Withholding tax riles government contractors.

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 serious cash management issues."

Cash Flow Issues Affected

The SBA noted that a recent study by the GAO concluded that disruptions caused by contracting with the Department of Defense can significantly affect the day-to-day operations of small business. And, "adding a 3 percent withholding requirement will only exacerbate the cash flow issues already experienced by small entities seeking to do business with the government."

Counties and local governments across the country are likewise concerned by the impact of Section 511. Many county officials have publicly stated that vendors and contractors will likely inflate their prices by 3 percent so as not to disrupt cash flow. For a county like Miami-Dade (Florida), which spends more than $900 million a year on goods and services, that would translate to an annual increase in the cost of goods of about $27 million.

Not all in Congress support the withholding provision. Sen. Larry Craig (R-Ida.) recently introduced S. 2821, the Withholding Tax Relief Act of 2006. If enacted, S. 2821 would eliminate the withholding requirement altogether. To date, the legislation resides in the Senate Finance Committee. On the House side, similar legislation may be introduced shortly.

In a floor speech discussing this issue, Senator Craig made it very clear that businesses, governmental entities and consumers will ultimately pay the price should the 3 percent withholding remain law:

"And the cost of this provision is high--nearly $7 billion over 10 years. This offset is not without strings, and it is not free. As portions of individuals and small businesses' income are withheld for as long as 15 months, cash flows will drop and opportunities to invest will go down. These expenses will result in a higher cost of business.

"Withholding is the ultimate hidden tax. When taxpayers no longer see the money that is withheld from their paychecks, the cost of government becomes obscured. And with government spending what it is right now, transparency is what we need."

Two FEI technical committees, the Committee on Taxation (COT) and the Committee on Government Business (CGB), have worked closely with the Government Withholding Relief Coalition to support the Craig legislation. With the impending Congressional recess in the run-up to the elections, insiders regard the prospects for repealing the provision this year as slim. But, the Coalition has made some important inroads, and the group hopes to repeal the withholding requirement sometime next year.

Mark Prysock ([e-mail]) is FEI's Director of Public Affairs and General Counsel in the Washington, D.C, office.