By Richard E. Gavin, CPA, CCIFP with contributions from Steve Mannhaupt, CPA and Alice Varisano, CPA
When baseball players were unknowingly on steroids (at least unknowingly to everyone but themselves), they were doing illogical things. Baseball records that had stood for years were being shattered and players were reaching levels of peak performance at ages that had previously signaled the end of their careers. Now, with the knowledge of widespread use of steroids, we have a logical answer to their illogical accomplishments.
Perhaps in a few years we will learn of a logical reason for this illogical legislation. It is another form of a stealth tax imposed by the government. No elected official wants to be associated with tax increases. With massive deficits to contend with, our creative thinkers inWashingtonhave conjured up another way to get more dollars from the public without being accused of increasing taxes. There is so much wrong with this and there is so much opposition, it’s unclear if it will ever be implemented. However, it is here, it has been signed into law and unless action is taken to repeal it, it will take effect next year.
History
Section 511 of the “Tax Increase Prevention and Reconciliation Act” of 2005, requires withholding at a rate of 3% on all government payments for products and services made by Federal, state and local governments with expenditures of $100 million or more. This encompasses ALL public construction projects, not just Federal contracts. The withholdings are credited as a tax payment to the recipient. The recipient will receive an informational return at the end of the year (presumably a form 1099) and then will apply that against their Federal tax liability. The final regulations delayed the implementation of the regulations from December 31, 2011 until December 31, 2012. Unless there has been a material modification, contracts executed by December 31, 2012 will be exempt from the withholding tax entirely, at least until January 1, 2014. For contractors working on public projects, this means every progress payment will be reduced by 3%, which will then show up on your tax return as a credit against your tax liability.
The original law was meant to increase compliance especially as related to defense contractors as Congress has been concerned about the projected billions of dollars of unpaid taxes due to fraudulent non-compliance of taxes. This withholding provision is aimed at shrinking this so-called “tax-gap” by taking the money directly from payments due to government suppliers and contractors, completely disregarding the fact that most contractors are law-abiding and pay their fair share of taxes. It also penalizes all businesses that work with governments. The law as written, and as viewed by most, unfairly penalizes the construction industry because the 3% withholding applies to the entire contract amount, and to every progress payment, not the profit on the contract. For example if a contractor has total requisitions on public projects of $10,000,000 for the year, the government will be withholding $300,000 from the progress payments. If the contractors’ gross profit on projects is 5% or 500,000 the contractor has lost 60% of its cash flow to purchase supplies, pay employees operate its business and make distributions to its owners. If you further assume the contractor has an additional 2.5% of overhead expenses, leaving a net taxable profit of $250,000, the government has already withheld more in taxes than the entire profit on the project. If you compare this with the actual tax liability of 35% of 250,000 or $87,500, the government has over withheld from the contractor $212,500. This is quite an onerous result on the already struggling construction industry. What we have here is a contractor, in a struggling economy, giving the government an interest free loan of $212,500. If the contractor cannot afford to give the government this loan, they will be forced to borrow the amounts from their bank, with interest.
Cash Is King
One thing all contractors know….Cash Is King. Contractors go out of business when they run out of money, not when they run out of work. Any contractor that involuntarily goes out of business, does so with a good amount of work on the books but no money in the bank.
The typical creditors for public contractors know this as well. The amount of credit banks and sureties extend to contractors is dependent on the analysis and frequent monitoring of their clients cash flow. When this withholding takes effect, all public contractors will see their cash flow reduced by 3% of their total billings. For example, a contractor billing $40 million in a year will have $1.2 million LESS cash flow to pay for materials, equipment, labor, subcontractors, overhead, insurances. $1.2 million less cash flow to fund the start up of new projects, that keeps their workers getting paychecks.
The withholding provision applies to prime contracts only. Contractors who subcontract part of their projects will not be able to pass this withholding to the subcontractors.
This potential over-withholding of tax dollars is incredibly dangerous for contractors that are already performing work before payment is made. In addition, reducing a contractors cash flow will keep many small businesses from bidding on public projects. This withholding has a direct negative effect on working capital, a primary driver in determining bonding capacity. More cash withheld means less working capital, resulting in reduced bonding capacity.
Tax Laws Already in Place
There are tax laws already in place that require the payment of taxes during the year. A typical employee has income taxes withheld from their wage. Corporations are required to make quarterly estimated tax payments based on their project liability. Self-employed individuals and owners of pass-through entities (sub-chapter S corporations and partnerships) are also required to make quarterly estimated tax payments. There are also provisions for penalties for those that underestimate their tax payments. This withholding provision gives no consideration to estimated tax payments that may have already been made. Public contractors will now have to project these withholdings for the year and factor that into the calculation of their quarterly tax payments. As we see from the above example, it is not unlikely that the withholdings will far exceed the tax liabilities.
For contractors that are Subchapter S Corporations or partnerships, this becomes even more onerous. Since these ‘pass-through’ entities do not pay taxes themselves, these withholdings will need to be allocated to the individual owners. The amount of overpayments will now appear as a refund receivable to the individual, not the business entity. It will be up to the individuals to return those dollars back to the business. And with many returns being placed on extension, these refunds, coming as a result of withholdings from progress payments made throughout the year, may not be returned to the company until 10 months after the end of the year.
In recent years many contractors have incurred Net Operating Losses (“NOL”) with their tax filings and expect to have reduced taxable net income in current and future years. If NOLs are utilized, the contractor can expect to have minimal or no tax liability BUT will still be forced to have the 3% of all progress payments withheld from their monthly requisitions and will not recoup these amounts until the tax returns are filed in the following year. This will be a significant reduction in their cash flow and a negative impact on their operations.
Contradiction to other Federal Policies
The U.S. Department of Transportation has adopted regulations that restrict the withholding of retainage of Federally funded projects due to the negative impact it has on small and disadvantaged businesses. This recognizes the necessity of cash flow to the survival of small business and is contradictory to 3% withholding tax.
In addition, since the initial passing of this provision, other initiatives have been put into place to monitor and certify the tax compliance for public contractors. More effort should be put in those areas rather than penalize an entire industry of public contractors.
Opposition is Growing
The Tax “Tax Increase Prevention and Reconciliation Act” of 2005 was signed into law on May 17, 2006. Within a year, in early 2007, bi-partisan legislation was introduced into the house and senate to repeal the 3% withholding provision. That initial legislation expired, but new legislation was introduced.
Organized public opposition is wide-spread. Opposition groups include :
- Government Withholding Relief Coalition; which includes over 120 member organizations, including 30 within the construction industry.
- All major construction industry trade organizations
- National Association of Counties
- National Council on Teacher Retirement
- National Institute for Government Purchasing
- American Council of Engineering Companies
The Department of Defense, in their March 2008 report, expressed concern that companies properly paying their tax obligations will experience cash shortages equal to the amounts withheld until the amounts are recovered through the normal federal income tax process.
In addition, the Associated General Contractors of America (“AGC”) has made recommendations that, short of repealing the provision in its’ entirely, would make the provision more fair, balanced and equitable for contractors. These have but been ignored. The group has designated this issue as a “Key Vote” which will be used in indicating an elected official’s support for the construction industry.
This is just a small sample but illustrates the broad cross-section of opposition to this provision.
Compliance Costs
A major detriment to this provision is the projected costs of compliance. All public owners are now required to incur massive costs to implement processes and procedures to comply with this requirement with no benefit to them. This is a costly and unfunded mandate for state and local governments already under fiscal stress. While the Federal government is getting accelerated tax payments, the public owners (states, counties, local agencies) must foot the bill to collect the withholdings, properly account and report them, and remit the money to the federal government. The public project owners get no benefit from this.
In April, 2008, the Department of Defense estimated that is would cost $17 billion in the first five years to comply with this provision. Final regulations issued by the IRS revised this estimate to be lower, but still ‘in the billions of dollars’. In comparison, this provision is estimated to raise $6 billion in the first year and slightly more than $200 million annually thereafter. Very little of these dollars are ‘closing the tax gap’ as was deemed the need for this provision, rather these dollars are being generated simply from accelerating tax payments.
In a letter to House Ways and Means Chairman Dave Camp (R-MI), the National Association of State Auditors, Comptrollers, and Treasurers wrote “State and local governments face unique challenges in preparing to implement Section 511, as the sophistication of systems necessary to capture and report the required data vary greatly between governments and most entities do not have the resources, capacity or staff to undertake the required withholding and remittance”. In addition, they raised particular attention concerning the costs to purchase or retrofit existing payment and procurement systems.
Contractors will be forced to develop a process for tracking the amounts withheld that will allow for a proper reconciliation of the amounts on their books with the records of the government’s at the end of the year. This new process will add an unnecessary burden to Contractors who have been reducing their overhead to bare minimum amounts due to the reduced levels of work and the reduced profits in that work.
Requisitions will have to be updated to include additional items for the amounts withheld. Internal controls will have to be updated to ensure new procedures are working properly. If the contractor does not track the amount withheld, the time needed at the end of the year to reconcile with the government’s records is immeasurable. As history has shown, the government’s reporting process may not always be accurate. Relying on the records provided by the government to take credit for the amounts withheld could result in lost dollars if they are not accurate.
Some companies will need to utilize technology staff or outside consultants to customize reports and provide for accurate internal accounting. These professionals will need to consult with tax compliance individuals in orders to develop the correct reports. This will all result in a cost to the contractors that will increase their operating budgets
Conclusion
The 3% withholding provision is an income tax withholding based on a flat percentage of revenues from all public projects and does not take into consideration a company’s taxable income. It will restrict cash flow, reduce a contractor’s working capital needed to start new projects and support day to day operations and reduce their bonding capacity making it more difficult to keep their businesses afloat. It is likely to cause significant over withholdings of taxes and force contractors to borrow money to fund this reduced cash flow. In addition, the administrative burden for implementation of processes and on-going compliance costs that this will impose on businesses and governments will be substantial and possible offset any benefit projected by the Federal government. Individuals, businesses, trade groups all must continue to voice their opposition to their local elected officials.
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