Withholding tax riles government contractors.

• Author: Prysock, Mark
• Position: WashingtonINSIGHTS

In May, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) into law. Section 511 of the bill received scant attention at the time, largely because it was inserted as a last-minute "revenue raise" (read: tax hike). Unfortunately for those who do business with the government--at the federal, state or local level--Section 511 may be here to stay.

What makes Section 511 so onerous for government contractors and vendors? It mandates that federal, state and local governments withhold 3 percent from payments for goods and services. The provision applies to payments for goods and services under government contracts, as well as payments to any person for a product provided to a government entity (such as Medicare or certain grants).

The provision's supporters have argued that such withholdings are necessary, since many federal contractors do not comply with their tax obligations. A recent General Accountability Office (GAO) report found that about 33,000 contractors that received substantial federal payments from civilian agencies owed more than $3 billion in unpaid taxes. The GAO stated that it found evidence of "abusive and potentially criminal" activity on the part of contractors with unpaid tax debts. This report triggered a strong Congressional backlash against contractors, and led to the development of Section 511.

Not surprisingly, those who will be most directly impacted by the provision are concerned. While the provision will not apply until 2011, contractors large and small are already publicly fretting about the significant administrative costs and information reporting requirements. Larger contractors, for example, will face tremendous administrative costs associated with the measure. In effect, they will be required to keep track of every payment--and the withheld amount--made by the government to them. For large contractors, this could mean tracking and properly accounting for withholdings made on thousands of payments each year.

Smaller companies doing business with the government face even greater concerns. For them, the withholding provision will directly impede their cash flow. In essence, Section 511 amounts to a tax penalty without a clear path for reimbursement. And the amount of the penalty is variable. As the Small Business Administration (SBA) Office of Advocacy noted in a recent letter, "If a contract generates a small profit or no profit, the additional withholding could present...