Extension of Withholding to Certain Payments Made by Government Entities, 26583-26603 [2011-10760]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 76, Number 89 (Monday, May 9, 2011)]
[Rules and Regulations]
[Pages 26583-26603]
From the Federal Register Online via the Government Printing 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 https://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

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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 i