New tax provision could cost Defense $17 billion

Complying with a new tax law will cost the Defense Department more than $17 billion in the first five years, including more than $22 million to modify its accounting and payment systems, according to a report Defense submitted to Congress this week. The full impact for other agencies won't be realized until the Internal Revenue Service establishes procedures for the law, which generally requires federal, state and local governments to withhold a tax of 3 percent from all payments to their contractors.

Section 511 of the 2005 Tax Increase Prevention and Reconciliation Act requires federal and state governments, as well as local governments with expenditures of $100 million or more to begin withholding the tax on Jan. 1, 2011. The withholdings would raise an estimated $7 billion by 2015. Congress added the provision following a 2004 Government Accountability Office report, which found that more than 27,000 Defense contractors owed about $3 billion in unpaid taxes as of Sept. 30, 2002.

The House Armed Services Committee asked Defense to assess the impact of compliance with the law, including costs to modify financial accounting systems and hire additional personnel, and consequences for contractors.

"The costs for DoD to comply with Section 511 will be significant -- over $17 billion for the first five years," James Finley, deputy undersecretary of Defense for acquisition and technology, wrote in a letter to members of the House and Senate committees on Armed Forces. In addition, he noted, the law "may limit the number of companies willing to enter into the government market, thereby reducing competition and access to new technologies."

The Defense report is based on the assumption that the law will require agencies to withhold 3 percent of affected payments, transfer those withholdings to the IRS, and report payment and withholding amounts to the IRS and the contractors. Any excess withholdings would then be recovered by the contractor through the normal income tax filing process.

Among the nonrecurring costs included in Defense's report were modifications to the accounting systems that maintain budget and expenditure data, and entitlement systems that essentially maintain accounts payable. The withholding likely will occur in the entitlement systems, which must integrate with accounting systems to ensure transactions are reconciled in the department's financial records.

According to the report, modifications to the 11 accounting systems affected would cost $6.9 million, or $625,000 each, while modifications to 19 entitlement systems would cost $15.4 million, or $812,500 each.

"This just includes system costs for DoD," said a staffer with a large defense contractor that consulted with the department about strategy for compliance. He asked to not be identified. "When you do this [same analysis] for every other agency's accounts payable center, including those in state and local government, the numbers really get big."

Other expenses noted in the report include $5.1 million annually for additional staff to support 511 reporting and reconciliation requirements and record retention, as well as $839.2 million annually in savings lost from the inability to use purchase cards issued as part of the General Services Administration's SmartPay program. Agencies would have no way to withhold the tax from payments made with the card, which helps them avoid an estimated $1.4 billion annually in administrative costs.

The impact on companies that sell goods and services to government also could be staggering, particularly if the IRS doesn't allow contractors to offset the amounts withheld against estimated quarterly income or payroll tax obligations. "Companies that properly pay their tax obligations will experience cash shortages equal to the amounts withheld until the amounts are recovered through the normal federal income tax process," the report noted.

"That would put companies out of business because many don't have margins that are 3 percent," said the industry official. He added that subcontractors could be disproportionately burdened as the 3 percent withholding likely will be determined by the total contract amount, not the smaller portion they were awarded.

The IRS did not respond to requests for comment.

A number of organizations continue to advocate the repeal of section 511, including the U.S. Chamber of Commerce and the Government Withholding Relief Coalition.