The year 2011 promises to be a year of reckoning for certain small businesses.

No, this is not a forecast about a shift in the earth’s rotation, or world economic system collapse. If you do business with government, something far more menacing is on the horizon – a mandatory 3 percent withholding requirement on all payments for goods and services made to federal, state and local contractors.

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The provision was slipped into the conference report of the final tax bill passed by Congress and signed by President George W. Bush. It mandates that government at all levels, starting in 2011, withhold taxes from payments made to contractors.

The withholding measure was thrown in as one of a handful of “revenue raisers” at the last hour. It’s a sure bet that some members of Congress were unaware of it when they cast their “yea” vote for the “Tax Increase Prevention and Reconciliation Act of 2005.”

To be sure, there are many good elements that were included in the broader tax package. The extension of lower capital gains and dividend tax rates, Section 179 expensing and a one-year Alternative Minimum Tax (AMT) fix for some taxpayers are a plus for entrepreneurs and the economy in general. However, critics of withholding expansion argue a principle is at stake regarding tax collections, and whether moving in on government contractors is the first step towards imposing a withholding scheme on all independent contractors.

"Proponents of the withholding provision describe it as 'closing a tax loophole,'" said Sen. Larry Craig, R-Idaho, in announcing legislation to repeal the withholding provision on the same day he voted for the tax bill. "That is nonsense. Reporting requirements are already in place for government contractors. All this does is buck the IRS's collection responsibilities to the taxpayers. Not only does the federal government spend taxpayers' dollars, but this provision would make taxpayers bear the burden and cost of collecting them, too.”

No doubt, withholding will present cash flow issues for many small business contractors. At the federal level alone, there were over five million individual government purchases from small businesses totaling $50 billion in 2001, according to the Federal Procurement Data System’s Report on Annual Procurement Preference Goaling Achievements.

“As portions of individuals and small businesses' income are withheld for as long as 15 months, cash flows will drop and opportunities to invest will go down. The government will end up holding this money, interest-free, instead of letting it circulate through the economy. On all counts, this is bad policy,” Craig said.

Internal Revenue Service (IRS) Commissioner Mark Everson suggested before a House Small Business Committee hearing in April that contractors who have no intention of paying their taxes likely factor in their cheating when bidding on government contracts, and therefore enjoy a competitive advantage.

“I suspect those compliant businesses would want us to be as aggressive as necessary to make sure, at least from a tax perspective, everyone is competing on the same basis,” said Everson in written testimony explaining IRS strategies to close the “tax gap.”

Earlier this year, the Government Accountability Office (GAO) reported that more than 3,800 federal contractors had tax debts totaling $1.4 billion. While this number is troubling, what could be more disconcerting is the IRS’s seeming incapacity to collect these taxes from businesses and individuals right under their nose. This is not the underground, or cash, economy.

According to Craig, “every head of every Federal executive agency that enters into contracts must file an information return reporting the contractor's name, address, date of contract action, amount to be paid to the contractor, and other information.”

Obviously, from a collections enforcement perspective, noncompliant contractors are low-hanging fruit. Why the IRS can’t collect from these taxpayers is a reasonable issue to explore.

More Costs for Governments and Small Business

The Congressional Budget Office reported on May 9 that the withholding provision constitutes an unfunded mandate on state and local governments, the cost of which exceeds the annual threshold established in the Unfunded Mandates Reform Act. Governments with less that $100 million in annual expenditures would be exempt from the requirement.

In addition to implementing a reporting and tax collection process, the cost of complying with the mandate could raise the price of procuring goods and services for local government. According to National Association of Counties and the National League of Cities and the Government Finance Officers Association, it will “put counties and cities at a severe competitive disadvantage to the private sector in purchasing goods and services.”

Which brings us back to the issue of whether the withholding effort actually levels the playing field for compliant government contractors, as Everson contends. Already, small business contractors are at a competitive disadvantage to larger contractors in the bidding process as they enjoy the benefits of scale, have staffs devoted to sifting through the complex rules governing the bidding process and are attractive to procurement officers because of “bundling” opportunities.
Small businesses may be forced to raise their bids to offset cash flow issues related to withholding, which will not only make their offers less attractive, but will raise costs for governments as well.

“This offset is not without strings, and it is not free. Withholding is the ultimate hidden tax. When taxpayers no longer see the money that is withheld from their paychecks, the cost of government becomes obscured. And with government spending what it is right now, transparency is what we need,” said Craig.

Are All Independent Contractors Next?

The successful push to withhold taxes on government contractors represents only one of several initiatives being pursued by the IRS and Treasury to increase compliance. With respect to independent contractors in general, Treasury makes no secret that it will study the standards used to distinguish between employees and independent contractors for purposes of withholding and paying federal employment taxes.

While advocates for independent contractors have been pushing for more clear classification rules to replace what they consider an arbitrary and outdated “twenty-factor test,” the IRS may move in the opposite direction by instituting rules that make it more difficult to be, or use, independent contractors.

This would be a shame as the 10.3 million independent contractors nationwide play a key role in nurturing economic growth. They embody the U.S. economic system’s flexibility, which allows our business and entrepreneurial sector to be the most dynamic, productive and innovative in the world.

As far as the outlook for repealing the withholding measure that kicks in in the year 2011 for government contractors, Craig predicts ultimate victory when taxpayers learn of the provision. To date, there are no Senate co-sponsors on Craig’s bill (S.2821), and similar legislation has not yet been offered in the House.

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Karen Kerrigan is president & CEO of the Small Business & Entrepreneurship Council, a research and advocacy group based in Washington, D.C. that works to protect small business and promote entrepreneurship. She is also founder of Women Entrepreneurs, Inc., an association helping women business owners succeed through education, networking and advocacy. Kerrigan can be reached at kkerrigan@sbecouncil.org.

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