In 2006 Congress enacted a statute that, for the purpose of increasing federal revenue, ordered all federal, state and local governments entering into contracts to withhold 3 percent from all payments made to government contractors. This plan to raid contractors’ pockets has been delayed until January 1, 2013. This is good news for contractors. Nevertheless, the plan is still in effect and regulations implementing the withholding requirement were recently published in the Federal Register on May 9, 2011. This article describes the genesis of the withholding plan, what it is meant to do and how it will affect contractors going forward.  


Congress enacted the Tax Increase Prevention and Reconciliation Act of 2005 on May 17, 2006. This legislation added § 3402(t) to the Internal Revenue Code. Similar to the requirement that employers withhold a percentage of employee wages, § 3402(t) mandates that all federal, state and local governments withhold 3 percent from payments to persons providing property or services to the government. Here is the statutory language:

  1. General rule

The Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies) making any payment to any person providing any property or services (including any payment made in connection with a government voucher or certificate program which functions as a payment for property or services) shall deduct and withhold from such payment a tax in an amount equal to 3 percent of such payment.

  1. Property and services subject to withholding

Paragraph (1) shall not apply to any payment —

  1. except as provided in subparagraph (B), which is subject to withholding under any other provision of this chapter or chapter 3,
  2. which is subject to withholding under section 3406 and from which amounts are being withheld under such section,
  3. of interest,
  4. for real property,
  5. to any governmental entity subject to the requirements of paragraph (1), any tax-exempt entity, or any foreign government,
  6. made pursuant to a classified or confidential contract described in section 6050M (e)(3),
  7. made by a political subdivision of a State (or any instrumentality thereof) which makes less than $100,000,000 of such payments annually,
  8. which is in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test, and
  9. to any government employee not otherwise excludable with respect to their services as an employee.
  1. Coordination with other sections

For purposes of sections 3403 and 3404 and for purposes of so much of subtitle F (except section 7205) as relates to this chapter, payments to any person for property or services which are subject to withholding shall be treated as if such payments were wages paid by an employer to an employee.

26 U.S.C. § 3402(t). The IRS believes that this legislation will both increase federal revenue and rein in those entities that operate under government contracts but also have outstanding federal tax liabilities. But by targeting all government contractors, the statute actually does much more.

When the statute was enacted, Congress intended to make this withholding requirement applicable to payments made on government contracts after December 31, 2010. On December 5, 2008, a Notice of Proposed Rulemaking implementing § 3402(t) was published in the Federal Register. See Withholding Under Internal Revenue Code Section 3402(t), 73 Fed. Reg. 74,082 (Dec. 5, 2008) (to be codified at 26 CFR pt. 31). The notice describes the proposed regulations implementing §3402(t). Here are some of the relevant details:

  • The new withholding obligations apply to only two types of contracts: (1) any new contract issued after December 31, 2010; and (2) any existing contract that is “materially modified” after December 31, 2010. Otherwise, the withholding obligations do not apply to existing contracts.
  • Nearly all federal, state and local government entities that enter into government contracts must comply: The withholding requirements apply to the entire federal government, as well as nearly all state and local government bodies. See 73 Fed. Reg. at 74,084.
  • Withholding applies uniformly to all contractors: Withholding applies to payments made to individuals, trusts, estates, partnerships, associations, companies and corporations.
  • $10,000 Threshold: The government need not make a withholding on any payment that is less than $10,000. See 73 Fed. Reg. 74,092. The Treasury Department and the IRS believe that the burden of withholding on such a low amount outweighs the benefit of increased withholding. This makes sense because the amount withheld on such a low amount would be only $300.
  • The “Anti-Abuse Rule”: The IRS and Treasury are equally concerned that government officials will skirt the payment threshold and thus avoid the bureaucratic nightmare of the new withholding requirement by manipulating payment amounts. Hence, the IRS has created an “anti-abuse rule.” This rule applies if a government entity divides a payment into separate portions less than $10,000. If the IRS or Treasury determines that the primary reason for the division into separate payments is related to § 3402(t), the separate payments will actually be treated as one payment for the purposes of the rule. See 73 Fed. Reg. 74,092.
  • Payments to the Prime: The withholding requirements apply only to payments made by the government to prime contractors. It does not apply to successive payments distributed by the prime to its subcontractors.
  • $100,000,000 Threshold: A political subdivision of a state is not required to withhold on its payments if it does not make $100,000,000 or more worth of payments for property or services annually. See 73 Fed. Reg. at 74,094.
  • Penalties for Failure to Withhold: If the government body fails to withhold properly, it may be liable itself for the payment of the tax to the IRS if it cannot prove that the payee has paid its income tax liability. See 73 Fed. Reg. at 74,090.

Following publication of the regulations, Congress passed the American Recovery and Reinvestment Act of 2009, 123 Stat. 115 (“Recovery Act”), on February 17, 2009. President Obama signed it into law shortly thereafter. Among other things, the Recovery Act pushed back the start date for § 3402(t) withholding by one year. The Recovery Act instructs that withholding should begin on payments made after December 31, 2011.

December 31, 2011 is Five Months Away— Now What?

On May 9, 2011, the government published a Notice of proposed rulemaking final regulations on § 3402(t). See Withholding on Payments by Government Entities to Persons Providing Property or Services, 76 Fed. Reg. 26,678 (May 9, 2011) (to be codified at 26 CFR pt. 31). The regulations delay enactment of the withholding program yet again. According to the regulations, withholding should begin on payments made after December 31, 2012. Withholding will apply only to (1) new contracts issued after December 31, 2012 or (2) existing contracts that are materially modified after December 31, 2012. However, the exception for existing contracts terminates after December 31, 2013. After that date, the withholding requirement will apply to all government contracts that are not otherwise excluded under one of the enumerated exceptions.

The final regulations also shed further light on what is considered a “material modification.” The language in the proposed 31 C.F.R. § 31.3402(t)-1 indicates that a material modification “includes only a modification that materially affects the property or services to be provided under the contract, the terms of payment for the property or services under the contract, or the amount payable for the property or services under the contract.” A renewal of a contract is not a material modification. Id. Likewise, if federal, state or local law requires that the contract be modified, that is not considered a material modification for the purposes of the withholding requirement. Id.

Where Do We Go From Here?

These successive delays no doubt show that support for the withholding plan is losing momentum. Moreover, Congress is beginning to recognize that this focus on government contractors may be unwarranted. There are currently three separate bills pending in committee that propose to repeal the withholding requirement. Senator David Vitter of Louisiana introduced Senate Bill 89 on January 25, 2011. Senator Scott Brown of Massachusetts introduced Senate Bill 164 that same day. The two bills are identical, except Brown’s bill includes a provision that uses available unobligated recovery funds to offset the loss in revenue by the proposed repeal. Representative Wally Herger of California introduced H.R. 674 on February 11, 2011, which also seeks to repeal §3402(t). We will continue to track these bills and provides updates as to whether this program will ever take effect.

Contractors have until August 8, 2011, to make comments or requests for public hearing on the latest proposed changes that were published on May 9, 2011. Comments may be submitted electronically via the Federal eRulemaking Portal, (IRS REG-151687-10). Comments may also be sent to CC:PA:LPD:PR (REG- 151687-10), Room 5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044 or handdelivered to CC:PA:LPD:PR (REG-151687-10), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, between 8:00 a.m. and 4:00 p.m.

If this program ever takes effect, it will undoubtedly disrupt contractors’ cash flows and impose greater administrative burdens on those government agencies performing the withholding. It is difficult to imagine how these increased costs will truly be offset by the increased tax revenue. Nevertheless, in these times, one underestimates the zeal and advocacy of the IRS at one’s own risk. We will continue to monitor this program and provide updates as new developments occur.