The American Recovery and Reinvestment Act (ARRA) provides Federal and State government contractors with a one-year reprieve from a mandatory withholding requirement on payments they receive from governmental agencies. The provision in question is Section 3402(t) of the Internal Revenue Code (the “Code”), which was enacted as part of the Tax Increase Prevention and Reconciliation Act of 2006. Section 3402(t) would require almost all Federal, State and local government agencies to withhold at a rate of 3% on almost all payments made to government contractors.  

The provision was originally effective for payments made after December 31, 2010; ARRA moved the date back one year, to payments made after December 31, 2011. This one-year delay, enacted to enable the IRS and Treasury Department further time to study the impact of the requirement, will also provide relief to the affected government agencies, which will have to design new systems and incur costs in order to implement the required withholding.  

When effective, the withholding requirement may have a substantial impact on contractors that receive a significant source of revenues from Federal or State governments, including those in the defense and health care industries. For many contractors, a withholding rate of 3% on gross receipts from government sources will be in excess of ultimate tax liability, resulting in significant cash flow issues, particularly in times of economic downturn.  


Report of the Joint Committee on Taxation  

The withholding requirement is rooted in a report issued by the Congressional Joint Committee on Taxation in 2005. The report, Options to Improve Tax Compliance and Reform Tax Expenditures, JCS-02-05 (Jan. 27, 2005), was prepared at the request of then Senate Finance Committee Chairman Charles Grassley and Ranking Member Max Baucus. The proposal is discussed in just a few of the more than 400 pages of the report.

The stated purpose of the requirement is to increase income tax compliance by government contractors. According to the Joint Committee report, “[t]he proposal attempts to balance the goal of greater compliance with concerns regarding administrative burdens by imposing withholding only on payments made by Federal, State and most local governments, as well as agencies of these entities.”  

As the basis for imposing a withholding requirement on government payments, the Joint Committee Report in turn cites a report of the General Accountability Office (GAO), Some DOD Contractors Abuse the Federal Tax System with Little Consequence, GAO-04-95 (February 2004). The GAO report found that over 27,000 DOD contractors owed significant amounts of unpaid taxes.1 This statistic, along with citations heralding the positive effects of wage withholding, forms the key basis of the Joint Committee’s rationale behind the proposal.

A further look into the GAO report, however, calls into question the link between the GAO findings and a broad-based withholding requirement. The GAO report indicates that much of the unpaid taxes are a result of fraud and abuse and involve the failure to pay withholding taxes (i.e., amounts withheld from employee wages for income and payroll taxes), rather than income taxes of the contractor. The GAO made a number of recommendations targeted at specific areas of noncompliance, including greater use of the IRS levy system to offset government payments by outstanding tax debt and further monitoring of compliance with the tax laws in awarding government contracts. The GAO did not recommend a proposal that would broadly affect government contractors as a whole.  


The 3% withholding requirement was enacted as part of the Tax Increase Prevention and Reconciliation Act of 2006. The provision was not in either the House or Senate version of the bill, but was added as a new provision in conference.  

Section 3402(t) is broad in scope; it requires 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 service (including any payment made in connection with a government voucher or certificate program which functions as a payment for property or services)” to deduct and withhold 3% of the payment. There are limited exceptions to this requirement. Withholding does not apply to the following:  

  • payments of wages to government employees;  
  • payments to which mandatory withholding (e.g., U.S.-source income of foreign taxpayers) or voluntary withholding (e.g., unemployment benefits) applies;  
  • payments of interest or for real property;
  • payments to a government entity subject to the withholding requirement, any tax-exempt entity or any foreign government;  
  • payments in connection with public assistance or public welfare programs for which eligibility is determined by a needs or income test (meaning, for example, that Medicaid payments are not subject to withholding; however, payments under Medicare are);  
  • payments made pursuant to a classified or confidential contract;  
  • payments subject to back-up withholding if amounts are being withheld; and  
  • payments made by a political subdivision of a State that makes less than $100 million of such payments annually.  

Proposed Regulations

In March of 2008, the IRS issued Notice 2008-38, inviting public comments on Section 3402(t), including requests on specific implementation issues. The IRS and Treasury Department issued proposed regulations under Section 3402(t) at the end of 2008. 73 Fed. Reg. 74082 (Dec. 8, 2008).  

The proposed regulations provide some detail with respect to how the requirement is to be implemented. The proposed regulations also include some helpful transition provisions. For example, the proposed regulations provide that the withholding requirement does not apply to payments made under a written binding contract in effect on the later of December 31, 2010, or six months after the publication of final regulations, unless the contract is materially modified. Presumably final regulations would change the December 31, 2010, date to December 31, 2011, to reflect the new ARRA effective date.  

What’s Next?  

A delay in the effective date may simply not be enough for contractors subject to the requirement. The withholding requirement may have a substantial impact on many contractors from a cash flow perspective. For example, in the case of contractors with Federal income tax liability of less than 3% of gross receipts from governmental agencies, there may be a substantial delay before the excess withholding may be recouped. The speed up in payments may be significant even for taxpayers who would not have excess withholding, especially in difficult economic times.  

The new requirement will also impose administrative costs on the governmental agencies responsible for withholding. Existing systems are not likely to be sufficient to deal with the magnitude of payments involved. The IRS as well will need to implement new procedures, including refund procedures.  

While the provision will impose additional costs, it is not clear that it will have the desired effect of increasing compliance. The provision is not targeted at those who create compliance issues as identified by the GAO. Rather, an effect of the withholding provision may be to impose significant costs on fully compliant taxpayers. The original $6.9 billion the proposal was estimated to raise is mainly the result of accelerating tax receipts; there is only a relatively minor ongoing effect from increased compliance.2 This revenue pattern is also evident from the revenue estimate for the ARRA one-year delay.3 According to that estimate, the delay resulted in shifting over $5.5 billion from fiscal year 2011 to fiscal year 2012, but the total revenue loss was less than $300 million over the 10-year budget window.  

Some on Capitol Hill may remain interested in further relief. ARRA as approved by the Ways and Means Committee and as passed by the House would have repealed Section 3402(t). According to the Ways and Means Committee Report “[T]he three-percent withholding requirement was not appropriately targeted to the noncompliant taxpayers for whom it was originally intended and has imposed significant and costly administrative burdens on State and local governments.”  

Stand-alone bills repealing the provision were introduced before the enactment of ARRA. S. 292, the Withholding Tax Relief Act of 2009, introduced by Senator Specter (R-PA), and H.R. 275, introduced by Congressman Meek (D-FL), would repeal Section 3402(t).  

ARRA’s delayed effective date will provide time not only for the IRS and Treasury Department, but also hopefully the Congress, to review the provision.