Municipal utilities will have to start withholding 3% of what they pay for electricity to independent generators starting as early as 2013 under new regulations the IRS issued in May.

US military bases will have to do the same.

Congress directed all federal, state and local government entities to withhold 3% of payments for “property or services” after learning that many contractors working for the US government during the Iraq war were not paying income taxes on their earnings under government contacts. The amounts are turned over to the IRS. The contractor can claim a credit against income taxes later when it files its tax return.

Withholding was originally supposed to start in 2011. Congress delayed it to 2012 in the American Recovery and Reinvestment Act. The IRS delayed it again to 2014 in May in order to give federal, state and local government agencies more time to program computers to withhold taxes. However, withholding will start earlier — in 2013 — on new contracts that are signed in 2013 or on existing contracts that are materially modified in 2013.

Withholding is required when a municipal utility, military base or other government entity pays a contractor to build a power plant for it.

It is required on prepayments under “prepaid service contracts” where a municipal utility prepays for a share of the electricity it will receive over a long-term power contract.

The US Department of Energy is guaranteeing the debt on some wind, solar and other renewable energy projects. If the debt goes into default and the government forecloses on the project, then payments the project company makes after foreclosure to third parties for property or services will become subject to withholding.

Withholding is on the gross amount of payments, even though part might be deducted later to pay sales taxes.

However, no withholding is required on a variety of payments.

It is not required on government grants.

It is not required on payments by government utilities or other government agencies in Puerto Rico and other US possessions. It is not required on payments by Indian tribes. It is not required on payments to tax-exempt entities, even if the payments are taxable to the tax-exempt entity as “unrelated business taxable income.” It is not required on interest. It is not required on rents to lease land, buildings or office space.

Municipalities do not have to withhold unless they pay more than $100 million a year for property and services.

A municipality should look at its spending for its fiscal year that ends two years before the year it is trying to decide whether it must withhold taxes. Thus, for example, a municipal utility that uses a June 30 fiscal year and is trying to decide whether to withhold on payments in 2013 should look at what it spent on property and services in its fiscal year that ended in 2011. It has the option instead of using its average spending in four of the five fiscal years ending in fiscal 2011.

When doing the $100 million calculation, the municipality should not count payments of a type that are exempted from withholding — for example, rent to lease office space.

Keith Martin