Proposed Changes in Congress Could Affect Law Firms
Law firms with over $10 million in revenue need to be aware of two proposals in Congress that may fundamentally change the way income is reported for federal tax purposes. Currently, most large law 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 law 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).
Law firms that are structured as partnerships do not recognize income themselves, but instead the firm’s income is recognized by the firm’s partners. This change would force the partners 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. 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 (adjustment period).
Partners that leave or retire during the adjustment period will likely be required to report income for the period in which they continued as partner, but not after they retire. New partners may be responsible to recognize the adjustment period income during the period in which they serve as partner, but not for the years of the adjustment period before they become partner. Because partners will likely have a very large tax burden during the adjustment period, firms should consider means to ease this burden. Firms may distribute cash to the partners in an amount equal to the cash to accrual conversion amount, or could help the partners secure loans. Firms need to consider the time it may take to secure financing and should plan ahead. Partnership agreements may need to be amended to record modifications in the firm’s income recognition, tax treatment and distribution policies.
The accrual method may lead to increased complexity in the firm’s accounting. For instance, under the accrual method, income is includible when all events have occurred that fix the right to receive income, and the amount thereof can be determined with reasonable accuracy. If rates are set by contract, the service revenue may be determined easily. If the fee is contingent or based on hourly rates, the revenue may need to be accrued based on standard realization rates.
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 engagement is complete, or whether income becomes fixed at separate stages of the engagement. A firm in such a position may want to argue that the income is not fixed until the entire representation is complete (such as when a settlement is reached), but the IRS may argue that a representation is divisible into parts, and that when each part is completed, income should be accrued.
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 may want to collect more of the billing sooner, and should discuss billing arrangements with clients. Firms will also need to analyze their existing books and records to determine income, accrued expenses and bad debt deductions.
Of course, these changes are merely proposals, and even if adopted, the effective date is unknown (maybe the 2014 tax year). However, firms should still consider the potential impact of the changes. They should begin assessing what amounts their partners might have to recognize over the adjustment period and discuss the potential means to address these burdens. Law firms should contact their tax advisors, who will continue to monitor the proposals and provide guidance regarding the changes.
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