The 3% withholding tax that most people are trying to identify is a federal rule that never took effect. Congress enacted Section 3402(t) of the Internal Revenue Code in 2006 to require federal, state, and local governments to withhold 3% from payments to contractors, then repealed it in 2011 before the first dollar was ever withheld. Today, a 3% rate on contractor payments survives only at the state level, where a number of jurisdictions apply withholding in that range to payments made to nonresident contractors and service providers.
The Federal 3% Rule That Was Repealed
Section 3402(t) was added by the Tax Increase Prevention and Reconciliation Act of 2006. It would have forced federal, state, and local government entities to hold back 3% of nearly every payment for property or services and send that amount to the IRS on the contractor’s behalf. The reasoning was collection: governments pay billions to outside vendors each year, and withholding at the source would have closed a compliance gap.
The rule was delayed repeatedly. Proposed regulations were published in December 2008, but opposition from business groups and government agencies kept it from going live.1Federal Register. Withholding Under Internal Revenue Code Section 3402(t) Public Law 112-56, signed on November 21, 2011, struck the provision from the code for all payments made after December 31, 2011.2Office of the Law Revision Counsel. 26 USC 3402 Income Tax Collected at Source
One point of confusion worth clearing up: the current Section 3402(t) in the code addresses withholding on qualified stock under Section 83(i), not government contractor payments. References to “3402(t)” in older compliance guides almost always mean the repealed rule.
Where 3% Withholding Still Applies
Several states impose their own withholding on payments to nonresident contractors, and the rate often lands somewhere between 3% and 7%. Some states set a flat percentage; others tie the rate to the state’s income tax brackets. The trigger is usually the same: a contractor based in another state performs work inside the taxing state’s borders, and the entity making the payment must withhold and remit to that state’s revenue department.
Dollar thresholds vary. Some states require withholding from the first dollar. Others only kick in after cumulative payments to the same contractor cross an annual amount, often between $1,500 and $10,000. The types of services covered also differ. Consulting, engineering, legal work, and construction are the most common triggers, but some states cover any service performed within their borders.
The payer is responsible for identifying whether a payment qualifies. If your state requires withholding on payments to an out-of-state contractor and you fail to withhold, you can be held personally liable for the amount that should have been deducted, even if the contractor later files and pays their own state return. Before issuing a large payment to an out-of-state service provider, check the nonresident withholding rules published by your state revenue department.
What Payers Need to Collect Before Paying
Compliance starts before the check goes out. For any U.S. contractor, collect a completed Form W-9, which captures the taxpayer identification number. That TIN can be a Social Security number, an individual taxpayer identification number, or an employer identification number, depending on the entity.3Internal Revenue Service. Form W-9 Request for Taxpayer Identification Number and Certification
States that impose nonresident withholding typically have their own certificates. Contractors use them to claim a reduced rate or a full exemption based on reciprocity between states, prior registration in the taxing state, or a threshold that hasn’t been met. Get the correct state form on file before you pay. Retroactive exemption claims are hard to process and may be rejected outright.
Entity Classification Changes the Answer
The contractor’s business structure can shift your obligations. A single-member LLC is a disregarded entity for federal income tax, so the IRS looks through it to the owner. A multi-member LLC defaults to partnership treatment. Either can elect corporate taxation by filing Form 8832.4Internal Revenue Service. Limited Liability Company (LLC) Some withholding rules exempt payments to corporations. If you plan to rely on that exemption, confirm the tax classification on the W-9 rather than guessing from the business name.
Recordkeeping
Keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later.5Internal Revenue Service. Recordkeeping That covers every W-9, state withholding certificate, payment ledger, and remittance confirmation. Digital copies are acceptable.
Remitting the Withheld Amount
Once you deduct withholding from a payment, the money belongs to the taxing authority on a set schedule. Federal employment taxes are typically reported on Form 941 each quarter, due by the last day of the month following quarter’s end.6Internal Revenue Service. Employment Tax Due Dates State nonresident withholding follows similar monthly or quarterly patterns depending on volume.
Most agencies now prefer electronic filing through their portals. Save the confirmation number or digital receipt after every remittance. You’ll pass this information to the contractor so they can claim the withheld amount as a credit.
How Contractors Claim the Withheld Money Back
If you’re the contractor, withheld tax isn’t lost. It functions as a prepayment against your annual tax liability. The payer reports the amount to you and to the tax agency on an information return, and you claim it as tax already paid when you file.
For U.S. contractors, withholding usually appears on Form 1099-NEC. Box 4 reports federal income tax withheld, which carries to your income tax return.7Internal Revenue Service. Form 1099-NEC Nonemployee Compensation State withholding is claimed on the corresponding state return. If the information return you receive doesn’t match what the payer filed with the tax agency, the credit can be disallowed, so verify the numbers before filing.
Penalties for Getting It Wrong
Withholding penalties escalate quickly, and payers usually underestimate them.
Failure to Deposit
If you withhold the tax but miss the deposit deadline, the IRS applies a graduated penalty on the unpaid deposit:
- 1 to 5 days late: 2%
- 6 to 15 days late: 5%
- More than 15 days late: 10%
- More than 10 days after the first IRS notice: 15%
These percentages apply to what you should have deposited, not the full contract.8Internal Revenue Service. Failure to Deposit Penalty
Failure to File or Pay
If you never file the required return, the penalty is 5% of the unpaid tax per month, capping at 25%. If you file but don’t pay, the penalty is 0.5% per month, also capping at 25%.9Office of the Law Revision Counsel. 26 U.S. Code 6651 – Failure to File Tax Return or to Pay Tax
Interest
Interest on unpaid withholding runs at the federal short-term rate plus three percentage points, recalculated each quarter, and it compounds daily from the original due date.10Internal Revenue Service. Quarterly Interest Rates
Personal Liability
Under IRC Section 6672, anyone responsible for collecting and remitting withheld tax who willfully fails to do so faces a penalty equal to 100% of the unpaid amount.11Office of the Law Revision Counsel. 26 U.S. Code 6672 – Failure to Collect and Pay Over Tax, or Attempt to Evade or Defeat Tax This is the trust fund recovery penalty, and the IRS can pursue individuals, including business owners, officers, and bookkeepers with check-signing authority, when the business can’t pay.12Internal Revenue Service. Trust Fund Recovery Penalty “Willfully” doesn’t require an intent to defraud. Knowing the taxes were due and using the money for something else, such as payroll or vendors, meets the standard.
Exemptions and Reduced Rates
Not every payment triggers withholding at the full rate. At the state level, many jurisdictions issue exemption certificates for nonresident contractors. Common grounds include reciprocity agreements between neighboring states, proof that the contractor is already registered and filing in the taxing state, or payments that fall below the state’s threshold.
The exemption paperwork must be completed before the payment goes out. When in doubt, withhold. Overwithholding produces a refund on the contractor’s return; underwithholding produces a liability with penalties attached to it.
A Note on the Other Federal Withholding Rates
Two federal withholding rates often come up in the same conversations as the 3% rule, and neither is the same mechanism. Payments of U.S.-source income to nonresident aliens and foreign entities are subject to a default 30% withholding under IRC Section 1441, reduced by treaty in many cases.13Office of the Law Revision Counsel. 26 USC 1441 Withholding of Tax on Nonresident Aliens14Internal Revenue Service. NRA Withholding Backup withholding, at 24%, applies when a U.S. payee fails to provide a valid TIN or the IRS notifies the payer that a TIN is incorrect.15Internal Revenue Service. Publication 15 (2026) If you’re seeing a 3% figure on a payment or invoice today, it’s almost certainly a state nonresident withholding rate, not a federal one.