A tax reform proposal now being considered by Congress could mean financial hardship for the nation’s largest law firms and outsized tax bills for those firms’ partners, according to business experts.
Draft legislation released in late November by Senate Finance Committee Chairman Max Baucus (D-Mont.) includes a fundamental revision to the way large law firms and other professional service firms report and pay their taxes. A draft bill in the House, first circulated in March, includes a similar provision.
Firms with gross receipts of greater than $10 million could no longer use the cash method of determining taxable income, but instead would use the much more complex accrual method, according to an analysis of the Baucus draft bill released last week by accounting firm PricewaterhouseCoopers. Given that the lowest-ranked firm on The American Lawyer’s most recent Am Law 200 list, Strasburger & Price, had gross revenue of $90.5 million in 2012, those operating at the high end of the U.S. legal market would clearly feel the full force of such a revision.
At law firms, partners would bear the burden of that change. Income would have to be reported earlier—even before cash is received—and would likely “generate an unexpected, front-loaded income tax liability that must be paid by law firm partners over a proposed four-year period,” the PwC analysis states.
But firms also would have to deal with the consequences, such as deciding whether and how to help partners with the additional taxes, PwC said. Other business and culture issues could need adjustment, including partnership agreements, accounting processes and systems, or benefit programs for partners, said David Gaulin, national assurance leader for PwC’s law firm services practice.
“Firms should not be sitting back waiting to see if and when this goes through,” Gaulin said in a telephone interview. “They should be setting up work streams to model it out and think about how it’s going to impact their organization, and make sure there are no negative consequences.”
The timing and likelihood of such a provision becoming law is far from certain. The proposal would depend on Congress’ appetite and ability to tackle broader tax reform. “Even the sponsors don’t know when this might come up,” said Tom Susman, the American Bar Association’s governmental affairs director. “Nobody knows. The problem is we have to be ready.”
And while Baucus has requested public comment by Jan. 17, he is poised to leave the finance committee to become U.S. ambassador to China, pending Senate confirmation.
Lawmakers are looking at the change as a temporary revenue bump to help fund other parts of a broader tax reform. “Because of the revenue impact, it will be very tempting to use this regardless of the public policy implications,” Susman said.
There is already opposition from professional service groups. The ABA’s Board of Governors voted in November to oppose any change from the cash to accrual method for professional service firms because it would increase cost of compliance and risk of non-compliance.
The ABA identified potential pitfalls of switching to the accrual method. Partners could be taxed on income in one year “even though they may not be around when the clients pay their bills (if the bills are ever paid),” the ABA states in the report.
And the legislation would discourage lawyers from joining together to create or expand a firm, even if it made economic sense and would benefit their clients, because it could trigger the accrual accounting requirement in the bill, the ABA states.
And the American Institute of CPAs wrote a letter to Congress this month voicing concerns that it would strain the ability of professional service firms to properly capitalize and maintain capital in their firms.
“The cash method of accounting is simpler in application, has fewer compliance costs, and does not require taxpayers to pay tax before receiving the income being taxed,” the AICPA wrote in a Dec. 5 letter to Baucus and Sen. Orrin Hatch (R-Utah), the finance committee’s highest-ranking Republican.
And a group of 71 lawmakers voiced concerns about the provision in a Nov. 25 letter to Ways and Means Committee Chairman Dave Camp (R-Mich.), who circulated a House proposal called the Tax Reform Act of 2013. The lawmakers called the accrual method “unnecessarily complex and financially burdensome for many of the businesses not currently using this method.”