In a letter sent to key lawmakers, the American Bar Association (ABA) has set out its objections to a tax reform proposal that would impose the accrual accounting method on law firms and other personal service businesses. The ABA stated that forcing these taxpayers to use the accrual method would, among other things, create unnecessary complexity, increase compliance costs, increase taxes on affected taxpayers, and adversely affect clients. Click here for the American Bar Association (ABA) letter to Orrin Hatch and Ron Wyden, Chairman and Ranking Member, respective, of the Senate Finance Committee (4/6/2015).
Background on accounting methods. Under the cash method of accounting, gross income includes cash or property actually or constructively received during the tax year. Deductions are usually taken in the year cash or property is actually paid or transferred. It doesn’t matter when the income was earned or when the expense was incurred.
Under the accrual method, income is reported in the tax year in which the right to income becomes fixed and the amount of the income can be determined with reasonable accuracy. Deductions are claimed in the period in which all events have occurred that determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy. (Code Sec. 446(c))
The accrual method is mandatory for purchases and sales (unless IRS consents to a change) where inventories must be used. (Reg. § 1.446-1(c)(2)(i)) Inventories must generally be used where the production, purchase, or sale of merchandise is an income-producing factor. (Reg. § 1.446-1(a)(4)(i))
However, there are exceptions that apply for small businesses, as follows: taxpayers (other than tax shelters) with 3-year average annual gross receipts of $1 million or less do not have to account for inventories or use an accrual method of accounting; and qualifying small businesses with 3-year average annual receipts of more than $1 million but not more than $10 million that are not prohibited from using the cash method and otherwise would have to keep inventories and use accrual accounting may, instead, use the cash method for an eligible trade or business. Qualifying small businesses that may use the cash method for all of their trades or businesses are (1) businesses whose principal business activity for the immediately preceding tax year is other than mining, manufacturing, wholesale trade, retail trade, or information industries; (2) service providers, including those providing property incident to those services; and (3) fabricators or modifiers of certain tangible personal property.
The cash method generally may not be used by C corporations, partnerships that have a C corporation as a partner, or tax shelters. (Code Sec. 448(a)) This rule doesn’t apply to farming businesses, qualified personal service corporations (defined in Code Sec. 448(d)(2), including many law and accounting firms), or entities with annual gross receipts of $5 million or less. (Code Sec. 448(b))
Discussion draft. In November of 2013, Senate Finance Committee Chairman Max Baucus (D-MT) released a discussion draft containing a number of tax proposals, including the reformation of certain tax accounting rules.
According to a summary of the proposals, businesses “must navigate a maze of tax accounting rules to determine their taxable income,” and “[s]imilarly situated businesses are often subject to substantially different tax accounting rules.”
The goals of the tax accounting proposals in the discussion draft are to simplify tax accounting rules so as to lessen compliance and enforcement costs, and improve tax neutrality by “eliminating the use of certain accounting methods that allow taxpayers in some industries to significantly defer or otherwise distort income measurement.”
To that end, the proposals in the discussion would:
- Allow all businesses (other than tax shelters) with 3-year average annual gross receipts of $10 million or less to (i) elect to adopt either the cash method or accrual method of accounting, regardless of whether inventory is a material income producing factor in the business; and (ii) immediately deduct the cost of inventory, even if it is a material income producing factor in the business if the cash method of accounting is adopted;
- Require business that do not satisfy the above gross receipts threshold, including those engaged in farming and personal service businesses, to adopt the accrual method of accounting.
ABA’s position. In a letter sent to Congressional leaders and Mark Mazar, Assistant Secretary of the Treasury for Tax Policy, William C. Hubbard, ABA President, stated that the ABA “unequivocally oppose[s]” proposals to require personal service businesses (namely, law firms) with annual gross receipts over $10 million to switch from the cash method to the “more complex and costly” accrual method. (The ABA letter focuses its criticism on the proposals in the discussion draft, above, but makes clear that it opposed all similar proposals.) The letter emphasizes that the ABA is generally in favor of tax reform and applauds efforts to simplify the Code, but strongly disagrees with this proposal and urges its removal from any new tax reform legislation.
The letter states that the mandatory accrual accounting proposal would significantly complicate tax compliance for many small business taxpayers. Sole proprietors and personal service corporations tend to favor the cash method because of its simplicity and because it correlates with how they operate their business. In particular, for law firms, imposing the accrual method would force them to calculate and pay taxes on multiple types of accrued income, including work in progress and other unbilled work, accounts receivable (i.e., where the work has been done and billed but not yet paid for), and accounts paid (where the work has been done, billed, and paid for). This, in turn, would require much more detailed work and billing records and, likely, additional accounting and support staff—raising compliance costs and also increasing the risk of noncompliance.
Enacting the proposal would also lead to economic distortions that would adversely affect the businesses that currently use the cash method and those that retain them—such as law firms and their clients. Namely, it would require the businesses to pay taxes on income that they have not and may never receive (“phantom income”). It would also force some firms to borrow funds in order to pay accelerated tax obligations. This would be especially burdensome for the legal profession because many lawyers aren’t paid by clients until long after the work is completed, according to the letter.
The ABA further reasons that mandatory accrual accounting would adversely affect clients since the firm would have to collect its fees much sooner than it currently does. Accident victims, start-up companies, and other clients who require an alternative or flexible fee basis would be especially affected, and many firms would have to reduce the amount of pro bono legal services that they currently provide.
The proposal would also constitute a “major, unjustified tax increase on small businesses.” According to the Joint Committee on Taxation, a comparable proposal would generate $23.6 billion in new taxes over 10 years—by forcing small businesses to pay taxes on phantom income up to a year or more before it is actually (if ever) received. It would also discourage professional service providers from joining with other providers to create or expand a firm and thus discourage the growth of small businesses.