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Federal Tax Proposal Would Adversely Affect Many Law Firms

Provisions in the Discussion Draft “Tax Reform Act of 2013” Will Require Law Firms to Pay Taxes Using the Accrual Method of Accounting
by Colleen K. O’Brien, Associate
Semmes, Bowen & Semmes (

Section 212 of the U.S. House of Representative’s Ways and Means Committee’s (“Committee”) discussion draft “Tax Reform Act of 2013” will require all law firms and other personal service businesses with annual gross receipts over $10 million to use the accrual method of accounting (“accrual method”) rather than the traditional cash receipts and disbursement method of accounting (“cash method”). According to correspondence from the American Bar Association (“ABA”) President to the House Ways and Means Committee Chairman, this would result in negative unintended consequences and cause substantial cash flow hardships to, among others, many law firms and other personal service businesses by requiring them to pay taxes on income accrued, i.e. income that they have not yet received and may never receive, due to write-offs, etc. The ABA has urged the Committee to remove this provision from the overall draft legislation.

Under current law, businesses are permitted to use the simple, straightforward cash method of accounting—in which income is not recognized until cash or other payment is actually received and expenses are not taken into account until they are actually paid—if they are individuals or pass-through entities (e.g., professional corporations, partnerships or subchapter S corporations), or their average annual gross receipts for a three year period are $5 million or less. In addition, all personal service businesses—including those engaged in the fields of law, accounting, engineering, architecture, health, actuarial science, performing arts, or consulting—whether organized as sole proprietorships, partnerships, limited liability companies, or S corporations, are exempt from the revenue cap and can use the cash method of accounting irrespective of their annual revenues, unless they have inventory.

Section 212 of the draft legislation would dramatically change current law by raising the gross annual receipts cap to $10 million while eliminating the existing exemption for personal service businesses, other partnerships and S corporations, and farmers. Therefore, if this proposal is enacted into law, all law firms and other personal service businesses with annual gross receipts over $10 million would be required to use the accrual method of accounting, in which income is recognized when the right to receive the income accrues and expenses are recorded when they are fixed, determinable, and economically performed — both aspects of which present complications, given the often significant lag between billing and collections.

Although Section 212 would allow certain small business taxpayers with annual gross receipts in the $5 million to $10 million range to switch to — and thereby enjoy the benefits of—the cash method of accounting, the proposal would significantly complicate tax compliance for a far greater number of small business taxpayers, including many law firms and other personal service businesses, by forcing them to use the accrual method. Partnerships, S corporations, personal service corporations and other pass-through entities favor the cash method because it is simple and generally correlates with the manner in which these business owners operate their businesses—i.e., on a cash basis. The increased complexity associated with the accrual method will raise compliance costs for many law firms and other personal service businesses—as separate sets of records will be needed to reflect the accrual accounting—while greatly increasing the risk of noncompliance with the Code.

In addition to creating unnecessary complexity and compliance costs, Section 212 would lead to economic distortions that would adversely affect all personal service businesses that currently use the cash method of accounting and those who retain them, including many law firms and their clients, in several ways. The proposal would place a new financial burden on millions of personal service businesses throughout the country—including many law firms—by requiring them to pay tax on income not yet received and which may never be received.

The existing cash method of accounting produces a sound and fair result because it properly recognizes that the cash a business actually receives in return for the services it provides—not the business’ accounts receivable—is the proper reflection of its true income and its ability to pay taxes on that income. While accounts receivable clearly are important to determining the overall financial condition of a business and assessing its future prospects, they do not accurately reflect its current disposable income or its present cash flow ability to pay taxes on that income.

The mandatory accrual accounting provisions in Section 212 of the draft bill would create unnecessary complexity in the tax law, increased compliance costs, and impose significant and unnecessary new financial burdens and hardships for many law firms and other personal service businesses throughout the country by requiring them to pay taxes on income not yet received, and that may never be received.

To avoid these harmful unintended consequences, the ABA has urged the Committee to remove Section 212 from the draft bill or from any tax reform bill that may be approved by the Committee. The ABA has recently asked state and local bar associations to join in the opposition of the proposal. DRI, the Voice of the Defense Bar, also plans to oppose this legislation. Law firms should monitor this legislation closely. MDC will provide periodic bulletins as significant developments occur.