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3% Withholding On Government Contracts Comes Under Fire

A controversial tax provision is scheduled to take effect in a little over a year, and it could have a huge impact on your cash flow. The provision requires most government entities to withhold 3% of payments for goods and services. A number of business groups oppose the new requirement and, as of this writing, several proposals are pending in Congress to repeal it.

Closing the Tax gap

The withholding requirement was added by the Tax Increase Prevention and Reconciliation Act of 2005. After having been postponed twice, it's scheduled to apply to payments made after Dec. 31, 2012, pursuant to contracts executed (or "materially modified") after that date. For payments made under existing contracts, the 3% withholding kicks in on Jan. 1, 2014.

The purpose of the requirement is to help close the "tax gap" created by government contractors' unpaid tax bills. The withholding is required for all payments for goods and services by federal, state and local government entities with total annual expenditures of $100 million or more.

Regulations finalized earlier this year create several exceptions to the withholding requirement, including payments to contractors of less than $10,000, wages and other payments already subject to income tax withholding, interest payments and payments for real property. Antiabuse rules prevent contractors from sidestepping the requirement by breaking up larger payments into several sub-$10,000 payments.

The regulations also clarify that withholding is required only for payments to prime contractors, that is, the main contractors who have contracts with the government. So, payments by a general contractor to a subcontractor wouldn't be subject to withholding. Payments by a government entity to a payment administrator would also be exempt, but the administrator would be required to withhold 3% of its payments to prime contractors.

Arguments for Repeal

Several organizations, including the Associated General Contractors of America and the American Institute of Certified Public Accountants, have urged Congress to repeal the requirement. Critics point out that:

• The 3% withholding - which applies to the total contract - will exceed many contractors' profit margins,
• The reduced cash flow will make it hard for contractors to grow their businesses and obtain bonding, and
• The cost of implementing the measure is estimated to exceed the revenue that will be raised.

A better solution, opponents say, is for the IRS to enforce existing laws that require all businesses to report their revenue and pay estimated taxes.

Stay Tuned

Opponents are hoping Congress will repeal the 3% withholding requirement well before its effective date. For the latest information, contact your tax advisor.