Accrual Accounting for Professional Services Firms – Playing Heads Up Ball
By Kenneth E. Winslow, CPA, PSA
Abstract: This article covers an overview of the American Bar Association’s appeal to Congress arguing against the implementation of an accrual accounting tax mandate for professional service businesses. It provides a brief primer on accrual v cash basis accounting and offers a discussion of how changing to an accrual based system will affect accounting for law firms and what you can do to maximize your firm’s bottom line.
(1) Background on the ABA’s appeal to Congress
A concept that most of us learned about in Accounting 101—accrual versus cash accounting—is now tabled for discussion and is generating some controversy. Section 3301 of H.R. 1, and Section 51 of a similar Senate draft bill, would require many personal service businesses—including law firms and accounting firms—that have annual gross receipts of more than $10 million to use the accrual method of accounting rather than the traditional cash receipts and disbursements method adopted by most professional services firms.
Under current law, professional service corporations, individuals and other pass-through entities with average annual gross receipts of $5 million or less over a three (3) year period—can use the cash method of accounting for tax reporting purposes. In addition, all law firms, accounting firms, and various other types of personal service businesses are allowed to use the cash method of accounting regardless of their annual revenue as long as inventory is not a significant component of their business.
The mandatory accrual accounting proposals are under active consideration in the new 115th Congress, cites the American Bar Association. If these proposals are enacted many law firms, accounting firms, medical firms, and other personal service providers would be required to pay Federal and related state income taxes on income earned long before funds are actually received.
American Bar Association (ABA) opposes the burdensome tax proposals and issued a bulletin in April 2017, prepared by Larson Frisby, requesting that Congress reject these mandatory accrual accounting proposals citing the following:
1 – Rather than simplifying the tax law as the sponsors claim – these proposals would create unnecessary new complexity in the tax law and increase compliance costs;
2 – Proposal would impose substantial new financial burdens on may law firms and other personal service businesses by forcing them to pay taxes up front on income they have not yet received and may never receive;
3 – Proposal would adversely affect clients, interfere with the lawyer- client relationship, and reduce the availability of legal services;
4 – The proposals would constitute a major, unjustified tax increase on small businesses, discourage economic growth and kill jobs
The ABA prepared letters dated April 21, 2017, to Orrin G. Hatch, Chairman of the Senate Finance Committee and Kevin Brady, Chairman of the House Committee on Ways and Means strongly opposing these proposals.
(2) The ABCs of cash vs. accrual accounting
For the most part—and to keep it simple, we’ll ignore hybrid and other exotic methods—there are generally two ways for businesses to account for their revenue and expenses; the cash basis and accrual basis of accounting.
Under the cash basis of accounting, revenue is recognized upon actual or constructive receipt and expenses are deducted in the tax year you actually remit the payment. So if “XYZ Law Firm” received $20 million in receipts, for the calendar year ended December 31, 2016, and pays out a total of $18 million in operating expenses; then we can say the firm earned $2 million in 2016 using the cash basis. Billings and unbilled work in process for clients through the year-end of $1,000,000, uncollected by the firm are excluded from income for the calendar year 2016. Likewise expenses of $400,000 unpaid at year end are excluded as deductions.
In contrast, under accrual basis accounting, revenue is generally recorded when it’s earned (technically when the right to receive it arises and it’s likely to be collected), not when the revenue is actually received. Expenses are generally reported when the cost is incurred, regardless of when payment is actually made.
So, all else being equal, XYZ Law Firm’s would have $1,000,000 more revenues net of $400,000 more expenses for the calendar year ended December 31, 2016 under the accrual basis of accounting. So instead of posting a $2 million cash basis profit in 2016, the law firm’s net profit under the accrual method would be $2.6 million (the increase of $600,000 represents the difference between the $1,000,000 in earned revenue offset by $400,000 in accrued expenses).
(3) Why Congress is interested in changing the rules about cash vs. accrual accounting
Tax revenue of course.
The cash method of accounting could let a firm defer tax liability by mismatching income and related expenses, typically by strategically timing when invoices go out and when expenses are paid and recorded. In fact the Cash Versus Accrual Accounting: Tax Policy Considerations report reveals that the Joint Committee of Taxation estimates the five-year revenue loss associated with cash basis accounting to be $10.9 billion between fiscal year 2014 and 2018 .
Such restructuring of a firm’s operating results and the resulting tax obligations will effect
1 – Partnership agreements for existing, future and retiring partners
The agreements will need to be reviewed and modified for valuation of a partner’s interest attributable to distributions to existing partners, the admission of new partners, and payouts to retiring partners;
2 – Debt financing agreements;
Firms will need to renegotiate loan agreements to address changes in financial covenants and additional financing requirements to cover the tax obligations;
3 – Financial reporting and measurement of income.
Firms will be required to address their measurement, billing and collection policies as their uncollected billings and services will now be subject to tax. In addition, expense reporting associated with bad debts, deferred and accrued expenses will require additional scrutiny.
(4) What can be done now?
Under this proposal the net change in taxable income, resulting from the increase in income offset by expenses incurred, under Section 481 (a), would be reportable as income over a four (4) year period.
Firms should consider preparing a proforma calculation to determine the potential Section 481 (a) adjustment and resulting tax obligations by reviewing and measuring the following:
1 – Receivables and unbilled work in process;
2 – Accounts payable, accruals and deferred charges.
3 – Calculate the net Federal and state tax obligation and allocation over four (4) year period.
Use the above calculation to address changes which may be required to partnership and financing agreements.
Although the proposals have been kicked around for a few years without being passed, the ABA and other organizations are still concerned. The Trump Administration has not yet taken a formal position on the mandatory accrual accounting proposals, but there is a possibility that they could be included in the new comprehensive tax reform legislation that is being discussed in the 115th Congress. Law firms, accounting firms, and many other types of small businesses should be aware of this and may wish to consult with their tax and other advisors.
About the Author
Kenneth E. Winslow, CPA, PSA is a partner at the firm Bederson LLP in Fairfield, New Jersey.
He specializes in accounting and advisory services for professional services businesses. He can be reached at [email protected]rson.com or 973-530-9115.
Major changes proposed for 2018 FF-SHOP enrollment
The Small Business Health Options Program (SHOP) was created under the Affordable Care Act to establish a centralized marketplace where small employers and their employees could choose coverage, complete enrollment and pay premiums. A subset called FF-SHOP (“federally facilitated SHOP”) was also established to perform such functions in states that don’t have a state-based SHOP. (Employers aren’t required to buy SHOP coverage unless they wish to receive the small business health care tax credit.)
Recently, the Centers for Medicare and Medicaid Services (CMS) announced its intention to issue proposed regulations that would change the enrollment process for small employers buying plans via FF-SHOP.
According to the CMS announcement, for plan years beginning on or after January 1, 2018, the proposed regulations would eliminate the FF-SHOP’s enrollment function. Instead, small employers would enroll directly with an insurer offering SHOP plans or with the assistance of an agent or broker registered with the FF-SHOP.
Although the announcement doesn’t directly address the FF-SHOP’s future role in collecting premiums from employers and forwarding them to insurers, it implies that the FF-SHOP will also discontinue this function. The CMS has stated that employers currently enrolled in FF-SHOP coverage for a plan year that began in 2017 would be able to continue to enroll employees and pay premiums through the FF-SHOP for the remaining portion of that plan year in 2018.
The announcement also states that employers would still use the HealthCare.gov website to obtain a determination of eligibility. And the CMS anticipates that state-based SHOPs would be able to provide for online enrollment or opt to direct small employers to insurers and SHOP-registered agents and brokers to directly enroll in SHOP plans.
Under transitional relief issued in April 2016, state-based SHOPs already have the option to use direct enrollment — through 2018. Although the CMS proposal would revise the way the FF-SHOP operates, the full extent of the change will have to be developed through the rulemaking process.
It seems clear that the SHOPs will have a role to play so long as they are linked to the small business health care tax credit. And there may be resistance to the potential loss of the FF-SHOP’s premium calculation, collection and payment functions. Contact your benefits advisor for the latest news on this developing issue.
Sidebar: IRS accepting renewals for expiring ITINs
The IRS has begun accepting applications from individuals seeking to renew individual taxpayer identification numbers (ITINs) that will expire at the end of 2017. ITINs are issued to individuals who are ineligible for Social Security numbers but must furnish taxpayer identification numbers for federal tax reporting or filing purposes. For example, ITINs must be obtained by nonresident aliens and some resident aliens who need to file U.S. tax returns.
Under the Affordable Care Act, providers of minimum essential coverage (MEC) generally must solicit and report taxpayer identification numbers — either Social Security numbers or ITINs — to report months of coverage for individuals enrolled in the MEC. Such coverage providers are mostly insurers, but also may include employers that self-insure.
ITINs are requested and renewed on IRS Form W-7. Under recent legislation, ITINs expire if they haven’t been used on a federal tax return at least once in three consecutive years. The legislation also establishes a schedule for the expiration of ITINs that haven’t expired because of disuse. (This schedule and other changes are discussed in IRS Notice 2016-48.)
Key ACA indexing adjustments for 2018
The IRS has announced 2018 indexing adjustments for two key percentages under the Affordable Care Act (ACA). They are as follows:
1. Affordability. This is the required contribution percentage used to determine whether employer-sponsored health coverage offered by an applicable large employer (ALE) is “affordable” for purposes of employer shared responsibility. The amount had increased from the 9.5% baseline to 9.69% for 2017 but will decrease to 9.56% for 2018.
2. Premium tax credits. A percentage is used to determine the amount individuals eligible for premium tax credits must contribute toward the cost of coverage obtained through a Health Insurance Marketplace (also referred to as an “exchange”). It will also see small decreases. The adjusted percentage, ranging from 2.01% to 9.56%, varies across household income bands.
The IRS announcement included a reminder that the required contribution percentage used to determine whether individuals are exempt from individual shared-responsibility penalties also decreased to 8.05% for 2018. (Individuals are exempt if the amount that they would be required to pay for minimum essential coverage exceeds a particular percentage of actual household income for a taxable year.) The percentage was announced in December 2016 regulations issued by the Department of Health and Human Services, establishing the 2018 benefit and payment parameters.
Clearly, adjustments to the affordability percentage will be of interest to ALEs and their advisors. Failure to offer affordable, minimum value coverage to full-time employees may result in employer shared-responsibility penalties.
Employer shared responsibility will remain the law unless and until legislation is passed to eliminate it.
Please contact Bederson with any questions you may have regarding these newly announced adjustments.
On Monday, December 28, 2015, the Internal Revenue Service announced in Notice 2016-4 that employers will have additional time to file annual reports required under the Patient Protection and Affordable Care Act (“ACA”). The ACA requires certain employers to report minimum essential coverage annually on Forms 1094 and 1095. These forms were originally due to employees on February 1, 2016 and employers had until March 31, 2016 to file the forms electronically with the IRS (February 29, 2016 for non-electronic filers). However, Notice 2016-4 extends both of those deadlines for all employers required to file Forms 1094 and 1095.
The new deadlines are as follows:
New Deadline for Forms 1095-B and 1095-C to Individuals: March 31, 2016.
New Deadline for Forms 1094 and 1095 to the IRS: June 30, 2016 for electronic filers and May 31, 2016 for non-electronic filers.
The IRS indicated that it had determined that providers needed “additional time to adapt and implement systems to gather, analyze and report this information.”
Employers should note that the penalties for failure to timely file (and failure to timely furnish) Forms 1095-C were increased earlier this year, from $100 per failure to $250 per failure. There are a number of exceptions and modifications that can reduce the penalties in certain circumstances, and can increase the penalties in other circumstances, but extending the deadlines so that employers have sufficient time to satisfy their obligations is the most effective penalty relief.
- NEW FBAR FILING DUE DATES – New due date is April 15 for returns for taxable years beginning after December 31, 2015. Taxpayers will be allowed a six-month extension to October 15. For any taxpayer required to file an FBAR for the first time, any penalty for failure to timely request or file an extension may be waived by the IRS. Please contact your tax preparer with any questions.
- PARTNERSHIP RETURN DUE DATES – New due date is March 15 (for calendar-year partnerships) and the 15th day of the third month following the close of the fiscal year (for fiscal-year partnerships). Currently, these returns are due on April 15, for calendar-year partnerships. Maximum filing extension of six months for Forms 1065, U.S. Return of Partnership Income. Please contact your tax preparer with any questions.
- C CORPORATION RETURN DUE DATES – New due date is the 15th day of the fourth month following the close of the corporation’s year (April 15 for calendar-year corporations) – these returns are currently due on the 15th day of the third month following the close of the corporation’s year.
C corporations will be allowed an automatic 6-month extension to file, except that calendar-year corporations would get a five-month extension until 2026. Corporations with a June 30 year end would get a seven-month extension until 2026. The new filing due dates will apply to returns for tax years beginning after December 31, 2015. However, for C corporations with fiscal years ending on June 30, the new filing due dates will not apply until tax years beginning after December 31, 2025
EXTENSIONS OF FILING TIME – New extensions for returns for taxable years beginning after December 31, 2015:
- 5 1/2 months ending on September 30 for calendar year taxpayers on Form 1041, U.S. Income Tax Return for Estates and Trusts;
- 3 1/2 months ending on November 15 for calendar year plans on Form 5500, Annual Return/Report of Employee Benefit Plan;
- 6 months ending on November 15 for calendar year filers on Form 990, Return of Organization Exempt From Income Tax;
- an automatic 6-month period beginning on the due date for filing the return (without regard to any extensions) on Form 4720, Return of Certain Excise Taxes
- an automatic 6-month period beginning on the due date for filing the return (without regard to any extensions) Form 5227, Split-Interest Trust Information Return;
- an automatic 6-month period beginning on the due date for filing the return (without regard to any extensions) on Form 6069, Return of Excise Tax on Excess Contributions to Black Lung Benefit Trust
- an automatic 6-month period beginning on the due date for filing the return (without regard to any extensions) on Form 8870, Information Return for Transfers Associated With Certain Personal Benefit Contracts; and
- the due date for Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, will be April 15 for calendar-year filers, with a maximum six-month extension. The due date of Form
- 3520–A, Annual Information Return of a Foreign Trust with a United States Owner, shall be the 15th day of the third month after the close of the trust’s taxable year, with a maximum six-month extension.
H.R. 3236 also requires tax payers to provide additional information on mortgage information statements and consistent basis reporting between estates and beneficiaries.
If your health insurance plan provides for self-insurance, includes a Health Reimbursement Account, post-retirement benefits, and/or certain Health Flex Savings Accounts you may be subject to an annual excise tax.
Please consult your Health Insurance Professionals for guidance and more information to determine if this excise tax applies to you.
The annual form 720 and required tax are due on July 31.
We can provide assistance with completing and filing of the form 720 to report the excise tax at your request, with information to be provided by your health insurance professionals