Last year at this time we brought to your attention tax reform legislation that would mandate the use of accrual basis (as opposed to cash basis) accounting for small businesses. Accrual basis accounting means that firms must report income in the calendar year in which the services are delivered, regardless of whether the corresponding cash is received that year. In other words, amounts in accounts receivable and work-in-progress are reportable as income for tax purposes, and expenses are deductible in the year they are used, not paid. Current law requires businesses with gross receipts of more than $10 million to use the accrual method but exempts professional service firms provided they have no inventory. Most professional service firms take advantage of the exemption and use the cash method of accounting, reporting income as it is received and expenses are paid. A mandate requiring the accrual method for all businesses, regardless of annual sales and providing no exemptions, would impose substantial financial burdens and potential hardships on personal service businesses -- a great number of our clients -- by fundamentally changing the manner in which they do taxes. Let’s take a look at where such proposals stand and just how dramatically your business could be affected if they are enacted this Congress.
Timeline and Status
In the spring of 2013, then Chairman Dave Camp released his original draft tax reform bill known as the “Tax Reform Act of 2013,” which included the accrual accounting requirements contained in Section 212 of the legislation. Draft tax reform legislation was also prepared by then Senate Finance Committee Chairman Baucus in 2013, and included similar mandatory accrual accounting language contained in Section 51 of that measure. Immediately there was major backlash. The American Bar Association and its members led the charge, but various other associations and entities protested, too. Members of Congress from both parties also voiced objections to the legislation. Chairman Camp released an updated version of his comprehensive tax reform legislation in February 2014, and then formally introduced the revised bill on December 10, 2014 at the end of the 113th Congress. The accrual accounting provisions in the revised bill are almost identical to those contained in the original. While the House and Senate bills generated extensive discussion, neither bill advanced during the 113th Congress.
In early 2015, the new chairmen of the House Ways and Means Committee and the Senate Finance Committee—Representative Paul Ryan (R-WI) and Senator Orrin Hatch (R-UT)— both announced plans to pursue comprehensive tax reform during the 114th Congress, and staff from both committees have indicated that the mandatory accrual accounting proposals are still very much on the table. Senate Finance Committee recently set up a series of tax reform working groups and requested written comments from interested stakeholders by April 15, 2015. Response has been great, but I fear that Washington’s desire to raise money (which this will accomplish) will trump any negative feedback.
Bracing for Impact
If enacted, these far-reaching proposals would create unnecessary new complexity in the tax law, increase compliance costs, and cause substantial hardship to many personal service businesses by requiring them to pay tax on income they have not yet received and may never receive. Here’s why:
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New complexity in the tax law and increased compliance costs. Personal service businesses favor the cash method of accounting—where income is not recognized until payment is actually received—because it is simple and generally reflects the way they operate their businesses, i.e., on a cash basis. Requiring them to switch to the more complex accrual method of accounting—where income is recognized when the right to receive it arises—would substantially raise their compliance costs by forcing them to keep more much detailed work and billing records and hire additional accounting and support staff.
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Substantial new financial burdens. Requiring businesses to pay taxes on “phantom income” long before it is actually received—and to use their scarce capital or borrow money to do so—would impose a serious financial burden and hardship on many firms. Personal service businesses are not paid by clients until long after the work is performed, making this particularly scary for those types of businesses.
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Ill effect on client relationships. If personal service firms are forced to pay taxes on accrued income they have not yet received, the resulting financial pressures would force many firms charging on a traditional hourly fee basis to collect their fees immediately after the services are provided to the clients (or at least much sooner than they currently do). Also, many firms would be unable to represent start-up companies or other clients on an alternative or flexible fee basis as they now do and would be forced to reduce the amount of pro bono services they currently provide to their poorest clients.
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Major, unjustified tax increase on small businesses and discouraged economic growth. Both proposals would discourage individual professional service providers from joining with other providers to create or expand a firm because it could trigger the costly accrual accounting requirement.
The Joint Committee on Taxation estimated that last year's House proposal alone would generate $23.6 billion in new taxes over ten years. That kind of money is just what’s giving mandated accrual accounting its traction. Sound tax policy should encourage—not discourage—the growth of small businesses, especially in today’s fragile economy. That’s not the direction we’re moving though. Keep a very close watch on this.
