New Withholding Tax on Government Payments - A Withholding on Tax or on Business?
Jim D. Brandenburg, CPA, MST, Shareholder - Tax email | bio
June 2011
Most everyone is familiar with federal and state taxes being withheld from their paycheck. Employers send these amounts to the government to be registered as tax payments for the employees when they file their annual income tax returns. Congress and the IRS are planning to apply this concept to payments made by government bodies to businesses.
Background. In May 2006, Congress enacted legislation to institute a withholding tax to be effective for certain government payments to recipients (mostly businesses). The IRS recently issued final regulations deferring the effective date to December 31, 2012. Therefore, 2013 will be the first year that these withholding rules apply.
These new withholding regulations are found in Section 3402(t) of the Internal Revenue Code. Basically, the new statute provides that 3 percent tax must be withheld from certain payments for property or services made by federal, state and local governments as well as state instrumentalities, state subdivisions or multi-state agencies (e.g., payments from a political subdivision to a government contractor). Further, the withholding requirement will also apply to payments made in connection with a government voucher or certificate program that functions as a payment for property or services. Payments subject to the 3 percent withholding tax will also be subject to information-reporting requirements. Thus, the gross payment made to the service provider by the government entity/agency must be reported along with the 3 percent tax withheld. (Please click here for the actual text of the final regulations and related introduction.)
Impact on Businesses. These new withholding rules will have a far-reaching impact on businesses in a variety of industries that deal with government entities. For instance, a contractor doing road work or building a local school will have this new 3 percent tax withheld on its payments from the government body. Many of these government construction contracts run on thin margins and the 3 percent could exceed the contractor's profit on the job. The 3 percent will eventually be recovered by the contractor, but it may be late in the process when cash flow damage has already been done. Any manufacturer selling its products to a government entity will be similarly impacted by these new rules. Also, a physician or medical group receiving government payments for its services (e.g., Medicare, Medicaid or other government insurance) will also be hindered by this withholding requirement.
Exceptions. As with most aspects of the tax law, there are exceptions to these rules. Several of the exceptions to the 3 percent withholding include payments:
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subject to backup withholding and from which amounts are already being withheld;
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for interest;
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for real property (This exception for real property does not apply to construction contracts and services.);
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to any governmental entity subject to these withholding rules (i.e., intra-governmental payments);
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to any tax-exempt entity;
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to any foreign government;
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made by a political subdivision of a state (or any state instrumentality) that makes less than $100 million of these payments annually;
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made in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test; and
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made to any government employee that is not otherwise excludable from these withholding rules with respect to his services as an employee.
Reporting Requirements. Once the new withholding requirements become effective in 2013, each qualified government is required to withhold tax on these payments. In addition, the government entity will also be required to provide the payee a written statement on Form 1099-MISC containing the following information:
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the name, address and taxpayer identification number of the person receiving the payment subject to withholding;
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the gross amount of the payment withheld upon;
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the amount of tax deducted and withheld;
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the name, address and taxpayer identification number of the government entity filing the form; and
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a notation on the form that such amount is being reported to the IRS.
As with other tax filings, the entity must also file a duplicate of this statement with the IRS.
New Guidance. The 3 percent withholding requirement and the corresponding reporting requirement apply for payments made after December 31, 2012, subject to an exception for contracts existing on December 31, 2012 that are not materially modified. Under the proposed regulations, this exception would terminate for payments made after December 31, 2013. Payments made under all contracts would be subject to the withholding and reporting requirements after that date. (Please refer to the regulations for specific guidance.)
Additionally, the final regulations provide an alternative method under which a local government may average the payments made during any four of the five consecutive accounting years for purposes of the above exception for small government entities with average payments of less than $100 million. This method will likely provide greater predictability for future years and allow political subdivisions and their instrumentalities to moderate the effect of the payments.
Certain Issues Reserved for Future Guidance. There were a number of issues that the IRS briefly addressed in the final regulations, but reserved for future guidance. These include: a definition of the term instrumentality; the potential application of these withholding rules to payments on credit card transactions; the application of these provisions for payments to prime contractors, subcontractors and payment administrators; and the application of the statute and regulations to payments made in connection with certain public assistance or public welfare programs.
What can you do? You may recall that as part of the health care reform legislation enacted last year, Congress added rules requiring Form 1099 expanded reporting for all businesses. The complexities and concerns with this change produced immediate opposition to the expanded reporting. The objections mounted from businesses of all sizes and in all industries. Legislation was soon introduced to undo the Form 1099 reporting. The result: the Form 1099 reporting law was eventually repealed in spring. Could a similar grassroots approach work again? Businesses and various trade associations are considering challenging the new 3 percent withholding requirement on government contracts, but the clock is ticking. Will they act again and reach out to Congress? We will keep you posted on what happens.
Please contact your Kolb+Co. tax professional or Jim Brandenburg (jbrandenburg@kolbco.com) at 262/752-9400 if you have any questions on the new withholding requirements for government contracts.