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New Withholding Tax on Contractors Contractors who perform public projects will soon be subject to a new Federal withholding tax. In 2005, allegations of tax evasion by contractors spurred lawmakers to address tax compliance and other tax reform issues. Therefore, a new law, which applies to all business entities (including construction contractors) furnishing goods or services to the government, was drafted to ensure tax compliance. More specifically, this law applies to governmental entities with total expenditures of $100 million or more per year for property or services. It covers contracts at all levels of government—federal, state and local. The rate of withholding is fixed at 3% on the total contract price. This legislation has been a source of some controversy, as it was incorporated into a bill under unusual circumstances. Oddly enough, neither the House of Representatives nor the Senate proposed this legislation. It was put into the bill by action of the Conference Committee of both Houses of Congress. The new withholding rule will undoubtedly affect the cash flow of construction contractors who perform government jobs with a low profit margin. Ultimately, the decrease in cash flow can be especially punitive to general contractors when it is time to pay suppliers and subcontractors. The examples outlined below show the impact the federal withholding has on cash flow and discuss both the least and most effective methods to avoid negative cash flow. Example 1: XYZ Construction Company, Inc. receives a $2 million contract with the State of Georgia Department of Transportation. Under the new tax law, the DOT would be required to withhold $60,000 of the total contract payments (3% of $2 million). Let's presume that XYZ will net only 3% on the contract, which it expects to perform in full this year. In this case, XYZ's taxable income from the contract is $60,000, and its Federal income tax, assuming a 35% marginal rate, would be only $21,000, which is far less than the $60,000 withheld. Observation: This withholding law will dramatically affect cash flow for the general contractor and, in turn, its subcontractors. Therefore, to avoid the negative cash flow resulting from over-withholding, the contractor must change its bidding price. Example 2: The same facts in Example 1 apply here. However, XYZ Construction Company, Inc. seeks to avoid the negative cash flow incurred due to the new withholding tax. Accordingly, it marks up its contract bid price by 3.1%. Instead of a $2 million contract, XYZ bids $2,062,000. The profit on this contract is now an additional $62,000. At the 3% withholding rate, the amount withheld is $61,860. Therefore, XYZ has made the withholding tax cash flow neutral. XYZ's anticipated profit is now $122,000 instead of $60,000. The profit margin has increased from 3% to 5.92%. XYZ's taxable income from the contract would be $122,000, and its Federal income tax, assuming a 35% marginal rate, would ultimately be only $42,700, still less than the $61,860 withheld. A $19,160 tax refund results when XYZ files its corporate tax return. Of course, this assumes XYZ wins the contract after bidding $62,000 more. Example 3: Using the same facts as Examples 1 and 2, XYZ Construction Company, Inc., decides not to increase its bid by 3.1%. Yet, XYZ is still concerned about the negative cash flow from the withholding tax, so it decides to steer a middle course and increases its bid by 1.5% to alleviate about half of the new withholding tax's effect. XYZ accordingly bids $2,030,000. The result is an added $30,000 of profit on the contract. At the 3% withholding rate, the amount withheld is $60,900. Therefore, XYZ has mitigated the effects of the withholding tax nearly halfway. XYZ's anticipated profit is now $90,000. The profit margin is now 4.43%. XYZ's taxable income from the contract would be $90,000, and its Federal income tax, assuming a 35% marginal rate, would ultimately be $31,500, which is less than the $60,900 withheld. This results in a $29,400 tax refund when XYZ files its corporate tax return. In this midstream approach, XYZ hopes to minimize its negative cash flow while still positioning the Company to win the contract award. As you can see, it will be more important than ever to perform detailed cash flow projections and arrange for proper amounts of project financing before a contract bid is made. The only good news from all this is that the new tax law takes effect January 1, 2011. Fortunately, the 2006 Congress, in its final moments, resisted efforts to accelerate the effective date to 2007!Large & Gilbert, P.C. |
