Withholding by Government Entities

If your company sells goods or services to government entities, a new 3% withholding tax will apply beginning on payments received after 2012.  The withholding provision was originally enacted as part of the Tax Increase Prevention and Reconciliation Act of 2005, to be effective in 2011.  The American Recovery and Reinvestment Act of 2009 delayed the effective date to 2012.  Now the IRS has issued final regulations (T.D. 9524) on the matter, further delaying the effective date to 2013.  A additional delay until 2014 is available if your company has a binding contract that is entered into before December 31, 2012.  Certain exceptions are outlined in the regulations.  Legislation was introduced in January 2011 to repeal this withholding provision, but it has not been acted upon.

Government entities are broadly defined to include the federal and state governments, and also political subdivisions and instrumentalities, including public colleges, public universities, and public hospitals.

Withholding is not an additional tax.  It is similar to tax withholding on wages.  While the withholding will have an impact on your cash flow, you will be able to count the withholding as prepaid federal income tax when your tax return is filed for the 2013 tax year.  Changes will need to be made to your internal record keeping systems to identify and track amounts that will be withheld.

UPDATE
On November 21, 2011, the President signed P.L. 112-56 that repeals this 3% withholding law, making the law never in effect.  In its place, Congress enacted a 100% continuous tax levy against federal contractors who are delinquent on their federal taxes.