[Federal Register Volume 76, Number 89 (Monday, May 9, 2011)]
[Rules and Regulations]
[Pages 26583-26603]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-10760]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 31

[TD 9524]
RIN 1545-BG45


Extension of Withholding to Certain Payments Made by Government 
Entities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to 
withholding by government entities. These regulations reflect changes 
in the law made by the Tax Increase Prevention and Reconciliation Act 
of 2005 that require Federal, State, and local government entities to 
withhold income tax when making payments to persons providing property 
or services. These regulations affect Federal, State, and local 
government entities that will be required to withhold and report tax 
from payments to persons providing property or services and also affect 
the persons receiving payments for property or services from the 
government entities.

DATES: Effective Date: These regulations are effective on May 9, 2011.
    Applicability Date: For dates of applicability, see Sec. Sec.  
31.3402(t)-1(d), 31.3402(t)-2(i), 31.3402(t)-3(g), 31.3402(t)-4(u), 
31.3402(t)-5(e), 31.3402(t)-6(d), 31.3402(t)-7(b), 31.3406(g)-2(i), 
31.6011(a)-4(d), 31.6051-5(g), 31.6071(a)-1(g), 31.6302-1(n), and 
31.6302-4(e).

FOR FURTHER INFORMATION CONTACT: A.G. Kelley, (202) 622-6040 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 31 under section 
3402(t) of the Internal Revenue Code (Code). This document also 
contains amendments to 26 CFR part 31 under sections 3406, 6011, 6051, 
6071, and 6302 of the Code.
    Section 3402(t) of the Code was added by section 511 of the Tax 
Increase Prevention and Reconciliation Act of 2005, Public Law 109-222 
(TIPRA), 120 Stat. 345, which was enacted into law on May 17, 2006. 
Section 3402(t)(1) provides that the Government of the United States, 
every State, every political subdivision thereof, and every 
instrumentality of the foregoing (including multi-State agencies) 
making any payment to any person providing any property or services 
(including any payment made in connection with a government voucher or 
certificate program which functions as a payment for property or 
services) shall deduct and withhold from such payment a tax in an 
amount equal to 3 percent of such payment. Section 3402(t)(2) provides 
exceptions to withholding under section 3402(t).
    Proposed regulations under sections 3402(t), 3406, 6011, 6051, 
6071, and 6302 of the Code were published in the Federal Register on 
December 5, 2008 (REG-158747-06, 73 FR 74082, 2009-4 IRB 362).
    After the issuance of the proposed regulations, section 1511 of the 
American Recovery and Reinvestment Act of 2009, Public Law 111-5 
(ARRA), 123 Stat. 115, 355, extended the effective date of section 
3402(t) withholding to payments made after December 31, 2011.
    Notice 2010-91, 2010-52 IRB 915, provided interim guidance on the 
application of section 3402(t) to payments by debit cards, credit 
cards, stored value cards, and other payment cards.
    Written comments were received in response to the proposed 
regulations, and a public hearing was held on April 16, 2009. All 
comments are available at http://www.regulations.gov or upon request. 
After consideration of all the comments, the proposed regulations are 
adopted as amended by this Treasury decision.

Summary of Comments and Explanation of Provisions

    The Treasury Department and the IRS received numerous comments in 
response to the proposed regulations, all of which were considered in 
formulating the final regulations. Commenters generally expressed 
concerns about the administrative burdens of compliance and the revenue 
effect on persons subject to section 3402(t) withholding. The final 
regulations are intended to balance the legislative intent to construct 
a withholding and reporting regime for payments by government entities 
for property and services (other than those specifically excepted under 
section 3402(t)(2)) with the goal of alleviating administrative burdens 
on both

[[Page 26584]]

government entities required to withhold and persons receiving payments 
subject to withholding where appropriate.
    As discussed in section IX of the preamble, these final regulations 
provide an additional one-year extension from the revised statutory 
effective date of payments made after December 31, 2011. Thus, under 
the final regulations, section 3402(t) withholding and reporting 
requirements apply to payments made after December 31, 2012, subject to 
an exception for payments made under contracts existing on December 31, 
2012, that are not materially modified (but see section IX of this 
preamble for discussion of accompanying proposed regulations that would 
apply section 3402(t) withholding and reporting requirements to 
payments made under all contracts after December 31, 2013, regardless 
of whether the contract was existing on December 31, 2012, and had not 
been materially modified).

I. Government Entities Subject to Section 3402(t)

A. Exception for Political Subdivisions and Instrumentalities Making 
Total Payments Under $100,000,000 (Section 3402(t)(2)(G))
    Section 3402(t)(2)(G) provides that section 3402(t) withholding 
does not apply to payments by a political subdivision of a State (or 
any instrumentality of that political subdivision) that makes less than 
$100,000,000 of payments for property or services annually (other than 
for payroll or of another type exempt from withholding under the 
regulations). Consistent with the proposed regulations, the final 
regulations provide as a general rule that eligibility for the 
exception for each calendar year is determined based on payments made 
during the accounting year ending with or within the second preceding 
calendar year. All payments for property and services during that 
accounting year, including payments that are less than the $10,000 
payment threshold, must be considered except payments qualifying for 
any of the exceptions under Sec.  31.3402(t)-4(a) through (q) of the 
final regulations (for example, payments to the employees of the 
government entity that are subject to income tax withholding and thus 
excludable under Sec.  31.3402(t)-4(a) (such as salary payments) and 
payments to employees of the government entity with respect to their 
services as an employee that are excludable under Sec.  31.3402(t)-4(i) 
(such as payments of nontaxable fringe benefits)).
    Commenters stated that if the political subdivision's or 
instrumentality's yearly payments generally are near $100,000,000, but 
do not always equal or exceed $100,000,000, the entity could incur 
considerable expense and difficulty administering withholding in some 
years but not in others. In addition, providing for withholding in 
contracts would be problematic and uncertain. Other commenters noted 
that due to substantial unusual capital spending, a political 
subdivision or instrumentality could exceed the $100,000,000 threshold 
in one year, even though the entity usually makes annual total payments 
well below the threshold. The burden of applying section 3402(t) 
withholding for a single year because of one year of unusual spending 
could be considerable.
    In response to these comments, the final regulations provide an 
optional rule under which a political subdivision or instrumentality 
may average the payments made during any four of the five consecutive 
accounting years ending with the accounting year that ends with or 
within the second preceding calendar year. An entity applying this 
optional rule must keep adequate records for each of the five years for 
the period of limitations for assessment applicable to the calendar 
year for which it claimed the exception. This rule is intended to 
provide a reasonable alternative method of determining expenditures for 
a political subdivision or instrumentality with an unusually high year 
of expenditures.
    This optional rule will give greater predictability for future 
years and will allow political subdivisions and their instrumentalities 
to moderate the effect of unusual years of expenditures. The entity may 
apply the optional rule at its discretion for any given taxable year 
and is not required to file a form or otherwise indicate to the IRS 
that it is using the optional rule. Additionally, under the final 
regulations, if a political subdivision or instrumentality withholds 
under section 3402(t), pays (or deposits) the withheld tax, and reports 
this withholding on payments in any calendar year for which it does not 
qualify for the section 3402(t)(2)(G) exception under the general rule, 
but could have qualified under the optional rule, it will be deemed to 
have waived any right to use the optional rule for that year. Thus, an 
affected entity should decide before the beginning of the calendar year 
whether it will rely on the optional rule for that year.
    One commenter requested a similar exception for Federal Government 
entities and State entities with total annual payments of less than 
$100,000,000. By its terms, section 3402(t)(2)(G) does not apply to the 
United States Government, States, or instrumentalities of the United 
States Government or States. Therefore, this comment was not adopted.
B. Determining Whether an Organization Is an Instrumentality
    The proposed regulations requested comments on how to determine 
whether an organization is an instrumentality of a government entity. 
Commenters did not request a definition. The final regulations do not 
define the term instrumentality, but reserve the issue for future 
guidance. See Sec.  31.3402(t)-2(e). Although the Code contains 
multiple references to government instrumentalities, neither the Code 
nor the regulations define the term instrumentality. Several revenue 
rulings provide guidance on determining whether an organization will be 
treated as an instrumentality of a government entity for purposes of 
other Code provisions. See Rev. Rul. 57-128, 1957-1 CB 311 (adopting a 
six-factor test for use in determining what is an instrumentality of a 
State or a political subdivision thereof for purposes of an exception 
from the requirement to pay tax under the Federal Insurance 
Contributions Act (FICA)); Rev. Rul. 65-26, 1965-1 CB 444; Rev. Rul. 
65-196, 1965-2 CB 388; and Rev. Rul. 69-453, 1969-2 CB 182. These 
rulings may be applied by analogy to determine whether an entity is an 
instrumentality for purposes of section 3402(t) withholding until final 
guidance is issued defining the term instrumentality for purposes of 
section 3402(t). See Sec.  601.601(d)(2)(ii)(b).

II. Payments Subject to Section 3402(t) Withholding

A. Payments by Credit Card or Other Payment Card
    The final regulations reserve for future guidance the issue of the 
potential application of section 3402(t) withholding to payment card 
transactions (including payments by credit, debit, stored value, and 
other payment cards). See Notice 2010-91 and Sec.  31.3402(t)-3(e). The 
Treasury Department and the IRS continue to study whether payments by 
payment card should be subject to section 3402(t) withholding and, if 
so, in what manner the withholding should apply. As provided in Notice 
2010-91, the section 3402(t) withholding requirements and the related 
reporting requirements will not apply to any payment made by payment 
card for any calendar year beginning earlier than at least 18

[[Page 26585]]

months from the date further guidance is finalized applying section 
3402(t) withholding to payments by payment card. This relief does not 
apply to convenience checks issued in connection with payment card 
accounts.
B. The $10,000 Payment Threshold
    Consistent with the proposed regulations, the final regulations 
provide that a payment subject to withholding arises when the 
government entity or its payment administrator pays a person for 
providing property or services. The final regulations adopt the rule in 
the proposed regulations that withholding will not apply to any payment 
that is less than $10,000 (subject to the anti-abuse rule described in 
section II.B.3 of this preamble).
1. Amount of Payment Threshold
    Commenters generally approved of the concept of a threshold, and 
many commenters approved of the proposed $10,000 threshold level. 
However, numerous commenters requested that the threshold be raised, 
and some commenters requested that the threshold be adjusted each year 
based on changes in the cost of living.
    The final regulations adopt the payment threshold of $10,000, which 
corresponds to a minimum withholding of $300. This $10,000 threshold 
level strikes a reasonable balance between alleviating administrative 
burdens and preserving the legislative intent that the withholding 
requirement apply broadly. The final regulations do not adopt an annual 
cost-of-living adjustment to the threshold. Computer processing and 
transaction systems are becoming increasingly cost-effective so that 
increasing the threshold annually is not warranted.
2. Application of the Payment Threshold to Individual Payments
    Some commenters requested that the payment threshold apply 
cumulatively rather than to individual payments. Under this suggestion, 
section 3402(t) withholding would begin to apply when the payee 
receives payments totaling $10,000 in the aggregate from the government 
entity during the calendar year, and then apply to all subsequent 
payments to the payee during the remainder of the year. The final 
regulations do not adopt this suggestion. As other commenters noted, 
one section or division of a government entity may not be able to 
coordinate its billing with another section's or division's billing on 
a real-time basis. Thus, a requirement to withhold immediately upon 
reaching an annual minimum payment threshold would require the 
establishment of new systems to track and coordinate payments.
3. Application of the Payment Threshold to Multiple Payments to the 
Same Recipient
    The $10,000 threshold applies on a payment-by-payment basis; 
therefore, if a government entity makes a single payment of $10,000 or 
more for multiple items of property or services, the entity must 
withhold on the payment. For example, if a person bills a government 
entity $5,000 each day for seven days of daily services, but the entity 
pays the bills by making one $35,000 payment, the payment threshold is 
applied to the $35,000 payment.
    Consistent with the proposed regulations, the final regulations 
provide that multiple payments by a government entity to a payee 
generally will not be aggregated in applying the $10,000 threshold. The 
final regulations also adopt the anti-abuse rule in the proposed 
regulations providing that if a payment is divided into multiple 
payments primarily to avoid the payment threshold, the payments will be 
treated as a single payment made on the date of the first payment for 
purposes of applying the threshold. For example, if a government entity 
is scheduled to make a contractual payment for landscaping services of 
$15,000 on July 2, 2013, but divides the payment into payments of 
$7,000 and $8,000 on July 1, 2013, and July 2, 2013, respectively, to 
avoid withholding, the government entity will be treated as having made 
a single payment of $15,000 on July 1, 2013. This anti-abuse rule will 
not apply if the primary reason for making multiple payments is 
unrelated to section 3402(t).
    Some commenters expressed concerns about the anti-abuse rule. Some 
argued that it was too subjective and would lead to conflicts between 
government entities and payees. Commenters noted that in many cases, 
the payee controls the billing and the government entity cannot 
determine whether the payee manipulated the billing to avoid the 
threshold or engaged in a normal business practice. Commenters also 
requested guidance on which entity (the payor or the payee) determines 
whether the anti-abuse rule applies. Commenters asserted that 
theoretically every payment below $10,000 will need to be examined to 
determine whether the anti-abuse rule applies.
    An anti-abuse rule is necessary because the parties could 
potentially avoid the threshold by manipulating the amount of each 
payment. Because the government entity is responsible for withholding 
and may not have sufficient information regarding the payee's billing 
process, the final regulations provide that the anti-abuse rule applies 
only if the government entity knew or should have known that the 
payment had been divided (whether by the government entity or as a 
result of divided billing) with the primary purpose of avoiding the 
withholding requirements. The final regulations further provide that in 
determining whether the anti-abuse rule applies, a significant factor 
is whether the government entity has exhibited a pattern or practice of 
intentionally dividing payments (or intentionally permitting divided 
billing) to avoid withholding. Thus, the anti-abuse rule is intended to 
apply only in a limited number of cases.
    Additionally, the final regulations permit a government entity and 
a person providing services or property to that government entity to 
contractually agree that the government entity will or may withhold in 
accordance with the rules governing withholding under section 3402(t), 
on specified payments not subject to section 3402(t) withholding, 
including payments below $10,000. Therefore, the parties could 
contractually agree to permit the government entity to apply, in its 
discretion as it deemed appropriate, the anti-abuse rule. This type of 
contractual provision would enable the parties to avoid disputes about 
whether the anti-abuse rule applies. This provision in the final 
regulations permitting additional withholding does not apply to 
payments already subject to section 3402(t) withholding notwithstanding 
the contractual provision, including amounts subject to section 3402(t) 
withholding solely due to the anti-abuse rule.
4. Application of the Payment Threshold to a Single Payment Covering 
Multiple Billing Items
    Commenters objected to applying the threshold to the payment amount 
where the government entity chooses for its convenience to make one 
payment for different ``unrelated transactions'' (which they termed 
``bundling'' the payment), causing the payment to meet the $10,000 
threshold. Commenters suggested that if a single payment covers more 
than one ``unrelated'' transaction, the threshold should apply 
separately to each transaction, invoice, or billing item, rather than 
to the full payment amount. According to these commenters, applying the 
threshold to bundled payments makes the threshold difficult to program 
into accounts payable systems because the threshold

[[Page 26586]]

amount cannot be applied at the time of the transaction but only at the 
time the payment is processed.
    The final regulations adopt the proposed rule applying the 
threshold on a payment-by-payment basis rather than a billing item 
basis. A billing item approach would require formulating a method for 
identifying a billing item or a similar term, which may not be easily 
identifiable in every case. As a result, disputes would likely arise 
about the number and amount of valid billing items, raising both 
compliance issues for government entities and enforcement issues for 
the IRS. A billing item approach also would require the government 
entity to maintain records of the items covered by a particular 
payment, and the supporting documentation justifying the separate 
billing item treatment, increasing the administrative burden. This 
approach could also facilitate abuse by parties seeking to avoid the 
threshold by dividing billing items.
C. Payments to Contractors, Subcontractors, and Payment Administrators
    Consistent with the proposed regulations, the final regulations 
provide that, if a government entity or its payment administrator makes 
a payment to a person that is subject to section 3402(t) withholding, 
no subsequent transfer of cash or property by that person to another 
person is treated as a payment for section 3402(t) purposes. Therefore, 
if the government entity contracts with a prime contractor for property 
and services, and that prime contractor separately contracts with 
subcontractors for delivery of certain property and services, section 
3402(t) withholding applies only to payments by the government entity 
or its payment administrator to the prime contractor, and does not 
apply to successive payments by the prime contractor to its 
subcontractors.
    Also consistent with the proposed regulations, the final 
regulations apply to payments made by the government entity or its 
payment administrator. A payment administrator is any person that acts 
with respect to a payment solely as an agent for a government entity by 
making the payment on behalf of the government entity to a person 
providing property or services to, or on behalf of, the government 
entity. The government entity is liable for the required withholding 
and responsible for all related reporting regardless of whether the 
government entity or its payment administrator makes the payment. 
Transfers of funds from a government entity to a payment administrator 
to be used by the payment administrator, on the government entity's 
behalf, to pay persons for providing property or services are not 
payments subject to section 3402(t) withholding. However, if the 
government entity pays the payment administrator a fee for its 
services, the fee is a payment subject to withholding.
    Many commenters requested additional guidance on the application of 
section 3402(t) to prime contractors, subcontractors, and payment 
administrators to specific factual situations. The final regulations 
adopt the rules in proposed regulations without change. These rules 
provide general guidance that can be applied to various specific 
situations and it is not practicable to describe all those situations 
explicitly in the regulations. However, the Treasury Department and the 
IRS may issue other forms of guidance in the future if it is determined 
that such guidance is necessary to assist with particularly problematic 
situations.
D. Advance and Interim Payments
    Commenters requested guidance on whether section 3402(t) 
withholding applies to any of the following payments that are made 
before the final delivery and acceptance of service by the government 
entity: Contract financing payments, performance-based payments, 
commercial advance payments, interim payments, progress payments based 
on cost, progress payments based on a percentage or stage of 
completion, or interim payments under a cost-reimbursement contract. 
Commenters requested exceptions for these types of payments because 
withholding would detrimentally affect the cash flows of contractors 
and could result in price increases for government contracts. 
Commenters also argued that in some cases withholding is unnecessary 
because amounts are already withheld from contract payments until the 
completion of a contract. Finally, commenters suggested that government 
entities are protected from loss through other provisions such as the 
Miller Act (40 U.S.C. 3131-3134, discussed in greater detail in section 
IV.E.1 of this preamble).
    Commenters specifically requested that section 3402(t) withholding 
apply to contract financing payments on the date the government entity 
accepts the services or property provided under the contract. Under 
Federal Acquisition Regulations (FAR), a contractor is not entitled to 
liquidate contract financing payments until the government entity has 
accepted the property or services. On this basis, a commenter asserted 
that contract financing payments are not payments for property or 
services until the contract is settled and the property or services are 
``accepted'' by the government entity. The commenter maintained that 
the payment date for section 3402(t) purposes should be the acceptance 
date because interest under the Prompt Payment Act (31 U.S.C. 3903) for 
late payments under a contract does not begin to run until the 
acceptance date.
    The final regulations do not adopt these suggestions. Treating the 
acceptance date as the payment date would add administrative complexity 
to section 3402(t) withholding, as would any attempt to distinguish 
between payments in advance of performance by the contractor, interim 
payments for partial performance, and other designated payments for 
property or services. Treating the date the funds are disbursed as the 
payment date ensures that there will be funds upon which to withhold. 
For these reasons, the final regulations provide that payment is made 
and withholding applies when the funds are disbursed and not when the 
contract is settled and the services or property accepted.
E. Utility Payments
    The proposed regulations provided that, unless otherwise excepted, 
utility payments are subject to section 3402(t) withholding on the same 
basis as payments for other property and services. Commenters requested 
that utility payments be exempted from the withholding requirement on 
the ground that utilities are already subject to regulation and that 
government entities might lose utility services if forced to withhold 
on payment of the utility bill.
    There is no statutory exception for utility payments. In addition, 
all persons receiving payments subject to section 3402(t) withholding, 
including utility companies, are paid the full amount charged, albeit 
in the form of a combination of a cash payment and a deposit of tax 
made to the IRS. Thus, unless otherwise excepted, utility payments are 
subject to section 3402(t) withholding.
F. Other Payments
    Commenters requested exemptions from withholding or lower rates of 
withholding based on a particular industry's profit margin or a 
particular payee's expectation that it will not have any income tax 
liability (because, for example, the payee had net operating losses). 
Commenters also requested exemptions for payees that are current in 
their Federal tax payments. The final regulations do not adopt these 
suggestions because differing rates for

[[Page 26587]]

differing industries or taxpayers are not contemplated by the statute 
and would raise administrative complexities.
    In addition, many commenters requested guidance on whether certain 
types of payments or designated portions of payments are payments for 
property or services subject to section 3402(t) withholding. The final 
regulations do not adopt most of these suggestions because the general 
rules provide sufficient guidance. For example, commenters requested 
guidance on certain amounts that typically are part of a payment for a 
specific service or property, but generally are stated separately in 
invoices to government entities, such as fuel surcharges. The final 
regulations do not except separately stated costs (other than the 
optional rule permitting sales, excise, and value-added taxes to be 
excepted from the amount subject to section 3402(t) withholding). In 
general, separately stated items such as fuel surcharges are treated as 
part of the payment for property or services by the government entity, 
and therefore are subject to section 3402(t) withholding unless an 
exception applies. For example, the amount subject to withholding 
includes late payment fees (that are not interest) and shipping and 
handling costs in connection with the purchase of property that is 
subject to section 3402(t) withholding.
    Commenters also requested guidance on determining the amount 
subject to withholding when a portion of one payment is subject to 
withholding, but the remainder of the payment is excepted from 
withholding. Commenters asserted that it would be difficult to identify 
which portion of the payment was excepted and to apply withholding only 
to the remainder. In response to these administrative concerns, the 
final regulations permit government entities to withhold on the full 
amount of a payment that combines an amount subject to withholding and 
an amount excepted from withholding, provided the payee has consented 
to this additional withholding.
    Commenters requested guidance on determining the amount of 
withholding when a payment for property or services to a person is 
subject to offsets for the person's outstanding debt or other amounts 
owed to the government entity. Because there is no exclusion or other 
provision under section 3402(t) for offsets, the payment to which the 
section 3402(t) withholding applies is not reduced by offsets. Rather, 
the amount of the payment subject to section 3402(t) withholding 
includes any portion of the payment that is offset to pay debt owed to 
the government entity or other offsets.

IV. Payments Excepted From the Section 3402(t) Withholding Requirements

A. Payments to Certain Exempt Payees (Section 3402(t)(2)(E))
    Consistent with the proposed regulations, the final regulations 
except from section 3402(t) withholding payments to other government 
entities required to withhold, to foreign governments, and to tax-
exempt organizations as provided in section 3402(t)(2)(E). A commenter 
asked whether the exception for payments to tax-exempt organizations 
extends to payments that are included in determining the organization's 
unrelated business income that is subject to income tax. A payment to a 
tax-exempt organization is excepted from section 3402(t) withholding 
regardless of whether it is treated as unrelated business income.
B. Payments to Indian Tribal Governments
    Consistent with the proposed regulations, the final regulations 
exempt payments to Indian Tribal governments. Because Indian Tribal 
governments are not subject to United States income tax, subjecting 
payments made by government entities to Indian Tribal governments to 
section 3402(t) withholding would be unduly burdensome. In response to 
comments, the final regulations also exempt payments to passthrough 
entities that are owned 80 percent or more by one or more persons each 
of which is an Indian Tribal government or a person described in 
section 3402(t)(2)(E).
C. Identifying Exempt Payees
    Commenters requested guidance on how to identify exempt payees. 
Exempt payees include: (1) Government entities required to withhold 
under section 3402(t), foreign governments, tax-exempt organizations, 
and Indian Tribal governments; (2) passthrough entities that are 80 
percent or more owned by those types of entities; and (3) nonresident 
alien individuals and foreign corporations that receive certain types 
of payments (and partnerships that receive certain types of payments 
and that are 80 percent or more owned by nonresident alien individuals 
and foreign corporations). The Treasury Department and the IRS expect 
to issue additional guidance on how a payee can claim an exemption. The 
guidance is expected to provide that if the government entity receives 
a payee statement indicating under penalties of perjury that the payee 
qualifies for an exemption from section 3402(t) withholding and 
identifying the particular exemption, the entity will be able to rely 
on that statement unless it knew or had reason to know that the payee 
did not actually qualify for the exception. The guidance is also 
expected to provide that a government entity need not obtain a payee 
statement if the name of the payee reasonably indicates or the payor 
knows the payee to be a government entity (including an Indian Tribal 
government) or foreign government. However, it is not anticipated that 
this ``eyeball'' test would apply to tax-exempt organizations, foreign 
corporations, nonresident alien individuals, or passthrough entities.
D. Payments of Interest (Section 3402(t)(2)(C))
    Section 3402(t)(2)(C) excepts payments of interest from section 
3402(t) withholding. Two commenters requested that a definition of 
interest be provided, and other commenters inquired whether certain 
specific types of payments are payments of interest for purposes of 
this exception.
    The Code and the regulations do not provide a general definition of 
interest. Rather, a definition of interest has arisen through case law. 
Generally, under long-standing case law, interest is compensation paid 
for the use or forbearance of money. See, for example, Old Colony R.R. 
Co. v. Commissioner, 284 U.S. 552 (1932), 1932-1 CB 274; Deputy v. 
DuPont, 308 U.S. 488 (1940), 1940-1 CB 118; see also Thompson v. 
Commissioner, 73 T.C. 878, 887 (1980) (interest is the charge per unit 
of time for the use of borrowed money); Dickman v. Commissioner, 465 
U.S. 330, 337 (1984), 1984-1 CB 197 (interest is the equivalent of rent 
for the use of funds). The general standard, as developed through the 
case law, may be applied to particular facts and circumstances. Thus, 
the final regulations do not provide a definition of interest. However, 
the Treasury Department and the IRS continue to study whether any 
particular guidance with respect to the application of section 3402(t) 
to interest payments may assist taxpayers in complying with the section 
3402(t) withholding and reporting requirements, and accordingly 
continue to reserve that section. See Sec.  31.3402(t)-4(c).

[[Page 26588]]

E. Payments for Real Property (Section 3402(t)(2)(D))
1. Construction Payments
    Section 3402(t)(2)(D) excepts payments for real property from 
section 3402(t) withholding. Consistent with the proposed regulations, 
the final regulations provide that the term payments for real property 
includes payments for the purchase and the leasing of real property, 
but does not include payments for the construction of buildings or 
other public works projects, such as bridges or roads.
    Commenters requested that payments for construction be treated as 
payments for real property. One commenter interpreted 40 U.S.C. 3131-
3134 (the ``Miller Act'') as already protecting the Federal Government 
for taxes owed by the contractor. The commenter stated that the Miller 
Act mandates that the contractor provide a performance bond to protect 
the Government, and a separate payment and performance bond to protect 
all persons supplying labor and material in carrying out the work 
provided for in the contract. According to the commenter, the 
protection afforded by these bonds includes taxes due under the Code. 
See 40 U.S.C. 3131(c)(1).
    The tax protection afforded by these bonds relates to employment 
taxes deducted from wages, not to income taxes which the contractor may 
owe. Therefore, these performance bonds do not protect against a 
contractor's failure to pay its correct income tax liability, and the 
Miller Act does not provide the Federal Government protection for the 
contracting entity's income tax liability.
    Another commenter suggested that treating payments for construction 
as payments for real property would be consistent with other tax 
provisions, including section 460(e)(4) and Sec.  1.460-3(a) (defining 
the term construction contract for purposes of determining whether an 
exception from the required use of the percentage of completion method 
in determining taxable income applies), and Sec.  1.263A-8 (defining 
the term real property to include land, buildings, and inherently 
permanent structures, and the structural components of both buildings 
and inherently permanent structures for purposes of the requirement to 
capitalize interest under section 263A). Another commenter cited other 
Code sections and regulations, including: (1) Section 469 (relating to 
passive activity losses and credits and providing that a ``real 
property trade or business'' includes ``any real property development, 
redevelopment, construction, reconstruction, acquisition, conversion, 
rental, operation, management, leasing, or brokerage trade or 
business''); (2) section 856 (defining ``interests in real property'' 
to include ``fee ownership and co-ownership of land or improvements 
thereon, leaseholds of land or improvements thereon, options to acquire 
land or improvements thereon, and options to acquire leaseholds of land 
or improvements thereon''); and (3) Sec.  1.1031(a)-1(b) (relating to 
like-kind exchanges and providing that the fact that any real estate 
involved is improved or unimproved is not material, for that fact 
relates only to the grade or quality of the property and not to its 
kind or class).
    The final regulations do not adopt these suggestions. None of these 
authorities provides as a general rule that payments for construction 
are payments for real property. Moreover, the Code and regulations 
sections cited serve different purposes. The relevant distinction here 
is between payment for a completed building (a payment for real 
property), and payment for the services and materials used to construct 
a building (not a payment for real property). There is no evidence that 
Congress intended to exempt payments for construction. Additionally, an 
exemption for construction would substantially reduce the scope of 
payments subject to section 3402(t) withholding.
2. Lease Payments
    The proposed regulations provided that the exemption for payments 
for real property extends to payments for the leasing of real property. 
A commenter asked whether payments for construction in leased buildings 
are treated as payments for real property if the government entity pays 
the person providing the property or services directly for facility 
improvements rather than the lessor. Commenters also asked whether 
payments to the lessor for services or property (such as for utilities 
or insurance) or for services under the lease agreement (such as for 
utilities provided at the lessor's expense) are considered payments for 
the lease. In addition, commenters asked whether payments to third 
parties required by the lease agreement (such as payments for utilities 
and insurance) are considered payments for the lease.
    The final regulations distinguish between payments to the lessor as 
part of the lease and payments to a third party. Payments to the lessor 
that are required under the lease agreement, such as payments for 
utilities or insurance, are payments for leasing, and are not subject 
to section 3402(t) withholding. In contrast, payments to third parties 
for services or property are subject to section 3402(t) withholding, 
even if required by the lease. Thus, under the final regulations, the 
lease terms generally govern whether payments for leasehold 
improvements and for services or property in connection with a lease 
are subject to section 3402(t) withholding. However, because of the 
potential to avoid the application of withholding to payments for 
construction by temporarily leasing before purchasing, rather than 
simply purchasing, the property on which the construction will occur, 
payments for construction are subject to section 3402(t) withholding 
even if required by a lease and paid to the lessor.
F. Payments Subject to Other Withholding (Section 3402(t)(2)(A) and 
(B))
    Section 3402(t)(2)(A) excepts from section 3402(t) withholding 
amounts that are subject to withholding under another provision of 
chapter 3 or chapter 24 (other than section 3406). Commenters asked 
whether unpaid compensation paid to beneficiaries or the estates of 
deceased employees is subject to section 3402(t) withholding. Although 
such amounts generally are not subject to wage withholding under 
section 3402(a) (see Rev. Rul. 86-109, 1986-2 CB 196), the final 
regulations provide that these payments are excepted from section 
3402(t) withholding under section 3402(t)(2)(I) as payments to an 
employee.
G. Payments Made Pursuant to a Classified or Confidential Contract 
(Section 3402(t)(2)(F))
    Section 3402(t)(2)(F) excepts payments made pursuant to a 
classified or confidential contract described in section 6050M(e)(3). 
Commenters asked whether this exception applies to other government 
operations not specifically covered by section 6050M(e)(3), 
recommending that the exception apply to any contract whose subject 
matter contains any scope of work subject to the National Industrial 
Security Program Operating Manual (NISPOM). Because of the express 
statutory language describing the confidential contracts to which the 
exception applies, the final regulations do not extend the exception 
beyond contracts described in section 6050M(e)(3).
H. Payments in Connection With a Public Welfare or Public Assistance 
Plan (Section 3402(t)(2)(H))
    Section 3402(t)(2)(H) excepts from section 3402(t) withholding any 
payment in connection with a public

[[Page 26589]]

assistance or public welfare program for which eligibility is 
determined by a needs or income test. Consistent with the proposed 
regulations, the final regulations adopt a broad definition of in 
connection with to include payments made to third parties under a 
public assistance or public welfare program for the benefit of the 
recipient of benefits under the program. Consistent with the 
legislative history, a program for which eligibility is determined 
under a needs or income test does not include a program under which 
eligibility is based on age only (for example, Medicare). For purposes 
of this exception, a program providing disaster relief to victims of a 
natural or other disaster is considered to be a program for which 
eligibility is determined under a needs test.
    Many commenters asked that the regulations address specific 
benefits under various plans. Questions about specific plans can be 
resolved by applying the statute and these final regulations, and 
special rules are not needed. However, the Treasury Department and the 
IRS may issue other guidance in the future, as necessary to address 
arrangements to which it is particularly difficult to determine the 
application of the statute and these final regulations.
    Commenters asked how section 3402(t) applies when a government 
office or portion of a government office is used to administer a public 
welfare program. Commenters asked whether payments for expenses of that 
office (utilities, property insurance, maintenance) that are 
attributable to administering the public welfare program qualify as 
payments made in connection with a public welfare program under section 
3402(t)(2)(H). The final regulations provide that government entities 
may determine the portion of any payment that is attributable to 
expenses to administer the public welfare program using any reasonable 
allocation method (including, for example, using prospective budget 
allocations). To ease administration, the final regulations also 
provide that, if a government entity makes a reasonable, good faith 
determination that only an insignificant portion of the government 
office's payments are attributable to administering a public welfare 
program (or to functions other than administering a public welfare 
program), that insignificant portion may be disregarded.
I. Payments to a Government Employee for Services as an Employee 
(Section 3402(t)(2)(l))
    Section 3402(t)(2)(I) excepts payments to a government employee for 
the employee's services as an employee. Consistent with the proposed 
regulations, the final regulations interpret this exception broadly to 
exclude any form of compensation that is paid to the employee or on the 
employee's behalf. For example, the final regulations exclude employer 
and employee contributions to employee benefit and deferred 
compensation plans, employer-provided fringe benefits, and employer 
payments for insurance under the Federal Employees Health Benefits 
Program.
    The final regulations further provide that, consistent with the 
proposed regulations, the section 3402(t)(2)(l) exception applies to 
payments to employees under an accountable plan for the employee's 
business travel expenses, and to payments made by the employee to 
providers of the employee's travel, meals, and lodging when the 
employee is traveling on government business and is reimbursed under 
the accountable plan. Payments to an employee made under a 
reimbursement or other expense allowance arrangement that do not exceed 
the substantiated expenses are treated as paid under an accountable 
plan and are not wages if the arrangement meets the requirements of 
section 62(c) and the expenses are substantiated within a reasonable 
period of time. See Sec.  31.3401(a)-4(a). In contrast, payments to an 
employee under a nonaccountable plan are includible in wages subject to 
income tax withholding under section 3402(a), and thus are excepted 
from section 3402(t) withholding by section 3402(t)(2)(A).
    Commenters requested that payments by a government entity to third 
party providers (and not to an employee) for employee travel and 
lodging also be excepted from section 3402(t) withholding, arguing that 
these payments are another way to pay for employee business travel 
expenses and should be excepted in the same manner as payments made 
under accountable plans. Commenters argued that applying withholding in 
this instance will complicate the travel arrangement process, reduce 
the use of more efficient central billing accounts, and create 
unjustified discrepancies in travel expense reimbursements based on the 
employer method of payment.
    The section 3402(t)(2)(I) exception by its terms applies only to 
payments to employees (or their successors in interest). If the 
government entity pays a provider directly for employee travel 
expenses, there is no payment from the government entity to the 
employee to invoke this exception. Payments to the provider by the 
government entity are payments for property and services, and therefore 
subject to section 3402(t) withholding unless another exception 
applies. The exception for employee fringe benefits does not apply 
where a payment is made directly to the provider because, while related 
to the provision of a fringe benefit to the employee, the payment 
itself is not a fringe benefit and is made to a third party rather than 
to the employee. However, payments made by payment card are excepted 
pending future guidance. See Notice 2010-91.
J. Grants
    The proposed regulations did not provide an explicit exception for 
grant payments. Commenters requested that all grant payments be 
excluded from section 3402(t) withholding because they are ``non-
exchange'' transactions in which the government entity is not making a 
payment for property or services for the direct benefit or use of the 
government entity. According to commenters, grant payments are 
distinguishable from payments in a transaction with a vendor in which a 
government entity is directly purchasing property or services for its 
own benefit or use.
    Commenters also recommended that section 3402(t) withholding not 
apply to the use of grant funds by grant recipients that are complying 
with the grant eligibility and award process. One commenter cited the 
example of a city or county fire department that receives a grant from 
a government entity specifically for the purchase of an emergency 
response vehicle. If the purchase of an emergency response vehicle by 
the local fire department were subject to section 3402(t) withholding, 
the commenter maintained the withholding would divert Federal grant 
money from the authorized acquisition use into the three percent 
withholding process.
    In cases where the grant recipient is another government entity or 
a tax-exempt organization, the grant payment will be excepted from 
section 3402(t) withholding under section 3402(t)(2)(E). In addition, 
grant payments may qualify as payments made in connection with a public 
assistance or public welfare program for which eligibility is 
determined by a needs or income test, and thus be excepted from 
withholding under section 3402(t)(2)(H). Thus, it seems likely that 
many grant payments

[[Page 26590]]

will qualify for these statutory exceptions.
    In light of the administrative difficulty and potential frustration 
to the intended use of the grant proceeds that may arise, the final 
regulations explicitly except all grants from section 3402(t) 
withholding. For this purpose, the final regulations define a grant as 
a transfer of funds by a government entity to a recipient (which may be 
a state government, local government, or other recipient) pursuant to 
an agreement reflecting a relationship between the government entity 
and the recipient when (1) the principal purpose of the relationship is 
to transfer a thing of value to the recipient to carry out a public 
purpose of support or stimulation authorized by law instead of 
acquiring (by purchase, lease, or barter) property or services for the 
direct benefit or use of the government entity; and (2) substantial 
involvement is not expected between the government entity and the 
recipient when carrying out the activity contemplated in the agreement.
    The exception from section 3402(t) withholding for grants does not 
apply to the distribution of grant proceeds by a government entity. 
Commenters' suggestions that grant proceeds be permanently excepted 
from withholding if the grant recipient is using the proceeds for the 
purposes specified in the grant is not supported by the statute and 
would be difficult to administer. Tracing would be required to 
determine which government entity purchases had been made with grant 
proceeds. Tracing would be particularly difficult if the grant 
agreement does not identify specific uses for the proceeds (for 
example, to purchase items necessary to improve emergency response 
time, which may include an additional emergency response vehicle) or if 
only a portion of a payment consists of grant proceeds. Accordingly, 
the final regulations do not adopt this suggestion.
K. Sales Tax, Excise Tax, and Value-Added Tax
    Commenters requested guidance on whether the payment subject to 
withholding includes the amount of any sales tax, excise tax, or value-
added tax. Sales taxes are generally paid by the purchaser, collected 
by the vendor, and remitted to the state. The sales tax amount 
generally is not included in the vendor's gross income.
    By comparison, information reporting under section 6041 and related 
backup withholding under section 3406 apply only to payments that are 
includible in the payee's income. Therefore, if the payee is liable for 
sales tax and the payor includes the amount of sales tax in the total 
payment to the payee, the payor includes the amount of sales tax on 
Form 1099-MISC, ``Miscellaneous Income,'' as part of the reportable 
payment. In contrast, if (as is generally the case) the payor is liable 
for any sales tax and the payee merely collects sales tax from the 
payor, the payor does not include sales tax in the total amount 
reported on Form 1099-MISC.
    A different reporting rule applies to reportable payment card 
transactions under section 6050W. Section 1.6050W-1(a)(6) provides that 
the gross amount reportable on Form 1099-K, ``Merchant Card and Third 
Party Network Payments,'' is the total dollar amount of aggregate 
reportable payment transactions for each participating payee without 
regard to any adjustments for credit, cash equivalents, discount 
amounts, fees, refunded amount or any other amounts. Thus, the gross 
amount reported on Form 1099-K includes the amount of sales tax, excise 
tax, or value-added tax paid as part of a payment transaction.
    Similar to reporting under section 6050W, but in contrast to 
reporting under section 6041, section 3402(t) withholding does not 
depend on whether an amount is includible in gross income. The entire 
amount paid for property or services is subject to withholding 
regardless of whether the vendor realizes a profit on transactions 
covered by the payments. Accordingly, the final regulations provide 
that the amount subject to withholding and reporting includes any 
sales, excise or value-added tax. However, the final regulations also 
permit government entities to exclude the amount of any sales, value-
added, or excise tax, for purposes of section 3402(t) withholding, 
provided the exclusion is applied consistently to all payments to a 
given payee during the calendar year. This rule is similar to the rules 
permitting payors to exclude the amount of the wager from gambling 
winnings for reporting and withholding purposes under Sec.  31.3406(g)-
2(d)(2) or to exclude commissions and option premiums in determining 
gross proceeds from securities sales for reporting purposes under Sec.  
1.6045-1(d)(5).
L. Loan Guarantees
    Commenters requested guidance on whether loan guarantees provided 
by government entities and payments on loan guarantees are subject to 
section 3402(t) withholding. The final regulations provide that the 
loan guarantee itself (meaning a guarantee provided by a government 
entity on a loan by a lender) is not a payment subject to section 
3402(t). The underlying amounts are still loans and guaranteeing a loan 
or making a loan that is expected to be repaid through the payment of 
principal and interest is not a payment for property or services.
    Payments of principal and interest by the government entity as 
guarantor of the loan so that the borrower can continue performing 
services under the contract are also not subject to withholding under 
section 3402(t). The government entity is making these payments as 
guarantor of the loan, and the payments are being made to the lender, 
not to a third party contractor that is performing services or 
transferring property. Thus, the final regulations provide that 
government entity payments of principal and interest on a loan pursuant 
to a loan guarantee are not subject to section 3402(t) withholding.
    Under some circumstances, borrowers use the funds from guaranteed 
loans to fund a specific project. As part of a loan guarantee, the 
government has the right to assume the operation of the underlying 
project if the borrower ceases making payments on the loan. If the 
government entity (through a right of subrogation) assumes the 
operation of the underlying project, the government entity as the 
operator of the project makes payments to the contractors providing 
services and property for the project. In that case, payments by the 
government entity to third party contractors are payments for property 
or services. Although the government exercised its right of subrogation 
pursuant to the loan guarantee or the underlying loan, and not as a 
party to the underlying contract between the borrower and the third 
party contractors, the government is stepping into the borrower's shoes 
and making payments for property or services directly to the third 
party contractors. Accordingly, the final regulations provide that 
section 3402(t) withholding applies in that case.
M. Debt Repayments and Stock and Bond Purchases
    Commenters requested clarification that a government entity's 
repayments of principal on a loan are not subject to section 3402(t) 
withholding. Generally, repayments of principal on a loan will not be 
subject to section 3402(t) withholding because they are not payments 
for property or services. However, if a government entity issues a debt 
obligation to a person providing services as part of the purchase 
price, the debt's fair market value is subject to section 3402(t) 
withholding when the obligation becomes effective, unless an exception 
applies. If a government

[[Page 26591]]

entity issues a debt obligation to a person providing property as part 
of the purchase price, the debt's issue price as determined under 
section 1273 or 1274, as applicable, is subject to section 3402(t) 
withholding unless an exception applies (for example, the exception for 
payments for real property will apply to a debt obligation issued as 
part of a government entity's purchase of real property). For 
administrative convenience, the regulations allow the government entity 
and the person providing property to agree to use the stated principal 
amount of the debt obligation in lieu of the issue price as the amount 
of the payment attributable to the debt obligation that is subject to 
section 3402(t) withholding. Thus, for example under these rules, if a 
government entity pays a person in 2013 for the performance of services 
with $50,000 cash and a 5-year note valued at $50,000, then the note's 
fair market value would be subject to section 3402(t) withholding in 
2013 along with the cash payment, but the repayment of the principal 
after the note matured in 2018 would not be subject to section 3402(t) 
withholding. If a government entity uses a third party debt obligation 
(a debt obligation issued by another government entity or by an entity 
other than a government entity) to pay for property or services, the 
fair market value of the debt obligation is subject to section 3402(t) 
withholding, unless an exception applies.
    The final regulations also except payments to purchase stock, 
bonds, and other negotiable instruments primarily for investment 
purposes. Although these payments are for intangible property, 
withholding on purchases in stock and bond markets is not practicable 
given the functioning of the investment markets in which buyers and 
sellers are paired on a virtually anonymous basis. However, a 
government entity's payment of investment advisory fees to investment 
advisors (including a payment from the government entity's account) is 
a payment for services subject to section 3402(t) withholding. In 
contrast, investment advisory fees paid, for example, by a mutual fund 
in which a government entity owns shares are not subject to section 
3402(t) withholding, since these payments are not made by the 
government entity.

V. Application of Section 3402(t) to Passthrough Entities

    The final regulations generally adopt the same basic rules as the 
proposed regulations on applying section 3402(t) where either the payor 
or the payee is a partnership or S corporation (a passthrough entity). 
Payments from a passthrough entity generally are not subject to section 
3402(t) withholding unless 80 percent or more of the passthrough entity 
is owned in the aggregate by government entities required to withhold 
under section 3402(t)(1). Similarly, payments to a passthrough entity 
generally are subject to section 3402(t) withholding unless 80 percent 
or more of the passthrough entity is owned in the aggregate by persons 
described in section 3402(t)(2)(E) (government entities required to 
withhold under section 3402(t)(1), tax-exempt entities, and foreign 
governments) and Indian Tribal governments. Expanding on the exceptions 
in the proposed regulations, the final regulations additionally provide 
that certain payments to a partnership that is 80 percent or more owned 
by foreign corporations or nonresident alien individuals are not 
subject to section 3402(t) withholding. This exception does not apply 
to S corporations because nonresident alien individuals and foreign 
corporations are not permissible shareholders of an S corporation under 
section 1361(b)(1). The regulations also provide that, as a general 
rule, whether a passthrough entity is subject to section 3402(t) is 
determined on the first day of the passthrough entity's taxable year. 
However, any manipulation of the ownership percentage with intent to 
avoid application of section 3402(t) will be recharacterized as 
appropriate to reflect the actual ownership percentage. Because the 
government entity is responsible for withholding and may not have 
sufficient information regarding the payee's ownership structure, the 
final regulations provide that this rule applies only if the government 
entity knew or should have known that the payee's ownership percentage 
had been manipulated with intent to avoid application of section 
3402(t).
    Commenters requested that payments to all passthrough entities be 
excepted from section 3402(t) withholding. The final regulations do not 
adopt this suggestion. A passthrough entity exemption would create 
opportunities for payees to circumvent section 3402(t) by using 
passthrough entities to receive government payments.

VI. Deposits and Reporting of Amounts Withheld Under Section 3402(t)

    The final regulations adopt the same reporting and payment rules 
for section 3402(t) withholding purposes as the proposed regulations. 
Final regulations under section 6011 provide that the payor required to 
withhold under section 3402(t) must file Form 945, ``Annual Return of 
Withheld Federal Income Tax,'' reporting the amounts withheld. Final 
regulations under section 6302 provide that the amounts withheld under 
section 3402(t) must be deposited and reported in the same manner as 
other nonpayroll withheld amounts, such as withholding on gambling 
winnings and pensions. Pursuant to existing regulations, these amounts 
are treated as if they were employment taxes for purposes of the 
deposit rules, but are subject to special rules for determining the 
payor's deposit schedule. See Sec.  31.6302-4. Additionally, final 
regulations under section 6051 provide that payors required to withhold 
amounts under section 3402(t) must file information returns and furnish 
payee statements on Form 1099-MISC, ``Miscellaneous Income'' (or any 
successor form), reporting such payments and tax withheld. Because this 
reporting is pursuant to regulations under section 6051, the exceptions 
provided in the regulations under section 6041 relating to Form 1099 do 
not apply.

VII. Crediting of Amounts Withheld

A. Credit Against Income Tax
    Commenters requested that the regulations permit fiscal year 
taxpayers to credit amounts withheld against their income tax liability 
for the fiscal year in which the tax is withheld. The final regulations 
do not adopt this suggestion because it is inconsistent with the 
statute. Section 31 governs the taxable year against which a taxpayer 
may credit income tax. Section 31(a)(1) provides that ``[t]he amount 
withheld as tax under chapter 24 shall be allowed to the recipient of 
the income as a credit against the tax imposed by this subtitle.'' 
Chapter 24 includes section 3402(t), and section 31(a)(1) is in 
subtitle A, income taxes. Thus, by its terms, section 31(a)(1) applies 
to persons who have had income tax withheld from a payment pursuant to 
section 3402(t). Section 31(a)(2) provides the general rule on the 
timing of the allowance of the credit allowed under section 31(a)(1): 
``The amount so withheld during any calendar year shall be allowed as a 
credit for the taxable year beginning in such calendar year. If more 
than one taxable year begins in a calendar year, such amount shall be 
allowed as a credit for the last taxable year so beginning.'' Thus, 
absent a special rule, section 31(a)(2) generally applies for purposes 
of withholdings required under chapter 24, which includes section 
3402(t).
    Section 31(c) provides a special rule solely for backup 
withholding. Under

[[Page 26592]]

section 31(c), any credit allowed by section 31(a) for backup 
withholding under section 3406 must be allowed for the taxable year of 
the recipient of the income in which the income is received. Section 
31(c) is limited by its terms to section 3406 withholding only, and 
thus does not apply to section 3402(t) withholding.
    Practical considerations also support the section 31(a)(2) 
crediting rule. Taxpayers generally will have received Forms 1099-MISC 
reporting the withholding prior to filing income tax returns crediting 
the income tax withheld, promoting accuracy in return filing.
B. Credit Against Estimated Income Tax Liability
    Commenters requested that taxpayers be permitted to credit the 
income tax withheld against the estimated tax liability for the 
specific tax quarter in which the income tax is withheld. However, the 
Code specifically provides that crediting for estimated tax purposes 
occurs in the taxable year in which the tax withheld may be taken as a 
credit against income tax liability. See sections 6654(g)(1) and 
6655(g)(1)(B). Thus, the final regulations do not adopt this comment.
C. Credit Against Employment Taxes or Other Taxes
    Many commenters requested that taxpayers be permitted to credit 
their section 3402(t) withholding against employment taxes on wages or 
other taxes. The final regulations do not adopt this suggestion. 
Section 3402(t)(3) directs that crediting occur under the rules in 
section 31(a), which provides for crediting against income tax. As 
noted in the preamble to the proposed regulations, if a statute permits 
income tax payments to be treated as employment tax payments, or vice 
versa, it makes specific provision for that treatment. See, for 
example, section 3510(b) (providing that domestic employment taxes are 
treated as taxes due for estimated tax purposes under section 6654); 
and section 31(b) (providing for the crediting against income tax of 
the special refund of social security tax under section 6413(c) 
applicable when an employee receives wages from two or more employers 
in excess of the social security contribution and benefit base). The 
Code does not provide for section 3402(t) withholding to be treated as 
payments of the taxpayer's employment tax liability. In addition, 
payments of income tax and employment taxes occur under different 
processes, using different forms, and are subject to different 
procedures for corrections of underpayments and overpayments, as well 
as different audit procedures and potential penalties. Therefore, the 
crediting of an amount withheld for income tax against an employment 
tax obligation is not administratively feasible.
D. Credits for Amounts Withheld on Payments to Passthrough Entities
    Amounts withheld on payments to passthrough entities are subject to 
the same crediting rules as payments made to other entities. Thus, a 
passthrough entity with a fiscal year may only claim the credit for its 
fiscal year beginning in the calendar year during which the amount was 
withheld pursuant to section 31(a)(2). The timing of when the owners of 
the passthrough entity take into account the credit would then be 
determined under the rules applicable to that type of passthrough 
entity (for example, section 706 for a partnership). Commenters 
specifically asked how the credit would be allocated by a partnership. 
This allocation is governed by the rules set forth in Sec.  1.704-
1(b)(4)(ii), with appropriate adjustments under section 705.

VIII. Correction of Errors and Liability of Government Entity

    Commenters requested clarification that a government entity is 
liable for tax that the entity was required to withhold under section 
3402(t) but did not withhold, unless the entity can demonstrate that 
the payee has paid its income tax liability. Commenters also requested 
clarification of the rules applicable to corrections of overwithholding 
and underwithholding, and guidance on the effect of repayments, 
underpayments, or overpayments for services or property on the 
determination of section 3402(t) liability.
A. Corrections of Overwithholding and Underwithholding
    Section 3402(t)(3) provides that, for purposes of sections 3403 and 
3404 and for purposes of so much of subtitle F (except section 7205) as 
relates to Chapter 24, Collection of Income Tax at Source, payments to 
any person for property or services that are subject to withholding are 
treated as if the payments were wages paid by an employer to an 
employee. If a government entity fails to withhold the tax imposed by 
section 3402(t), section 3403 applies to determine the government 
entity's liability.
    Section 3403 provides that the employer is liable for the payment 
of tax required to be deducted and withheld under Chapter 24, and is 
not liable to any person for the amount of that payment. Section 
31.3403-1 of the Employment Tax Regulations provides that every 
employer required to deduct and withhold the tax under section 3402 
from an employee's wages is liable for the payment of the tax whether 
or not the employer collects the tax from the employee. If the employer 
fails to withhold all or part of the amount required to be withheld, 
and thereafter the employee pays the tax, section 3402(d) provides that 
the tax will not be collected from the employer. Thus, for purposes of 
section 3402(t), the government entity generally will be liable if it 
fails to withhold unless under section 3402(d) it can demonstrate that 
the contractor reported the amount subject to section 3402(t) 
withholding on its return and paid the income tax due (which may 
include payment through an amended return or settlement of an audit).
    Pursuant to section 3402(t)(3), the rules for adjustments of 
overpayments or underpayments of income tax withholding on wages also 
apply to section 3402(t) withholding. See section 6413, Sec.  
31.6413(a)-2(c)(1), and Sec.  31.6413(a)-1(b)(1)(i) (repayments and 
reimbursements to employees of overwithholding, and correction of 
overpayments of income tax withholding); section 6205 and Sec.  
31.6205-1 (corrections of underpayments of income tax withholding). If 
an error is discovered before a return is filed, the payor must report 
on the return and pay to the IRS the correct amount of income tax 
withholding. Corrections of overwithholding or underwithholding of 
income tax before the return is filed are not adjustments, and a payor 
that discovers an error before a return is filed but does not report 
and pay the correct amount of tax to the IRS may not later correct the 
error through an adjustment.
    For purposes of correcting overpayments of income tax withholding, 
a payor must repay or reimburse the overwithheld income tax to the 
payee in the same calendar year as the original payment in order to 
make an adjustment. The payor can then make that adjustment on its 
return at any time before the period of limitations on credit or refund 
under section 6511 expires for that calendar year. If the amount of the 
overwithheld income tax is not repaid or reimbursed to the payee in the 
same calendar year as the original payment, there is no overpayment to 
be adjusted; rather the amount withheld will be credited to the payee 
and subject to a potential tax refund. However, an adjustment may be 
made to correct an

[[Page 26593]]

administrative error (that is, an inaccurate reporting of the amount 
actually withheld).
    For purposes of correcting underpayments of income tax withholding, 
an adjustment can generally only be made in the same calendar year as 
the original payment. An exception to this general rule applies to 
corrections for administrative errors (that is, an inaccurate reporting 
of the amount actually withheld).
    Pursuant to section 3402(t)(3), the rules for claims for refund of 
income tax withholding on wages also apply to section 3402(t) 
withholding. See section 6414 and Sec.  31.6414-1. Section 6414 permits 
refunds of income tax withholding only to the extent the amount of the 
overpayment was not actually deducted and withheld from the payee.
    Amounts withheld under section 3402(t) are reported on an annual 
Form 945.
    Accordingly, any corrections of overwithholding or underwithholding 
during the calendar year are not adjustments; the government entity 
must report and pay to the IRS the correct amount of tax on Form 945. 
For example, if a government entity pays an amount subject to section 
3402(t) withholding in error to a contractor and the contractor repays 
the net amount to the government entity within the same calendar year, 
the government entity should not report the amount and the related 
withholding on the annual Form 945 (that is, the government entity 
should report and pay the correct amount of tax on Form 945). Because 
the correction is made before the return is filed, the correction does 
not constitute an adjustment. The government entity may reduce its 
deposit of other withholding reportable on Form 945 for that calendar 
year to account for the deposit of section 3402(t) withholding on the 
amount repaid by the contractor. If the contractor repays the 
government entity an amount in a later calendar year, no adjustment can 
be made because an adjustment is permitted only in the case of an 
administrative error (an inaccurate reporting of the amount actually 
withheld) discovered after the filing of the Form 945. The contractor 
already received a credit for the amount withheld under the general 
rules for crediting income tax withholding.
    Similarly, the government entity can collect underwithholding only 
during the same calendar year as the payment (except corrections made 
in the case of administrative errors). If the underpayment is 
discovered in a later calendar year, the government entity is liable 
under section 3403 for any amount that should have been withheld, 
unless under section 3402(d) it can demonstrate that the contractor 
reported the amount subject to section 3402(t) withholding on its 
return and paid the income tax due (which may include payment through 
an amended return or settlement of an audit). The contractor is liable 
for any income tax due on any payment subject to withholding regardless 
of whether the government entity actually withholds any amount from the 
payment.
B. Application of the $10,000 Threshold to Corrections of Erroneous 
Payments
    The final regulations provide that the $10,000 payment threshold 
applies to the actual payment made by the government entity, even if 
the amount of the actual payment is incorrect. For example, if an 
excessive payment is subject to section 3402(t) withholding, the 
subsequent repayment of all or a portion of the initial payment does 
not affect whether the $10,000 threshold was met with respect to the 
initial payment. Any correction of income tax withholding applies only 
to the withholding on the amount repaid and not to the remaining 
portion of the original payment, even if that remaining portion is less 
than $10,000. Similarly, if the payment was less than $10,000 due to an 
insufficient payment to the payee, the $10,000 threshold applies 
separately to the initial payment and the subsequent payment (to make 
up for the insufficient payment) unless the anti-abuse rule applies 
(that is, unless the payment was divided into two or more payments 
primarily to avoid the $10,000 payment threshold).

IX. Extension of Applicability Date and Transition Relief for Existing 
Contracts

    Numerous commenters indicated that an extended period of time 
following the issuance of final regulations would be necessary for 
government entities to adopt the systems and processes necessary to 
comply with the Sec.  3402(t) withholding and related reporting 
requirements. Noting the necessity to formulate government acquisition 
rules that are consistent with the final regulations, as well as the 
infrastructure needed to apply those rules, some commenters stated that 
government entities would need at least 18 months from the issuance of 
final regulations under section 3402(t) to be able to comply.
    In response to these practical considerations, the final 
regulations provide that the withholding and reporting requirements 
under these regulations apply to payments made after December 31, 2012, 
subject to an existing contract exception. Thus, under the regulations, 
payments made under written binding contracts in effect on December 31, 
2012, are not subject to section 3402(t) withholding, while payments 
made after December 31, 2012, under contracts entered into after 
December 31, 2012, are subject to section 3402(t) withholding unless 
otherwise excepted. In addition, if an existing contract is materially 
modified after December 31, 2012, the contract ceases to be an existing 
contract and payments under the contract become subject to section 
3402(t) withholding. With respect to payments before January 1, 2013, 
government entities are not required to apply section 3402(t) 
withholding and the related reporting, and accordingly will not be 
subject to any liability, penalties or interest for failure to do so.
    Commenters requested that the material modification rule be removed 
because of the difficulty in determining whether it applies. Commenters 
anticipated disputes between parties about what constitutes a material 
modification and questioned how such disputes would be resolved. 
Certain commenters also requested that a mere contract renewal not be 
considered a material modification. Some commenters suggested that, in 
lieu of a material modification rule, withholding should apply to all 
contracts after a certain effective date, including those that have not 
been materially modified.
    In response to these comments, at the same time that these final 
regulations are being issued, the IRS and the Treasury Department are 
proposing regulations to provide that the exception for payments made 
under existing contracts will not apply to payments made on or after 
January 1, 2014. See REG-151687-10. Thus, under these proposed 
regulations, payments on or after January 1, 2014, under all contracts 
(existing and new) would be subject to withholding under section 
3402(t) unless an exception applies.
    The final regulations retain the material modification rule but 
provide that a mere contract renewal will generally not be considered a 
material modification. For this purpose, a modification is not a 
material modification unless it materially affects either the payment 
terms of the contract or the services or property to be provided under 
the contract. Thus, for example, a change order (meaning a change in 
the specifications of a contract that the government entity is 
authorized to make under the contract without the contractor's consent) 
generally would not be a material

[[Page 26594]]

modification unless the change materially affected the price or other 
payment terms, or the services or property to be provided. The final 
regulations also provide that modifying a contract to conform to 
changes in the applicable law is not a material modification.
    Several commenters requested guidance on the application of section 
3402(t) withholding to payments under Medicare provider agreements. 
Under the final regulations, Medicare provider agreements in effect as 
of December 31, 2012, are existing contracts for purposes of the 
existing contract exception unless materially modified after December 
31, 2012. Additionally, renewals of Medicare provider agreements will 
not be treated as material modifications to the extent the agreement is 
modified to conform to Federal law. As with other existing contracts, 
the proposed regulations issued with these final regulations would 
provide that payments made by government entities on or after January 
1, 2014, under both existing and new Medicare provider agreements will 
be subject to section 3402(t) withholding.

X. Transition Rule for Interest and Penalties on Underpayments

    Consistent with the proposed regulations, the final regulations 
provide a transition rule for payments for property and services made 
before January 1, 2014. Under this rule, a government entity will not 
be liable for interest and penalties for failure to withhold on 
payments for property or services made before January 1, 2014, if the 
entity made a good faith effort to comply with section 3402(t). 
However, this rule does not relieve the entity from liability for the 
amount of tax required to be withheld under section 3402(t).

Effective/Applicability Date

    These regulations apply to payments made after December 31, 2012. 
In addition, the regulations will not apply to payments under a 
contract existing on December 31, 2012, unless the contract is 
materially modified after December 31, 2012.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking preceding this regulation was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these final regulations is A. G. Kelley, 
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 31

    Employment taxes, Fishing vessels, Gambling, Income taxes, 
Penalties, Pensions, Railroad retirement, Reporting and recordkeeping 
requirements, Social Security, Unemployment compensation.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 31 is amended as follows:

PART 31--EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

0
Paragraph 1. The authority citation for part 31 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *.


0
Par. 2. Sections 31.3402(t)-0, 31.3402(t)-1, 31.3402(t)-2, 31.3402(t)-
3, 31.3402(t)-4, 31.3402(t)-5, 31.3402(t)-6, and 31.3402(t)-7 are added 
to read as follows:


Sec.  31.3402(t)-0   Outline of the Government withholding regulations.

    This section lists paragraphs contained in Sec. Sec.  31.3402(t)-1 
through 31.3402(t)-7.

31.3402(t)-1 Withholding requirement on certain payments made by 
government entities.

    (a) In general.
    (b) Special rules.
    (c) Deposit and reporting requirements.
    (d) Effective/applicability date.

31.3402(t)-2 Government entities required to withhold under section 
3402(t).

    (a) In general.
    (b) Government of the United States.
    (c) State.
    (d) Political Subdivision.
    (e) [Reserved].
    (f) Possessions of the United States.
    (g) Passthrough entities.
    (h) Small entity exception.
    (i) Effective/applicability date.

31.3402(t)-3 Payments subject to withholding.

    (a) In general.
    (b) Payment threshold of $10,000.
    (c) No withholding on successive payments.
    (d) Payments made through a payment administrator or to a 
contractor.
    (e) [Reserved].
    (f) Examples.
    (g) Effective/applicability date.

31.3402(t)-4 Certain payments excepted from withholding.

    (a) Payments subject to withholding under chapter 3 or chapter 
24 (other than section 3406).
    (b) Payments subject to withholding under section 3406 with 
backup withholding deducted.
    (c) [Reserved].
    (d) Payments for real property.
    (e) Payments to government entities, tax-exempt organizations, 
and foreign governments.
    (f) Payments made pursuant to a classified or confidential 
contract.
    (g) Exception for political subdivisions or instrumentalities 
thereof making less than $100,000,000 of payments for property or 
services annually.
    (h) Payments made in connection with a public assistance or 
public welfare program.
    (i) Payments made to any government employee with respect to his 
or her services.
    (j) Payments received by nonresident alien individuals and 
foreign corporations.
    (k) Payments to Indian Tribal governments.
    (l) Payments in emergency or disaster situations.
    (m) Grants.
    (n) Sales tax, excise tax, value-added tax, and other taxes.
    (o) Loan guarantees.
    (p) Debt.
    (q) Investment securities.
    (r) Partially exempt payments.
    (s) Determination of eligibility for exemption.
    (t) Withholding relief for 2012.
    (u) Effective/applicability date.

31.3402(t)-5 Application to passthrough entities.

    (a) In general.
    (b) Definitions.
    (c) Payments from a passthrough entity.
    (d) Payments to a passthrough entity.
    (e) Effective/applicability date.

31.3402(t)-6 Crediting of tax withheld under section 3402(t).
    (a) Crediting against income tax liability only.
    (b) Taxable year of credit.
    (c) Estimated tax.
    (d) Effective/applicability date.

31.3402(t)-7 Transition relief from interest and penalties.

    (a) Good faith exception for interest and penalties on payments 
before January 1, 2014.
    (b) Effective/applicability date.

[[Page 26595]]

Sec.  31.3402(t)-1  Withholding requirement on certain payments made by 
government entities.

    (a) In general. Except as provided in Sec. Sec.  31.3402(t)-3(b) 
and 31.3402(t)-4, the Government of the United States, every State, 
every political subdivision thereof, and every instrumentality of the 
foregoing (including multi-State agencies) making any payment to any 
person providing any property or services must deduct and withhold from 
the payment a tax in an amount equal to 3 percent of such payment.
    (b) Special rules. See Sec.  31.3402(t)-2 for government entities 
required to withhold under this section, Sec.  31.3402(t)-3 for what 
constitutes a payment to a person for property or services and when 
such payment is deemed to occur for purposes of this section, and Sec.  
31.3402(t)-4 for payments that are excepted from withholding under this 
section.
    (c) Deposit and reporting requirements. See Sec.  31.6302-4 for 
deposit requirements with respect to withholding under section 3402(t). 
See Sec. Sec.  31.6011(a)-4(b) and 31.6051-5 for the reporting 
requirements with respect to withholding under section 3402(t).
    (d) Effective/applicability date. (1) Except as provided in 
paragraph (d)(2) of this section, this section applies to payments by 
the Government of the United States, every State, every political 
subdivision thereof, and every instrumentality of the foregoing 
(including multi-State agencies) to any person providing property or 
services made after December 31, 2012.
    (2) Payments made under a written binding contract that was in 
effect on December 31, 2012, are not subject to the withholding 
requirements of this section. The preceding sentence does not apply to 
payments made under any contract that is materially modified after 
December 31, 2012. For this purpose, a material modification includes 
only a modification that materially affects the property or services to 
be provided under the contract, the terms of payment for the property 
or services under the contract, or the amount payable for the property 
or services under the contract. Notwithstanding the foregoing, a 
material modification does not include a mere renewal of a contract 
that does not otherwise materially affect the property or services to 
be provided under the contract, the terms of payment for the property 
or services under the contract, or the amount payable for the property 
or services under the contract. A material modification also does not 
include a modification to the contract to the extent required by 
applicable Federal, State or local law.


Sec.  31.3402(t)-2  Government entities required to withhold under 
section 3402(t).

    (a) In general. The requirement to withhold under section 3402(t) 
and Sec.  31.3402(t)-1(a) applies to the Government of the United 
States (see paragraph (b) of this section) and every State (see 
paragraph (c) of this section), as well as instrumentalities of the 
foregoing. The requirement also applies to political subdivisions of 
every State (see paragraph (d) of this section) and their 
instrumentalities, unless the small entity exception of Sec.  
31.3402(t)-4(g) applies.
    (b) Government of the United States. The Government of the United 
States includes the legislative branch, the judicial branch, and the 
executive branch, and all components of the United States Government. 
Thus, departments and agencies are included within the definition of 
United States Government.
    (c) State. The term State includes the District of Columbia. 
However, an Indian Tribal government is not considered a State for 
purposes of section 3402(t) and Sec.  31.3402(t)-1(a). See section 
7871(a).
    (d) Political subdivision. The term political subdivision for 
purposes of section 3402(t) and Sec.  31.3402(t)-1(a) is defined as a 
political subdivision within the meaning of Sec.  1.103-1(b) of this 
chapter, except that a subdivision of an Indian Tribal government is 
not considered a political subdivision. See section 7871(a) and (d).
    (e) [Reserved].
    (f) Possessions of the United States. For purposes of section 
3402(t) and Sec.  31.3402(t)-1(a), the government of a possession or 
territory of the United States is not treated as a government entity 
subject to the withholding requirements of section 3402(t)(1).
    (g) Passthrough entities. See Sec.  31.3402(t)-5(c) for the 
treatment of payments from certain passthrough entities as subject to 
the withholding requirements of Sec.  31.3402(t)-1.
    (h) Small entity exception. See Sec.  31.3402(t)-4(g) for the 
exception from the withholding requirements of Sec.  31.3402(t)-1 for 
political subdivisions and instrumentalities thereof making less than 
$100,000,000 of payments for property or services annually.
    (i) Effective/applicability date. This section applies to amounts 
paid on or after January 1, 2013.


Sec.  31.3402(t)-3  Payments subject to withholding.

    (a) In general. A payment is subject to withholding for purposes of 
Sec. Sec.  31.3402(t)-1 through 31.3402(t)-7 when paid by a government 
entity to any person, as defined in Sec.  301.7701-6(a) of this 
chapter, for property or services. If, however, the government entity 
uses a payment administrator to pay a person for property or services, 
payment occurs when the payment administrator pays such person. The 
government entity subject to the withholding requirements of Sec.  
31.3402(t)-1 is liable for the withholding required and responsible for 
all related reporting regardless of whether the government entity or 
its payment administrator makes the payment for property or services. 
For this purpose, if a government entity makes an advance payment, 
interim payment, financing payment, or similar payment, the amount is 
treated as paid by the government entity at the time the funds are 
disbursed, regardless of whether the government entity has received or 
accepted the property or services at that time.
    (b) Payment threshold of $10,000-- (1) In general. The term payment 
threshold means an amount equal to $10,000. The withholding 
requirements of Sec.  31.3402(t)-1 will not apply to any payment that 
is less than the payment threshold. Whether a payment is equal to or in 
excess of the payment threshold is determined when the payment is made. 
Thus, the payment threshold applies to the actual payment even if the 
amount of the actual payment is incorrect (except to the extent the 
anti-abuse rule in paragraph (b)(3) of this section applies). A later 
determination that the amount of the payment was in error does not 
affect the application of the payment threshold (except to the extent 
the anti-abuse rule in paragraph (b)(3) of this section applies), so 
that the payment threshold applies to the erroneous payment when made, 
and separately to any additional payment intended to correct an 
erroneous underpayment.
    (2) Payment threshold applied per payment. If a government entity 
makes a single payment to a person for property or services combining 
charges for more than one transaction with the person, the 
determination of whether the payment threshold provided by paragraph 
(b)(1) of this section is met is based on the amount of the single 
payment, rather than the amount attributable to each separate 
transaction. Thus, if a government entity makes a single payment of 
$10,000 or more to a person, the government entity is required to 
withhold on the payment, even if the payment is for more than one 
property or service. The same rule applies if a government entity 
enters

[[Page 26596]]

into multiple transactions with a single person, each of which would 
result in a payment of less than $10,000 if paid separately, but elects 
to make a single payment covering all the transactions such that the 
aggregated payment is $10,000 or more. Under these circumstances, the 
government entity is required to withhold on the aggregated payment.
    (3) Anti-abuse rule. If a government entity or payment 
administrator divides a payment or payments to any person for property 
or services into two or more payments (or permits a person providing 
property or services to divide a request for payment into two or more 
requests for payments) primarily to avoid the $10,000 payment threshold 
provided in paragraph (b)(1) of this section on one or more of these 
payments, the divided payments will be treated as a single payment made 
on the date that the first of these payments is made. This rule will 
not apply to a government entity or payment administrator that makes a 
payment in accordance with the contractual terms, including any 
requests for payments submitted by the person providing property or 
services in compliance with the contractual terms, unless it knows, or 
has reason to know, that the contractual terms regarding payments were 
adopted, or the person providing property or services implemented such 
contractual terms, with the primary purpose of avoiding the $10,000 
payment threshold. In determining whether this paragraph (b)(3) 
applies, a significant factor is whether the government entity or 
payment administrator has exhibited a pattern or practice of dividing 
payments to avoid the $10,000 payment threshold.
    (4) Withholding on excepted payments. A government entity and a 
person providing property or services to that government entity may 
agree in writing that the government entity will or may apply section 
3402(t) withholding to payments not subject to section 3402(t) 
withholding, or an identified portion of payments not subject to 
section 3402(t) withholding (for example, only such payments made from 
a specified agency of the government entity), including payments below 
the payment threshold provided in paragraph (b)(1) of this section. 
This paragraph (b)(4) does not apply to government entity payments that 
are subject to section 3402(t) withholding notwithstanding a 
contractual provision between the parties.
    (c) No withholding on successive payments. If a government entity 
or its payment administrator makes a payment that is subject to the 
withholding requirements of Sec.  31.3402(t)-1 to a person, no 
subsequent transfer of cash or property from that payment by such 
person to another person is treated as a payment subject to withholding 
for purposes of Sec. Sec.  31.3402(t)-1 through 31.3402(t)-7.
    (d) Payments made through a payment administrator or to a 
contractor--(1) Definition. The following rules apply for purposes of 
this section:
    (i) A payment administrator is any person that acts with respect to 
a payment solely as an agent for a government entity by making the 
payment on behalf of the government entity to a person providing 
property or services to, or on behalf of, the government entity.
    (ii) A payment administrator is treated as a person providing 
property or services for purposes of the withholding requirements of 
section 3402(t) to the extent it receives a fee from the government 
entity for its services as a payment administrator for the government 
entity.
    (2) Payments to a contractor. If a person provides property or 
services to a government entity under a contract and is not a payment 
administrator, the person, who is in privity with the government 
entity, is treated as the person providing property or services subject 
to withholding under section 3402(t) for all payments received from the 
government entity, regardless of whether some payments the person 
receives relate to invoices for property or services provided by 
subcontractors.
    (3) Application of payment threshold. Where a government entity 
uses a payment administrator to make a payment, the determination of 
whether the payment meets the payment threshold is made at the time the 
payment administrator makes the payment to the person providing 
property or services. If a government entity makes one transfer of 
funds to a payment administrator that is composed of a fee to 
compensate the payment administrator for its services and other funds 
that are to be paid to persons providing property or services, the 
determination of whether the payment threshold is met on the portion 
that is the fee is made at the time of the transfer of the funds to the 
payment administrator.
    (e) [Reserved].
    (f) Examples. This section is illustrated by the following 
examples:

    Example 1. (i) Prime contractor X has a contract with a 
government entity to provide services and property to the government 
entity. X contracts with numerous subcontractors to provide services 
and property in connection with the contract. While the engagement 
of any particular subcontractor is subject to approval by the 
government entity, the subcontractors are not parties to the 
contract between X and the government entity, and the government 
entity is not a party to the contracts between X and subcontractors. 
Under its contract with the government entity, X submits an invoice 
for $48,000 for providing services and property to the government 
entity, including charges for services and property provided by two 
subcontractors, M and N. The invoice reflects charges of $16,000 for 
M and $2,000 for N. The government entity pays X the entire amount 
of the invoice in one payment of $48,000. X pays M for M's billed 
portion of the invoice in a single payment of $16,000, and X pays N 
for N's billed portion of the invoice in a single payment of $2,000.
    (ii) Under the facts of this Example 1, X is the person 
providing property or services to, or for the benefit of, the 
government entity with respect to the entire amount of the $48,000 
payment under the invoice, including the charges for services or 
property provided by its subcontractors M and N. X is not a payment 
administrator (as defined in paragraph (d)(1)(i) of this section) 
because X is not making payments solely as an agent of the 
government entity to persons providing property or services. 
Instead, X makes payments to subcontractors M and N pursuant to X's 
separate contracts with these subcontractors to which the government 
entity is not a party. Therefore, under paragraphs (a) and (d)(2) of 
this section, the entire amount of the $48,000 payment to X under 
the invoice, including the charges for services and property 
provided by its subcontractors M and N, is the payment subject to 
withholding for purposes of section 3402(t).
    (iii) Under paragraph (b)(1) of this section, the determination 
whether the payment meets the payment threshold is based on the 
entire amount of the payment from the government entity to X. 
Withholding under section 3402(t) applies to the government entity's 
$48,000 payment to X because the payment meets the payment threshold 
and is not otherwise excepted from section 3402(t) withholding. 
Thus, the payment is subject to withholding of 3 percent, or $1440.
    (iv) Payments made by X to the subcontractors, M and N, are not 
payments by the government entity or its payment administrator. 
Thus, X's $16,000 payment to M and X's $2,000 payment to N for 
services or property under the contract are not subject to 
withholding under section 3402(t). See paragraphs (c) and (d)(2) of 
this section.
    (v) The government entity is liable for the $1440 withholding 
required under section 3402(t) on its payment to X and is 
responsible for the related reporting required under Sec.  31.6051-
5. See paragraph (a) of this section. X is the person receiving the 
payment for purposes of reporting under Sec.  31.6051-5. Thus, the 
government entity is responsible for furnishing X with a Form 1099-
MISC, ``Miscellaneous Income'' (or successor form), including the 
entire amount of the payment ($48,000) and the entire amount of the 
withholding ($1440) and filing a Form 1099-MISC with the Internal 
Revenue Service.

[[Page 26597]]

    Example 2. (i) Z has a contract with a government entity to make 
payments as an agent of the government entity to persons providing 
services or property to, or on behalf of, the government entity. The 
only services Z provides under the contract are its services in 
acting as an agent for the government entity in making payments to 
persons providing property or services to, or on behalf of, the 
government. The government entity transfers funds of $71,000 to Z, 
which includes a fee of $1,000 to Z for its services as an agent 
under the contract. Z then makes payments of the $70,000 remainder 
of the funds to persons providing property or services to, or on 
behalf of, the government entity, including a single payment of 
$18,000 to P and a single payment of $7,000 to R.
    (ii) Under the facts of this Example 2, Z is a payment 
administrator (as defined in paragraph (d)(1)(i) of this section) 
because Z makes payments solely as an agent for the government 
entity to persons providing property or services to, or on behalf 
of, the government entity. Under paragraphs (a) and (d) of this 
section, Z is not treated as a person providing property or services 
with respect to $70,000 of the transfer of funds (the amount of the 
funds to be paid to persons providing property or services to, or on 
behalf of, the government entity). Because Z is not treated as a 
person providing property or services with respect to this $70,000 
portion of the funds, this portion of the transfer of funds by the 
government entity to Z is not subject to withholding under section 
3402(t) when transferred to Z.
    (iii) Under paragraph (d)(1)(ii) of this section, the payment 
administrator is treated as a person providing property or services 
with respect to the portion of the $71,000 fund transfer that is a 
fee for its services as a payment administrator, or $1,000. Under 
paragraph (d)(3) of this section, the determination of whether the 
payment threshold is met with respect to the fee portion of the 
payment from the government entity to Z at the time of the payment 
from the government entity to Z is made. Because the $1,000 fee 
portion of the payment falls beneath the $10,000 payment threshold, 
withholding under section 3402(t) is not required with respect to 
that portion of the payment.
    (iv) P and R are persons providing services or property to, or 
on behalf of, the government entity with respect to the payments 
they receive from Z.
    (v) Withholding is required under section 3402(t) on the payment 
by Z, a payment administrator, to a person providing property or 
services to, or on behalf of, a government entity provided the 
payment meets the payment threshold and is not otherwise excepted. 
Under paragraph (d)(3) of this section, the determination of whether 
the payment threshold is met on the payment Z makes to a person 
providing property or services is made at the time Z pays the person 
providing property or services. Under the facts of this Example 2, 
Z's payment to P of $18,000 meets the payment threshold, and 
therefore withholding of $540 under section 3402(t) applies. Z's 
payment to R of $7,000 does not meet the payment threshold, and 
therefore, no withholding under section 3402(t) is required.
    (vi) The government entity, not Z, is liable for any withholding 
required under section 3402(t) on the payments from Z to persons 
providing property or services. Also, the government entity, not Z, 
is responsible for any reporting required under Sec.  31.6051-5 on 
the payment from Z to persons providing property or services. See 
paragraph (a) of this section. Each person providing property or 
services for which withholding is required, not Z, is the person 
receiving the payment for purposes of the reporting required under 
Sec.  31.6051-5 if withholding under section 3402(t) applies. Thus, 
the government entity is responsible for furnishing P Form 1099-MISC 
reflecting the amount of the payment from Z to P of $18,000 and the 
amount of withholding of $540 and filing a Form 1099-MISC with the 
Internal Revenue Service.
    Example 3. (i) On March 1, 2013, a government entity makes a 
payment of $12,000 to Y for providing property or services. The 
payment for property or services is not excepted from withholding 
under Sec.  31.3402(t)-4. On March 20, 2013, it is determined that 
the payment should have been $9,000, and therefore, Y owes the 
government entity $3,000 to repay the excess payment.
    (ii) The facts are the same as in paragraph (i) of this Example 
3, except that, in addition, on April 30, 2013, the government 
entity makes a net payment of $6,000 to Y for providing property or 
services, which is based on the payment of a bill for property or 
services equal to $11,000, which is offset by the repayment of the 
$3,000 debt that Y owes with respect to the erroneous March 1, 2013, 
payment, and the repayment of a $2,000 unrelated debt to the Federal 
Government. No exception from withholding under Sec.  31.3402(t)-4 
applies to the $11,000 amount.
    (iii) The facts are the same as in paragraph (ii) of this 
Example 3, except that, in addition, on May 31, 2013, the government 
entity makes a single payment of $14,000 to Y that consists of a 
$9,000 portion that is subject to section 3402(t) withholding 
(without regard to the payment threshold) and a $5,000 portion that 
is excepted from section 3402(t) withholding under Sec.  31.3402(t)-
4.
    (iv) Under the facts of paragraph (i) of this Example 3, the 
payment on March 1, 2013, is subject to withholding under section 
3402(t) because it meets the payment threshold under paragraph (d) 
of this section. The government entity is liable for withholding 
section 3402(t) tax on the payment equal to 3% of $12,000, or $360. 
The subsequent determination on March 20, 2013, that an incorrect 
amount was paid to Y does not affect the application of the $10,000 
payment threshold to the payment on March 1, 2013. If there were no 
additional payments or repayments between the government entity and 
Y during 2013, and if the government entity correctly withheld $360 
under section 3402(t), the government entity would issue Y a 2013 
Form 1099-MISC (or successor form) reporting $12,000 of payments 
subject to section 3402(t) withholding and $360 of withholding.
    (v) Under the facts of paragraph (ii) of this Example 3, the 
payment on April 30, 2013, is also subject to withholding under 
section 3402(t). As an initial matter, the government entity 
calculates its liability for withholding section 3402(t) on the 
payment equal to 3% of $11,000, or $330, because the amount of the 
payment for purposes of section 3402(t) and the payment threshold is 
not reduced by the amount of offsets for debts owed the government. 
Thus, the payment exceeds the payment threshold under paragraph (d) 
of this section. However, the repayment within the same calendar 
year of the $3,000 excess amount which was paid on March 1, 2013, 
means that the government is entitled to correct its income tax 
withholding liability with respect to Y by the amount of section 
3402(t) withholding paid with respect to the $3,000, or $90. Thus 
the net withholding amount deducted from the $6,000 net payment is 
$240. The offset of $2,000 for other unrelated debt owed the Federal 
Government has no effect on section 3402(t) liability. Neither the 
offset for the $3,000 repayment nor the offset for the $2,000 other 
debt affects the application of the payment threshold to the March 
1, 2013, payment or the April 30, 2013, payment. If there were no 
additional payments or repayments between the government entity and 
Y during 2013, and if the government entity withheld properly, the 
government entity would be required to furnish Y a Form 1099-MISC 
(or successor form) reporting $20,000 of payments subject to section 
3402(t) withholding ($12,000 plus $11,000 less $3,000 repayment) and 
$600 withholding ($360 plus $330 less $90) and to file a Form 1099-
MISC with the Internal Revenue Service.
    (vi) Under the facts of this paragraph (iii) of this Example 3, 
the government entity is not required to withhold on the payment 
because only $9,000 of the payment is potentially subject to section 
3402(t) withholding and this amount does not meet the payment 
threshold. However, under the optional rule of Sec.  31.3402(t)-
4(r), because only a portion of the payment is exempt from section 
3402(t) withholding, the government entity may treat the entire 
amount of the payment as subject to section 3402(t) withholding 
provided the payee has agreed to this withholding. If the government 
entity applies the optional rule of Sec.  31.3402(t)-4(r), the 
payment threshold would be met and the government entity would 
withhold under section 3402(t) the amount of $420, or 3% of the 
$14,000 payment. If the government entity treats the entire amount 
of the payment as subject to section 3402(t) withholding and 
withholds, the entire amount of the payment ($14,000) plus the $420 
withholding would be reported on Form 1099-MISC (or successor form).

    (g) Effective/applicability date. This section applies to payments 
by the Government of the United States, every State, every political 
subdivision thereof, and every instrumentality of the foregoing 
(including multi-State agencies) to any person providing property or 
services made after December 31, 2012.

[[Page 26598]]

Sec.  31.3402(t)-4  Certain payments excepted from withholding.

    (a) Payments subject to withholding under chapter 3 or chapter 24 
(other than section 3406)--(1) In general. Payments are excepted from 
withholding under section Sec.  31.3402(t)-1(a) if they are subject to 
withholding under chapter 3 of the Internal Revenue Code (Code) or 
under sections 3401 through 3405 (other than section 3402(t)).
    (2) Payments subject to withholding under chapter 3. Payments 
subject to withholding under chapter 3 of the Code include those 
payments that are subject to, but exempt from, withholding under 
chapter 3 of the Code on the ground that the payments are exempt from 
United States income tax pursuant to an income tax convention to which 
the United States is a party.
    (3) Payments subject to withholding at election of payee. For 
purposes of this exception from section 3402(t), payments for which the 
payee may elect withholding are exempt from withholding under Sec.  
31.3402(t)-1(a) regardless of whether the payee in fact makes such an 
election. These payments include--
    (i) Unemployment compensation as defined in section 85(b) (see 
section 3402(p)(2));
    (ii) Social security benefits as defined in section 86(d) (see 
section 3402(p)(1)(C)(i));
    (iii) Any payment referred to in the second sentence of section 
451(d) that is treated as insurance proceeds, relating to certain 
disaster payments received under the Agricultural Act of 1949, as 
amended, or Title II of the Disaster Assistance Act of 1988 (see 
section 3402(p)(1)(C)(ii));
    (iv) Any amount that is includible in gross income under section 
77(a), relating to amounts received as loans from the Commodity Credit 
Corporation that the taxpayer has elected to treat as income (see 
section 3402(p)(1)(C)(iii)); and
    (v) Any payment of an annuity to an individual.
    (b) Payments subject to withholding under section 3406 with backup 
withholding deducted. A payment is not subject to withholding under 
section 3402(t) if the payment is subject to withholding under section 
3406, relating to backup withholding, and if backup withholding is 
actually being withheld from such payment.
    (c) [Reserved].
    (d) Payments for real property. Payments for real property are not 
subject to the withholding requirements of Sec.  31.3402(t)-1. For 
purposes of this exception, the term payments for real property 
includes the purchase and the leasing of real property (including 
payments made by a lessee to a lessor related to the use or occupancy 
of the leased property and made in accordance with the terms of the 
applicable lease, but not including either a payment for construction, 
or payment to a person other than the lessor, even if related to the 
use or occupancy of the leased property and required by the terms of 
the lease). However, payments for the construction of buildings or 
other public works projects, such as bridges or roads, are not payments 
for real property.
    (e) Payments to government entities, tax-exempt organizations, and 
foreign governments--(1) Government entities. Payments are not subject 
to withholding under section 3402(t) if the payments are made to 
government entities that are subject to the withholding requirements of 
section 3402(t)(1) pursuant to Sec.  31.3402(t)-2. For purposes of this 
exception, payments to government entities that qualify for the 
exception for political subdivisions and instrumentalities making less 
than $100,000,000 of payments for property and services annually, as 
provided by section 3402(t)(2)(G) and paragraph (g) of this section, 
are treated as payments to government entities that are subject to the 
withholding requirements of section 3402(t)(1).
    (2) Tax-exempt organizations. Payments to an organization that is 
exempt from taxation under section 501(a) as an organization described 
in section 501(c), 501(d), or 401(a) are not subject to withholding 
under section 3402(t).
    (3) Foreign governments. Payments to foreign governments are not 
subject to withholding under section 3402(t). For purposes of this 
paragraph (e), a government of a possession or territory of the United 
States is treated as a foreign government.
    (f) Payments made pursuant to a classified or confidential 
contract. Payments made pursuant to a classified or confidential 
contract described in section 6050M(e)(3) are not subject to 
withholding under section 3402(t).
    (g) Exception for political subdivisions or instrumentalities 
thereof making less than $100,000,000 of payments for property or 
services annually--(1) In general. Section 3402(t) withholding is not 
required on payments made by a political subdivision of a State (or any 
instrumentality of a political subdivision of a State) that makes less 
than $100,000,000 of payments for property or services annually.
    (2) Determination of whether an entity is a political subdivision 
of a State. Whether an entity is a political subdivision of a State for 
purposes of paragraph (g)(1) of this section is determined under Sec.  
31.3402(t)-2(d).
    (3) Determination of whether a political subdivision or 
instrumentality makes less than $100,000,000 of payments for property 
or services annually--(i) General determination rule. In general, 
whether a political subdivision or instrumentality makes less than 
$100,000,000 of payments for property or services annually for purposes 
of paragraph (g)(1) of this section is determined for each calendar 
year based on the total payments made by the entity for property or 
services in the entity's accounting year ending with or within the 
second preceding calendar year. For this purpose, payments that qualify 
for the exceptions from withholding under Sec.  31.3402(t)-4(a) through 
(q) (or would have qualified had these regulations been in effect) are 
not included in determining total payments made. However, payments that 
are not subject to withholding because the payments are less than the 
$10,000 payment threshold described in Sec.  31.3402(t)-3(b), or based 
on the applicability date rules or transition rules contained in Sec.  
31.3402(t)-1(d), Sec.  31.3402(t)-2(i), Sec.  31.3402(t)-3(g), Sec.  
31.3402(t)-4(u), or Sec.  31.3402(t)-5(e), or based on the withholding 
relief for 2012 provided in Sec.  31.3402(t)-4(t), but are not 
otherwise excepted, are included in determining total payments. For 
this purpose, the accounting year refers to the fiscal year (consisting 
of 12 months) or calendar year used by the government entity in setting 
its budgets and keeping its accounting books. If a political 
subdivision or instrumentality was not in existence in the second 
preceding calendar year or if no 12-month accounting year exists ending 
in the second preceding calendar year, eligibility for this exception 
is determined based on the total projected payments for the accounting 
year consisting of 12 months ending in that calendar year.
    (ii) Optional determination rule. A political subdivision of a 
state or an instrumentality of that political subdivision may treat 
itself as eligible for the exception provided in paragraph (g)(1) of 
this section for a calendar year if the average of the total payments 
calculated under the rules of paragraph (g)(3)(i) of this section for 
four of the five successive accounting years, the fifth year of which 
is the entity's determination year, is less than $100,000,000. For this 
purpose, for a calendar year the political subdivision's

[[Page 26599]]

or instrumentality's determination year is the accounting year ending 
with or within the second preceding calendar year. If a political 
subdivision or instrumentality withholds and pays (or deposits) tax 
under section 3402(t) for a calendar year and files a return reporting 
the withheld tax under section 3402(t) for that calendar year based on 
the general determination rule of paragraph (g)(3)(i) of this section, 
it is deemed to have waived any right to use the optional determination 
rule of this paragraph (g)(3)(ii) of this section for that calendar 
year.
    (4) Examples. The following examples illustrate the provisions of 
paragraph (g) of this section:

    Example 1. (i) Government entity X, which qualifies as a 
political subdivision or instrumentality of a political subdivision 
for calendar years 2013 and 2014, uses a fiscal year ending June 30 
to determine its budgets and to keep its accounting books. During 
its fiscal year ending June 30, 2011, X made payments to persons for 
property and services of $200,000,000, including $102,000,000 of 
payments that would have been excepted under Sec.  31.3402(t)-4(a) 
through (q) if section 3402(t) had been in effect.
    (ii) During its fiscal year ending June 30, 2012, X made 
payments for property and services of $210,000,000, including 
$106,000,000 that would have been excepted under Sec.  31.3402(t)-
4(a) through (q) if section 3402(t) had been in effect. The payments 
X made for property or services during the fiscal year ending June 
30, 2012, included $15,000,000 of payments below the $10,000 payment 
threshold described in Sec.  31.3402(t)-3(b).
    (iii) For the calendar year 2013, the general determination rule 
of paragraph (g)(3)(i) of this section applies to determine whether 
X is eligible for the exception provided in paragraph (g)(1) of this 
section based on the total payments X made for its accounting year 
ending June 30, 2011. Because total payments for this purpose 
exclude payments that would be excepted under Sec.  31.3402(t)-4(a) 
through (q), total payments were $200,000,000 less $102,000,000, or 
$98,000,000. Therefore, for calendar year 2013, X would be eligible 
for the exception provided in paragraph (g)(1) of this section, and 
would not be required to withhold under section 3402(t).
    (iv) For the calendar year 2014, the general determination rule 
of paragraph (g)(3)(i) of this section applies to determine whether 
X is eligible for the exception provided in paragraph (g)(1) of this 
section based on the total payments it made for its accounting year 
ending June 30, 2012. Because total payments for this purpose 
exclude payments that would have been excepted under Sec.  
31.3402(t)-4(a) through (q), but include payments below the $10,000 
payment threshold described in Sec.  31.3402(t)-3(b), total payments 
were $210,000,000 less $106,000,000, or $104,000,000. Therefore, for 
calendar year 2014, X would not qualify for the exception provided 
in paragraph (g)(1) of this section and would be required to 
withhold under section 3402(t), provided it is not eligible for or 
does not use the exception under the optional determination rule 
provided in paragraph (g)(3)(ii) of this section.
    Example 2. (i) Government entity Y, which qualifies as a 
political subdivision or instrumentality of a political subdivision 
for calendar years 2013 and 2014, uses a fiscal year ending June 30 
to determine its budgets and to keep its accounting books. During 
its fiscal year ending June 30, 2007, Y made payments to persons for 
property and services of $195,000,000, including $110,000,000 of 
payments that would have been excepted under Sec.  31.3402(t)-4(a) 
through (q) if section 3402(t) had been in effect.
    (ii) During its fiscal year ending June 30, 2008, Y made 
payments to persons for property and services of $204,000,000, 
including $115,000,000 of payments that would have been excepted 
under Sec.  31.3402(t)-4(a) through (q) if section 3402(t) had been 
in effect.
    (iii) During its fiscal year ending June 30, 2009, Y made 
payments to persons for property and services of $215,000,000, 
including $124,000,000 of payments that would have been excepted 
under Sec.  31.3402(t)-4(a) through (q) if section 3402(t) had been 
in effect.
    (iv) During its fiscal year ending June 30, 2010, Y made 
payments to persons for property and services of $225,000,000, 
including $130,000,000 of payments that would have been excepted 
under Sec.  31.3402(t)-4(a) through (q) if section 3402(t) had been 
in effect.
    (v) During its fiscal year ending June 30, 2011, Y made payments 
to persons for property and services of $275,000,000, including 
$135,000,000 of payments that would have been excepted under Sec.  
31.3402(t)-4(a) through (q) if section 3402(t) had been in effect.
    (vi) During its fiscal year ending June 30, 2012, Y made 
payments for property and services of $235,000,000, including 
$140,000,000 that would have been excepted under Sec.  31.3402(t)-
4(a) through (q) if section 3402(t) had been in effect.
    (vii) For the calendar year 2013, the general determination rule 
of paragraph (g)(3)(i) of this section applies to determine whether 
Y is eligible for the exception provided in paragraph (g)(1) of this 
section based on the total payments Y made for its accounting year 
ending June 30, 2011. Because total payments for this purpose 
exclude payments that would be excepted under Sec.  31.3402(t)-4(a) 
through (q), total payments were $275,000,000 less $135,000,000, or 
$140,000,000. Therefore, for calendar year 2013, Y would not qualify 
for the exception provided in paragraph (g)(1) of this section and 
would be required to withhold under section 3402(t), unless it was 
eligible for, and used, the optional determination rule provided in 
paragraph (g)(3)(ii) of this section.
    (viii) For the calendar year 2013, under the optional 
determination rule of paragraph (g)(3)(ii) of this section, Y would 
have total payments for this purpose in the accounting year ending 
June 30, 2007, of $85,000,000; in the accounting year ending June 
30, 2008, of $89,000,000; in the accounting year ending June 30, 
2009, of $91,000,000; in the accounting year ending June 30, 2010, 
of $95,000,000; and in the accounting year ending June 30, 2011, of 
$140,000,000. The average of four of those years (excluding the 
highest year of $140,000,000) would be $90,000,000 (85,000,000 plus 
89,000,000 plus 91,000,000 plus 95,000,000 equals 360,000,000; 
360,000,000 divided by 4 equals 90,000,000). Thus, for the calendar 
year 2013, under the optional determination rule of paragraph 
(g)(3)(ii) of this section, Y is eligible for the exception provided 
in paragraph (g)(1) of this section and is not required to withhold 
under section 3402(t). Alternatively, Y could apply the general 
determination rule, ignore the optional determination rule, and 
withhold under section 3402(t).
    (ix) For the calendar year 2014, under the general determination 
rule of paragraph (g)(3)(i) of this section, Y has total payments of 
$95,000,000. Thus, Y is eligible for the exception provided in 
paragraph (g)(1) of this section and is not required to withhold 
under section 3402(t).

    (h) Payments made in connection with a public assistance or public 
welfare program--(1) In general. Section 3402(t) withholding does not 
apply to payments made in connection with a public assistance or public 
welfare program for which eligibility is determined by a needs or 
income test.
    (2) Needs or income test. Eligibility for a public assistance or 
public welfare program is not considered to be determined by a needs or 
income test if eligibility for the program is based solely on the age 
of the beneficiary. A public assistance program providing disaster 
relief to victims of a natural or other disaster is considered to be a 
program for which eligibility is determined under a needs test. 
Payments under government programs to provide health care or other 
services that are not based on the needs or income of the recipient are 
subject to section 3402(t) withholding, including programs where 
eligibility is based on the age of the beneficiary.
    (3) Payments to third parties. The exception provided by this 
paragraph (h) also applies to payments made to third parties to provide 
benefits to beneficiaries under a public assistance or public welfare 
program for which eligibility is determined by a needs or income test.
    (4) Allocation of payments. If only a portion of a payment is made 
in connection with a public assistance or public welfare program for 
which eligibility is determined by a needs or income test, the portion 
that is made in connection with the program and therefore is not 
subject to section 3402(t)

[[Page 26600]]

withholding may be determined using any reasonable allocation method. 
If the government entity makes a reasonable, good faith determination 
that either the excludable or the nonexcludable portion is 
insignificant in comparison to the entire payment, the insignificant 
portion may be disregarded for purposes of this paragraph (h) (so that 
the entire payment is either eligible or ineligible for the exception 
provided by this paragraph (h)).
    (i) Payments made to any government employee with respect to his or 
her services. Section 3402(t) withholding does not apply to payments 
made to any government employee with respect to his or her services as 
an employee of the government. This exception applies to contributions 
to deferred compensation plans on behalf of an employee, contributions 
to employee benefit plans on behalf of an employee, fringe benefits 
provided to employees, and payments to employees under accountable 
plans for expenses incurred by the employee for the employee's travel 
while on government business. This exception also applies to payments 
made by the government employee under accountable plans (as defined in 
Sec.  1.62-2(c)(2) of this chapter) to providers of the employee`s 
travel, meals, and lodging when the government employee is traveling on 
government business.
    (j) Payments received by nonresident alien individuals and foreign 
corporations. Section 3402(t) withholding does not apply to any payment 
received by a nonresident alien individual or foreign corporation for 
providing services or property if the payment is derived from sources 
outside the United States, as determined under sections 861, 862, 863, 
and 865, and is not effectively connected with the conduct of a trade 
or business within the United States by the nonresident alien 
individual or foreign corporation.
    (k) Payments to Indian Tribal governments. Section 3402(t) 
withholding does not apply to any payment made to an Indian Tribal 
government or its political subdivisions.
    (l) Payments in emergency, disaster, or hardship situations. The 
Internal Revenue Service may provide by publication in the Internal 
Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this chapter) for 
additional exceptions from section 3402(t) withholding for certain 
payments made in an emergency, disaster, or hardship situation if the 
Internal Revenue Service determines that withholding from the payments 
would impede a government entity's efforts to respond to the emergency, 
disaster, or hardship.
    (m) Grants--(1) In general. Section 3402(t) withholding does not 
apply to any grant as defined in paragraph (m)(2) of this section. This 
exclusion does not apply to the use by a government entity of the 
proceeds of a grant received by that government entity (unless the 
government entity uses the proceeds to make a grant).
    (2) Definition of grant. For purposes of this paragraph (m), a 
grant is a transfer of funds by a government entity to a recipient 
(which may be a state government, local government, or other recipient) 
pursuant to an agreement reflecting a relationship between the 
government entity and the recipient when the principal purpose of the 
relationship is to transfer a thing of value to the recipient to carry 
out a public purpose of support or stimulation authorized by law 
instead of acquiring (by purchase, lease, or barter) property or 
services for the direct benefit or use of the government entity, and 
substantial involvement is not expected between the government entity 
and the recipient when carrying out the activity contemplated in the 
agreement.
    (n) Sales tax, excise tax, value-added tax, and other taxes. For 
purposes of this section, section 3402(t) withholding applies to any 
payment of sales tax, excise tax, value-added tax, or other tax made as 
part of a payment to any person providing property or services. 
Notwithstanding the foregoing, the payment of sales tax, excise tax, 
value-added tax, or other tax may be excluded from section 3402(t) 
withholding, provided this exclusion is applied consistently to all 
payments to a given payee during the calendar year.
    (o) Loan guarantees. Section 3402(t) withholding does not apply to 
a loan guarantee or the payment of principal and interest on a loan 
pursuant to a loan guarantee. However, if a government entity (through 
a right of subrogation or similar right) assumes the operation of a 
project or activity funded by the loan, section 3402(t) withholding 
applies to payments by the government entity for property or services 
relating to the project or activity unless otherwise excepted under 
this section.
    (p) Debt. Section 3402(t) withholding does not apply to payment of 
principal on a loan. However, if a government entity issues a debt 
obligation to a person providing services as all or part of the 
purchase price, the debt obligation's fair market value is subject to 
section 3402(t) withholding, unless an exception applies. If a 
government entity issues a debt obligation to a person providing 
property as all or part of the purchase price, the debt obligation's 
issue price as determined under section 1273 or section 1274, whichever 
is applicable to the debt obligation, is subject to section 3402(t) 
withholding, unless an exception applies. In lieu of the issue price, 
the government entity and the person providing property may agree to 
treat the stated principal amount of the debt obligation as the payment 
amount attributable to the debt obligation that is subject to section 
3402(t) withholding. If a government entity uses a third party debt 
obligation (a debt obligation issued by any entity other than that 
government entity) to pay for property or services, the fair market 
value of the debt obligation is subject to section 3402(t) withholding, 
unless an exception applies.
    (q) Investment securities. Section 3402(t) withholding does not 
apply to any payments to purchase stock, bonds, or other securities 
primarily for investment purposes.
    (r) Partially exempt payments. If a payment includes both an amount 
subject to section 3402(t) withholding and an amount that is not 
subject to section 3402(t) withholding, section 3402(t) withholding 
applies only to the relevant portion of the payment. Notwithstanding 
the foregoing, a government entity may apply section 3402(t) 
withholding to the entire payment provided the payee has agreed to this 
withholding.
    (s) Authorization for additional rules and procedures on payees and 
payments exempt from section 3402(t) withholding. The Commissioner is 
authorized to provide rules and procedures concerning payments that are 
exempt from withholding, including the classification of additional 
types of payees or payments as exempt from section 3402(t) withholding, 
and procedures under which a government entity may determine the 
eligibility of a payee for an exemption from section 3402(t) 
withholding (and may rely on this determination notwithstanding the 
payee's eligibility for this exemption), in revenue procedures, 
notices, or other guidance published in the Internal Revenue Bulletin 
(see Sec.  601.601(2) of this chapter).
    (t) Withholding relief for 2012. Withholding under section 3402(t) 
is not required with respect to payments made before January 1, 2013. 
Any person that deducts and withholds tax under section 3402(t) from 
payments made in 2012 shall deposit and report such tax withheld 
pursuant to Sec.  31.6302-4 and Sec.  31.6011(a)-4(b), and include the 
payment and the amount withheld on Form 1099-MISC, ``Miscellaneous 
Income,'' or successor form, unless the amount of tax withheld

[[Page 26601]]

under section 3402(t) is repaid to the payee before January 1, 2013.
    (u) Effective/applicability date. This section applies to payments 
by the Government of the United States, every State, every political 
subdivision thereof, and every instrumentality of the foregoing 
(including multi-State agencies) to any person providing property or 
services made after December 31, 2012, except that paragraph (t) of 
this section applies to payments made after December 31, 2011, and 
before January 1, 2013.


Sec.  31.3402(t)-5  Application to passthrough entities.

    (a) In general. Section 3402(t)(1) does not apply to payments made 
by passthrough entities except as described in paragraph (c) of this 
section. In addition, section 3402(t)(1) applies to payments made to 
passthrough entities except as described in paragraph (d) of this 
section.
    (b) Definitions. The following definitions apply for purposes of 
this section:
    (1) Passthrough entity. The term passthrough entity means a 
partnership (for Federal income tax purposes) or an S corporation.
    (2) Owner. The term owner means a partner (for Federal income tax 
purposes) or an S corporation shareholder.
    (3) Ownership percentage. The term ownership percentage means an 
owner's interest, as a percentage, in partnership profits or capital 
(whichever is greater) in the case of a partnership, or an owner's 
interest, as a percentage, in S corporation stock in the case of an S 
corporation.
    (4) Testing day. The term testing day refers to the first day of a 
passthrough entity's taxable year.
    (c) Payments from a passthrough entity--(1) General rule. Section 
3402(t)(1) does not apply to payments made by passthrough entities 
during the taxable year, except as provided in paragraph (c)(2) of this 
section.
    (2) Exception. Section 3402(t)(1) applies to any payment during the 
taxable year from a passthrough entity if the aggregate ownership 
percentage held, directly or indirectly, in the entity on the testing 
day by one or more of the government entities described in section 
3402(t)(1) is at least 80 percent. For purposes of this paragraph 
(c)(2), any manipulation of the ownership percentage with an intent to 
avoid application of section 3402(t) will be recharacterized as 
appropriate to reflect the actual ownership percentage.
    (d) Payments to a passthrough entity--(1) General rule. Section 
3402(t)(1) applies to payments made to passthrough entities during the 
taxable year, except as provided in paragraph (d)(2) of this section.
    (2) Exception--(i) In general. Section 3402(t)(1) does not apply to 
any payment during the taxable year to a passthrough entity if the 
aggregate ownership percentage held, directly or indirectly, in the 
entity on the testing day by one or more persons each of which is 
described in section 3402(t)(2)(E) or is an Indian Tribal government is 
at least 80 percent. For purposes of this paragraph (d)(2)(i), any 
manipulation of the ownership percentage with an intent to avoid 
application of section 3402(t) will be recharacterized as appropriate 
to reflect the actual ownership percentage, if the government entity 
making the payment knew or should have known that the payee's ownership 
percentage had been manipulated with intent to avoid application of 
section 3402(t).
    (ii) Payments derived from sources outside the United States. 
Section 3402(t)(1) does not apply to any payment during the taxable 
year to a partnership if the aggregate ownership percentage held, 
directly or indirectly, in the partnership on the testing day by one or 
more persons each of which is a nonresident alien individual or foreign 
corporation is at least 80 percent, and the payment to the partnership 
is not effectively connected with the conduct of a trade or business 
within the United States by the partnership, and is derived from 
sources outside the United States, as determined under sections 861, 
862, 863, and 865. For purposes of this paragraph (d)(2)(ii), any 
manipulation of the ownership percentage with an intent to avoid 
application of section 3402(t) will be recharacterized as appropriate 
to reflect the actual ownership percentage, if the government entity 
making the payment knew or should have known that the payee's ownership 
percentage had been manipulated with intent to avoid application of 
section 3402(t).
    (e) Effective/applicability date. This section applies to payments 
by the Government of the United States, every State, every political 
subdivision thereof, and every instrumentality of the foregoing 
(including multi-State agencies) to any person providing property or 
services made after December 31, 2012.


Sec.  31.3402(t)-6  Crediting of tax withheld under section 3402(t).

    (a) Credit against income tax liability only. Tax withheld under 
section 3402(t) is allowable as a credit against the tax imposed by 
Subtitle A of the Internal Revenue Code (Code) upon the recipient of 
the income in accordance with the rules set forth in section 31(a) and 
Sec.  1.31-1 of this chapter. Tax withheld under section 3402(t) is not 
allowable as a credit against taxes imposed on wages or compensation of 
employees under Chapters 21, 22, 23, or 24 of the Code.
    (b) Taxable year of credit. Tax withheld under section 3402(t) 
during any calendar year is allowed as a credit against the tax imposed 
by Subtitle A in accordance with section 31(a)(2) of the Code and Sec.  
1.31-1(b) of this chapter.
    (c) Estimated tax. The tax withheld under section 3402(t) and 
allowable as a credit under section 31(a) may be taken into account in 
determining estimated tax liability under sections 6654 and 6655 for 
the taxable year against which the taxes may be credited under 
paragraph (b) of this section.
    (d) Effective/applicability date. This section applies with respect 
to amounts withheld under section 3402(t) after December 31, 2012.


Sec.  31.3402(t)-7  Transition relief from interest and penalties.

    (a) Good faith exception for interest and penalties on payments 
made before January 1, 2014. Government entities that make a good faith 
effort to comply with the withholding requirements in Sec.  31.3402(t)-
1 will not be liable for interest and penalties with respect to income 
tax withholding under section 3402(t) that the government entity failed 
to withhold from payments made before January 1, 2014. However, this 
provision does not relieve the government entity of liability for 
income tax that it failed to withhold. See, however, Sec.  31.3402(d)-
1.
    (b) Effective/Applicability Date. This section applies with respect 
to payments made after December 31, 2012.

0
Par. 3. Section 31.3406(g)-2 is amended by adding paragraphs (h) and 
(i) to read as follows:


Sec.  31.3406(g)-2  Exception for reportable payment for which 
withholding is otherwise required.

* * * * *
    (h) Certain payments made by government entities. A government 
entity that is required to withhold both on reportable payments 
pursuant to section 3406(a) and on certain payments pursuant to section 
3402(t) must comply with the withholding requirements of section 3406, 
and not section 3402(t), for each payment to which both types of 
withholding would apply. Pursuant to section 3402(t)(2)(B), withholding 
under section 3402(t) does not apply to a given payment if amounts are 
being withheld

[[Page 26602]]

under section 3406 for that payment. If a government entity fails to 
withhold as required under section 3406, the payment will not be deemed 
to be subject to withholding under another provision of the Internal 
Revenue Code for purposes of this paragraph (h). Thus, even if the 
government entity withholds on such payment pursuant to section 
3402(t), it will remain liable for the amount required to be withheld 
under section 3406.
    (i) Effective/applicability date. Paragraph (h) of this section 
relating to certain payments made by government entities applies to 
payments made by government entities under section 3402(t) made after 
December 31, 2012.

0
Par. 4. Section 31.6011(a)-4 is amended by revising paragraphs (b)(4) 
and (5) and adding paragraph (b)(6) and revising paragraph (d) to read 
as follows:


Sec.  31.6011(a)-4  Returns of income tax withheld.

* * * * *
    (b) * * *
    (4) Pensions, annuities, IRAs, and certain other deferred income 
subject to withholding under section 3405;
    (5) Reportable payments subject to backup withholding under section 
3406; and
    (6) Certain payments made by government entities subject to 
withholding under section 3402(t).
* * * * *
    (d) Effective/applicability date. Paragraph (b)(6) of this section 
(relating to certain payments made by government entities subject to 
withholding under section 3402(t)) applies to payments made by 
government entities under section 3402(t) made after December 31, 2012.

0
Par. 5. Section 31.6051-5 is added to read as follows:


Sec.  31.6051-5  Statement and information return required in case of 
withholding by government entities.

    (a) Statements required from government entities. Every government 
entity required to deduct and withhold tax under section 3402(t) must 
furnish to the payee a written statement containing the information 
required by paragraph (d) of this section.
    (b) Information returns required from government entities. Every 
government entity required to furnish a payee statement under paragraph 
(a) of this section must file a duplicate of such statement with the 
Internal Revenue Service. Such duplicate constitutes an information 
return.
    (c) Prescribed form. The prescribed form for the statement required 
by this section is Form 1099-MISC, ``Miscellaneous Income,'' or any 
successor form.
    (d) Information required. Each statement on Form 1099-MISC (or any 
successor form) must show the following--
    (1) The name, address, and taxpayer identification number of the 
person receiving the payment subject to withholding under section 
3402(t);
    (2) The amount of the payment withheld upon;
    (3) The amount of tax deducted and withheld under section 3402(t);
    (4) The name, address, and taxpayer identification number of the 
government entity filing the form;
    (5) A legend stating that such amount is being reported to the 
Internal Revenue Service; and
    (6) Such other information as is required by the form and the 
instructions.
    (e) Time for furnishing statements. The statement required by 
paragraph (a) of this section must be furnished to the payee no later 
than January 31 of the year following the calendar year in which the 
payment subject to withholding was made. However, the February 15 due 
date under section 6045 applies to the statement if the statement is 
furnished in a consolidated reporting statement under section 6045. See 
Sec. Sec.  1.6045-1(k(3), 1.6045-2(d)(2), 1.6045-3(e)(2), 1.6045-
4(m)(3), and 1.6045-5(a)(3)(ii) of this chapter.
    (f) Cross references. For provisions relating to the time for 
filing the information returns required by this section with the 
Internal Revenue Service and to extensions of the time for filing the 
returns, see Sec. Sec.  31.6071(a)-1(a)(3), 1.6081-1 of this chapter, 
and 1.6081-8 of this chapter. For penalties applicable to failure to 
file information returns and furnish payee statements, see sections 
6721 through 6724.
    (g) Effective/applicability date. This section applies for calendar 
years beginning on or after January 1, 2013.

0
Par. 6. Section 31.6071(a)-1 is amended by revising paragraphs 
(a)(3)(i) and (g) to read as follows:


Sec.  31.6071(a)-1  Time for filing returns and other documents.

    (a) * * *
    (3) Information returns--(i) General rule. Each information return 
in respect of wages as defined in the Federal Insurance Contributions 
Act or of income tax withheld from wages as required under Sec.  
31.6051-2 or of income tax withheld from payments by government 
entities as required under Sec.  31.6051-5 must be filed on or before 
the last day of February (March 31 if filed electronically) of the year 
following the calendar year for which it is made, except that, if a tax 
return under Sec.  31.6011(a)-5(a) is filed as a final return for a 
period ending prior to December 31, the information return must be 
filed on or before the last day of the second calendar month following 
the period for which the tax return is filed.
* * * * *
    (g) The requirement under paragraph (a)(3)(i) of this section 
pertaining to the information return in respect of income tax withheld 
by government entities as required by Sec.  31.6051-5 of this part 
applies for calendar years beginning on or after January 1, 2013.

0
Par. 7. Section 31.6302-1 is amended by:
    1. Revising paragraph (e)(1)(iii)(C).
    2. Adding paragraph (e)(1)(iii)(E).
    3. Revising paragraph (n).
    The revisions and additions read as follows:


Sec.  31.6302-1  Deposit rules for taxes under the Federal Insurance 
Contributions Act (FICA) and withheld income taxes.

* * * * *
    (e) * * *
    (1) * * *
    (iii) * * *
    (C) Certain annuities described in section 3402(o)(1)(B);
* * * * *
    (E) Certain payments made by government entities under section 
3402(t); and
* * * * *
    (n) Effective/applicability date. Except for the deposit of 
employment taxes attributable to payments made by government entities 
under section 3402(t), Sec. Sec.  31.6302-1 through 31.6302-3 apply 
with respect to the deposit of employment taxes attributable to 
payments made after December 31, 1992. Paragraph (e)(1)(iii)(E) of this 
section applies with respect to the deposit of employment taxes 
attributable to payments made by government entities under section 
3402(t) made after December 31, 2012.
* * * * *

0
Par. 8. Section 31.6302-4 is amended by:
0
1. Revising paragraph (b)(4).
0
2. Revising paragraph (b)(5).
0
3. Adding paragraph (b)(6).
0
4. Revising paragraph (e).
    The revisions and additions read as follows:


Sec.  31.6302-4  Deposit rules for withheld income taxes attributable 
to nonpayroll payments.

* * * * *

[[Page 26603]]

    (b) * * *
    (4) Amounts withheld under section 3405, relating to withholding on 
pensions, annuities, IRAs, and certain other deferred income;
    (5) Amounts withheld under section 3406, relating to backup 
withholding with respect to reportable payments; and
    (6) Amounts withheld under section 3402(t), relating to certain 
payments made by government entities.
* * * * *
    (e) Effective/applicability date. Section 31.6302-4(d) applies to 
deposits and payments made after December 31, 2010. Paragraph (b)(6) of 
this section relating to certain payments made by government entities 
applies to payments made by government entities under section 3402(t) 
made after December 31, 2012.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: April 26, 2011.
Michael Mundaca,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2011-10760 Filed 5-6-11; 8:45 am]
BILLING CODE 4830-01-P