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Law Firms Stay Tuned: Proposals Banning Cash Method of Accounting Would Cause Significant Financial Impact


The following two proposals currently in Congress would – if passed – require many law firms and personal service providers to switch from using the traditional cash method of accounting to the more complex accrual method:

  1. House Ways and Means Committee Chairman Dave Camp proposed the Tax Reform Act of 2014, an update to the original draft proposed in 2013. Section 3301 of the 2014 proposal asserts that the accrual method offers a more accurate reflection of income and provides needed simplicity in the area of tax accounting law.
  2. In late 2013, former Senate Finance Committee Chairman Max Baucus developed a similar Senate draft tax reform bill that would require all businesses with annual gross receipts over $10 million to use the accrual method of accounting instead of the cash method. Section 51 of the draft bill addresses the provision.

10/22/14

If certain legislators have their way, many law firms and other personal service providers will be forced to stop using the traditional cash method of accounting. Two separate proposals currently in Congress would mandate accrual accounting for law firms and other personal service businesses with average gross receipts (for the preceding three years) over $10 million.

Opposition to the proposals has been strong. In August 2014, nearly half of all U.S. Senators signed a letter to Senate Finance Committee Chairman Ron Wyden and Ranking Member Orrin Hatch encouraging the continued use of the cash basis of accounting versus a switch to the accrual method.1 In addition, the American Bar Association (ABA), the American Institute of CPAs (AICPA), the National Conference of CPA Practitioners (NCCPAP), and various other professional associations held a hearing in July 2014 before the House Committee on Small Business Subcommittee on Economic Growth, Tax and Capital Access, asserting that the complex nature of accrual accounting would increase compliance costs and ultimately pose a considerable hardship to many law firms and other personal service providers.

However improbable the chances of the proposals passing may be considering such clear disapproval, the possibility does remain. Consequently, law firms should continue to monitor the issue and assess the implications of the potential switch – namely that it stands to impose a sizeable financial impact on covered firms, requiring businesses to recognize income when it is earned and expenses recognized when they are incurred, regardless of when cash actually changes hands.

Cash vs. Accrual Method of Accounting

Today, most law firms use the simple, straightforward cash method of accounting, recognizing income when cash is collected and recognizing expenses when paid. Under current law, businesses with average annual gross receipts of $5 million or less are permitted to use the cash method, as are most individuals, partnerships, S corporations, and other pass-through entities. In addition, personal service businesses, including law firms, may use the cash method – regardless of their business structure or their amount of gross receipts – unless they have inventories.

Businesses that use the accrual method must follow a complex set of rules to determine the timing of income and expense; generally, with income reported when the right to receive the income arises, not necessarily when the income is actually collected.

Impact on Law Firms

There are currently two proposals related to the ban. One proposal would apply to tax years beginning after 2013, while the other would be effective a year later. The proposals would increase the dollar threshold from $5 million to $10 million and eliminate the exemptions for individuals, pass-through entities, and personal service businesses. As a result, all law firms with average annual gross receipts for the preceding three years exceeding $10 million would be required to use the accrual method.

For most law firms, converting from cash to accrual would mean accelerating income into the year of conversion with little ability, if any, to alter the timing of expenses. Essentially, year-end work in process (WIP) and accounts receivable (A/R) would be included in taxable income, requiring the firm – or, in the case of a pass-through entity, its partners or shareholders – to pay tax on income that has not yet been received.

To prevent the draft legislation from becoming enacted, law firms should urge their Senators to oppose Section 51 of the draft Senate bill and likewise express opposition to Section 3301 of the draft House bill. The ABA has prepared sample letters that law firms can send to their U.S. Representatives and Senators specifically in opposition to Section 3301 of the Camp proposal:

To ease the burden of recognizing this additional income in a single tax year, firms would be allowed to spread it over a four-year (or, possibly, eight-year) period. Still, converting to the accrual method would result in a significant tax liability without a corresponding cash inflow to cover it. It may prompt many firms to revisit their capital structures and compensation systems, and to amend their partnership agreements.

Issues to Consider

In the event that the provision requiring professional firms with over $10 million of average annual gross receipts to switch to the accrual method were to be enacted, law firms would have to consider the following issues:

  • How will the firm finance the additional tax liability? Should the firm borrow money to pay the taxes, or, in the case of a pass-through entity, to fund distributions to partners or shareholders to cover their shares of the taxes? How will this new debt affect the firm’s financial performance and capital structure? Will the firm need to renegotiate loan covenants on existing debt?
  • What happens when partners leave the firm through retirement or a buyout? Does the partnership agreement require the firm to distribute a partner’s capital account in cash when he or she exits the firm? If so, how will the firm fund the portion of the capital account that is attributable to income that has been accrued, but not yet received? Borrowing is one possibility. Another option is to amend the partnership agreement to change the distribution schedule so that it coincides, to the extent possible, with the firm’s receipt of cash. Likewise, buyouts – which are typically based on collections, years of service, client retention and the like – may require the firm to modify its payout structure in order to alleviate any potential cash shortage.
  • What about new partners or partners transitioning from equity to non-equity status? Will the firm take steps to ease the burden of increased non-cash income on partners who join the firm? For partners moving from equity to non-equity status, they may pay tax under the accrual method, though never see the cash after having picked up the income following their change in status.
  • Does the firm need to modify its compensation policies? If the partnership agreement calls for partner compensation based on “income,” it may be necessary to amend the agreement to clarify that compensation is based on cash collected, not taxable income.
  • Will the firm require additional resources? The added complexity of accrual accounting may require updated policies, procedures, and systems – as well as additional staff – to track, analyze, and document income and expenses. Also, because income includes items that have not yet been collected – or, in some cases, billed – additional resources will be required to evaluate the collectability of A/R and WIP and support bad debt deductions.
  • Should the firm change its billing arrangements? Mandatory accrual accounting would be particularly hard on law firms because of the time lag that typically exists between doing the work and getting paid. One way for firms to soften the impact would be to incorporate more progress payments into their billing arrangements.
  • How would this change affect the firm’s growth strategies? Will the firm’s hiring, M&A, and other growth strategies cause it to cross the $10 million gross receipts threshold? This is not to suggest that firms should avoid these growth opportunities, but it is important to take tax costs into account.
     

What Does CohnReznick Think?
It is uncertain whether accrual accounting will become mandatory for law firms and other personal service businesses. As mentioned above, legislators and several organizations, including the ABA and AICPA, have expressed vehement opposition to the proposals. Nevertheless, law firms should continue to monitor the status of the proposals and consider the potential impact of the legislation, in the event they should pass.

Contact

For more information, please contact Luda Mirne, senior manager, at 732-380-8646, or Richard Puzo, partner and Law Firm Industry Practice Leader, at 973-364-6675.

To learn more about CohnReznick’s Law Firm Industry Practice, visit our webpage


[1] http://www.aicpa.org/Advocacy/Issues/DownloadableDocuments/cash-accounting-senate-letter-final-8-6-2014.pdf


Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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