John Steffes

You may recall during the summer of 2006, many contractors became concerned about legislation indicating contractors performing services or selling property to federal, state or local governments would have income tax withheld on their contract payments.  National construction trade groups, journals and interested parties spoke out about the burden this placed on the industry and vowed to see the legislation repealed.

Fast forward to December 5, 2008, and to the frustration of contractors across the nation, the Internal Revenue Service (IRS) issues proposed treasury regulations providing guidance on the implementation of such a withholding practice.

This article will help contractors understand the source of this new law, its impact, key concepts and how to prepare for its coming implementation.

Internal Revenue Code Section 3402(t) was created in May 2006 as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA).  TIPRA was primarily enacted to modify the Alternative Minimum Tax (AMT) on individuals for 2006, extend the favorable capital gains and qualified dividends tax rates through 2010 and to increase the amount of the Section 179 provisions allowing the current expensing of certain depreciable property.  However, with the good came the bad, and TIPRA also included a provision for withholding requirements on government contracts.

Section 3402(t) of the Internal Revenue Code specifically indicates the federal government, state governments and every political subdivision thereof are required to withhold 3% on any payment to any person providing property or services after December 31, 2010.  (Note:  The American Recovery and Reinvestment Act of 2009 (ARRA) stimulus bill provided a one-year reprieve by delaying the enactment until after December 31, 2011.) The regulations clarify which government entities are affected, when withholding is required, how the entities pay the tax, how contractors claim the tax withheld and what tax liability of the taxpayer this withholding satisfies.

Generally, the government bodies that will have contract withholding include (with broad general exceptions noted):

• Any contracts for the federal government—all branches, federal agencies, etc. (exception for confidential/classified contracts and certain public assistance/welfare programs with income-based eligibility)
• Any contracts for state governments—including the District of Columbia (exception for Native American tribal governments)
• Any contracts for political subdivisions of the state governments:  county, local, municipal governments (exception for political subdivisions making payments of less than $100 million annually)
• Withholding on payments for real property and interest has a general exception

Persons subject to withholding include any individual, estate, trust, partnership, association, company or corporation providing property or services to the above government bodies.  The regulations clarify the payment must be $10,000 or greater to generate a withholding requirement.  The $10,000 requirement is based on the payment issuance by the government subdivision, not on invoicing practices of the contractor and is subject to anti-abuse provisions.

How does this affect your business?  Before entering into contracts that continue past the December 31, 2011, cut-off date, consider the following:

• What cash reserve requirements will you have if 3% of these post December 31, 2011, contracts are withheld until the filing of your tax return (potentially greater than one year)?
• Do you need to modify your contractual requirements for payments with subcontractors for this withholding?
• Does the governmental contract qualify for an exemption from the withholding requirements?
• Should your business plan be modified to pursue or avoid these types of public works contracts?
• Do you need to plan for increases in your working capital lines of credit to cover this new withholding requirement?

Although you have some time before December 31, 2011, construction companies and business owners need to adequately plan for these changes.  Contact your BKD advisor for more help with this issue.