.

Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), however, Congress removed this exemption. Therefore, unless another exemption applies, all tax-exempt interest paid after December 31, 2005 on any tax-exempt bond, regardless of the date of issuance of the bond, is subject to the reporting and backup withholding requirements.

“Payor” means, within the meaning of the Income Tax Regulations, a person who (a) makes a payment of tax-exempt interest to any other person during a calendar year or (b) who collects on behalf of another person payments of tax-exempt interest, or who otherwise acts as a “middleman” with respect to such payments.  See also Section 1.6049-4 of the Income Tax Regulations.

“Middleman” means, within the meaning of the Income Tax Regulations, any person, including a financial institution, a broker or a dealer, or a nominee, who makes payment of interest for, or collects interest on behalf of another person or otherwise acts in a capacity as intermediary between a payor and a payee.  See also Section 1.6049-4 of the Income Tax Regulations.

No information return is required with respect to any payment made to an “exempt recipient.”  “Exempt recipient” includes corporations, tax-exempt organizations (including 501(c)(3) organizations), the federal government, any state or the District of Columbia, or any political subdivision thereof, financial institutions, nominees or custodians, and securities dealers and brokers. Exempt recipients do not include individuals, partnerships or any entity that is taxed as a partnership for federal tax purposes.  Interest paid by a municipality to a financial institution which is the holder of the related bond would, therefore, not require the municipality to provide IRS Form 1099-INT to the financial institution.

Portions of the above description were taken from a McGuireWoods news letter posted here, titled “Update on New Reporting Requirement for Tax-Exempt Interest” dated March 27, 2007.

Apparently, the first drafts of TIPRA included a provision that would have required municipalities to report interest earned by bondholders to the IRS. This provision was removed in the version of the act adopted by Congress. This effectively clarifies that a municipality generally is not required to report and take backup withholding measures.