Tax Withholding on Contracts May Hit Hard at Small Businesses

Lately, the federal government has launched new or expanded preference programs to benefit small businesses, enabling them to compete better with larger companies and to keep their strong foothold in the economy.

However, a little-known tax provision, if it remains part of federal law, is going to have a disproportionately harmful effect on those same small businesses, which need to become aware of this possibility and follow it closely.

The provision is Section 511 of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which requires government agencies at all levels that have procurement budgets of $100 million or more to withhold 3 percent of their payments to contractors for goods and services. The idea behind it was to ensure that government contractors pay their fair share of taxes.

Section 511 has been very unpopular among government contractors, and for good reason.  As Mick Mulvaney (R-S.C.), chairman of the House Small Business Committee, said at a May 26, 2011, hearing, “Instead of rewarding those small businesses that choose to compete for and win contracts, the government essentially pre-accuses them of cheating on their taxes and withholds 3% of all payments.”

However, this provision hasn’t yet gone into effect.  Although it’s never been repealed, its effective date has been delayed several times. Just recently, in May 2011, the Internal Revenue Service delayed it again – this time until January 1, 2013.

Section 511 would strike particularly hard at small businesses, it’s clear.

At that May 26 House hearing, James P. Gaffney, an owner of Goshen Mechanical Contractors, Inc., a small business in Malvern, Pa., said that “the 3% withholding could be larger than the entire profit margin on some jobs and would impede cash flow and viability for small companies doing government work.”

Gaffney was representing the Mechanical Contractors Association of America (MCAA), a nationwide specialty construction employer trade association based in Rockville, Md.  The vast majority of MCAA member companies, Gaffney said, are small businesses, and many of them perform projects of the type that will be covered by the 3% withholding.

Gaffney also commented at the hearing that “it is completely unnecessary to penalize tax-compliant law-abiding businesses to ensnare or deter tax-avoiding, non-compliant businesses.”

The debate over Section 511 doesn’t appear to be a partisan one: Both houses of Congress have bipartisan bills that would repeal the withholding. However, repeal has been attempted in earlier Congresses and has failed.

The Hill recently reported that the U.S. Chamber of Commerce and more than 130 other groups are trying to marshal support for a repeal bill introduced by Sens. Scott Brown (R-Mass.) and Olympia Snowe (R-Maine).

Small businesses should therefore keep a close eye on Section 511 and should contribute their views and energy, if possible, to the repeal efforts.  But in case repeal doesn’t occur, small businesses must prepare their bids, proposals and change proposals with the 3 percent withholding in mind so that, starting in about a year and a half, implementation of Section 511 won’t jeopardize their financial viability.

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