05.13.11

IRS has issued final regulations deferring for one year the amended effective date of regulations relating to the withholding from and reporting of certain payments made by government entities. Therefore, the withholding obligation generally applies to payments made after Dec. 31, 2012. IRS also issued proposed regulations that would provide that the exclusion for payments under existing contracts that had not been materially modified would terminate with payments after Dec. 31, 2013, and payments made under all contracts would be subject to Code Sec. 3402(t) withholding as of that date.

RIA observation: Code Sec. Section Code Sec. 3402(t), as added by §511 of the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 209-222, 5/17/2006), was to be effective for payments made after Dec. 21, 2010. However, §1511 of the American Recovery and Reinvestment Act of 2009 (P.L. 111-5, 2/17/2009) amended the effective date of the Code Sec. 3402(t) withholding so that it applies only to payments made after Dec. 31, 2011. The effective date is now pushed back again, effective for payments made after Dec. 31, 2012.

Background

Code Sec. 3402(t) provides that, once effective, the federal government and the government of every state, political subdivision of a state, and instrumentality of a state or state subdivision (including multi-state agencies) making certain payments to a person providing any property or services (e.g., payments from a political subdivision to a government contractor) will have to deduct and withhold tax from that payment in an amount equal to 3% of the payment. The withholding requirement will also apply to a payment made in connection with a government voucher or certificate program that functions as a payment for property or services. (Code Sec. 3402(t)(1)) Payments subject to withholding under this rule will also be subject to information reporting requirements. (Code Sec. 3402(t)(3))

Withholding under the above rules won't apply to any payment:

1. Except as provided at (2), below, that's subject to withholding under any other provision of Chapter 3 (dealing with withholding on nonresident aliens and foreign corporations), or Chapter 24 (dealing with collection of income tax at source on wages);
2. That is subject to backup withholding under Code Sec. 3406 and from which amounts are being withheld under that section;
3. Of interest;
4. For real property;
5. To any governmental entity subject to these withholding rules (i.e., intra-governmental payments), any tax-exempt entity, or any foreign government;
6. Made under a classified or confidential contract described in Code Sec. 6050M(e)(3);
7. Made by a political subdivision of a state (or any state instrumentality) that makes less than $100 million of these payments annually;
8. That is made in connection with a public assistance or public welfare program for which eligibility is determined by a needs or income test; or
9. To any government employee that is not otherwise excludable from these withholding rules with respect to his services as an employee. (Code Sec. 3402(t)(2); Notice 2008-38, 2008-13 IRB 683)

Reporting requirements

Once the withholding requirements are effective, each government entity that is required to withhold tax under Code Sec. 3402(t) will also be required to furnish to the payee a written statement on Form 1099-MISC containing:

1. The name, address, a taxpayer identification number of the person receiving the payment subject to withholding;
2. The amount of the payment withheld upon;
3. The amount of tax deducted and withheld;
4. The name, address, and TIN of the government entity filing the form:
5. A legend stating that such amount is being reported to IRS; and
6. Other information required on Form 1099-MISC.

The entity must also file a duplicate of that statement with IRS. (Prop Reg § 31.6051-5)

The concern

In response to the earlier proposed regulations published in December of 2008, commentators expressed concern that the requirement to differentiate between payments subject to withholding and payments not subject to withholding based on whether the payment was made under a contract existing on Dec. 31, 2011, and whether that contract had been materially modified, would be burdensome to apply.
Commentators also expressed concern that political subdivisions or instrumentalities, the yearly payments of which are generally near $100 million but do not always equal or exceed that threshold amount, could incur considerable expense and difficulty administering withholding in certain years but not others.

New guidance

The final and proposed regulations extend the effective date of the 3% withholding requirement, and the corresponding reporting requirement, for one year. They now generally apply for payments made after Dec. 31, 2012, subject to an exception for contracts existing on Dec. 31, 2012 that are not materially modified. Under the proposed regulations, this exception would terminate for payments made after Dec. 31, 2013, and payments made under all contracts would be subject to the withholding and reporting requirements after that date.

Additionally, the final regulations provide an optional alternative method under which a political subdivision or instrumentality may average the payments made during any four of the five consecutive accounting years, ending with the accounting year that ends with the second preceding calendar year.  This method will give greater predictability for future years and allow political subdivisions and their instrumentalities to moderate the effect of the payments

Certain issues reserved for future guidance

There were a number of issues that IRS briefly addressed in the final regulations, but reserved for future guidance. These included a definition of the term “instrumentality” and the potential application of Code Sec. 3402(t) withholding to payment card transactions (which Notice 2010-91, 2010-52 IRB 915 provided wouldn't apply to any payment made by payment card for any calendar year beginning earlier than at least 18 months from the date further guidance is finalized applying Code Sec. 3402(t) withholding to payments by payment card, see Federal Taxes Weekly Alert 12/09/2010). IRS also stated that it may issue further guidance in the future, if necessary, regarding the application of Code Sec. 3402(t) to prime contractors, subcontractors, and payment administrators, as well as the application of the statute and regulations to payments made in connection with certain public assistance or public welfare programs.

Should you have any questions about how this might affect you, please contact your Argy Tax Professional at 703.893.0600.

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Source: Federal Tax Updates on Checkpoint Newsstand tab 5/9/2011

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