Recently, the Internal Revenue Service (IRS) issued final regulations (the Regulations) that delay the implementation of the requirement that governmental entities withhold 3% of payments they make for goods and services (the Withholding Requirement) (T.D. 9524).
Payments will be subject to the Withholding Requirement if they are made under a contract entered into after December 31, 2012. For payments under contracts existing on December 31, 2012, that are not materially modified after that date, proposed Treasury Regulations would require withholding on payments made thereunder beginning on January 1, 2014. The Withholding Requirement will have significant implications for all levels of government and for all government contractors, such as construction contractors and service providers.
Under the Withholding Requirement, government entities that make payments of at least $100 million for goods and services in a year must withhold a tax of 3% of the gross contact value (unless the payment is less than $10,000) and report that information to the IRS. The government entities required to withhold include the United States, every state, every political subdivision, and every instrumentality (including multistate agencies). Governmental entities that fail to withhold 3% of payments could be liable for payment of the 3% tax.
The new withholding procedures are analogous to employment tax withholding; 3% of any payment subject to the Withholding Requirement must be withheld and remitted to the IRS along with information returns. The tax withheld by the government entities will be allowed as a credit against federal income taxes owed by the contractor.
This is the second time that the effective date of the Withholding Requirement has been postponed. Originally, the Withholding Requirement was effective on January 1, 2011, but the effective date was pushed back to January 1, 2013, by the American Recovery and Reinvestment Act.
In addition to payments that fall below the $10,000 threshold, the Regulations exempt the following payments from the Withholding Requirement:
- Payments subject to other withholding provisions (e.g., wages);
- Payments of retirement benefits, unemployment compensation, or Social Security;
- Payments subject to backup withholding;
- Payments in exchange for real property;
- Payments of interest;
- Payments to exempt recipients, including other governmental entities, tax-exempt organizations, foreign governmental entities, Indian tribal governments (and pass-through entities of which an Indian tribal government owns 80% or more);
- Payments made in connection with a public assistance or public welfare program, for which eligibility is determined based on need;
- Payments made under a confidential or classified government contract;
- Payments in emergency, disaster, or hardship situations;
- Payments made by credit card (pending future guidance); and
Whether you are a government contractor or are in government, this is the time to understand and address the compliance issues caused by the Withholding Requirement. Because the Withholding Requirement is based on the gross contract price, the withheld tax may adversely affect the cash flow of government contractors. In addition to educating themselves about the various exemptions, contractors may want to consider alternative pricing proposals for government contracts to account for the time value of money. Additionally, governmental entities should take steps to understand the detailed Regulations and to ensure that all required systems are in place to comply with the Withholding Requirement in 2013.