By KENT HOOVER
khoover@bizjournals.com

Business groups have launched a grass-roots effort to repeal a tax provision that requires federal, state and local governments to withhold 3 percent of their payments to contractors and suppliers.

The governments would then remit this money to the Internal Revenue Service.

The provision was first passed in 2005 as a way to help make sure government contractors pay their taxes.

It originally was scheduled to go into effect this year, but that date was pushed back to 2012 by the economic stimulus bill. In May, the Internal Revenue Service delayed implementation until 2013.

Government contractors complain this provision will cause cash-flow problems, especially for small businesses, and that it hurts honest companies, not just tax cheats. Many contractors, especially in the construction industry, operate at such low profit margins that they don't end up owing 3 percent of the contract amount in taxes.

As a result, the federal government will get "an interest-free loan on the backs of many honest taxpayers," said Giovanni Coratolo, vice president of small-business policy at the U.S. Chamber of Commerce.

The chamber and 125 other trade associations are teaming on a campaign to repeal this withholding provision.

It will be modeled on the business community's successful effort to repeal a health-care reform law provision that would have required businesses to file a 1099 form with the IRS any time they spend more than $600 with another business.

Like the 3 percent withholding provision, the 1099 requirement was aimed at reducing the tax gap - the difference between how much is owed in taxes and how much is actually paid.

Third-party reporting of income, such as through 1099s, is designed to make businesses less likely to hide income from the IRS. Small businesses complained, however, that the expanded 1099 reporting requirement would dramatically increase their paperwork burden. Congress repealed this provision in April.

The business case for repealing the 3 percent withholding provision was bolstered by testimony May 29 from government officials, who complained about the cost and complexity of implementing this requirement.

The rule will cost the Department of Defense alone billions of dollars, said Brian George, deputy director of the department's Office of Cost, Pricing and Finance.

The Pentagon also is concerned that withholding "will limit the number of companies willing to enter into the government market, thereby reducing competition and access to new technologies," George said at a House Small Business Committee hearing.

The 3 percent withholding requirement also "presents an administrative nightmare" for state and local governments, said South Carolina Treasurer Curtis Loftis Jr.

"Modifications to accounting systems and other administrative processes will have to be resolved," Loftis said. "Add up the manpower and dollar costs of the withholding provision for all of the local and state governments across the country and you will find the amount is astronomical."

Three business owners also testified at the hearing.

The cash-flow problems created by the 3 percent withholding requirement were illustrated by Ian Frost, principal and founder of EEE Consulting Inc., an environmental engineering consulting firm with three offices in Virginia.

Nearly all of the firm's work is for local, state and federal agencies. Based on its projected revenue this year, $130,000 would be withheld from EEE Consulting if this provision were in effect for 2011. That would deplete its cash reserves by 30 percent, Frost said.

The company wouldn't be able to recover any of this money until it files its annual tax return. It might have to borrow money to cover operating expenses.

"The withholding could limit our ability to make payroll each month and limit our use of our profits to give bonuses to our employees, expand our business and hire new employees," Frost said.

The other business owners noted the federal government has other ways to make sure its contractors pay their taxes.

"Instead of punishing all contractors, the federal government should enforce the laws already on the books," said Mike Murphy, president of Turner Murphy Co., a construction company based in Rock Hill, S.C.

Bidders for federal contracts of $100,000 or more are required to certify that they have no tax delinquencies.

Procurement officials also can check a new government database to make sure contractors are current on their taxes.

Despite these safeguards, evidence persists that some government contractors fail to pay their taxes on time.

A recent Government Accountability Office found that 3,700 businesses and nonprofit organizations that received contracts or grants through economic stimulus funds owed $757 million in back taxes.

Many of these stimulus-funded contracts were awarded by state and local governments.