Recent Congressional proposals could have a major impact on how many larger law firms report their taxable income for U.S. federal income tax purposes. Under the proposals, law firms with revenues of more than $10,000,000 would be required to change from cash to the accrual method of accounting.
John Fitzgerald, Berdon LLP audit partner and Chair of Law Firm Services, and attorney and tax principal Marc Ausfresser answer questions that address the significant consequences law firms and their attorneys may face as a result of these proposals.
Q. Where do the proposals stand?
A. There are two proposals sitting on the table: The Baucus proposal—Section 51 of a draft Senate bill, and the Camp proposal— Section 3301 of the House Ways & Means Committee‘s Tax Reform Act of 2014. Both the ABA and the AICPA have expressed strong opposition to each on a number of fronts, among them:
Q. If the proposals are enacted, what will be the tax consequences?
A. The consequences would be substantial for both firms and individual partners. The firm’s taxable income would be accelerated. Accounts receivable (A/R) and work in progress (WIP) would become reportable for U.S. federal tax purposes. To temper this, tax law allows for an adjustment of this income to spread it over a four-year period.
Partners would be taxed on their allocable share of the accelerated income at their individual tax rate. For example, if a New York State resident partner is allocated an additional $125,000 of income, he will be required to make a $60,000 tax payment before the cash has been collected.
Q. What are our options for financing these new obligations?
A. Your options will be determined by your firm culture and your available financial resources. Consider the following:
Q. Will we need to amend our partnership agreement?
A. Most likely you will need to make changes that address both the transition period from cash to accrual as well as how you will do business in the new environment. Since this will be a fundamental change, it is prudent to build in time to discuss, negotiate, and agree upon the amendments. Among the areas you will need to address in the partnership agreement are income recognition, distributions, tax payments, and rules for partners joining, departing, and retiring from the firm.
Q. How will current partners be affected?
A. Partners will have to be more effective in their relationships with clients as they need to make a greater effort in seeking timely payments from clients. This may require further training for many partners. Additionally, individual partners will need to make adjustments in their personal tax planning.
Q. Are there considerations for exiting and retiring partners?
A. The change raises the possibility of cash flow problems in making payouts to retiring partners. The firm may need to increase its borrowing. Looking ahead, it may also be time to reconsider the firm’s retirement formulas.
Q. Will there be any impact on our financial statements?
A. This will depend on your corporate structure. If the firm is a corporation, corporate taxes can be accelerated and liabilities can be added to the balance sheet. For firms operating as partnerships, liabilities will be on the partner level.
Q. How will billing and collections be affected?
A. The billing and collections process will become even more crucial and may need to be modified. Firm estimates on the collectability of WIP will become more meaningful. Prompt payment by clients must become a first order of business, which will likely require more direct partner involvement to help ensure that the client complies. Some firms have billing cycles of as much as 90 days. This is untenable under the accrual method and the 30 day cycle will have to become the new standard.
Q. Are there implications for our banking relationships?
A. Yes. It is likely that you will need to completely redesign your loan covenants and credit facilities. The firm will probably need to increase its borrowing or arrange a partner loan program.
Q. What can we do to prepare?
A. There are a number of practical steps to help pave the way to a smooth transition.
These are just some of the questions and concerns stemming from the very real possibility that these Congressional proposals, in some form, may become a reality. With the future shrouded in uncertainty, it is prudent to plan ahead and take steps to ease the way towards a potential transition.
John Fitzgerald (212.331.7411 | firstname.lastname@example.org) is an audit partner and Chair of Law Firm Services at Berdon LLP. An advisor to practices of all types and sizes, he consults on maximizing opportunities in purchases, sales, and acquisitions; obtaining financing and refinancing; preserving and transferring wealth; and on improving operations.
Marc Ausfresser (212.331.7639 |email@example.com) is a Berdon tax principal and attorney with expertise that extends to planning the organization of business entities to minimize taxes and maximize financial return. The firm has offices in Jericho and New York City.