Update on Withholding on Government Contracts

Published:

by Brandon Cook, CPA | Partner, Tax Services Group and Member of the Construction Services Group

The IRS has once again postponed the effective date on the implementation of mandatory 3% withholding on payments to businesses that contract with the federal, state, and/or local government entities. The effective date is now for payments made after December 31, 2012.

This law, which was actually enacted in 2005 with an original effective date of January 1, 2011, could have adverse affects on many industries that conduct business with the government, but it could especially hinder the construction industry. As the law reads at the date of publishing, most contracts that are performed for a governmental body will be subject to the mandatory 3% withholding (there are a few exceptions). Contractors already face challenges with cash flow due to low margins and slow paying owners, so a 3% reduction in the amount of cash received from a project could add additional stress to general, or prime, contractors. The Government Withholding Relief Coalition (GWRC) was formed shortly after this tax act was signed into law in the hopes of eventually helping to repeal this section of the tax law. Some arguments the GWRC has against the new withholding tax include:

  • The withholding applies to the total contract price and not the net income associated with the contract
  • The law places an undue burden on S Corporations and LLC’s since those companies pay tax at the shareholder/partner level. This would tie up cash unnecessarily at the corporate level while owners are also distributing cash to pay quarterly estimates.
  • Some construction contracts do not make a 3% profit, especially in today’s environment
  • It will put a burden on many companies’ cash flow and could ultimately affect their ability to receive bonding since the contractor’s cash flow will not be as attractive
  • Many companies already pay quarterly estimated tax payments, so an additional withholding requirement may be excessive
  • Since this only applies to those that have the contract with the government, the subcontractors are not being impacted in the same way, but the general contractor will likely want to pass on the burden to the subcontractors

Many of the construction industry associations already belong to the GWRC, including the American Subcontractors Association, the Associated Builders and Contractors, and the Plumbing-Heating-Cooling-Contractors. A complete listing of the GWRC’s members can be found at www.withholdingrelief.org. In addition to the items listed above, there are many additional unanswered questions as to how the withholding process would work.

Brandon participated in an IRS Webinar on this topic in July 2011. The webinar covered numerous items including: the types of industries to be affected, exceptions, and reporting rules. If you’d like additional information on this topic please contact Brandon.