Proposed Regulations [REG-158747-06] were published in the Federal Register December 5, 2008, for new Internal Revenue Code subsection 3402(t). This subsection, created by the Tax Increase Prevention and Reconciliation Act of 2005, requires that payments by governmental entities for goods or services after December 31, 2010, are subject to 3% income tax withholding, with some exceptions. For more details, please see the Proposed Regulations, which can be accessed here. Comments or requests for a public hearing may be made until March 5, 2009. To submit comments electronically, go to www.regulations.gov and search for (IRS REG-158747-06). The Summary in the published regulations contains procedures for submitting comments in person or by mail.
Major features of the law and the proposed regulations are discussed below.
Which Government Entities Are Required To Withhold
The following are subject to the new requirement:
- The entire U.S. government, including all federal agencies, the executive branch, the legislative branch and the judicial branch.
- All states including the District of Columbia (but not including Indian tribal governments).
- All political subdivisions of a state government or every instrumentality of such subdivisions unless the instrumentality makes annual payments for property or services of less than $100 million.
Generally, withholding is required on all payments to all persons providing property or services to the government, including individuals, trusts, estates, partnerships, associations, and corporations. Withholding is required at the time of payment, and applies to payment in any form (cash, check, credit card or payment card). If the government entity fails to withhold the tax required under section 3402(t), it becomes liable for the payment of the tax.
Payment Threshold
The proposed regulations create a payment threshold of $10,000 and provide that payments below the threshold are not subject to withholding. The regulations also include an anti-abuse rule that payments of $10,000 or more may not be divided into payments of less than $10,000 solely for the purpose of avoiding the withholding requirements.
Exceptions from the 3 Percent Withholding Requirement
The proposed regulations provide the following exceptions from the withholding requirements:
- Payments otherwise subject to withholding, such as wages.
- Payments for retirement benefits, unemployment compensation, or social security.
- Payments subject to backup withholding, if the required backup withholding is actually performed.
- Payments for real property.
- Payment of interest.
- Payments to other government entities, foreign governments, tax exempt organizations, or Indian tribes.
- Payments made under confidential or classified contracts, as described in IRC 6050M(e)(3).
- Payments made by a political subdivision of a state, or instrumentalities of a political subdivision of a state that make annual payments for property of services of less than $100 million.
- Public assistance payments made on the basis of need or income. However, assistance programs based solely on age, such as Medicare, are subject to the requirements.
- Payments to employees in connection with service, such as retirement plan contributions, fringe benefits, and expense reimbursements under an accountable plan.
- Payments received by nonresident aliens and foreign corporations.
- Payments made by Indian tribal governments.
- Payments in emergency or disaster situations.
Exception for Small Entities
Subdivisions of a state, or instrumentalities of a subdivision of a state, are exempt from the withholding requirement if its total annual payments for property and services (not including wages) are less than $100 million. The proposed regulations provide a simple rule for determining whether an entity makes annual payments less than $100 million. In general the entity looks to its accounting year ending with or within the second preceding calendar year For example, if total payments for the entity’s 2009 accounting year exceed $100 million, the withholding requirement will apply in 2011.
How To Report Withheld Tax
Withholding is required at the time of payment. Payments subject to the withholding requirement must be shown on Form 945, Annual Return of Withheld Income Tax. These amounts are subject to the deposit rules for that form. The deposit rules are discussed in Publication 15, Circular E, Employer’s Tax Guide. All amounts withheld must be reported by the government entity on Form 1099-MISC, Miscellaneous Income, at the end of the calendar year. Amounts withheld may not be applied as a credit against the employment tax liabilities of the payee. The payee will include withheld amounts in total withholding on the individual or business tax return. The proposed regulations provide an explanation of the timing of credit for the withholding to be taken when the recipient operates under a fiscal tax year.
Transitional Rules
The proposed regulations provide that generally the withholding requirement do not apply to payments under contracts existing on December 31, 2010. The proposed regulations also provide that government entity will not be liable for interest and penalties with respect to the failure to pay the tax on payments for property and services made before January 1, 2012 if the entity made a good faith effort to comply with the withholding requirements.
The office of Federal, State and Local Governments (FSLG) will continue to provide information on these provisions, as it becomes available, on its website.
Comments or requests for a public hearing may be made until March 5, 2009.
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