Cash versus Accrual Method of Accounting – How potential legislation would affect Professional Service companies.

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Congress has considered tax reform proposals that would require many professional service firms to move from the cash method to the accrual method of accounting for income tax purposes. Such a change would impose new financial burdens on professional service firms and their partners/shareholders – including a large, unexpected tax liability.

Most professional service firms currently use the cash method of accounting. Under that method, taxpayers report income as it’s received and expenses are paid. If firms were required to switch to the accrual method, recognition of revenue would be accelerated. Under this method, firms must report income in the calendar year in which the services are delivered, regardless of whether the corresponding cash is received that year. In other words, amounts in accounts receivable and work-in-process are reportable as income for tax purposes. Additionally, expenses are deductible in the tax year that the products or services are used, not when they are paid.

To reduce the burden for accelerated income, affected professional service firms would be allowed to spread the income adjustment over a four-year period. The adjustment can be reduced for amounts that are deemed uncollectible.

This congressional proposal has generated a vocal backlash. A major concern is partner/shareholder tax liability. The tax burden will fall to the partners/shareholders. Firms will need to choose from several options, including increasing draws/distributions to cover estimated tax liabilities. This could cause a need for additional financing from lenders or required new capital contributions from partners/shareholders. This may cause partners/shareholders to obtain personal loans.

Alternatively, firms could change their schedule of draws/distributions of profits to allow for accounts receivable and work-in-process to be converted to cash before making distributions.

The worst option, of course, would simply leave it to the individual partners/shareholders to pay their own increased taxes.

In August 2014, The American Institute of CPAs (AICPA) and the American Bar Association (ABA) expressed their opposition. Both organizations are urging the lawmakers to consider the financial burden the proposal, if enacted, would place on businesses and its partners/shareholders.

In December 2014, a revised proposal was introduced, but the accrual method provisions were almost identical to those contained in the original proposal introduced in the spring of 2013. Both the House and Senate have announced plans to pursue comprehensive tax reform during the new 114th Congress, and the mandatory accrual accounting provision will most likely be discussed during this legislation.

Greenwalt CPAs will stay on top of this topic and will release any new information as it comes to light. If you have any questions on how this proposal may affect your business or its partners/shareholders, please feel free to contact Jim Wagoner at 317-260-4428 or jwagoner@greenwaltcpas.com.