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Federal reform would make firms pay taxes on unrealized income

By: DOLAN MEDIA NEWSWIRES//March 4, 2014//

Federal reform would make firms pay taxes on unrealized income

By: DOLAN MEDIA NEWSWIRES//March 4, 2014//

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By Traci R. Gentilozzi
Dolan Media Newswires

Many law firms would have to switch their accounting methods and pay taxes on income before the money actually is collected, if a proposed federal tax reform makes its way through Congress.

The proposal would force law firms with gross receipts of $10 million or more to use the accrual method of accounting instead of the cash method.

Under the cash method, income is realized when it is actually or constructively received. But under the accrual method, income is realized when the right to receive it exists.

While the issue would seem to occupy the attention mostly of a firm’s bean-counters, the change could have significant practical import: A firm may see its cash flow affected, including any payouts for partner compensation or for firm expenditures such as technology purchases. And the change may affect client relationships, including how much heat a firm will need to put on a slow-pay client, because the need for having cash in the bank will be heightened.

While the proposal is only in the beginning stages, law firms are being warned not to take a wait-and-see approach. Instead, they should be planning now for the potential consequences.

Detroit attorney Michael P. Donnelly said that his firm, Fraser Trebilcock Davis & Dunlap PC, is assessing the situation.

“What kind of tax liability will this give us? That’s the real question,” he said. “We would not be getting money on the bills yet, but we’d have to pay taxes on those bills.”

Donnelly cautioned the proposal would not just effect larger law firms.

“Mid-size firms like us, we can gross $10 million or more,” he said. “When you’ve got 30 to 40 attorneys at a firm, you’re probably talking at least that much.”

Donnelly said he is uncertain why the reform has been suggested. “If there’s a particular problem that’s being addressed by this proposal, we haven’t identified it yet,” he said.

Certified public accountant David Ambrose said the proposal has one purpose: to help the federal government collect money that it needs.

2014 tax reform?

The tax reform proposal was suggested by U.S. Senate Committee on Finance Chair Max Baucus, D-Mont.

Baucus recently was appointed U.S. ambassador to China, and some say the appointment may sideline the reform until another election season. But House Budget Committee Chairman Paul Ryan, R-Wis., has hinted there still could be tax reform in 2014.

Under the proposal, businesses with average annual gross receipts for a three-year taxable period of $10 million or less could choose to adopt either the cash method of accounting or the accrual method. However, businesses that meet the three-year gross receipts threshold would be required to adopt the accrual method.

The American Institute of Certified Public Accountants does not favor the reform and sent a letter to Baucus letting him know. The AICPA said the proposal would impose “undue burdens” by requiring “significant additional planning to prepare for, and comply with, the new requirements.”

calculatorUnder the cash method, income is realized when received and expenses are recorded when paid, the AICPA said, calling these “straightforward and easily applied tests.”

But with the accrual method, “income is recognized when the right to receive the income exists, and expenses are recorded when they are fixed, determinable, and economically performed (i.e., all-events test),” the AICPA said. “All-events tests are more complex, do not track the financial accounting concepts of the accrual method, and increase costs of compliance.”

Concern #1: Cash flow

The major concern for law firms is that the accrual method could create cash-flow issues.

According to the AICPA, in order to cover the accelerated need to pay taxes, businesses would have to make cash distributions to their owners from other sources, and this would potentially threaten their operations due to less cash flow. Some law firms also raise capital solely by the individual professionals who own the firm, and cannot raise capital from outside investors, the AICPA said.

“Because of these limitations,” the group said, “an acceleration of tax on income that has not actually been collected in cash would place a strain on the ability of such professional owner-operators to properly capitalize and maintain capital in their firms.”

Ambrose said the accrual method definitely would cause cash-flow issues for law firms.

“Law firms tend to pull cash out of the business at year’s end, and partners’ compensation may be deferred until the firm knows what the final numbers are,” he explained. “So a portion of their compensation is affected by this proposal.”

Compensation would be linked to what the firm thinks the final numbers will be, Ambrose said.

“They will start out the year with not a lot of cash,” he said, “and if there are a lot of bills to pay, they would have to come up with the money.”

Another concern, Ambrose said, is what happens when a firm tries to implement new technology.

“Technology may often be part of the end budget,” he said. “But on an accrual basis, there could be some limits on it because the firm is not exactly sure what the final numbers will be.”

The difficulties in using the accrual method may end up being a one-time-only concern, Ambrose noted. This is because, once firms start using the accrual method, they will likely know what to anticipate.

Concern #2: Client relationships

Another concern is the effects on client relationships.

“Some of the companies we represent are in financial distress because they are in litigation or are a startup,” Donnelly explained. “We run significant account receivables with them, and we’re confident we will get paid at the end of the day. And with these small and mid-size companies, cash flow is sometimes already an issue.”

Under the proposal, law firms could be required to “float” money to clients in distress and end up paying taxes without receiving income, he said. In the long run, “this would affect our ability to expand, add new attorneys and add new staff,” Donnelly noted.

According to Donnelly, the accrual method could be particularly problematic when representing small and mid-size companies.

“There could be a significant amount of fees incurred very quickly and early in these cases,” he said. “For example, if we get a case three months before tax season, the company may not be able to actually pay until later. But the law firm would still have to pay taxes on that.”

The accrual method would require a firm to anticipate what the payment is going to be and maintain a sufficient amount on hand to pay it, Donnelly explained.

“This would be a real deterrent to representing small to mid-size companies, especially if they’ve racked up significant costs,” he said.

Concern #3: Growth limitations

The proposal would hinder natural business growth, the AICPA said, because once $10 million in receipts is met or exceeded, an “accounting change” would be triggered.

“In other words, a business’ inability to use the cash method of accounting would create an artificial obstacle to the acquisition of or merger with another service firm,” the AICPA wrote in its letter to Baucus.

Donnelly agreed. “It could significantly impact our ability to grow and hire people,” he said. “And that is certainly something we’re looking at. For a firm like us, where we’re always looking to expand, this is tough. It would be an added barrier.”

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