On May 17, 2006, President Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which extends various tax provisions scheduled to expire, including alternative minimum tax relief and lower capital gains and dividend tax rates. But hidden in the new law was a provision (Section 511) that would require all government entities- federal, state and local- to deduct and withhold from all payments made to any individual or business providing any goods or services an amount equal to 3 percent of the total payment.
Thrown in as a "revenue raiser" at the last hour, Section 511 was not in the original House- or Senate-passed bills. In order to "find" an additional $7 billion to fund the other tax cuts, Senate legislative staff inserted the withholding requirement during conference negotiations despite the fact there had been no hearings on the proposal or even a hint it would be included in TIPRA.
Three Percent Withholding on Government Contracts
Section 511 Tax Increase Prevention and
Reconciliation Act of 2006 (P.L. 109-222)
Background-A new law requires federal, state, and local governments withhold 3-percent from all payments on goods and services as a guard against possible business tax evasion. The law:
- Requires withholding of 3% on all government payments for products and services made by the federal, state, and local governments with total expenditures of $100 million or more
- Affects payments for goods and services under government contracts as well as payments to any person for a service or product to a government entity (e.g. Medicare, certain grants)
- Applies to all payments starting in 2011
Key Points for Construction- Withholding applies to the total contract, not to the net revenue generated from a project. For construction contractors, this means the government is withholding funds necessary to complete a project, such as those necessary to pay for subcontractors, material and suppliers.
- For example, a small business contractor may hold one government contract which is estimated to be completed in one year for $1 million. Section 511 would require the government entity to withhold 3 percent, or $30,000, of the $1 million payment. For argument's sake, let's assume the contractor earns a 3 percent profit - which approximates the national average in construction contracts - on the project. That means the contractor would expect a profit of $30,000, or 100 percent of the amount withheld. Let's further assume that the contractor is taxed at the top corporate income tax rate - currently 35 percent. Because businesses are taxed only on their profits, the tax liability on this $1 million project would be $10,500. So in effect, the contractor would float the Federal government an interest-free loan for $19,500 on this particular project.
- The Federal law requires construction contractors carry several types of bonds. Surety companies who provide these bonds look at cash-flow when deciding to cover a contract. This withholding provision will restrict cash-flow, leading to higher costs for bonds or the denial of coverage, all of which drives up the cost of construction. In addition, the increased costs and difficulty in bonding will force smaller firms out of the public sector market.
- Senator Larry Craig (R-ID) and Congressmen Kendrick Meek (D-FL) and Wally Herger (R-CA) have introduced legislation, the Withholding Tax Relief Act of 2006 (S. 777 and H.R. 1023) which would repeal Section 511 outright.
Additional Resources
ABC's legislative position on Three Percent Tax Withholding