Administration backs delay of contractor tax withholding

Controversial provision would require the government to withhold 3 percent of its payments to industry firms.

The Obama administration is supporting the delay of a controversial requirement that the government withhold a percentage of its payments to most contractors for tax purposes.

The law mandates that federal, state and local governments with expenditures of more than $100 million withhold 3 percent of payments for products and services worth more than $10,000, including nonconfidential or classified contracts, grants to for-profit companies, and farm and Medicare payments.

The requirement, which industry contractors and trade associations have sharply opposed, is scheduled to take effect on Jan. 1, 2012.

The administration said it still is preparing to move forward with the withholding requirement, but officials concede agencies might need more time to get ready for the change.

"OMB and the agencies have completed preparatory analysis of agency financial systems, payment processes and contract award procedures associated with implementation while awaiting the issuance of a final regulation by [the Treasury Department]," Office of Management and Budget spokeswoman Moira Mack said in a statement to Government Executive. "Given the significant implementation challenges involved with the 3 percent withholding requirement, the administration would consider a delay to help implement the requirement as long as it were fully paid for."

Mack would not put a time frame on how long a postponement should last, suggesting only that the delay be "reasonable."

The 3 percent provision was included in the 2005 Tax Increase Prevention and Reconciliation Act in an effort to ensure that individuals and companies that receive new payments from the federal government do not accrue tax debt.

A report that the Treasury Inspector General for Tax Administration released this week found that more than 11 percent of all Internal Revenue Service contractors had delinquent federal tax accounts totaling $10.6 million.

The new process would closely mirror the withholding system on individual salaries and wages. The government would set aside 3 percent of the gross payments and the information and funds would then be transmitted to the Internal Revenue Service. At the end of the year, the amount withheld would be credited toward taxes owed.

Critics suggest the provision is unnecessarily burdensome during an economic downturn and numerous regulatory and legislative measures have been passed in recent years increasing the tax compliance of companies that receive government payments.

"This withholding is much more trouble than it's worth," said Phil Bond, president and chief executive officer of TechAmerica, a technology-based trade association. "Agencies will incur costs so significant that they are likely to consume any revenue gains the government is anticipating. Only the IRS stands to benefit from the significant but temporary increase in tax revenues before it has to refund that revenue to the tax filers. This withholding is onerous for all of the government's private sector partners, but particularly so for small and midsize businesses whose margins could be completely obliterated."

Congressional estimates have suggested that repealing the bill would cost $10.9 billion over 10 years. But, the Acquisition Reform Working Group, an industry-backed coalition, has disputed that figure.

The withholding tax is expected to eventually generate between $575 million and $734 million in actual revenues annually, "far less than the costs to businesses and governments of implementing and complying with the withholding requirement," the group wrote in a March 2010 report.

The provision is not particularly popular with government agencies either. In an April 2008 memorandum to the House and Senate Armed Services committees, James Finley, then-deputy undersecretary of Defense for acquisition and technology, wrote that implementing the provision would cost the Pentagon more than $17 billion in the first five years -- a price tag that included escalating costs that contractors charge. The provision also could "limit the number of companies willing to enter into the government market, thereby reducing competition and access to new technologies," Finley wrote.

The law initially was set to go into effect on Jan. 1, 2011, but a provision in the 2009 Recovery Act delayed the implementation date by one year. The IRS already had worked up a proposed rule to implement the provision in December 2008 and is scheduled to release its final rule soon.

Congress, however, will have the final say on the withholding measure. Sens. Scott Brown, R-Mass., and David Vitter, R-La., have introduced separate bills to repeal the provision. Rep. Wally Herger, D-Calif., has sponsored a House version. Both bills have bipartisan support.