Federal Tax Withholding Will Impose A New And Substantial Burden On Contractors

The Tax Increase Prevention and Reconciliation Act of 2005 amended Section 3402(t) of the Internal Revenue Code to require the mandatory withholding of 3% from all payments to contractors who provide goods and services to the federal government. This new law applies to federal, state, and local governments with an annual budget of $100 million and requires the 3% withholding from every contract payment exceeding $10,000. The 3% is held by the government until the contractor files its income tax return and pays its taxes, which could be many months after the contractor’s performance of the contract work is completed.

Contractors recently caught a break because the IRS delayed implementation of this new law, postponing its effective date one year to January 1, 2013 (26 C.F.R. § 31 (May 6, 2011)).

1. Purpose of the Law.

The law is intended to collect under-reported tax revenues and to increase the tax compliance of entities that perform public contracts. The law is in response to a 2004 Government Accountability Office (GAO) report that “[the Department of Defense] and IRS records showed that over 27,000 contractors owed about $3 billion in unpaid taxes as of September 20, 2002.” The GAO indicated that in some cases, the unpaid taxes were the result of “abusive and potential criminal behavior.”

2. Criticism.

The new law has been widely criticized because of the significant administrative costs the law will impose on both on government and private entities that contract with the government. Among others, the administrative expenses include:

(a) Capital expenses for system changes (because neither the governments nor private entities have accounting systems set up to handle the withholding in this matter);

(b) Annual compliance costs (additional employees will be needed to implement the additional administrative burden); and

(c) Finance costs (the 3% withheld will significantly interrupt cash flow).

The Department of Defense estimates that it will cost more than $17 billion in the first 5 years to comply with the withholding requirement which, not surprisingly, exceeds any expected revenue gains from the increased tax compliance.

3. Example of Hardship on Contractors

More disconcertingly is the fact that the withholding will likely result in higher bids from contractors who will pass along the increased costs to the government. Construction contractors will be most negatively affected because of the thin profit margins, particularly in big building construction, which often does not exceed 3% of the total contract price.

As an example, on a $5 million contract under the law, the government will withhold $150,000. If the general contractor’s profit margin is 2.5%, after paying for labor, materials, equipment, subcontractors and other ordinary business expenses, the contractor’s profit on the project is expected to be $125,000. The tax on the net revenue generated will be at most 35% (the maximum corporate income tax rate), which means the maximum tax owed by the general contractor for the $5 million project is $43,750 (35% of $125,000). Under the new law, the government will withhold $150,000 (3% of $5 million) for a tax obligation of only $43,750, thus depriving the contractor use of $106,250, until the contractor pays its taxes after year end.

That cost of capital will be passed on to the federal government (taxpayers) in the form of higher bid prices. It is also likely that general contractors faced with this type of withholding will apply similar withholdings to the subcontractors, increasing the costs to the federal government taxpayers in the long run.

The law requires that the government withhold taxes from entities, even if those entities owe no taxes. Many general contractors are “S” corporations or limited liability entities that owe no taxes themselves because the tax obligations of these entities are passed through to the individual owners. Thus, the 3% will be withheld from entities that do not even owe taxes and will greatly complicate tax returns of the individual owners of these business entities. The government should target known tax evaders rather than creating a larger problem by lumping all contractors together in the same group and creating a bigger problem both for the construction contractors who build the projects and for the taxpayers who pay for those projects.

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