Changing tax rates tends to get a lot of media attention, the kind of attention that makes for an almost certain death for politicians in an election year. But fear of media attention does not mean that the men and women in Washington stop trying to raise money. To skip the battle over true tax reform, less obvious ways of raising revenue, such as changing deductions, are often put forth. This year, small businesses are a potential target for such efforts.
Congress is currently debating whether small businesses should be required to use the accrual basis of accounting rather than cash basis. Current law allows most businesses with annual gross receipts of $5 million or less to use the cash method of accounting for tax purposes. This means that means income is not recognized until cash or other payment is received and deductions are not allowed until payments are made. Personal service businesses such as law firms, accounting firms, engineering firms, medical practices and others, are allowed to use the cash method of accounting regardless of their annual revenue, unless they carry inventory.
Proposals now before Congress would change current law by raising the gross receipts cap to $10 million. At first glance, that would allow more large businesses to use cash-basis accounting, but the problem lies in a parallel provision that would eliminate the existing exemption for personal service businesses. Essentially, all businesses would have to pay income taxes on money they have not yet received, but expect to at a later date. That’s left a lot of people feeling squeamish.
The main thing to understand here is that, if passed, such a law would result in significant financial and compliance burdens for small businesses. While the tax on accounts receivable (also being called “phantom income”) would be partially offset by deductions to accounts payable (bills the business owes but hasn’t paid yet), the problem is that receivables are normally much higher than payables. Businesses could potentially have to borrow money just to pay the taxes on receivables that may not be collected for some time. Finding a bank to lend on those terms will be extremely difficult, and the accruing interest on the loan is an unfair burden on the business. Partners or shareholders transitioning out of a partnership or Subchapter S corp would also face an unfair burden since they would have to pay the tax on money they will never see. And compliance for all small businesses would be an absolute nightmare. The cash basis is just far easier.
Experts estimate an almost $23 billion in tax revenue over the next decade if accrual accounting becomes the law of the land. Still, there is strong opposition. Last week, a group of 46 senators (led by Ron Wyden (D., OR) and Orrin Hatch (R., UT)), sent a letter to the Senate Finance Committee saying that small businesses should not be forced to change their accounting methods to raise revenue for broader tax reform. Professional organizations, from the American Bar Association to the American Institute of CPAs (AICPA), have voiced strong opposition as well. The financial burden, they claim, is just too great.
The discussion on tax policy over the past few years has been on simplifying the tax code and this is a clear departure from that goal. Still, this is one of those things that will likely fly under the radar of media attention and not be a major talking point this election season. It’s of major significance to the small business community, however, so be sure to keep your eye on it.
