There’s a lot to chew on in The Tax Reform Act of 2014 as submitted by House Ways and Means Committee Chair Dave Camp (R-MI). And by a lot, I mean 194 pages (downloads as a pdf).
The Act is intended to “simplify” our current Tax Code. I’ve been following Congressional tax reform efforts for awhile. You know, if you’re a regular reader, that I’m pretty well convinced that nobody actually wants to simplify the Tax Code, they just want to pay less in taxes and those two things are, unfortunately, not necessarily consistent. But I’ll let my colleagues from Forbes ruminate on most of the provisions for now – they’ve done a fantastic job so far (you’ll see some of their pieces embedded to the left).
Instead, I’ll focus on one of the provisions that doesn’t get much play – and it’s one that affects lawyers.
I know, you hate lawyers. It’s fun to hate lawyers. We make a good punchline and it’s easier to blame lawyers for the state of things than it is, say, greedy plaintiffs or unsavory CEOs. But that’s a post for someone else to tackle.
I’m going to focus on lawyers and tax reform.
For starters, I should clarify that even though it’s lawyers screaming the loudest on this one (see the American Bar Association, for example, as well as many of the smaller ones like sections of my own Pennsylvania Bar Association), the particular provision in Camp’s proposal that affects lawyers doesn’t just affect lawyers. It affects a number of other professionals in qualified personal service corporations. Qualified service corporations include those that primarily perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. It’s a pretty broad brush.
Under current law, those folks are allowed to use the cash method for tax and accounting purposes without regard to average annual gross receipts. The cash method means that you report income as received and you report expenses as paid. It’s pretty simple. Most sole proprietors and service companies like simple.
A business that has inventory generally uses the accrual method for tax and accounting. The accrual method means that you report income when it’s ordered or performed – even if it’s not paid for – but you also get to report expenses when those happen – even if they’re not paid for. It’s more complicated but tends to serve companies that rely on advance orders pretty well in order to balance out income and expenses.
Under the proposed law, those affected companies with average annual gross receipts of $10 million or less can continue to use the cash method of accounting. However, qualifying businesses with more than $10 million would be required to use accrual accounting.
There’s an exception – because there are always exceptions – in the tax world. There’s one is for farmers no matter how much income they make. You know, because we like farmers. And there’s one for sole proprietors no matter how much income they make. Because who’s going to vote against Mom and Pop? But everyone else – the doctors, the lawyers, the consultants, the architects, the engineers, the actuaries, and the performing artists would have to make the switch.
Let me be clear: it’s a stupid law.
The whole purpose of the bill is to make the Tax Code more simple. There is no more simple accounting method than the cash method.
The Ways and Means Committee acknowledges this in their draft but says that the accrual method provides a “more accurate reflection of income.” They are wrong.
Let me tell you why. I work in a law firm. Like doctors and engineers and architects, it’s not unusual for me to work on a matter and not get paid in the same year that I do the work.
Sometimes, I do it for the convenience of the client. Maybe the client can’t pay the bill and they’re paying me in installments. Maybe the client can’t pay the bill until they probate the will or get a tax refund.
Sometimes, I do it because the court says so. We have a matter pending right now where the parties didn’t agree on a solution: my firm worked on the matter for 14 months without getting paid. In another case, the executor of an estate we were administering died, and, for a number of reasons, an administrator cannot be appointed just yet. We have nearly two years of legal fees unpaid.
Sometimes, I do it because the work simply isn’t yet finished. Tax matters can drag on. Corporate dissolutions take time.
There are a number of reasons why I might perform services but not get paid. And ditto for doctors and architects and consultants and others dragged into this mess of a bill.
It’s a particularly onerous burden. In service professions where compensation is traditionally tied to income received, you’re creating a system where companies are now taxed on income that might not be received this year – and might never be received. To combat the potential burden, you’re allowed a tax write off for fees not collected (something that you’re not allowed to do if you’re a cash-based taxpayer) but that requires a triggering event in the future – and how is that more simple?
Realizing that, the Committee included a provision to allow the deferral advance payments for certain goods and services in income for tax purposes up to one year (but not longer than any deferral for financial statement purposes). And again, that’s more simple, how?
(And yes, there are more exceptions for farming in that particular provision.)
It’s not just about the tax burden for paying tax on income that you never actually received. It’s also about the costs to make the switch to an entirely new method of accounting. Tracking income and expenses will be completely different.
The easiest answer for companies is to demand full payment at the time of service. And that’s not at all good for consumers.
You think medical billing is bad now? Wait until hospitals and doctor’s office realize how complicated the accrual system might be.
The logical step, of course, if the bill is passed, is for companies to stunt their own growth. If you are a company offering these qualified services, if you plan not to grow, you don’t have to switch your accounting method. Not growing beyond that $10 million mark (no mergers, no acquisitions, no partnerships) means that you have the luxury of choosing your own tax and accounting method. And make no mistake: most will continue to choose the cash method if given the choice.
I’m not going to try and convince you to give law firms a tax break. Or doctors. Or engineers. Or consultants. Or any of a number of cherry-picked professions under the law. But why make their lives (and most importantly, those of their clients) more difficult?
But even putting that aside, this particular provision doesn’t advance the supposed purpose of the tax reform one little bit. I’m all about tax reform if it accomplishes the goals we claim we want. But this doesn’t. What about this provision is more simple or fairer? Or pro-growth? Or pro-business? I think you have your answer.