Contributed by Husch Blackwell Partner Bert Wolf, Esq.

Government contractors are relieved that they won’t immediately face having 3% of their invoices withheld as an advance against future tax liability. The IRS’s final rule implementing the 3% withholding tax won’t go into effect until 2013.  Absent a material modification, contracts executed by December 31, 2012 will be exempt from the withholding tax entirely, at least until January 1, 2014. But that isn’t the end of the story. Here is a bit of the background on the source of the 3% withholding tax, why it has been delayed, and some thoughts on why it’s not a great solution to the problem at hand.

A 2004 GAO report [PDF] identifies what could only be characterized as a serious problem with tax compliance among defense contractors. The report opens with the remarkable conclusion that “DOD and IRS records showed that over 27,000 contractors owed about $3 billion in unpaid taxes as of September 30, 2002.” The problem was not contractor oversight or the IRS’s lack of diligence. In some cases, GAO said that the unpaid taxes were the result of “abusive and potentially criminal behavior.”

Section 3402(t)

The natural result of such an outrageous conclusion, of course, is legislation. The 3% withholding tax appeared in section 511 of the Tax Increase Prevention and Reconciliation Act of 2005 [pdf], which was introduced in late 2005 and signed into law on May 17, 2006. As written, the law would require federal, state, and local governments who pay $100 million or more for property or services annually to withhold 3% of each payment to contractors of $10,000 or more. It appears at section 3402(t) of the Internal Revenue Code.

When it was first passed, the 3% withholding tax would have applied to payments made after December 31, 2010. Language in the statute specified this effective date, as did the IRS’s 2008 proposed regulations. The first delay in the implementation of the 3% withholding requirement appeared in section 1511 of the American Recovery and Reinvestment Act of 2009. That provision pushed the effective date back to December 31, 2011.

Final IRS regulations

The IRS’s May 9, 2011 final regulations push the effective date back another year, this time to December 31, 2012. According to the IRS, the rationale for the additional delay is to allow federal agencies sufficient time to implement the new withholding requirement:

Noting the necessity to formulate government acquisition rules that are consistent with the final regulations, as well as the infrastructure needed to apply those rules, some commenters stated that government entities would need at least 18 months from the issuance of final regulations under section 3402(t) to be able to comply.

Definition of “material modification”

Another reason for the delay is to allow clarification of how the withholding requirement will be implemented. According to the explanatory material accompanying the IRS’s final rule, the IRS received several comments identifying potential ambiguities in its proposal to exempt existing contracts from the withholding requirement unless they were “materially modified.” What exactly is a “material modification”? Is renewing a contract or exercising an option a material modification?

To address the ambiguity in the material-modification provision, the IRS proposed yet another regulation [pdf]. The proposed rule provides that contracts in effect on December 31, 2012 will be subject to the 3% withholding requirement after January 1, 2014, unless they are “materially modified.” It clarifies the definition of material modification to exclude the “mere renewal” of a contract. Under the proposed rule, a material modification is one that “materially affects the property or services to be provided under the contract, the terms of payment for the property or services under the contract, or the amount payable for the property or services under the contract.”

Next steps

It’s easy to conclude from the history of the 3% withholding requirement that it may never actually go into effect. A law passed in 2006 will now go into effect at its earliest on January 1, 2013. Aside from the strong advocacy from contractors and trade groups and the general political hostility towards imposing new tax burdens on businesses, there are problems with the 3% withholding approach. Chief among them is that it burdens all federal, state, and local government contractors rather than targeting the actual violators. Rather than creating exceptions to mitigate the cash-flow impact on those most hurt by the rule, why not just require contractors to certify their compliance with their tax obligations?


Congress has voted to repeal the 3% contractor withholding tax. Our entry on the new legislation includes a link to the roll call voting records in the House and Senate as well as to the Administration’s statement of position.