How much will the 3% income tax withholding affect your business?
New law repeals ruling On November 21, 2011, the President signed into law H.R. 674, the "3% Withholding Repeal and Job Creation Act" (the Act). The Act repeals Code Sec. 3402(t)'s controversial 3% withholding requirement on government contractor payments.
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You might not be aware, but there is a federal tax law that requires a 3% income tax withholding on many government payments. Although it is a law, it doesn't apply yet. Some businesses are optimistic that Congress will repeal the law and it will never really apply. Let's hope so.
The new withholding doesn't apply to all payments, but it's fair to say it applies to most payments in the amount of $10,000 or more. What does this mean to you? If any single payment your business receives from the government amounts to $10,000 or more, a 3% tax withholding may apply to that payment.
Qualified exclusions from withholding apply to payments to or for:
- Wages
- Retirement benefits
- Unemployment compensation
- Payments for interest (and principal)
- Real property (lease or purchase, but not construction)
- Other governments
- Tax exempt entities
- Foreign persons and entities
- Indian tribal governments
- Public welfare benefits
- Emergency/disaster payments
Congress and the IRS have been pushing back the effective date on the law passed in 2006 that subjects many payments of $10,000 or more made by a government entity – federal, state or local – to 3% federal income tax withholding.
In May of 2011, the IRS issued final regulations to implement the 3% withholding. The good news for you is that the effective date was delayed again until January 2013. The bad news is that it looks like withholdings will actually start in January 2013, unless repealed in the interim.
One bright aspect of the final regulations is that all payments on contracts in effect on December 31, 2012 will be exempt from withholding. But, if a contract is materially modified after 2012, the exclusion no longer applies. However, on the same day that final regulations were published, proposed regulations were also published that would "sunset" this exclusion after 2013.
Also, payments by a political subdivision (a city, county, etc. and their instrumentalities) will be exempt if the total of all annual payments for property and services by the political subdivision to all vendors is under $100 million.
Many people think of the 3% withholding as applying only to government contractors – the hard hat type. Those people are in for a surprise. Here is a partial list of businesses subject to the 3% withholding that will give you an idea of its impact:
- Accountants
- Airlines
- Attorneys
- Building contractors
- Car dealers
- Doctors
- Equipment dealers
- Financial services companies
- Gas companies
- Hotels
- Painters
- Property maintenance companies
- Road builders
- Software companies
- Utilities
In short, if you have a copy of the yellow pages, open it and you will find a comprehensive list of those that will be subject to withholding.
One can only hope that the 3% withholding is repealed for its lack of popularity - much like the extremely unpopular law requiring Form 1099 reporting for payments to corporations.
The new 3% withholding will make business more challenging for many.
Case in point: Any business that contracts with the government and then subcontracts the work with other contractors is sure to feel the squeeze. Construction general contractors will find that the 3% withholding will cause a greater cash-flow challenge as soon as they pay subcontractors. The general contractor is due the full contracted amount, but they now only have 97% of that amount available to pay subcontractors. There is no way for them to "pass on" the 3% withholding and therefore must fund the difference.
And for some businesses, taking an income tax credit for the 3% withholding will not be as simple as it seems. Final regulations explain that a delay may exist for businesses with a tax accounting year other than the calendar year.
Example: Some taxpayers report their taxes on a non-calendar year end basis (meaning their tax year ends in a month other than December). Let's consider a September 30th year end. For the year ended September 30, 2015, a corporation reports its income and pays its taxes for the 12 months ending September 30, 2015. However, the credit for the withholding is granted on a calendar year basis and the calendar year in question is the one that ends during the tax year. So for our September 30, 2015 corporation the 3% withholding credit will only be allowed for the amounts withheld during the 2014 calendar year. Consequently, amounts withheld during the months of January through September 2015 can't be claimed immediately. Those months are part of the calendar year 2015 and will be credited on the September 30, 2016 tax return. This situation creates a significant delay, cash flow problem and mismatch for the non-calendar year taxpayer.
[ Read the whitepaper on the provisions of the final regulations ]