By Kenneth E. Winslow, CPA, PSA
Abstract: This article covers an overview of the American Bar Association’s appeal to Congress arguing against the implementation of an accrual accounting tax mandate for professional service businesses. It provides a brief primer on accrual v cash basis accounting and offers a discussion of how changing to an accrual based system will affect accounting for law firms and what you can do to maximize your firm’s bottom line.
(1) Background on the ABA’s appeal to Congress
A concept that most of us learned about in Accounting 101—accrual versus cash accounting—is now tabled for discussion and is generating some controversy. Section 3301 of H.R. 1, and Section 51 of a similar Senate draft bill, would require many personal service businesses—including law firms and accounting firms—that have annual gross receipts of more than $10 million to use the accrual method of accounting rather than the traditional cash receipts and disbursements method adopted by most professional services firms.
Under current law, professional service corporations, individuals and other pass-through entities with average annual gross receipts of $5 million or less over a three (3) year period—can use the cash method of accounting for tax reporting purposes. In addition, all law firms, accounting firms, and various other types of personal service businesses are allowed to use the cash method of accounting regardless of their annual revenue as long as inventory is not a significant component of their business.
The mandatory accrual accounting proposals are under active consideration in the new 115th Congress, cites the American Bar Association. If these proposals are enacted many law firms, accounting firms, medical firms, and other personal service providers would be required to pay Federal and related state income taxes on income earned long before funds are actually received.
American Bar Association (ABA) opposes the burdensome tax proposals and issued a bulletin in April 2017, prepared by Larson Frisby, requesting that Congress reject these mandatory accrual accounting proposals citing the following:
1 – Rather than simplifying the tax law as the sponsors claim – these proposals would create unnecessary new complexity in the tax law and increase compliance costs;
2 – Proposal would impose substantial new financial burdens on may law firms and other personal service businesses by forcing them to pay taxes up front on income they have not yet received and may never receive;
3 – Proposal would adversely affect clients, interfere with the lawyer- client relationship, and reduce the availability of legal services;
4 – The proposals would constitute a major, unjustified tax increase on small businesses, discourage economic growth and kill jobs
The ABA prepared letters dated April 21, 2017, to Orrin G. Hatch, Chairman of the Senate Finance Committee and Kevin Brady, Chairman of the House Committee on Ways and Means strongly opposing these proposals.
(2) The ABCs of cash vs. accrual accounting
For the most part—and to keep it simple, we’ll ignore hybrid and other exotic methods—there are generally two ways for businesses to account for their revenue and expenses; the cash basis and accrual basis of accounting.
Under the cash basis of accounting, revenue is recognized upon actual or constructive receipt and expenses are deducted in the tax year you actually remit the payment. So if “XYZ Law Firm” received $20 million in receipts, for the calendar year ended December 31, 2016, and pays out a total of $18 million in operating expenses; then we can say the firm earned $2 million in 2016 using the cash basis. Billings and unbilled work in process for clients through the year-end of $1,000,000, uncollected by the firm are excluded from income for the calendar year 2016. Likewise expenses of $400,000 unpaid at year end are excluded as deductions.
In contrast, under accrual basis accounting, revenue is generally recorded when it’s earned (technically when the right to receive it arises and it’s likely to be collected), not when the revenue is actually received. Expenses are generally reported when the cost is incurred, regardless of when payment is actually made.
So, all else being equal, XYZ Law Firm’s would have $1,000,000 more revenues net of $400,000 more expenses for the calendar year ended December 31, 2016 under the accrual basis of accounting. So instead of posting a $2 million cash basis profit in 2016, the law firm’s net profit under the accrual method would be $2.6 million (the increase of $600,000 represents the difference between the $1,000,000 in earned revenue offset by $400,000 in accrued expenses).
(3) Why Congress is interested in changing the rules about cash vs. accrual accounting
Tax revenue of course.
The cash method of accounting could let a firm defer tax liability by mismatching income and related expenses, typically by strategically timing when invoices go out and when expenses are paid and recorded. In fact the Cash Versus Accrual Accounting: Tax Policy Considerations report reveals that the Joint Committee of Taxation estimates the five-year revenue loss associated with cash basis accounting to be $10.9 billion between fiscal year 2014 and 2018 .
Such restructuring of a firm’s operating results and the resulting tax obligations will effect
1 – Partnership agreements for existing, future and retiring partners
The agreements will need to be reviewed and modified for valuation of a partner’s interest attributable to distributions to existing partners, the admission of new partners, and payouts to retiring partners;
2 – Debt financing agreements;
Firms will need to renegotiate loan agreements to address changes in financial covenants and additional financing requirements to cover the tax obligations;
3 – Financial reporting and measurement of income.
Firms will be required to address their measurement, billing and collection policies as their uncollected billings and services will now be subject to tax. In addition, expense reporting associated with bad debts, deferred and accrued expenses will require additional scrutiny.
(4) What can be done now?
Under this proposal the net change in taxable income, resulting from the increase in income offset by expenses incurred, under Section 481 (a), would be reportable as income over a four (4) year period.
Firms should consider preparing a proforma calculation to determine the potential Section 481 (a) adjustment and resulting tax obligations by reviewing and measuring the following:
1 – Receivables and unbilled work in process;
2 – Accounts payable, accruals and deferred charges.
3 – Calculate the net Federal and state tax obligation and allocation over four (4) year period.
Use the above calculation to address changes which may be required to partnership and financing agreements.
Although the proposals have been kicked around for a few years without being passed, the ABA and other organizations are still concerned. The Trump Administration has not yet taken a formal position on the mandatory accrual accounting proposals, but there is a possibility that they could be included in the new comprehensive tax reform legislation that is being discussed in the 115th Congress. Law firms, accounting firms, and many other types of small businesses should be aware of this and may wish to consult with their tax and other advisors.
About the Author
Kenneth E. Winslow, CPA, PSA is a partner at the firm Bederson LLP in Fairfield, New Jersey.
He specializes in accounting and advisory services for professional services businesses. He can be reached at [email protected] or 973-530-9115.