Third-party network transactions and backup withholding rules

If your clients sell online or take payments through apps, Form 1099-K, Payment Card and Third-Party Network Transactions, questions are already part of your daily workflow. Now add backup withholding.

The IRS issued proposed regulations that update the backup withholding rules under §3406 to reflect statutory changes made by the One Big Beautiful Bill Act (OBBBA). The proposed rules focus on when third-party network payments become “reportable payments” for backup withholding purposes and how withholding applies once a payee crosses the reporting thresholds.

For tax pros, this proposal is worth paying attention to because it adds clarity to an area that has been inconsistent for years. It also gives a clean way to explain to clients why withholding may start midyear, why it does not apply to smaller sellers and why crossing a threshold changes everything.

The big picture: backup withholding now tracks the 1099-K thresholds

Third-party settlement organizations, or TPSOs, are payment platforms that settle transactions for sellers. The IRS explains that §6050W requires payment settlement entities, including TPSOs, to report certain payments to participating payees on Form 1099-K.

The proposed rules explain that OBBBA retroactively reverted the Form 1099-K reporting threshold to the pre-American Rescue Plan Act (ARPA) rule. Under that rule, a TPSO reports payments only when a payee exceeds both:

• More than 200 transactions
• More than $20,000 in aggregate payments during the calendar year

The proposed regulations implement a new statutory rule under §3406(b)(8) that treats third-party network payments as reportable payments only if both of those thresholds are exceeded in the calendar year.

In plain terms, if the payee does not exceed both thresholds, backup withholding on third-party network transactions generally does not apply.

Why this matters in practice

Tax pros have seen clients panic when they hear “backup withholding” because they assume it applies to every payment the way withholding applies in payroll. If the client is a small seller who never meets the Form 1099-K thresholds, backup withholding on third-party network payments is generally not triggered. If the client is a high-volume seller who will cross the thresholds, withholding becomes a cash flow issue that requires planning.

It also matters to payors and platforms because it clarifies when they should begin withholding, reducing inconsistent treatment.

When withholding starts and which payments are subject to withholding

The most important technical detail for client conversations is not the thresholds. It occurs when the payee crosses them.

The proposed rules state that the amount subject to backup withholding includes:

• The entire amount of the transaction that causes either the total number of transactions to exceed 200 or the total dollar amount paid to exceed $20,000, whichever occurs later
• Any subsequent transactions made to the payee during that same calendar year

This is where the “mid-year surprise” can happen. A payee may have 220 transactions by September, but only $18,000 in payments. There is no withholding yet. Once the payee exceeds $20,000 later in the year, withholding applies to that transaction and continues for the rest of the year.

That also means a payee could cross $20,000 first but not exceed 200 transactions until later. Withholding begins when the second threshold is exceeded.

Your client-facing takeaway: it is not “when you get paid.” It is when you cross the second threshold.

The prior-year rule: a payee who crossed the threshold last year may not get the same treatment this year

The proposed rules also highlight a prior-year concept that tax pros should watch closely.

Section 3406(b)(8)(B) provides that the special third-party network threshold rule does not apply for a year if one or more payments made to the participating payee during the preceding year were reportable payments.

The proposed regulations reflect that statutory rule. If the payee had reportable payments in the prior year, the special threshold treatment does not apply in the current year.

This provision is important for clients who crossed the threshold last year and expect to do so again. It suggests withholding may be triggered more easily in the current year once the payee is already in the reportable payment category. This is a planning issue because it affects cash flow and the estimated tax strategy.

Applicability date and what guidance is being replaced

The proposed regulations are intended to apply to payments made in calendar years beginning after Dec. 31, 2024, and make obsolete three notices that conflict with the updated statutory revisions: Notice 2023-10, Notice 2023-74 and Notice 2024-85.

What tax pros should do now

Even though these are proposed rules, you can use them now to improve client education and reduce confusion.

Start with your platform clients and categorize them into two groups.

Group one: clients who are unlikely to exceed the thresholds. For these clients, reinforce that income is still taxable, but backup withholding tied to third-party network transactions generally will not apply unless they exceed both thresholds.

Group two: clients who routinely exceed the thresholds. For these clients, discuss cash flow planning, withholding expectations and documentation. A client who expects to cross the threshold should know that withholding can begin late in the year and can apply to the triggering transaction and later transactions.

If you advise payor-side clients or platforms, the key action item is monitoring. The proposed rules make clear that transaction counts and gross payment totals drive the withholding trigger. Help your clients prepare for these changes now.

Additional comments

The IRS invites comments or public hearing requests through the Federal eRulemaking Portal or paper submissions to the IRS within 60 days of the rules being published in the Federal Register.