Mandatory Accrual Accounting for Law Firms

Overview

Congress is considering 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 H.R. 1, the “Tax Reform Act of 2014” introduced by then House Ways & Means Committee Chairman Dave Camp (R-MI) during the 113th Congress, and Section 51 of a similar Senate draft bill prepared by then 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 disbursements method.  If the proposals are enacted in this Congress, many law firms, accounting firms, medical firms, and other personal service providers would be forced to pay taxes on "phantom" income long before it is actually received.

Current law allows individuals and most partnerships, S corporations, 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 complex accrual method of accounting, in which income is recognized when the right to receive the income arises, not when the income is actually received.

Mandatory accrual accounting proposals like Section 3301 of the House bill and Section 51 of the Senate bill would dramatically change current law by raising the gross receipts cap to $10 million while eliminating the existing exemption for law firms, other personal service businesses, and for other pass-through entities.  If enacted, these far-reaching proposals would create unnecessary new 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, then Chairman Camp released his original draft tax reform bill known as the “Tax Reform Act of 2013,” which included many provisions such as 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 then Senate Finance Committee Chairman Baucus in 2013, including similar mandatory accrual accounting language contained in Section 51 of that measure.

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, 2014 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.  The ABA also sent letters to hundreds of law firm managing partners 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 leaders of the House Ways and Means Committee expressing concerns over the accrual accounting provisions in the original draft House bill.  Subsequently, 46 Senators sent a letter to the Senate Finance Committee leadership on August 6, 2014 supporting cash accounting and opposing mandatory accrual accounting legislation, and 233 Representatives (a majority) sent a similar letter to the House leadership on September 11, 2014.  In addition, the House Small Business Subcommittee on Economic Growth, Tax and Capital Access held a hearing on July 10, 2014 on the benefits of cash accounting for small business, and the ABA submitted a written statement in support of preserving cash accounting for law firms and other personal service businesses.

Chairman Camp released an updated version of his comprehensive tax reform legislation on February 26, 2014, and then formally introduced the revised bill on December 10, 2014 at the end of the 113th Congress as H.R. 1.  The accrual accounting provisions in the revised bill are almost identical to those contained in the original Camp bill, though the provisions were moved to Section 3301 of the new bill (from Section 212 of the previous bill).  While the House and Senate bills generated extensive discussion, neither bill advanced during the 113thCongress. 

In early 2015, the new chairmen of the House Ways and Means Committee and the Senate Finance Committee—Representative Paul Ryan (R-WI) and Senator Orrin Hatch (R-UT)— both announced plans to pursue comprehensive tax reform during the 114th Congress, and staff from both committees have indicated that the mandatory accrual accounting proposals may still be included in the new legislation.

The Senate Finance Committee recently set up a series of tax reform working groups and requested written comments from interested stakeholders by April 15, 2015. In response to this outreach, the ABA sent a letter to the Senate Finance Committee and a letter to the House Ways and Means Committee on April 6, 2015. The ABA also sent an updated Legislative Action Alert to state and local bars on April 7, 2015 urging them to send new letters to their Members of Congress.

Key Points

Congress should reject the proposed mandatory accrual accounting legislation because:

  • Instead of simplifying the tax law as its sponsors claim, the proposals would create unnecessary new complexity in the tax law and increase compliance costs. Law firms and other personal service businesses favor the cash method of accounting—where income is not recognized until payment is actually received—because it is simple and generally reflects the way they operate their businesses, i.e., on a cash basis. Requiring them to switch to the more complex accrual method of accounting—where income is recognized when the right to receive it arises—would substantially raise their compliance costs by forcing them to keep more much detailed work and billing records and hire additional accounting and support staff.
  • The proposals would impose substantial new financial burdens on many law firms and other personal service businesses by forcing them to pay taxes on income they have not yet received and may never receive. Requiring these businesses to pay taxes on phantom income long before it is actually received—and to 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 are not paid by their clients until long after the work is performed.
  • The proposals would adversely affect clients, interfere with the lawyer-client relationship, and reduce the availability of legal services. If law firms are forced to pay taxes on accrued income they have not yet received, the resulting financial pressures would force many firms charging on a traditional hourly fee basis to collect their fees immediately after the legal services are provided to the clients (or at least much sooner than they currently do). Also, many firms would be unable to represent as many accident victims, start-up companies, or other clients on an alternative or flexible fee basis as they now do and would be forced to reduce the amount of pro bono legal services they currently provide to their poorest clients.
  • The proposals would constitute a major, unjustified tax increase on small businesses and discourage economic growth. The Joint Committee on Taxation estimated that last year's House proposal would generate $23.6 billion in new taxes over ten years by forcing many thousands of small businesses to pay taxes on phantom income up to a year or more before it is actually received (if it is ever received). Both proposals would also discourage individual professional service providers from joining with other providers to create or expand a firm because it could trigger the costly accrual accounting requirement. 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 any proposed legislation, regulations, or other governmental measures that 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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