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Managing a business requires constant attention to cash flow.  For federal government contractors, understanding the implications of the withholding requirements introduced by the Tax Increase Prevention and Reconciliation Act of 2005 (the Act) will be critical to effective cash flow management in future years. This article summarizes some of the more important aspects of this significant legislation.

In general, the Act will require the federal government and every state to withhold a three percent income tax on payments for property or services.  Subject to the exemptions identified below, this three percent withholding will apply to individual payments of $10,000 or more.

The withholding requirement was originally intended to be effective for payments made after December 31, 2010, but the American Recovery and Reinvestment Act of 2009 extended the implementation date to payments made after December 31, 2011.  When the regulations regarding withholding procedures were finally published, the effective date was further extended. As it stands now, the three percent withholding will be required on all payments made after December 31, 2012, unless these payments fall into those categories specifically exempt from withholding.

One such exemption is available to existing contracts as of the enactment date.  If a contract is in place as of December 31, 2012 and it is not materially modified after such date, withholding on payments made under such a contract is not required. However, the Treasury has issued proposed regulations that would eliminate the exemption for existing contracts effective January 1, 2014. This would mean that all contract payments would be subject to withholding as of January 1, 2014, regardless of whether the contract existed as of December 31, 2012, and regardless of whether the contract had been materially modified after that date. 

Federal grant payments are also exempt from the withholding requirement.  Grants by nature do not provide any direct benefit to the federal government; rather, they provide a public service and have been deemed to be excluded from the withholding requirements.  Various other payments are exempt from withholding including, but not limited to, the following:

Payments for the purchase or lease of real property
Payments for interest or principal on loans
Payment to foreign governments
Payments made for confidential or classified contracts
Payments made in connection with a public assistance or public welfare program
Payments made by subdivisions or instrumentalities of a state government if the annual total of such payments is less than $100 million
While the effective date is not imminent, the implications of three percent withholding are significant for the cash flow management of all federal government contractors.  Depending on the size of your organization, available cash reserves, and ready access to credit or float, the withholding requirement may force changes in business operations.  Proper consideration should be taken to plan and prepare for these issues.  

For more information or additional insight into these regulations please contact your Rubino & McGeehin, at 301-564-3636.