Federal Tax Reform and the Potential Repeal of the Cash Method of Accounting
In the wake of the introduction by President Trump of his Tax Reform proposal on April 26, 2017, Congress, especially the U.S. House of Representatives Committee on Ways and Means, will be considering various methods to fund tax rate reductions. The White House formally delivered the President’s proposed budget to Congress on May 23, 2017. One proposal likely to be under consideration is the repeal of the cash method of tax accounting for service businesses, though many experts dispute whether many of the budget’s finer details will ever pass both houses of Congress.
Under current law, the cash method of accounting cannot be used for income tax purposes by (i) businesses that sell goods and therefore must keep inventories, and (ii) C corporations with average annual gross receipts of $5,000,000 or more. A taxpayer-favorable exception from the C corporation rule is available for qualified personal service corporations, consisting of personal service corporations (PSCs) in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, when at least 95% of the stock of such PSCs is owned directly or indirectly by employees performing services in one of such fields. To oversimplify things, this means that law firms pay federal tax based on actual cash receipts, not based upon billings or upon what their books show is owed to them.
In contemplating what Congress might do with the PSC exception, which has been threatened with repeal for a number of years now, most commentators point to Section 3301 of H.R. 1 introduced by prior Ways & Means Chairman Rep. Dave Camp during the 113th Congress. The Camp proposal required all businesses with average gross receipts over $10 million, not just C corporations, to use the accrual method of accounting. Such a proposal would require all large and most medium-sized service businesses to use the accrual method, regardless of whether the business is a PSC, an S corporation, LLC, LLP, or other form of pass-through entity.
Affected businesses need to realize that this change is not just a tax increase with a dollar impact. The accrual method would need to be applied to all sources of revenue and deductions. Although the Camp proposal did include a mechanism to defer the initial adverse impact of conversion from the cash to accrual method, deferral would be practically difficult to implement with respect to ongoing retiring and newly hired partners or stockholders of S corporations. That is, how will a service partnership or PSC allocate the deferred income tax impact of conversion from cash to accrual among an always-changing group of partners or shareholders? This is just one major problem with the Camp proposal or other alternatives.
In addition, while service firms might be able to reduce the adverse tax impact of the accrual method though whole or partial bad debt accruals, the partial bad debt deduction must first be taken for book purposes. Identifying and quantifying partial write-downs can be a difficult and time-consuming drill to perform with respect to work-in-process or recently billed invoices. When a company’s fiscal year end is fast approaching, what CFO or managing partner wants to be making decisions regarding which two-month old receivables or work-in-process to partially write off, in order to limit the damaging cash flow results of paying taxes early? Making this process even worse, if the firm generates audited financial statements, the outside auditors will be forced to question those write-off decisions, as well as the balances in accounts receivable and work-in-process at year-end, as part of their audit engagement to ensure that the financial statements fairly present the business’s results of operations.
Some commentators have expressed concern that a repeal of the cash method of accounting with a $10 million threshold would mean that small personal service firms would have an implicit disincentive to grow beyond that threshold, thereby inhibiting mergers or joint ventures that would push such companies above the $10 million threshold.
For all of these reasons, and many others, small and medium-sized personal service firms and their respective trade associations find themselves stepping up their advocacy and lobbying in opposition to any repeal of the cash method of accounting. Trade associations such as the American Bar Association, AICPA, American Dental Association, and the New Jersey State Bar Association have gone on record as opposing such a repeal.
If you would like more information on any aspect of the potential repeal of the cash method of accounting, or if you would like to discuss ways to convey your concerns to your Congressional representatives in Washington D.C. with respect to the threatened repeal of the cash method, please reach out to the Gibbons Tax and Government & Regulatory Affairs attorneys.