In an attempt to address tax noncompliance, Congress amended the Internal Revenue Code (the Code) to require withholding of 3 percent from payments made by governmental agencies in the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 209-222).1 Payments under government programs for providing health care or other services that are based on the needs or income of the recipients (e.g., Medicaid) are exempt from withholding. However, payments under programs where eligibility is based on the age of the beneficiary (e.g., Medicare) are not exempt. This withholding was scheduled to apply to payments made after December 31, 2010, but, in February 2009, Congress extended the effective date to require withholding on payments made after December 31, 2011.2
New Section 3402(t)(1) of the Code generally provides that all governmental agencies and instrumentalities, including multi-state agencies, that make payments to a person providing property or services must deduct and withhold from such payment a tax in an amount equal to 3 percent of such payment. For this purpose, the term "person" means an individual, trust, estate, partnership, association, company or corporation.3
Relevant Exceptions and Transition Relief
No Exception for Medicare
There are several exceptions to this withholding, the most notable of which is for payments made in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test.4 The fact that the government entity is making payments for services provided to third-party patients is not grounds for exemption.5 Consequently, payments under government programs to provide health care or other services to individuals and which are not based on the needs or income of the recipients are subject to withholding, including programs where eligibility is based on the age of the beneficiary.6 Proposed regulations issued in 2008 (the Proposed Regulations)7 are consistent with this statutory provision and its legislative history. The preamble to the Proposed Regulations provides that "a program for which eligibility is based on age only (for example, Medicare)" does not qualify as program for which eligibility is based on a needs or income test, and, therefore, Medicare payments are subject to withholding.
Exception for Nominal Payments, but Payments May be Aggregated
In the Proposed Regulations, the Internal Revenue Service (the IRS) specifically noted that no exception will be granted in cases in which the 3 percent withholding rate would be expected to exceed either the profit margin in the taxpayer’s industry or the income tax the taxpayer will owe for reasons particular to the taxpayer’s business. However, notwithstanding that there is no statutory exception for de minimis payments made by a government entity,8 these proposed regulations provide that the withholding requirements will not apply to any payment that is less than $10,000.9 If the government payor makes a single payment that combines charges for more than one transaction with the payee, the determination of whether the $10,000 threshold is exceeded will be based on the amount of the single payment rather than the amount attributable to each separate transaction. This same rule applies if a government payor enters into multiple transactions with a single person, each of which would result in a payment of less than $10,000 if paid separately, but the government payor elects to make a single payment covering all the transactions such that the aggregated payment is $10,000 or more. Thus, in these circumstances, the government entity is required to withhold on the aggregated payment.
Many commenters requested that § 3402(t) withholding not apply to payments made under contracts in existence prior to its effective date because such contracts do not contemplate withholding. In response to this request, the Proposed Regulations provide that payments made under written, binding contracts in effect on the later of December 31, 2010 or the date that is six months after the publication of final regulations are not subject to withholding, unless they are materially modified.10 The Proposed Regulations were issued prior to the 2009 extension of the effective date, and it is therefore unclear whether the reference to December 31, 2010 will be changed to 2011 if final regulations are issued. The Proposed Regulations do not define "material modification" and do not address the impact of options to renew the contract contained in existing contracts.
Information Reporting and Credits
A government payor making a payment subject to withholding under § 3402(t) must report the payment on Form 945 to the IRS, and must issue a Form 1099-MISC to the payee.11
Amounts withheld from any payment under § 3402(t) are creditable against the income taxes of the payee.12 Thus, for calendar year taxpayers, taxes due on March 15 (for corporations) and April 15 (for individuals) will be reduced by amounts withheld under § 3402. For fiscal year taxpayers, however, taxes withheld in a calendar year are creditable against taxes for years beginning in such year. "The effect of [this rule] is that fiscal year taxpayers may be entitled to take credit for withholding … only in a taxable year subsequent to the taxable year in which the amount was withheld. For example, if amounts were withheld … from a June 30 fiscal year taxpayer during the period from January 1, 201 to June 30, 201, the taxpayer will be entitled to take credit for the withheld tax on its income tax return for the fiscal year ending June 30, 201, rather than its income tax return for the fiscal year ending June 30, 201."13
For taxpayers making estimated tax payments, tax withheld under § 3402(t) and allowed as a credit may be taken into account in determining estimated tax liability.14 For calendar year taxpayers, § 3402(t) withholding generally would be treated as a payment of estimated tax for the same calendar year and liability for other payments of estimated tax for that year would be reduced. Taxpayers using a fiscal taxable year, however, "could have the problem of delay in taking account of the credit if withholding occurs in the part of the calendar year before the beginning of the fiscal year that begins in that calendar year."15
Although Medicare pays about $61 for the most commonly billed physicians’ services,16 most health care providers aggregate their requests when filing Medicare claims. Under the Proposed Regulations, if Medicare pays more than $10,000 due to this aggregation, 3 percent must be withheld from the payment. Consequently, health care providers will be receiving only 97 percent of their Medicare payments beginning in 2012, which will drain cash on hand. Because the payee will ultimately receive an income tax credit for the withheld tax, this withholding represents a (forced) interest-free loan to the government.
Moreover, § 3402(t) imposes information reporting requirements on the payors of Medicare. This rule is consistent with Congress’s attempt over the past several years to increase tax compliance. For example, the Patient Protection and Affordable Care Act (P.L. 111-148) requires taxpayers to report, beginning in 2012, payments of more than $600 per year to a corporation and payments that are consideration for property (both of which were previously not subject to information reporting). These provisions prompted a backlash from the business community and, as a result, Congress is reconsidering these proposals. The rules of § 3402(t) have not, however, received similar reconsideration, notwithstanding similar commentary from affected payees.
Health care providers should begin evaluating the manner in which they seek Medicare reimbursement and whether it would be practicable to limit the applicability of § 3402(t). To remain under the $10,000 payment threshold and thereby receive payments from the government free of withholding, a health care provider could unbundle its Medicare claims (or only bundle them to the extent the claims, in the aggregate, remain under the $10,000 threshold). Assuming the health care provider can establish such a practice without sacrificing efficiency or incurring additional costs, hurdles remain. Most health care providers will have no control over the manner in which claims are submitted, as they are either a member of a health care system or use a third-party contractor that processes Medicare claims. In addition, the use of electronic submissions provides the government with the ability to elect to make a single payment covering each of the submissions. As noted above, in such case the payments are aggregated and the $10,000 threshold will likely be exceeded. The application of the threshold to Medicare has been criticized,17 and it remains unclear whether the IRS will modify the $10,000 threshold to address this inequity in final regulations.
Health care providers should also evaluate whether they can take advantage of the transition relief provided by the Proposed Regulations. This transition relief only applies for written, binding contracts in effect on the later of December 31, 2010 or six months after the publication of final regulations (unless the contract is materially modified). At this point, no final regulations have been issued, and it is unclear whether the reference to December 31, 2010 will be modified to December 31, 2011 by reason of the extension of the effective date of new § 3402(t). However, with some foresight, health care providers can attempt to time their execution of new contracts or renewal of old contracts to delay the impact of the new 3 percent withholding rule. The inclusion of options to renew may extend this period further, but, as noted above, the IRS is still considering the impact of any such options contained in contracts. For example, if final regulations are issued March 1, 2011 and the reference to December 31, 2010 is not modified, then contracts must be in place prior to September 1, 2011 to qualify under the transition relief.
Lastly, and at a minimum, health care providers should evaluate the impact § 3402(t) will have on their cash flow, and plan accordingly. While this article primarily focuses on Medicare, payments from TriCare, the Railroad Retirement Board or the Veterans Administration, eligibility for which is not based on an income or needs test, may also be subject to this new withholding.
We will keep you posted on any developments.