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July 01, 2014

ABA says keep it simple and fair with cash accounting

ABA President-elect William C. Hubbard urged a House panel this month to protect the ability of personal service businesses, including law firms, to use the cash method of accounting because it is simple and generally correlates with the manner in which they do business − on a cash basis.

Hubbard also warned that the proposal by House Ways and Means Committee Chairman Dave Camp (R-Mich.) to require accrual accounting for many law firms would add unnecessary complexity and cause serious financial harm to these firms.

“In addition to promoting simplicity, the cash method of accounting also 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 measure of its true income,” Hubbard said in a statement submitted for the record of a July 10 hearing before the House Small Business Subcommittee on Economic Growth, Tax and Capital Access.

Subcommittee Chairman Tim Rice (R-S.C.) convened the hearing to examine how the cash accounting method is utilized by small businesses and whether current policies should be changed to allow small firms more flexibility in choice of accounting methods. Witnesses included representatives of the National Conference of CPA Practitioners, National Association of Enrolled Agents, the Kogod Tax Center at American University, and the South Carolina Farm Bureau, who each echoed Hubbard’s concerns over the harm that mandatory accrual accounting would cause to many small businesses around the nation.

Under current law, businesses generally are only are permitted to use the simple straightforward cash receipts and disbursement method of accounting − in which income is not recognized until cash or other payment is actually received and expenses are not taken into account until they are actually paid − if their average annual gross receipts for a three-year period are $5 million or less. However, all individuals, partnerships, S corporations, law firms, and other personal services businesses also are permitted to use the cash method irrespective of their annual revenue unless they have inventory.

In his statement, Hubbard emphasized the ABA’s strong opposition to the Camp proposal, which 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 business, and other entities that can currently use cash accounting regardless of their annual income. This would force those businesses to use the accrual method of accounting, in which income is recognized when the right to receive the income exists rather than when payment is received, and would require affected firms and other businesses to pay taxes on income long before it is received.

“If the tax rules are changed to disconnect cash collections from how income is taxed, the very business model upon which many law firms and other personal service businesses operate will be turned on its head,” Hubbard said.

Camp’s proposal – contained in Section 3301 of his draft “Tax Reform Act of 2014” – would create “unnecessary complexity and compliance costs,” according to Hubbard, and adversely affect businesses in several ways. In particular, the bill would:

• require personal service businesses, including many law firms, to pay taxes on “phantom” income they have not yet received and may never receive;

• cause the legal profession to 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;

• adversely affect clients, interfere with the lawyer-client relationship, and reduce the availability of legal services in various ways; and

•constitute a major tax increase on small and medium-sized businesses and discourage economic growth.

According to the Joint Committee on Taxation, Section 3301 would generate $23.6 billion in new taxes over 10 years.

Hubbard said the ABA has been working in close cooperation with a broad and diverse coalition of associations, law firms and other organizations to raise awareness of the Camp proposal and its unintended harmful consequences. He emphasized that the mandatory accrual accounting issue has become one of the most important issues to the ABA and many state and local bars throughout the country because of the serious negative effects the proposal would have on law firms and many other types of small and medium-sized businesses.   

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