Proposed Changes In Congress Could Affect Engineering Firms

Proposed Changes In Congress Could Affect Engineering Firms

Currently, most engineering firms use the cash method of accounting, but new proposals would force taxpayers with gross receipts greater than $10 million to use the accrual method of accounting. Such a change in accounting method would force firms to accelerate the recognition of taxable income. For instance, a firm’s accounts receivable and work in process may become immediately reportable under these proposals (rather than reportable when actually received, as under the cash method of accounting).

Engineering firms that are structured as partnerships or S Corporations do not recognize income themselves, but instead the firm’s income is passed-through and recognized by the firm’s owners. This change would force the owners of such firms to pay taxes on their share of the firm’s accounts receivable and work in process in the year in which all events have occurred that fix the right to receive such income, and the amount thereof can be determined with reasonable accuracy. Because firms likely have a fixed right to receive fees when performance occurs, rather than when due or received, these amounts would need to be recognized immediately. Nevertheless, nearly 85% of the average engineering firm’s costs are attributable to labor and related taxes and benefits. Thus,firms must regularly pay their employees even if they are not paid by their clients for several months. This could cause some firms to experience serious cash flow problems. However, this burden is eased by the section 481(a) adjustment which allows the recognition of this income in the year of conversion to the accrual method to be spread over a four-year period known as the adjustment period.

Because partners and S Corporation shareholders will likely have a very large tax burden upon conversion to the accrual method of accounting (or during the four-year adjustment period if elected), firms may need to consider cash distributions or other means to ease this burden. Firms may distribute cash to the owners in an amount equal to the cash to accrual conversion amount, or could assist the owners in securing loans. Firms need to consider the time it may take to secure financing and should plan ahead. Partnership and Shareholder agreements may need to be amended to record modifications in the firm’s income recognition, tax treatment and distribution policies.

Determining when income is accrued is another area of complexity because it is not always clear when the right to receive income becomes fixed. The issue is whether income is accrued when the whole project is complete, or whether income becomes fixed at separate stages of the engagement.

Uncollectible accounts also create additional complexity. Under the accrual method, a receivable would be initially reported as income. If it were to become wholly or partially uncollectible, the firm would deduct it. Calculation of the amount and timing of the deduction needs to either be self-tested or fall under one of six safe harbors.

Because these changes will significantly affect a firm’s tax reporting, firms should consider process changes to match these potential tax changes. Firms will want to collect more of the billing sooner, and should discuss billing arrangements with clients such as requiring additional fees paid in advance. Firms will also need to analyze their existing books and records to determine income, accrued expenses and bad debt deductions. The American Council of Engineering Companies (ACEC) has joined in a coalition with five other organizations representing the nation’s accountants, architects, dentists, farmers and S corporations in opposing the proposals made by Camp and Baucus. Recently it was reported that more than half of the House is pressing lawmakers to preserve the use of the cash basis of accounting for engineering firms operating as partnerships and S Corporations as well.

Of course, these changes are merely proposals, and even if adopted, the effective date is unknown (maybe the 2015 tax year). However, firms should still consider the potential impact of the changes. They should begin assessing what amounts their pass-through owners might have to recognize over the adjustment period and discuss the potential means to address these burdens. Engineering firms should contact their tax advisors, who will continue to monitor the proposals and provide guidance regarding the changes.