By Thomas J. Kelleher, Jr., Smith, Currie & Hancock LLP
In 2006 Congress added Section 3402(t) to the IRS Code (26 CFR Part 31). That section provides that the Government of the United States, every State, every political subdivision thereof, and every instrumentality of the foregoing (including multi-State agencies) making any payment to any person providing any property or services on a public project (including any payment made in connection with a public program) shall withhold 3% from all payments as a guard against possible business tax evasion. Under the statute, as amended, this section will apply to payments beginning in January 1, 2012. This tax withholding provision encompasses essentially all public construction projects, not just federal contracts. Moreover, it applies to the total contract price, not to the net revenue or income generated from the project.
Example: a small contractor holds a $5 million public contract which is estimated to be completed in one year. This 3% withholding law requires withholding of $150,000 on that contract. Meanwhile the contractor expects to net approximately 2.5%, $125,000, after paying for supplies, services, subcontractors and other ordinary business expenses. The tax on the revenue generated is at most 35% of the net revenue, which means the maximum tax owed on the $5 million project is $43,750. Ultimately, the government has withheld $150,000 for $43,750 in tax liability.In addition, the IRS published proposed (draft) regulations to implement this tax provision in 73 Fed. Reg. 74082 (12/05/2008). While the comment period ended nearly two years ago, the final regulations have not yet been released. While the draft regulations are fairly extensive, one provision, at 26 CFR § 31.3402(4)-3(c) is expressly noteworthy. It reads:
(c) No withholding on successive payments. If a government entity or its payment administrator makes a payment that is subject to the withholding requirements of § 31-3402(t)-1 to a person, no subsequent transfer of cash or property from that payment by such person to another person is treated as a payment subject to withholding for purposes of §§ 31.3402(t)-1 through 31.3402(t)-7. (Emphasis added)Example No. 1 to this draft regulation discusses the treatment of a progress payment of $48,000 to the prime contractor which includes $18,000 for work done by subcontractors. Under the IRS’s example, the entire amount paid to the prime contractor is subject to the 3% withholding. However, the prime contractor’s payments to its subcontractors are not subject to this withholding. Whether intended or not by the IRS, some industry representatives interpret this example to mean that the prime contractor may not withhold any part of this 3% withholding from lower tier firms. There are currently several bills (H.R. 674 & S. 89) containing language to repeal the 3% withholding provision as several Senators and Representatives recognize the negative effect of this provision on a firm’s cash flow. It could also stimulate needless prime/subcontractor issues related to the implementation of the withholding provision. If you believe that this provision should be repealed, please consider writing your Senators and Representative as soon as possible. Click here for a suggested draft letter. Alternatively, visit AGC’s Legislative Action Center to write your Senators and Representative. Currently H.R. 674 has 73 cosponsors in the House. To see if your Senators and Representative are or have been a cosponsor of legislation to repeal the 3 percent withholding mandate, click here.For more information, contact Karen Lapsevic at (202) 547-4733 or lapsevick@agc.org.