Partner Profits and the Fight Over Cash Accounting
Proposed legislation could force firms into accrual accounting and hit partners with big tax bills.
Congress is currently considering proposals to require certain professional service firms—including law firms—with revenues in excess of $10 million to move from the cash basis of accounting to the accrual method. This may sound like a dry and irrelevant subject for most lawyers, but it will have fundamental implications as to how law firms fund themselves and calculate and distribute their taxable profits, and it could require their partners to pay significantly higher tax bills over a number of years.
Two proposals now exist: One, by Chairman Dave Camp of the House Committee on Ways and Means, has a proposed effective date of the tax year commencing in 2014. The other, by Senate Finance Chairman Max Baucus, would take effect in the tax year commencing in 2015. Whether the legislation will be passed and, if it is, what the effective date will be is still uncertain. But if the change is implemented, law firms will be faced with major financial and managerial challenges both in the transition period and thereafter.
Cash accounting is relatively simple. Cash received (i.e., bills paid by clients) in the tax year is the firm's revenue, and expenses actually paid in the tax year are its expenses. The difference between the two is the firm's taxable profit, on which tax is paid. (In fact, the tax is paid by the partners on the share of the profits allocated to them.)
Accrual accounting is more complex. Revenue is recognized when work has been performed and the firm can determine the amount due with reasonable accuracy. Accordingly, revenue generally will include work done but unbilled where the income is foreseeable (for instance, the client has agreed to certain hourly rates), accounts receivable where the work has been done and billed but the bill has not been paid, and accounts paid where the work has been done, billed and paid for. This revenue figure is adjusted for amounts that are unlikely to be collected.
Expenses are deductible in the period the products or services are used, whether or not they were actually paid in that year. For a firm with a December 31 year-end, rent paid in December that relates to December, January and February would only be deductible that year in relation to the portion attributable to December, with the January and February rental expense being a deduction in the following year. Similarly, an electricity bill relating to December that was not paid until January would still be deductible in the year to which it related rather than the year in which it is paid.
For law firms used to cash accounting, the effect of the change is to accelerate the recognition of the revenue into the period in which the work is done rather than the period in which it is paid for. For example, if a firm has cash-basis revenues of $100 million and expenses of $70 million and at year-end has work in progress of $12 million and accounts receivable of $8 million, its taxable revenue would break out as in the table below.
In the year of conversion to the accrual method of accounting the firm's revenue will include the aggregate value of all work in progress and accounts receivable, minus allowances for write-downs and bad debts. If there are no major adjustments to the expenses, the gross revenue will increase to $120 million, producing a taxable profit of $50 million, compared to $30 million under the cash method. This $20 million of extra "profit" is not represented by any extra cash in the firm and will be taxable at the partners' highest marginal rate.
In subsequent years, effectively, only the increase or decrease in work in progress and accounts receivable over the prior year is treated as revenue. However, in those subsequent years, even if the firm records $100 million in revenue and $30 million in profit, it will be in a significantly different cash position, since its work in progress and accounts receivable will not yet have been received in cash at year-end. (For some firms, the level of work in progress and accounts receivable may be significantly higher than in this example, so the impact would be even more substantial.)
The current proposals would not amend other existing tax laws and would therefore permit the initial accrual conversion adjustment to be amortized evenly over four years. So in this example, taxable profits would not increase from $30 million to $50 million in year one but from $30 million to $35 million in each of years one, two, three and four.
If adopted, the accrual method of accounting will require firms to adopt a range of tax and accounting rules regarding income and expenditures that will be recognized in any one financial year. For revenues, these may include special rules for contingency fees so that they are recognized only when the contingency has occurred or is sufficiently likely to occur. Fixed fees could be prorated: For a matter where a fixed fee of $50,000 has been agreed upon, it may be apportioned so that if half the work has been done at year-end, $25,000 of revenue will be recognized, irrespective of the value of the time actually recorded. Firms will also want to adjust the value of work in progress and accounts receivable to allow for further client discounts or for bad debts. Regarding expenses, firms may need to alter the treatment of the benefit of any rent-free period or landlord's contribution to an office fit-out. Accruals may also be necessary for unused holiday pay, bonuses and other liabilities that accrue in one period but are paid later.