The American Recovery and Reinvestment Act of 2009, which was signed into law on February 17, 2009, delays for one year the new withholding requirement for government payments to contractors under Internal Revenue Code subsection 3402(t). The requirement now applies to payments made after December 31, 2011.

Internal Revenue Code subsection 3402(t) was originally created by the Tax Increase Prevention and Reconciliation Act of 2005 and required that all payments made by governmental entities for goods and services after December 31, 2010, are subject to an income tax withholding of 3%. As stated above, this withholding requirement has now been delayed by law to apply to payments made after December 31, 2011.

Payments by the following governmental entities will be subject to the withholding requirement:

  1. The entire U.S. government, including all federal agencies, the executive branch, the legislative branch, and the judicial branch.
  2. All state governments, including the District of Columbia (but not including Indian tribal governments).
  3. All political subdivisions of a state government or every instrumentality of such subdivisions unless the instrumentality makes annual payments for property, goods, or services totaling less than $100 million in a calendar year, based upon the second preceding calendar year before the year in which the withholding requirement will apply. As an example, if total payments by a given governmental entity exceed $100 million in 2010, the withholding requirement will apply in 2012.

Generally the withholding requirement applies to all persons or business entities providing goods and services to the government, including individuals, trusts, estates, partnerships, LLC's, corporations (including S corporations), and associations.

The amounts paid to such persons, as well as the 3% withholding, will be reported to the payees on Form -MISC. The withholding amounts withheld in any calendar year will be reported by the payees as credits against their income tax for the tax year beginning in that calendar year. For example, if a governmental entity withholds amounts on a corporation in 2012 whose fiscal year begins on July 1, 2012 and ends on June 30, 2013, the payee corporation will take credit for the amounts withheld on its tax return for its 2012 fiscal year, which ends on June 30, 2013.

Payees may take the 3% withholdings into account in computing their estimated taxes for the applicable tax year.

If the governmental entity fails to withhold as required, under the law, it will become liable for the tax.

There are exceptions for payments below $10,000 as well as an anti-abuse rule that payments of $10,000 or more may not be divided into payments of less than $10,000 solely for the purpose of avoiding the withholding requirements. There are also exceptions for payments made by the governmental entity for payments otherwise subject to withholding, such as wages, retirement benefits, payments already subject to backup withholding requirements, and other such items.

Also, the regulations contain numerous other exceptions from the withholding, such as payments made to other governmental entities, payments made to nonresident aliens and foreign corporations, payments made under confidential or classified contracts as described in IRC 6050M(e)(3), and more.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.