Issue Resources: 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, 2012, 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.

 

Talking Points


The Ask:  Urge your Senators and Representatives to oppose the draft legislation that would force all law firms and other personal service businesses with annual gross receipts over $10 million to use the accrual method of accounting (instead of the traditional cash method) and thereby pay taxes on income long before it is received.  In particular, urge your Senators to oppose Section 51 of the draft Senate bill and convey their opposition to Senate Finance Committee Chairman Ron Wyden and Ranking Member Orrin Hatch, and urge your Representatives to oppose Section 3301 of the draft House bill and convey their opposition to House Ways & Means Committee Chairman Dave Camp and Ranking Member Sander Levin.


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 proposals will 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—will 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 will 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—will impose a serious financial burden and hardship on many of these firms. The legal profession will 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 will 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 will 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 will be unable to represent as many accident victims, start-up companies, or other clients on a contingent fee basis as they now do and will be forced to reduce the amount of free, pro bono legal services they currently provide to their poorest clients.


  • The proposals will constitute a major, unjustified tax increase on small businesses and discourage economic growth. The Joint Committee on Taxation estimates that the House proposal will 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). Also, individual professional service providers will be discouraged 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 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.

 

Jump to Any of the Following Sections:

 

 

Contact

 

R. Larson Frisby
Associate Director

Governmental Affairs Office
American Bar Association
1050 Connecticut Avenue, NW, Suite 400
Washington, DC 20005
Direct: (202) 662-1098
FAX: (202) 662-1762
larson.frisby@americanbar.org