On May 17, President Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which extends various tax provisions scheduled to expire, including alternative minimum tax relief and lower capital gains and dividend tax rates. But the new law isn't good news for the contracting community. Hidden in the fine print is a provision (Section 511) that would require all government entities—federal, state and local—to deduct and withhold from all payments made to any individual or business providing goods or services an amount equal to 3 percent of the total payment.
The 3 percent
Advocates of Section 511 argue that withholding payments to contractors is one way of closing the "tax gap"—the difference between what taxpayers should pay and what they actually pay on a timely basis. And because these advocates allege government vendors are among the most egregious abusers of tax filing and payment obligations, they reason it's only fair to impose this new requirement.
The problem is this argument wrongly assumes 3 percent of the gross payment on a contract will match a contractor's tax liability on a particular project. Consider a contractor who signs a $1 million contract with the city of Chicago to reroof a municipal property. Section 511 would require Chicago to withhold 3 percent, or $30,000, of the $1 million payment. Then, assume the contractor earns a 3 percent profit—the national average in construction contracts—on the project. That means the contractor would expect a profit of $30,000, or 100 percent of the amount withheld. If the contractor qualifies as a small business and falls in the 30 percent corporate income tax bracket and because businesses are taxed only on their profits, the tax liability on the $1 million project would be $9,000. So the contractor would float the federal government an interest-free loan for $21,000.