It’s still only a discussion draft issued by the U.S. House Ways and Means Committee1, but it has the potential to change your firm’s method of accounting Ultimately, if enacted, it could also increase your firm’s need to borrow money.
In the proposed legislation, Congress would require partnerships, S corporations, personal service corporations and other pass-through entities with annual gross receipts of over $10 million to use the accrual method of accounting. Most law firms use the simple and straightforward cash method of accounting where partners pay taxes only on income that has been collected and expenses are not taken into account until they are actually paid. Switching to the accrual method could require tax payments on income that has been earned, but is not necessarily in hand.
This proposed legislation raises concerns on many fronts, including income reporting, partnership agreements, borrowing, and receivables. On 1.17.14, it prompted a coalition of six business organizations, among them the American Institute of CPAs, to send a letter opposing this proposal to the Senate Finance Committee. Here are just some of the issues.
Some firms may find themselves in a tight cash squeeze under the accrual method where uncollected income is reported and taxed. As a result, a law firm may not have enough cash to distribute to the partners to fulfill their tax obligations.
It may then become necessary to borrow to make up the shortfall. Alternatively, some partners might need to reach into their personal reserves — which could be a serious problem for younger members of a firm who are just beginning to build wealth.
Tighter tracking of receivables will become a higher priority. This may be a logistical and organizational chore that will eat into time and increase costs. Some firms have billing cycles of as much as 90 days. This cycle will not work well under the accrual method, so many may have to notify clients that a 30 day cycle is the new norm.
Firms, struggling with the need to fulfill their tax obligations with money not yet in the till, may have to renegotiate and restructure their partnership agreements as they relate to retired partners.
Those firms with overseas operations where the accrual method is more common, as it is in the United Kingdom, may have already made adjustments. But, for the vast majority, it is important to monitor activity in the Capital dome and be prepared should this concept or some modified version be enacted.
1 Ways and Means Committee discussion draft, March 12, 2013