Proposed Accrual Accounting Requirement Opposed by Many
Congress is considering tax reform legislation. One particular area of concern getting a great deal of push back from 32 states, 46 senators, and variety of professional organizations, deals with a proposal to make the accrual method of accounting a requirement.
Most personal service businesses, such as law firms, accounting firms, medical firms and other personal service providers, use the cash method of accounting to report their income and expenses. The reason is, its simplicity and because it makes sense from a cash flow perspective.
Cash Method vs Accrual Method
Under the cash method of accounting you report income on your tax return only when you actually receive it. Under the accrual method you report income in the year it is earned, regardless of when you actually get paid.
For example, under the cash method, if you invoice clients during December 2014 for services rendered but don't get paid until November 2015, you would report the income on your 2015 return.
In contrast, under the accrual method, you would be required to report the income on your 2014 tax return, the year the income was earned.
The example shows how the accrual method puts you in the position of having to caugh up cash to pay taxes on income before you actually receive payment. Not a good place to be when cash is tight and may be needed to make payroll or to pay other important business expenses.
Section 3301 of the draft “Tax Reform Act of 2014” prepared by House Ways & Means Committee Chairman Dave Camp (R-MI) and Section 51 of a similar Senate draft bill developed by former Senate Finance Committee Chairman Max Baucus (D-MT) would require all such businesses with annual gross receipts over $10 million to use the accrual method of accounting rather than the traditional cash receipts and disbursement method.
August 6, 2014 AICPA Letter
The AICPA said an August 6 letter to Senate Finance Committee chairman Ron Wyden, D-Ore., and ranking member Orrin Hatch, R-Utah, was signed by 46 senators from 32 states.
“As the Finance Committee develops its comprehensive tax reform package, we ask that you consider the negative impact that this proposal would have on the professional services sector as well as farming and ranching businesses,” the senators wrote. “We believe that such a change has not been fully vetted and many of the concerns raised by these businesses have not been addressed.”
The AICPA noted that it is a leading opponent of tax reform proposals to mandate the use of accrual accounting for businesses and individuals who exceed $10 million in annual gross receipts. The AICPA has partnered with state CPA societies and CPA firms to voice the profession’s concerns about the accrual accounting requirement
Another Letter to Finance Committee From Six Professional Organizations
Here's the full text of another letter dealing with the accrual accounting concern. Six major professional organizations signed onto it (Max Bauces was still chairman then):
January 17, 2014
The Honorable Max Baucus, Chairman
Senate Committee on Finance
Washington, D.C. 20510
The Honorable Orrin Hatch, Ranking Member
Senate Committee on Finance
Washington, D.C. 20510
RE: Cash Basis Method Should be Retained for All Professional Firms and Farms
Dear Chairman Baucus and Ranking Member Hatch:
We, the undersigned associations, represent businesses from across the entire American economy, including literally thousands of providers of essential services nationwide. We are writing to oppose a proposed change in the taxation of our businesses included in the Cost Recovery and Accounting Discussion Draft dated November 21, 2013 (Discussion Draft). This proposal would require many of our members to change the method of accounting used for tax purposes from the cash basis method to the accrual method.
Many of our members’ businesses include pass-through entities and personal service corporations that, essentially, are comprised of groups of individuals who have banded together to share resources, such as office space and staff. These businesses do not carry inventory or have other expenses that can reasonably be deferred. Generally, each owner in a firm is responsible for the business’s operations and the form of organization, whether a partnership, limited liability company, or personal services corporation, is chosen to facilitate efficient businesses practices.
Most significantly, a change from the cash basis method for tax purposes would result in those who own and operate these businesses to pay tax before cash is received. They would be required to recognize revenue in advance of actually getting paid. Because the expenses of such organizations would essentially remain the same, this requirement would result in higher net taxable income for Federal tax purposes. In addition, switching from the cash method to the accrual method of accounting will lead to significant cash-flow problems. For example, among professional services firms, the primary cost is labor, and businesses must regularly pay their employees even if they are not paid by their clients for several months. The use of cash accounting helps to mitigate this challenge by allowing the business’s owners to make tax payments after receiving payment for their services.
Farm and ranch businesses have an additional complication because the growing of crops and raising of livestock is a production activity under accrual accounting. As a result, production costs could not be expensed but instead would be accumulated as inventory and deducted when the commodity is sold. The inability to match revenue with expenses to target an optimum level of income for tax purposes will result in higher effective tax rates. This problem is exacerbated by the volatility of commodity prices caused by uncontrollable weather and unpredictable markets.
The Discussion Draft calls for increasing the gross receipts test from $5 million to $10 million for all businesses in order to continue to utilize the cash basis method. This is a welcome change. Farms and businesses operating in the personal service sector, which include accounting firms, law firms, medical and dental practices, architecture firms, engineering firms and others, should be allowed to continue to use the cash basis method for paying Federal taxes. We strongly oppose requiring these personal service entities to use the accrual method and lowering the current $25 million threshold for farms.
We believe that tax reform is a laudable goal and that simplification of the tax code is very important. However, converting from the cash method to accrual basis would not be simpler and may actually create a significant burden on these professional services sector businesses and farms.
Thank you for consideration of our views.
American Council of Engineering Companies
American Dental Association
American Farm Bureau Federation
American Institute of Architects
American Institute of CPAs
S Corporation Association