Back up withholding on pass through dividends

[Guest P A Weick]

Does back up withholding apply to pass through ESOP dividends? We (ESOP trustee) just received a so called C Notice requiring us to institute back up withholding on three participants due to their failure to properly report dividend income on their tax returns. Everything I have read indicates that no form of withholding, including back up, applies to 404(k) dividends. Has anyone else had to deal with this issue and if so how did you finally resolve it?

[RLL]

IRC section 3405(e)(1)(B)(iv) exempts ESOP dividend distributions from the withholding rules applicable to deferred compensation plans.

Notwithstanding the IRS position that ESOP dividend distributions are generally reportable on Form 1099-DIV (rather than on Form 1099-R), such payments are not "dividends" taxable to the recipient under section 61(a)(7)...they are employee plan distributions taxable under section 402(a) and subject to the withholding rules under section 3405. Employee plan distributions are not "reportable payments" as defined in the backup withholding rules of section 3406.

The IRS may not agree with this analysis....but I think the IRC supports it.

[Guest Judy S]

I have a client that is getting ready to distribute pass-through dividends and has just received a backup withholding notification for one of the participants. The 2006 instructions to the 1099-DIV specifically state that 404(k) dividends are not subject to backup withholding, but the client has been told by their accountant that they must withhold 28% from the participant's dividend check. Have the rules changed since 2001 when this original post was started? What are the consequences of withholding the 28% from the pass-through dividends if withholding is not required, and vice versa? RLL's statement that the IRS may not agree with his/her analysis leaves me wondering what is correct.