The Department of the Treasury and the Internal Revenue Service (IRS) have issued proposed regulations (REG-112829-25) addressing backup withholding obligations for Third Party Settlement Organizations (TPSOs). These proposals are designed to harmonize the backup withholding regulations under Internal Revenue Code (IRC) section 3406 with the recent statutory amendments to IRC section 6050W enacted by the "One, Big, Beautiful Bill Act" (OBBBA).

For tax professionals advising TPSOs or participating payees, these proposed regulations represent a significant technical shift from the existing regulatory framework. Specifically, they modify the determination of "reportable payments" subject to backup withholding by incorporating the de minimis thresholds found in section 6050W(e).

Aligning Withholding Obligations with Reporting Thresholds

The core conflict addressed by REG-112829-25 lies in the discrepancy between the thresholds for informational reporting (Form 1099-K) and the thresholds for backup withholding under current regulations.

Under the existing §31.3406(b)(3)-5(b), the determination of a reportable payment is expansive. The current regulation states: "In the case of payments made in settlement of third party network transactions, the amount subject to withholding under section 3406 is determined without regard to the exception for de minimis payments by third party settlement organizations in section 6050W(e) and the associated regulations". Consequently, under existing rules, a TPSO could theoretically be required to backup withhold on a payee failing to furnish a TIN (Taxpayer Identification Number) on the very first dollar paid, regardless of whether the transaction volume or dollar amount triggered a Form 1099-K filing requirement.

The OBBBA retroactively reverted the section 6050W reporting threshold to the pre-American Rescue Plan Act levels—specifically, payments exceeding $20,000 and 200 transactions in a calendar year. To reflect this statutory change, the proposed regulations amend §31.3406(b)(3)-5(b)(2) to explicitly reverse the "without regard" standard.

The proposed regulation text mandates that: "In the case of payments made in settlement of third party network transactions, the amount subject to withholding under section 3406 is determined with regard to the exception for de minimis payments by third party settlement organizations in section 6050W(e)".

Accordingly, a payment is treated as a reportable payment subject to backup withholding only if two conditions are met within the calendar year:

"the aggregate number of transactions with respect to the participating payee... exceeds the number of transactions specified in section 6050W(e)(2)" (currently 200); and
"the aggregate dollar amount of the current transaction and all previous transactions to the participating payee... exceeds the dollar amount specified in section 6050W(e)(1)" (currently $20,000).

Timing of the Withholding Liability

Tax professionals must note that the withholding obligation is not retroactive to the first dollar once the threshold is crossed, but rather attaches to the specific transaction that triggers the threshold excess.

The proposed regulations clarify that the amount subject to withholding is "the entire amount of the transaction that causes either the total number of transactions to exceed the number of transactions specified in section 6050W(e)(2), or the entire amount of the transaction that causes the total dollar amount paid to the participating payee to exceed the dollar amount specified in section 6050W(e)(1) at the time of such payment, whichever occurs later, and the amount of any subsequent transactions made to the participating payee during the calendar year".

The Preamble to the proposed regulations offers a concrete example of this application in Proposed §31.3406(b)(3)-5(b)(4)(i). In the example, a TPSO "makes 201 payments in settlement of third party network transactions that total $20,000.01." The TPSO must backup withhold "on the entire amount of the 201st transaction because that transaction caused Y to exceed the de minimis reporting threshold for calendar year 2026 of 200 transactions and $20,000 in gross payments".

The Preceding Year Look-Back Rule

A critical provision in the proposed regulations that may trap unwary payors is the look-back rule contained in Proposed §31.3406(b)(3)-5(b)(3). This subsection creates an exception to the de minimis threshold protection based on prior year activity.

The proposed regulation states: "Paragraph (b)(2) of this section [the de minimis exception] does not apply with respect to payments to any participating payee during any calendar year if one or more payments in settlement of third party network transactions made by the payor to the participating payee during the preceding calendar year were reportable payments".

This means if a payee was subject to Form 1099-K reporting in Year 1, the TPSO must backup withhold on all payments to that payee in Year 2 (assuming a withholding condition, such as a missing TIN, exists), regardless of whether the payee reaches the $20,000/200 transaction threshold in Year 2.

The proposed regulations illustrate this in Example 2: "During calendar year 2027, A makes 199 payments in settlement of third party network transactions that total $18,000.00. A must backup withhold on each payment made to Y in settlement of a third party network transaction during 2027... because one or more payments in settlement of third party network transactions made by A to Y during the preceding calendar year (2026) were reportable payments".

This obligation persists until a full calendar year passes without reportable payments. As shown in Example 4, if a TPSO makes no payments in 2029, and then makes payments totaling $18,000 in 2030, the TPSO "is not required to backup withhold on any payment... because A did not make any reportable payments to Y during the preceding calendar year (2029), and A did not make payments in settlement of third party network transactions that exceed the de minimis reporting threshold".

IRS Justification and Statutory Authority

The IRS justifies these changes as necessary compliance with the statutory amendments to section 3406(b) enacted by the OBBBA. Section 3406(b)(8) was added to the Code to explicitly link the definition of a reportable payment for TPSO transactions to the thresholds in section 6050W.

Previously, under section 3406(b)(4), "whether a payment is reportable is determined without regard to the minimum amount that must be paid before a return is required". The new proposed regulations reflect the specific statutory override provided by OBBBA section 70432(b)(1), which dictates that a payment is reportable "only if (1) the aggregate number of transactions... exceeds the number of transactions specified in section 6050W(e)(2), and (2) the aggregate dollar amount of transactions... exceeds the dollar amount specified in section 6050W(e)(1)".

From an economic perspective, the Treasury Department notes that "because the threshold to backup withhold would increase under the proposed rules, the proposed rules would reduce the frequency with which entities must backup withhold".

Updates to General Backup Withholding Regulations

In addition to the specific TPSO amendments, the proposed regulations update §31.3406(a)-1, the general backup withholding requirement overview. The proposed amendment adds a cross-reference to the new TPSO exception.

The updated text for §31.3406(a)-1(c) reads: "The requirement to withhold does not apply to certain de minimis payments as described in §§31.3406(b)(3)-1(a)(3), 31.3406(b)(3)-5(b)(2), and 31.3406(b)(4)-1". This amendment integrates the specific TPSO relief into the broader exemption framework of the backup withholding regulations.

Effective Dates and Obsoleted Guidance

The proposed regulations are slated to apply to "payments made in calendar years beginning after December 31, 2024".

Furthermore, upon publication of these regulations, several prior IRS Notices that provided transitional relief or guidance inconsistent with the OBBBA are rendered obsolete. Specifically, "Notice 2023-10, 2023-3 I.R.B. 403, Notice 2023-74, 2023-51 I.R.B. 1484, and Notice 2024-85, 2024-51 I.R.B. 1349 are inconsistent with the statutory revisions and are obsoleted".

Practitioners should review their clients’ backup withholding systems to ensure they can track both the current-year aggregate thresholds and the preceding-year reporting status of payees to remain compliant with these proposed rules.

Prepared with assistance from NotebookLM.