CPA & Business Advisory Blog

Effects of 3 Percent Withholding on Payments to Government Contractors

In May of 2006, Congress enacted the Tax Increase Prevention and Reconciliation Act of 2005. The two most notable pieces of the bill were the extension of the reduced tax rates on capital gains and dividends as well as the extension of the alternative minimum tax (AMT) reduction. For government contractors and individuals, such as farmers and medical professionals, another important part of the bill was the 3 percent withholding on payments made to government contractors, and for Medicare, farm, and certain other payments. Although the effective date of the provision was originally set for January 1, 2011, that has now been delayed until January 1, 2013. The reason for the delay? CPAs, government contractors, farmers, and medical professionals are urging Congress to repeal the bill.

If the provision goes into effect as planned on January 1, 2013, this will create significant challenges for small businesses. Governmental accounting and procurement systems, as well as state and local governments, will need to be reprogrammed to adapt with the new law and this will come at a costly price.  In addition, they will need to make the change during a weak economic time and with low budgetary availability.

In addition, three percent is more than the profit margin that some contractors are earning on jobs, in current economic conditions. Enacting the 3 percent withholding also assumes that the contractor is making money on all its contracts and overall operations – considering many construction companies are bidding jobs low to land work, this is an unfair assumption. Whether a company is affected by both of these issues or just one, their cash flow is negatively affected.

Another sector that will be affected is businesses involved in government contracting.  “For example, should a company have 3 percent withholding imposed on the services it provides as a government prime contractor, the company might find it extremely difficult to adjust subcontractor arrangements to pass the timing and cost of withholding on to the subcontractors.” This example illustrates the impact that this provision could have on the cash flow of a contractor, and possibly even their financing costs. The tightening of their cash flow could also have a potential domino effect on their operations as well.  And in a time of recovery for contractors, this would be a major setback in their rebuilding. The provision will create very complicated tax estimate obligations.

As the bill continues to gain momentum and January 1, 2013 approaches, government contractors, medical professionals, and CPAs will be waiting to see if they get hit with a three at the buzzer or if they block the shot and move on to the next challenge.

Have questions about the Tax Increase Prevention and Reconciliation Act of 2005? Post a comment below or contact our Real Estate and Construction Group at 440-449-6800.

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