Both government agencies and government contractors will need to prepare for the effects of new withholding rules.

Tax law contains a provision that requires the federal government and every state and local government making payments for goods or services to withhold tax from each payment at the rate of 3 percent. This provision was enacted as part of the Tax Increase Prevention and Reconciliation Act of 2005, which added Sec. 3402(t) to the Internal Revenue Code.

This law was to be effective for payments made after Dec. 31, 2010. However, the American Recovery and Reinvestment Act of 2009 delayed the effective date to payments made after Dec. 31, 2011.

Now the IRS has issued regulations providing another one-year delay. Therefore, the withholding obligation generally applies to payments made after Dec. 31, 2012.

The IRS also issued proposed regulations providing for an exception available for payments under pre-existing contracts that have not been materially modified will terminate for payments after Dec. 31, 2013. Payments made under all contracts will be subject to Code Sec. 3402(t) withholding as of that date.

Governments with less than $100 million of annual expenditures are generally exempt from the withholding requirement. The regulations provide an optional alternative method under which a political subdivision or instrumentality may average multiple prior year payments to determine if they have a withholding obligation. Note that withholding is imposed on gross payments regardless of the actual profitability of the contract.