As a response to the “Tax gap” problem (estimated at $290 billion according to The Wall Street Journal’s June 13, 2007 article), Section 511 of the Tax Increase Prevention and Reconciliation Act of 2005 or TIPRA (P.L. 109-222) was added to require Federal, state, and local governments to withhold 3% of a contract’s total payments made for goods and services.  Section 511 will go into effect on January 1, 2011.  The payment and amounts withheld must be reported to the IRS.  There are no de minimis exceptions for small contractors.

There are some payments, however, that are not subject to the 3% withholding (see IRC §3402(t)(2), as added by the Tax Reconciliation Act of 2005). The withholding requirement generally does not apply to any payment:

• which is subject to withholding under any other provision
• which is subject to withholding under Code Sec. 3406 (backup withholding) and from which amounts are being withheld under such section
• of interest
• for real property
• to any governmental entity, any tax-exempt entity or any foreign government
• made pursuant to a classified or confidential contract described in IRC §6050M(e)(3)
• made by political subdivision of a state (or any instrumentality thereof) which makes less than $100 million of such payments annually
• which is made with respect to a public assistance or public welfare program, eligibility for which is determined by a needs or income test
• to any government employee not otherwise excludable with respect to their services as an employee

The questions regarding this act are flowing at a rapid pace… Will the 3% come entirely from the Contractor’s gross payment or will the government also hold back payments to subcontractors?  If not, will Contractors be permitted to withhold payment from sub’s to reduce the impact of this provision? What if a contract spans multiple years and government payments are not even? What if a contractor has no current-year tax liability due to prior-year net operating loss carry forwards?  How will the Federal Acquisition Regulations (FAR) treat the 3% withholding and related administrative costs?  At this point, these issues remain unresolved.

This issue is a legislative priority for NDIA (National Defense Industrial Association) and they have written to the House and Senate Leadership expressing their concerns.  NDIA is also a member of the Government Withholding Relief Coalition (GWRC), a group of 50 similarly concerned associations that are actively working to oppose the implementation of section 511.  The GWRC argued the case of America’s government contractors in a January 17, 2007 letter to U.S Representative Peter DeFazio.  The letter states, “This requirement will sap cash flows needed for day-to-day business operations and force some companies to alter their business models and pricing schemes when dealing with government customers.”  In addition, the GWRC has been instrumental in the development and support of H.R. 1023, a bill that calls for a complete repeal of the 3% governmental withholding provision.

Cash flow can be as important to contractors as profits.  Unless act 511 is repealed, the 3% withholding provision will significantly impair the ability of many contractors to conduct business. Fewer firms will be able to bid on government contracts, as companies with tight margins or irregular cash flows would lose vital funds for day to-day operations and would be at a competitive disadvantage in the bidding process.

Ron Kouzel

Tax Partner

Argy, Wiltse & Robinson, P.C.

8405 Greensboro Drive

McLean, VA  22102

703.770.6326

rkouzel@awr.com

Ron Kouzel has created effective solutions in both public and corporate accounting for over twenty years. His proven expertise lies in tax planning and compliance, entity and accounting method selection / change, tax aspects of business acquisition and sale, and advising rapidly growing businesses and their owners.