MUNICIPAL UTILITIES and other government entities will have to withhold 3% of payments for property or services starting in 2011. This includes payments by municipal utilities for
electricity or gas. 

The IRS issued proposed regulations in late December explaining when withholding will be required. The withholding is required under section 3402(t) of the US tax code. 

All federal, state and local agencies and instrumentalities will have to withhold. Indian tribes will not. A partnership that has government entities as partners must withhold if they own at least 80% of the partnership. 

However, a local government entity — but not a federal or state agency — is exempted from withholding if its total payments for property and services two years before were less than $100 million. For example, a municipal utility would look at what it paid for property and services in its 2009 accounting year to determine whether it must withhold on payments it makes in calendar year 2011.Wages paid to employees are not counted.

Certain payments are exempted from withholding. No withholding is required on payments from one government entity to another or on payments to tax-exempt entities or foreign corporations. Most payments to foreign corporations are already subject to 30% withholding at the US border unless waived by treaty. Withholding is not required on interest payments or on rent for use of land or buildings. It is not required on individual payments of $10,000 or less, unless the payments are purposely sized to avoid withholding.

Many people complained that it is unfair to require withholding on payments under existing contracts that were signed before companies doing business with governments were on notice about the withholding.The IRS agreed. It said no withholding will be required under “binding” written contracts that are in effect on December 31, 2010 or, if later, six months after the IRS reissues the proposed regulations in final form. However, payments under such a contract will become subject to withholding if the contract is later materially  modified.“Binding” is a term of art. For example, a contract is not binding if it limits the damages that will have to be paid upon cancellation to less than 5% of the total contract
price.

Payments by government agencies to private prime contractors will attract withholding.There is no further withholding when the prime contractor makes payments to its subcontractor.
Any company that has money withheld will get a credit for the withholding that it can use against its income taxes. Companies that do not use the calendar year as