As if tax law wasn’t complicated enough, there’s an accounting method change on the horizon that industry experts believe could cause new – and unnecessary – burdens and hardships for many large companies nationwide.
Congress is considering tax-reform legislation that would change the manner in which law firms and other personal service businesses are required to pay their taxes. Similar bills prepared by House Ways and Means Committee Chairman Dave Camp, R-Mississippi, and former Senate Finance Committee Chairman Max Baucus, D-Montana, would require businesses with annual gross receipts over $10 million to switch to an accrual method of accounting, as opposed to the traditional cash method.
Under the current law, most partnerships and businesses with annual gross receipts less than $5 million are required to pay tax on their income as they collect cash, according to Jude Coard, Long Island tax chair and partner at Berdon in Jericho. In other words, income is not recognized until a cash payment is received.
In addition, regardless of their annual revenue, all law and accounting firms – as well as various other personal-service businesses – are able to use the cash method of accounting, unless they maintain inventory.
With the accrual method of accounting, however, income is recognized once a service has been provided and a business is entitled to it, not when the income is actually received, Coard said. Currently, if a business bills a client in December but doesn’t receive payment until mid-January, the business enjoys an entire year deferral on income for tax purposes, he said.
Under the new proposal, the same business that billed a client in December would be taxed on the income regardless of if and when it received payment.
While the bill is “nowhere close to being law,” according to Coard, “it is still very worrisome.”
Opposing lobbyists are making lots of noise about the legislation – “The legal community is up in arms and medical services firms are pushing against it,” Coard said – and many state and local bars have adopted anti-legislation resolutions. In addition, many members of Congress from both parties have expressed concern over the accrual accounting provisions in the draft bills, which were introduced last year as part of a larger tax-reform package.
“There will [continue to be] a ton of pushback because there are definitely some logistic problems taxpayers will be faced with [if this bill becomes law],” said James Wienclaw, tax and business services partner at Marcum in Melville.
Namely, the cost will be prohibitive to taxpayers, according to Wienclaw.
For instance, cash-basis taxpayers forced to switch to the accrual method would have to figure out the cumulative effect of switching at the end of the tax year, he noted. All of the income that had been deferred would now have to be picked up over a step period (under the Camp proposal, the income could be picked up every two years over eight years).
“It will also hurt their cash flow since they are paying taxes on money they haven’t collected, which could lead to increased need to borrow money to pay the taxes,” said Garden City-based accountant Salvatore Armao. “This will create additional costs in terms of interest expense and bank fees.”
In addition to imposing new financial burdens on many firms, the bill’s passage could be a deterrent to business mergers, Wienclaw noted.
“Say you have two individuals, each with $11 million a year in revenue who are providing a service,” he said. “Individuals can stay in a cash basis. But if you put the individuals together, you have a partnership. The cost will be immediate in terms of tax and may get in the way of these individuals coming together.”
Coard agreed, noting a company that’s grossing $9 million may think twice before merging with a practice making $1.1 million, in an effort to avoid grossing more than $10 million and having to switch to the accrual method.
One of the only positives, Coard said, is that the bill would enable businesses to look at a client’s track record. For instance, if a business owner bills a client for $100 but, historically, the client only pays $90, the business would only be taxed on the $90. Analyzing receivables takes a lot of time, however, Coard said.
“It’s not going to simplify anything,” he added. “I don’t see it as being the first place to make a change. It seems like there are other, lower-hanging fruits than this.”