The IRS recently published final regulations regarding withholding certain payments made by government entities. Generally under the regulations, governmental entities and agencies are required to withhold 3% of payments made for property or services. The final regulations clarified and changed several withholding rules:
● The effective date was pushed back one year from 1/1/2012 to 1/1/2013. Contracts in place at 12/31/2012 that carry into 2013 are not subject to the withholding requirements as long as the terms are not materially modified.
● Only governmental entities that make more than $100,000,000 in payments annually are subject to the withholding. Payments under $10,000 are exempt from withholding.
● Certain entities and transactions are exempt from withholding. Payments for the purchase or lease of real property are not subject to withholding and tribal governments are not subject to withholding rules.
Contractors, the AICPA (American Institute of Certified Public Accountants) and construction association groups fear this new provision will spell the end for many companies and thus they have been trying to repeal the law. The main concerns are:
● The withholding is based on gross contract price, not net profit. According to Construction Executive magazine, general contractors realize an average of 2.2% net profit from contracts, meaning that they will be operating at an "out-of-pocket" loss on all contracts subject to withholding.
● Cash flow and profit will be severely impacted. The combination of retainage, an average of 5%-10% of contract price, and the 3% withholding will severely impact contractors' ability to pay workers, subcontractors, and suppliers.
● There is a negative impact on bonding capacity. The 3% withholding decreases cash and working capital, which is a key determination for bonding capacity. Additionally, the 3% withholding will be treated as a distribution for pass-through entities. Owners will be deemed to receive a pro-rata distribution for their share of the withholding, and this deemed distribution will unnecessarily decrease equity, which is another key bonding factor.
If you have questions about the upcoming law changes, please contact Eric Curtiss, Senior Tax Manager and leader of Berntson Porter's Real Property Practice Group at 425-289-7624 or firstname.lastname@example.org.