August 1, 2011

Government Contractors Get a 3 Percent Reprieve


By Brad Eriksen

Summer 2011

Contractors and suppliers on federal, state, and local public works projects received a temporary reprieve from the IRS this month.

Tax law changes adopted in 2005 and scheduled to go into effect in 2012 mandated that all state, local, and federal governments withhold 3 percent on all payments to government contractors and suppliers. But final regulations issued by the IRS in May 2011 have delayed the effective date of the withholding requirements to 2013. At a time when burdensome regulations are on the increase, even a short reprieve is a welcome change.

Numerous groups are lobbying not just for delayed implementation but for outright repeal of the mandatory withholding. As a result, the additional year of deferral, and another election cycle, may be sufficient to get the withholding requirement reversed.

A major criticism of the new withholding requirements is the potential harmful impact on prime contractors. Prime contractors may find it difficult to modify payment arrangements with their subcontractors and suppliers in order to pass the timing and cost of the withholding on to the subs and suppliers. For a contractor or project with low profit margins, the new withholding requirement alone could be fatal to cash flow, threatening the contactor's operations.

The final regulations attempted to address this concern by providing that when the government pays a prime contractor, only the amount of the payment for the prime contractor is subject to withholding, not the contractor's payments to subcontractors. Whether the details of the regulation adequately address these concerns remains to be seen.

The new mandatory withholding requirements have also been criticized as unduly burdensome to both governmental entities and contractors. Mandatory withholding seems unnecessary given the tools currently available to the IRS that monitor contractor compliance with federal tax law. Many state and local governments have complained that the mandatory withholding requirement is yet another unfunded federal mandate that will create significant challenges for government accounting and procurement systems. Expensive revision and reprogramming of existing payment systems at a time of tight budgets and difficult economic times is not a wise use of limited resources.

Under the final regulations issued by the IRS, the withholding threshold is $10,000 for a single payment. Although the regulations also impose interest and penalties for any failure to withhold, these are delayed as well, and will now apply to payments made after January 1, 2014.

The IRS has built in many exceptions to the withholding requirement, but few if any seem to apply to public works contractors and suppliers. For example, the purchase or lease of real property or improvements is exempt from mandatory withholding. However, this exemption does not extend to the construction of buildings, roads, bridges, or other public works projects.

Because such disparate groups as farmers, state and local governments, health care professionals, and public works contractors continue to oppose implementation of the new mandatory withholding requirements, we may not yet have heard the last word on this new mandate, even though the IRS has issued "final" regulations.

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