While law firms are increasingly modeling their business practices after their clients’, one they have not been interested in mimicking is the accrual method of accounting.
But it may be coming.
Leaders of some of Pennsylvania’s largest law firms are calling a piece of proposed tax reform legislation floating around in Congress a “gimmick” to get what one firm leader estimated was an extra $10 billion in tax revenue from the Am Law 200 firms alone, with the end result being heavy tax burdens on partners and firms being forced to borrow money.
Law firms and other professional services firms are currently exempt from having to use an accrual method of accounting, which would require them to pay taxes on accounts receivable and work in process as well as the cash they bring in. Currently, they pay tax only on actual cash receipts.
Max Baucus, the former chairman of the Senate Finance Committee before leaving Congress earlier this month to serve as the U.S. ambassador to China, and Rep. Dave Camp, R-Mich., chairman of the House Ways and Means Committee, each introduced comprehensive tax reform legislation that included a requirement for professional services firms with more than $10 million in revenue to switch to an accrual method of accounting. The switch in methods would be phased in over four years.
With Baucus, a Montana Democrat, out and a midterm election coming up this year, bankers and firm leaders who spoke to The Legal said passage of a tax overhaul was unlikely in the very near future. But the bankers said firms need to prepare just in case and law firm leaders are concerned the measure would be plucked from the tax reform legislation and added into a more easily passed bill to help finance whatever that proposal may be.
K&L Gates managing partner Peter Kalis said in an email that while the proposals are aimed at businesses, they “profoundly” impact the individual owners of these businesses—the partners, who will have to pay taxes on “phantom” income they have not, and may never, receive. He said this switch would drive law firms into debt to fund operations, partner compensation and tax obligations.
“On the heels of the global financial crisis and its aftermath, it is sheer folly to drive the legal industry into a deficit position requiring massive bank borrowing to fund operations and partners’ now-artificially-swollen tax obligations,” Kalis said in the email. “In the nascent recovery of the legal markets, the timing of this blindsided blow to U.S. law firms and their individual partners could not be worse. There is no credible justification for causing law firms to abandon cash accounting, to single out their partners to be taxed on phantom income, and to drive them and their firms into debt.”
Kalis further noted that such a switch would create a competitive disadvantage for U.S. firms in comparison to their British, Chinese and other global competitors.
”This appears to be a one-time revenue-raising gimmick that would impose a significant tax penalty on professions whose members are already paying tax at the highest ordinary income rates,” Dechert CEO Daniel O’Donnell said.
He said his firm joined several other law firms and the American Bar Association in opposing a switch to the accrual method. The ABA adopted in November a resolution opposing Camp’s version of the legislation.
“This change would sacrifice simplicity by disallowing the use of the cash method while increasing compliance costs and corresponding risks of manipulation,” the ABA said in its resolution. “Moreover, it would be inequitable and cause substantial hardship to personal service businesses—including many law firms, accounting firms, architectural and engineering firms, and many other small businesses—by requiring them to pay tax on income that they have not yet received and may never receive.”
While there are ways to write off some of the income never collected, bankers who spoke to The Legal put the average law firm’s realization rate at about 85 percent, meaning 15 percent of what they bill they aren’t collecting.
Eckert Seamans Cherin & Mellott CEO Timothy P. Ryan, who called the proposed changes “horrific” for the industry, said standard accrual accounting principles would allow firms to have a “bad debt reserve” in which they could write off that uncollected portion. But Ryan said the pending legislation is unclear as to whether that will be allowed.
Even if firms can write off uncollected fees, and therefore not have to pay taxes on them, the cost of getting an accounting firm to audit a firm’s finances would be “astronomical,” Ryan said. Compliance and auditing costs would go up along with taxes, forcing firms to borrow to help partners shoulder that burden, he said.
Mike McKenney, head of lending for Citi Private Bank’s Law Firm Group, said that for firms of 150 lawyers or more, the switch would mean an approximate one-time increase in gross revenue of about 30 percent. That means partners of a partnership, or the firm itself if it is a corporation, will have to pay tax on that extra 30 percent despite not actually having collected that cash yet from clients, he said.
“That will create a funding need,” McKenney said, adding firms could borrow money or call for more capital from their partners.
Though a switch to the accrual method would even out over time and firms would adjust, the initial hit, which some firm leaders have described as substantial, is what has them worried.
Kalis said a firm with $1 billion in revenue probably has about $250 million in work in process and accounts receivable. In applying the highest tax rate of nearly 40 percent, Kalis said that firm would face an additional $100 million in taxes.
Both Kalis and O’Donnell said the change would stifle growth of law firms and affect plaintiffs firms as well as large defense firms.
“Apart from the immediate tax consequences, adoption of the proposal would discourage growth, particularly for smaller firms that are approaching the $10 million threshold, and would penalize growth by larger firms by requiring them to borrow money or find other sources of cash to distribute to partners who would have to pay tax on phantom income,” O’Donnell said. “The proposal would also have a significant adverse effect on firms representing plaintiffs who participate in structured settlements.”
Kalis noted plaintiffs lawyers who earn a contingency fee would have to pay tax on the entire fee when it was awarded even though the client may pay the fee to the lawyer over several years.
In a December 2013 white paper by PricewaterhouseCoopers’ Law Firm Services unit, PwC pointed out the impact the rule change would have on partners who pay tax on fees generated but leave the firm before it is collected, new partners who have to pay the increased tax rate plus their new capital requirements and whether firms paying departing partners their capital would include the partners’ shares of accounts receivable and work in process.
“Most law firms would have to restructure their partnership or operating agreements,” Ryan said.
Currently, when a partner leaves a firm, his right to income is cut off the day he leaves. But if that partner has already paid taxes on unpaid bills, Ryan said he thinks the partner may have a legitimate claim to the money when it comes in. Ryan said that complicates a law firm’s accounting.
Another fallout from this change, Ryan said, would be firms becoming much more cognizant of the creditworthiness of their clients and a renewed pressure on partners to be very conservative about what they say is collectible.
Collections Crunch Exacerbated
If the end-of-the-year push for collections seems chaotic now, some who spoke to The Legal said it would only get worse under the accrual method.
PwC said in its white paper that firms may have to change their processes for billing clients to better match when a bill is issued and when the fees are collected. PwC further noted firms could improve their collection of cash in the year the work was billed.
Both McKenney and Mary Ashenbrenner, regional director of Wells Fargo’s legal specialty group, said firms would become much better under an accrual system of estimating what their work is worth and their ability to collect on it.
Ashenbrenner said the more sophisticated law firms have already moved their collections responsibility from the partners to a centralized billing department.
“I would think that those efforts to streamline that process and move it out of the hands of that partner and into the hands of the professional collecting the receivables would increase,” Ashenbrenner said.
McKenney said firms currently push for collections at year-end to have that cash on hand.
“Even if you go to accrual, you still want the cash,” McKenney said. “You still want a fast cash-conversion cycle because otherwise you are supporting that balance sheet with debt or equity.”
Ashenbrenner said it isn’t clear to her how the accounting change would improve anything in terms of running a law firm aside from the one-time revenue gain for the government. She said it would create a “huge tax burden” for law firms and their partners.
Firms need to start preparing for the possibility that this could happen, Ashenbrenner said, noting some Pennsylvania firms are “extremely concerned” and others “sort of have their heads in the sand” about the issue.
It’s clear that some firms are paying attention—and they don’t seem to like what they see.
“Law firms such as K&L Gates with no debt will be driven into debt for the first time to fund their operations and partner compensation,” Kalis said in the email. “Law firms with existing debt will have difficulty locating new sources of borrowing. I predict law firm failures, layoffs, rising costs, an avoidance of [alternative fee arrangements] that trigger tax obligations before cash is collected, and an impact on billing rates.”
Camp’s office referred comment to the Ways and Means Committee. A spokeswoman for the committee said it “continues to review the feedback and input we’ve received.”