Effective January 1, 2013, many federal, state, and local governments will be required to withhold 3% from nearly all contract payments made to government contractors and other persons providing them with property or services. The withholding requirement was first added as part of the Tax Increase Prevention and Reconciliation Act of 2005, in response to a perceived tax compliance problem with government contractors. With its impending effective date looming, the withholding requirement has been criticized by industry groups who fear it will result in costly compliance burdens both on businesses and governments.

1. Withholding On Payments To Government Contractors
Effective January 1, 2013, many federal, state, and local governments will be required
to withhold 3% from nearly all contract payments made to government contractors and
other persons providing them with property or services. The withholding requirement
was first added as part of the Tax Increase Prevention and Reconciliation Act of 2005,
in response to a perceived tax compliance problem with government contractors. With
its impending effective date looming, the withholding requirement has been criticized by
industry groups who fear it will result in costly compliance burdens both on businesses
and governments.
In general, the withholding requirement provides that once effective, the federal
government and the government of every state, political subdivision of a state, and
instrumentality of a state or state subdivision (including multi-state agencies) making
certain payments to a person providing any property or services (e.g., payments from a
political subdivision to a government contractor) will have to deduct and withhold tax
from that payment in an amount equal to 3% of the payment. Payments subject to
withholding under this rule will also be subject to information reporting requirements.
Despite the rule’s broad application, there are several notable exceptions. For example,
withholding is not required for payments that are less than a $10,000 threshold,
measured on a payment-by-payment basis. In addition, withholding is not required for
any payments that are made by a political subdivision of a state (or any state
instrumentality) that makes less than $100,000,000 of such payments annually. Other
types of payments that are not subject to withholding (and that also should not be
counted toward the $100,000,000 threshold) include the following payments:
• Payments made to government employees, such as wages, fringe benefits, or
employee benefit plans;
• Payments subject to other types of withholding or backup withholding;
• Payments for real property;
• Payments to federal, state or local government entities, tax-exempt organizations, or
foreign governments;
• Payments under certain classified or confidential contracts;
• Payments in connection with a public assistance or welfare program;
• Payments received by nonresident alien individuals and foreign corporations in
certain cases;
• Payments of grants;
• Payments of loan guarantees;
• Payments for interest and principal on a loan; and
• Payments for investment securities

2. The amount to withhold, and the application of the $10,000 payment threshold, are
determined on a payment-by-payment basis and are based on the actual amount paid
to a contractor. However, if payments are divided for the primary purpose of avoiding
withholding, they will be treated as one payment for purposes of applying the $10,000
payment threshold. In addition, any amount of retainage (i.e., a hold-back of part of the
payment as security to ensure contract completion) is excluded until the retainage is
actually paid to the contractor.
Withholding is also required on payments to pass-through entities (such as partnerships
and S corporations). Although no direction on the application of these payments has
yet been issued, the IRS has stated it is currently working on guidance that will address
how the owners of a pass-through entity such as a partnership or S corporation will
claim the credit for their allocation of any amount withheld from a payment to the pass-
through entity.
IRS CIRCULAR 230 NOTICE: Any U.S. tax advice contained in this communication (or
in any attachment) is not intended or written to be used, and cannot be used, for the
purpose of (i) avoiding federal tax penalties or (ii) promoting, marketing or
recommending to another party any transaction or matter addressed herein
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