The IRS issued final regulations (T.D. 9524) further postponing implementation of mandatory 3% withholding on payments from government entities to contractors and providing interim guidance. The final regulations also adopt a $10,000 withholding threshold for any single payment and provide a transition rule under which interest and penalties will not apply for a failure to withhold on payments made before January 1, 2014.
The withholding requirement was added to Sec. 3402(t) by the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222). The provision requires the withholding from payments by the federal or state governments or their instrumentalities or subdivisions (including multistate agencies) to any person for services or property.
The provision’s effective date was first postponed by the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). The final regulations now delay it by another year, to apply to payments made after December 31, 2012.
The statute excludes from the withholding requirement payments made to other governmental entities, tax-exempt entities and foreign governments; those made by political subdivisions of states or instrumentalities of those subdivisions that make less than $100 million of such payments annually; payments to government employees for services as an employee; payments for interest or real property; and payments subject to withholding under other Code provisions (with the additional requirement, for backup withholding under Sec. 3406, that those amounts must actually be withheld). Under Notice 2010-91 issued in December 2010, withholding will not apply to payments made by payment card transactions (other than convenience checks issued in connection with payment card accounts) until at least 18 months after further guidance is finalized.
In letters earlier this year, the AICPA called on Congress to repeal the withholding provision, calling it an undue burden for both governments and contractors and unnecessary given existing tools that already monitor contractors’ federal tax compliance. Medical providers and farmers could be particularly hard-hit by the requirement, the AICPA said.
The IRS received “numerous” comments about the administrative burden of complying with the withholding provision in response to proposed regulations issued in 2008 (REG-158747-06). The Service said it has tried to balance the concerns with the statute’s legislative intent. The IRS noted commentators’ assertion that governments would need at least 18 months from issuance of final regulations to adapt their systems and procedures to comply.
Besides extending the effective date, under the final regulations the withholding requirement does not apply to payments made after December 31, 2012, if the payments are made under a written binding contract in effect on December 31, 2012. However, if an existing contract is materially modified after that date, subsequent payments will be subject to withholding. The final regulations provide guidance on what constitutes material modification of a contract for purposes of the exception.
Under proposed regulations (REG-151687-10) issued simultaneously with the final regulations, the exception for payments made under existing contracts would no longer apply starting January 1, 2014.
Other guidance the final regulations provided included:
- The $10,000 payment threshold applies to each payment to a person, regardless of the number of items of property or services a payment covers. Under an anti-abuse rule, withholding may not be circumvented by dividing a payment.
- Where the government entity pays a prime contractor, only the payment to that contractor is subject to withholding, not the contractor’s payments to subcontractors.
- The date of a payment subject to withholding is considered to be that on which payment is made, without regard to the date on which the government entity accepts the services or property or whether the payment is made under various forms of advance, interim or performance-based measures.
- Payments for utility services are not exempt.
- The exception for tax-exempt payees applies regardless of whether a payment is treated as unrelated business income to the tax-exempt entity.
- The exception for real property includes purchase or lease of existing real property but does not extend to construction of buildings, roads or bridges or other public works projects.
- The exception for government employee compensation includes employer-provided fringe benefits.
- Grants made by government entities for certain public purposes are generally excluded from withholding.
- The amount of payment subject to withholding includes any sales, excise or value-added tax; however, the government entity may exclude the tax if it does so consistently for all payments to the same payee during a calendar year.
The final regulations were effective May 9, 2011.