Government contractors should take notice of proposed legislation to repeal the mandate to withhold 3 percent on all payments over $10,000 made by federal, state, and local governments and agencies.

Enacted in 2006, the Tax Increase Prevention and Reconciliation Act of 2005 included a section (Section 511) that mandated the 3 percent withholding provision on new contracts, which was scheduled to take effect January 1, 2011. Additionally, while amounts withheld could be applied to estimated income taxes, they could not be used to offset employment taxes. The rule did not include any provisions allowing a prime contractor to flow down the requirement to subcontractors and the withholding was required on pass-through entities, even though these entities pay no tax (there was no indication of how this amount would be credited to the owners of such entities or how the government would track such payments to make sure they were credited to the proper taxpayers).

At each year end, the government would issue a 1099-MISC to each vendor noting the amount available to offset income taxes. State and local governments were notified that they were required to have systems and processes in place to track these credits by December 2011. However, to our knowledge, Florida is the only state that has been actively putting a system in place.

Under the American Recovery and Reinvestment Act of 2009, section 511’s implementation date was moved to Jan. 1, 2012.  In May, the IRS decided to DELAY, not rescind, the withholding proposal until Jan. 1, 2013.

Three bills pending in Congress would fully repeal Section 511. Therefore, we recommend all businesses contact their federal representatives to urge their support in repealing Section 511 as soon as possible.

In other government contractor news:

  • Small businesses will begin receiving payments sooner on Department of Defense contracts.

The Department of Defense expanded its accelerated payment provisions to all small businesses, as opposed to just disadvantaged small businesses. Under these guidelines, payments to small business contractors should occur within 14 days of the receipt of a proper invoice from the contractor. Contractors will NOT be entitled to interest for delays over 14 days.

  • Interest is clearly unallowable; however, contractors may still get some reimbursement.

Even though interest expense is typically an unallowable cost under the Federal Acquisition Regulations (FAR), some interest may be allowable. Under Section 31.205-10 of the FAR, a contractor can apply to recover “facilities capital cost of money.” Under these provisions, a contractor computes the facilities capital cost of money by multiplying the average book basis of the asset by the government established interest rate. This amount can be included in the contractor’s allowable costs (with the approval of the contractor’s cognizant auditor).

  • Government auditors are more aggressive in asserting penalties for expressly unallowable costs.

We are seeing more and more articles and hearing more from contractors about government auditors who are being much more aggressive in asserting that costs are “expressly unallowable” and subject to the 300 percent penalty for including such costs in incurred cost submissions. In most cases, we do not believe the penalty should be asserted, but contractors need to be more aware than ever of the importance of identifying and segregating expressly unallowable costs in their general ledgers.

David E. Shaffer can be reached at Email or 215.441.4600.