IRS Defers Withholding Requirement to 2013

This week the IRS issued final regulations to implement the three-percent federal income tax withholding requirement on government contract payments.  Enacted into law in 2006, this provision requires all federal, state and local government entities and instrumentalities to withhold three percent of payments made for goods and services.  Initially set to go into effect in 2010, legislative extensions had pushed the effective date to January 1, 2012.  And, in an unexpected twist, the IRS regulations defer the effective date for compliance for an additional year.  Now, enforcement of the three-percent withholding will not kick in until January 1, 2013.

Since its enactment, CompTIA consistently has called for repeal.  As a general rule, prepayments of tax (either withholding tax or estimated tax payments) historically have born some direct relationship to a taxpayer’s estimated income tax liability for a specific tax period.   However, this new three-percent withholding requirement departs from the traditional federal tax scheme, because the static three-percent withholding rate bears no relation to anticipated taxable income.  Indeed, a VAR working under a government contract with a slim profit margin actually could experience a net loss for the tax year; even so, that VAR still would be subject to the three-percent withholding.

Since its enactment, repeal legislation had been introduced in each session of Congress but with no success.  Currently, there are three active pieces of legislation that would repeal this provision, H.R. 674, S. 89,  and S. 164.  Similar to the recently repealed 1099 requirement, this three-percent provision was slipped into the 2006 legislation without notice or vetting by the small business community.  And, like the onerous 1099 provision, once enacted, it has proved difficult to undo because of the $7 billion in revenue (over 10 years) it was estimated to raise.

Emboldened by the success of the 1099 repeal campaign, many of the same organizations have rejoined to support repeal of this three-percent withholding requirement.  And, like the 1099 provision, repeal of the three-percent requirement has a very broad base of support.  Even so, repeal does require cooperation of both the House and Senate, which has been in short supply recently.