Mandatory Accrual Accounting for Law Firms

Overview

Congress is poised to consider tax reform legislation that would impose substantial new financial burdens and potential hardships on many law firms and other types of personal service businesses throughout the country by fundamentally changing the manner in which they must pay their taxes.  Section 3301 of the draft “Tax Reform Act of 2014” prepared by House Ways & Means Committee Chairman Dave Camp (R-MI) and Section 51 of a similar Senate draft bill developed by former Senate Finance Committee Chairman Max Baucus (D-MT) would require all such businesses with annual gross receipts over $10 million to use the accrual method of accounting rather than the traditional cash receipts and disbursement method.  As a result, many law firms, accounting firms, medical firms, and other personal service providers would be forced to pay taxes on income long before it is actually received.

Current law allows individuals and most partnerships and other pass-through entities—as well as other types of businesses with annual gross receipts of $5 million or less—to use the simple cash method of accounting for tax purposes, in which income is not recognized until cash or other payment is actually received.  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 unless they have inventory.  Most other businesses are required to use the more complicated accrual method of accounting, in which income is recognized when the right to receive the income arises, not when the income is actually received.

Section 3301 of the draft House bill and Section 51 of the draft Senate bill would dramatically change current law by raising the gross receipts cap to $10 million while eliminating the existing exemption for law firms and other personal service businesses, and for other partnerships and S corporations.  Therefore, these provisions would create unnecessary complexity in the tax law; increase compliance costs; and cause substantial hardship to many law firms and other personal service businesses by requiring them to pay tax on income they have not yet received and may never receive.

Status

In the spring of 2013, Chairman Camp released his original draft tax reform bill known as the “Tax Reform Act of 2013,” which included many provisions including the accrual accounting requirements contained in Section 212 of the legislation.  The ABA Board of Governors subsequently adopted a Resolution in November 2013 opposing Section 212 of the original Camp draft bill and any other similar measures that would require law firms and other personal service businesses to switch from the cash to the accrual method of accounting.  Draft tax reform legislation was also prepared by former Senate Finance Committee Chairman Baucus last fall, including similar language in Section 51 that would require many law firms and other personal services businesses to switch to the accrual method of accounting.

On January 13, 2014, the ABA sent a letter to the House Ways & Means Committee and a separate letter to the Senate Finance Committee opposing the accrual accounting provisions in the respective draft bills and urging the Committees to remove these provisions from the legislation.  The ABA also sent a Legislative Action Alert to state and local bar leaders on January 31 urging them to adopt their own resolutions opposing the legislation and to send letters to their Members of Congress.  Numerous state and local bars subsequently adopted resolutions or sent letters to their congressional delegations opposing the legislation.  ABA President James Silkenat also sent a letter to several hundred law firm managing partners on February 3 requesting their firms’ assistance in defeating the harmful legislation.

In addition to the concerns raised by the ABA, state and local bars, and various other associations and entities, many Members of Congress from both parties have voiced objections to the legislation.  On November 25, 2013, 71 Representatives sent a letter to House Ways and Means Committee Chairman Camp and Ranking Member Sander Levin (D-MI) expressing concerns over the accrual accounting provisions in the original draft House bill.  Although Chairman Camp released an updated version of his comprehensive tax reform legislation on February 26, 2014, known as the "Tax Reform Act of 2014," the accrual accounting provisions in Section 3301 of the new bill are almost identical to those contained in Section 212 of the previous bill.  While the House and Senate draft bills have generated extensive discussion and debate, neither bill has been formally introduced, and no hearings or other action has been scheduled on either measure.

Key Points

The Congress should reject the accrual accounting requirements in Section 3301 of the draft House bill and Section 51 of the draft Senate bill because:

  • Instead of simplifying the tax law as its sponsors claim, the provisions would create unnecessary new complexity in the tax law and increase compliance costs.  Law firms and many other types of personal service businesses favor the cash method of accounting—in which income is not recognized until cash or other payment is actually received—because it is simple and generally correlates with the manner in which these business owners operate their businesses, i.e., on a cash basis.  The increased complexity associated with the accrual method of accounting—where income is recognized when the right to receive it arises—will raise compliance costs for businesses while greatly increasing the risk of noncompliance with the Tax Code.
  • The provisions would impose new financial burdens on many law firms and other personal service businesses by requiring them to pay taxes on income they have not yet received and may never receive.  The traditional cash method of accounting produces a sound and fair result because it properly recognizes that the cash a business actually receives in return for the services it provides—not the business’ accounts receivable—is the proper reflection of its true income and ability to pay taxes on that income.  Requiring law firms and other personal service businesses to pay taxes on income long before it is actually received—and to either use their scarce capital or borrow money to do so—would impose a serious financial burden and hardship on many of these firms.
  • The legal profession would suffer even greater financial hardships than other professions because many lawyers and law firms are not paid by their clients until long after the work is performed.  Many types of lawyers—such as business lawyers working on complex transactions and litigators involved in lengthy trials or appeals—often are not paid until the end of the case or project, which can be years after the work is performed.  This sets lawyers and law firms apart from many other types of professionals—such as doctors, dentists, and accountants—who typically work on a pay-as-you-go basis.  Thus, requiring personal service providers to pay taxes on income that has accrued but not yet been received will create special hardships for many in the legal profession.
  • The provisions would lead to economic distortions that would adversely affect all law firms and other personal service businesses that currently use the cash method of accounting.  Most law firms are organized as partnerships owned by lawyers who practice together, and in many firms, the partners change from year to year as older lawyers retire, younger lawyers are promoted, and other lawyers switch firms.  Firms operating on the cash method can ensure that the partners working at the firm are taxed on the income actually received that year, but if they are forced to use the accrual method, partners will be taxed on income their firms accrue on paper in the current year even though the partners may not be around when the clients actually pay their bills (if they ever do).
  • Individual professional service providers would be discouraged from joining with other providers to create or expand a firm because it could trigger the costly accrual accounting requirement.  For example, solo practitioner lawyers would be discouraged from entering into law firm partnerships—and many existing law firms would be discouraged from expanding—because once a firm exceeds $10 million in annual gross receipts, it would be required to switch from cash to accrual accounting, thereby accelerating its tax payments.  Sound tax policy should encourage—not discourage—the growth of small businesses, especially in today’s fragile economy.

ABA Policy

Although the ABA supports simplification of the tax laws, the Association opposes the accrual accounting provisions in the draft House Ways & Means and Senate Finance Committee bills, as well as any other similar proposed legislation, regulations, or other governmental measures, which would require law firms and other personal service businesses that now compute taxable income on the cash receipts and disbursements method of accounting to convert to the accrual method of accounting.

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