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    Mandatory Accrual Accounting for Law Firms

    Overview

    On December 22, 2017, President Trump signed sweeping tax reform legislation known as the Tax Cuts and Jobs Act of 2017 (P.L. 115-97), which includes several key tax provisions on which the ABA successfully lobbied. The new tax law includes ABA-supported language allowing the owners of law firm pass-through businesses to deduct 20% of their “qualified business income” up to certain income thresholds; retaining the existing deduction for student loan interest that benefits lawyers with law school debt; and preserving the current deduction for upfront litigation expenses incurred by attorneys with contingency fees in the 9th Circuit. Perhaps most importantly, however, the new tax law does not include ABA-opposed mandatory accrual accounting proposals that would have required many law firms to pay taxes on their work in progress, accounts receivable, and other “phantom income” long before it is received from clients.

    For over four years, the ABA worked closely with 34 state, local, and specialty bars, dozens of law firms, and its other coalition allies to protect the legal profession from several mandatory accrual accounting proposals that would have imposed substantial new financial burdens and potential hardships on many law firms and other types of personal service businesses throughout the country. 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 have forced 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 propsoals had become law, many law firms, accounting firms, medical firms, and other personal service providers would have been forced to pay taxes on 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 cash 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 it arises, not when the income is actually received.

    Mandatory accrual accounting proposals like Section 3301 of the previous House bill and Section 51 of the previous Senate bill would have dramatically changed current law by raising the gross receipts cap to $10 million while eliminating the existing exemption for law firms, other personal service businesses, and other pass-through entities. If enacted, these far-reaching proposals would have created unnecessary new complexity in the tax law; increased compliance costs; and caused 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 method of accounting to the accrual method.  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 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.

    At the end of the 113th Congress in late 2014, Chairman Camp introduced a revised version of his comprehensive tax reform legislation as H.R. 1, and the mandatory accrual accounting provisions in Section 3301 of that legislation were almost identical to those contained in Section 212 of the original Camp bill. However, while H.R. 1 and the draft Senate bill generated extensive discussion, neither bill advanced during the 113th Congress. 

    During the 114th Congress, the new chairmen of the House Ways & Means Committee and the Senate Finance Committee—Representative Kevin Brady (R-TX) and Senator Orrin Hatch (R-UT)—both announced plans to pursue comprehensive tax reform, and members and staff from both committees reiterated that the previous mandatory accrual accounting proposals remained viable options to help pay for tax rate reductions. After the Senate Finance Committee created a series of tax reform working groups and requested written comments from interested stakeholders, the ABA sent new letters to that committee and to the House Ways & Means Committee in April 2015 urging them to preserve cash accounting for law firms and other personal service businesses and to oppose any proposals requiring these businesses to switch to the accrual method. The ABA also sent an updated Legislative Action Alert to state and local bars in April 2015 urging them to send new letters to their Members of Congress.

    After receiving input from many stakeholders, the Senate Finance Committee’s Business Income Tax Working Group issued its Report to the full Committee in July 2015 discussing various tax proposals and options. Although the Report did not expressly endorse the previous mandatory accrual accounting proposals, it stated that “it would be difficult to achieve significant rate reduction in a revenue-neutral tax reform process without curtailing many of the most popular tax expenditures utilized by pass-through businesses, such as…cash accounting,” and the Report also listed the Baucus and Camp accrual accounting proposals as viable “Options” for the Committee to consider (See Report at page 27 and the Appendix at pages A-5 to A-8).

    In February 2016, Speaker Ryan created a new House Tax Reform Task Force chaired by House Ways & Means Committee Chairman Brady to develop a new tax reform plan based on several key principles including tax simplification, closing loopholes, lowering rates, and encouraging the growth of small businesses.  The House tax reform plan, known informally as the “Blueprint,” was released in June 2016 and included several major proposals such as lower corporate and individual tax rates, a new 25% tax rate for small pass-through businesses, and full expensing.  To pay for these tax reductions, committee members and staff carefully examined many other possible changes to the tax code, including the previous mandatory accrual accounting proposals.

    To address this continuing threat, the ABA sent a new letter to the House Ways and Means Subcommittee on Tax Policy on April 13, 2016 in connection with its hearing on "Fundamental Tax Reform Proposals."  The ABA also sent similar letters to the full House Ways and Means Committee and the Senate Finance Committee in April 2017.

    Although the Trump Administration did not take a formal position on the mandatory accrual accounting proposals, the proposals remained under active consideration by the House Ways and Means and the Senate Finance Committee while the Tax Cuts and Jobs Act was being developed as one possible means for paying for lower tax rates. Therefore, the ABA and its coalition allies were very pleased when the final tax bill approved by Congress and signed into law by President Trump in December 2017 did not include the harmful accrual proposals.

    Key Points

    Congress properly rejected the proposed mandatory accrual accounting legislation because:

    • Instead of simplifying the tax law as its sponsors claim, the proposals would have created 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 have substantially raised 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 have imposed substantial new financial burdens on many law firms and other personal service businesses by forcing them to pay taxes up front 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 have imposed a serious financial burden and hardship on many of these firms. The legal profession would have suffered 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 have adversely affected clients, interfered with the lawyer-client relationship, and reduced the availability of legal services. If law firms were forced to pay taxes on accrued income they have not yet received, the resulting financial pressures would have required many firms charging on a traditional hourly fee basis to collect their fees in advance or immediately after the legal services are provided to the clients (or at least much sooner than they currently do). Also, many firms would have been 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 have had to reduce the amount of pro bono legal services they currently provide to their poorest clients.
    • The proposals would have constituted a major, unjustified tax increase on small businesses, discouraged economic growth, and killed jobs. The Joint Committee on Taxation estimated that the House proposal would have generated approximately $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 have also discouraged individual professional service providers from joining with other providers to create or expand a firm because it could trigger the costly accrual accounting requirement. The proposals could have also pressured many firms to shed existing employees to avoid the accrual accounting requirement or to help pay the firms' accelerated tax liabilities. Sound tax policy should encourage—not discourage—the growth of small businesses and job creation, 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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    Contact

    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
    [email protected]