PwC s Law Firm Services Proposal to require accrual method of accounting could yield challenges: Six questions to help identify next steps June 2014
In brief Executives from larger law firms may have some tough decisions to make regarding Congressional proposals that have the potential to fundamentally shift how their firms report taxable income to the Internal Revenue Service (IRS). Under the proposals, the cash method of accounting for US tax purposes would be limited to taxpayers generally with gross receipts of $10,000,000 or less. The result is that many law firms may no longer qualify for the favorable cash method of accounting and could be required to shift to the accrual method of accounting. If enacted, this shift would result in law firms reporting US taxable income to the firm s partners much sooner in other words, an unexpected and potentially large IRS bill may arise. And, the proposals could mean significantly more complex analysis through-out the year with respect to IRS reporting. For more detailed information, please see previously released PwC thought leadership, December 2013. While the prospects for enactment remain unclear, law firms may consider the following non-exhaustive list of threshold questions to help gauge what actions, if any, to consider in response to these proposals. If enacted, this shift would result in law firms reporting US taxable income to the firm s partners much sooner in other words, an unexpected and potentially large IRS bill may arise. Six threshold questions to think about 1. How would the relationship between the firm and its partners change? A critical consequence of shifting from the cash to accrual method of accounting for US tax purposes is the acceleration of taxable income required upon conversion. In effect, the law firm s accounts receivable and work in process (less any payables) would generally become reportable income to the IRS in the year of the change in law. The proposals would lessen this burden by allowing the adjustment to income to be spread over a four-year (potentially eight-year) period. In the eyes of the IRS, under current law the firm s partners would generally be liable for this tax. But who should bear this upfront cash burden the partners, the firm, or some combination thereof? Even if a partner is legally liable for the tax, the firm may want to consider assisting the partner financially to help pay for such tax liability. This will create additional obligations between the partner and the firm. A complicating factor will be the occurrence of partner adjustments such as partners leaving, retiring, or joining during the eight-year phase-in period (as currently proposed) when determining which partners bear the burden. Other challenges affecting the firm s relationships with its partners will arise. For example, how should income be allocated to the partners given that the allocation could later result in an additional after-tax cash windfall to such partners? If a proposal is enacted, a partner s capital account may need to reflect accrual earnings without corresponding payments of cash. In this situation, who ultimately receives this accrual capital? Does the partner receive this amount when he or she retires or otherwise leaves the firm or is such amount returned to other partners in the final year so the accrual capital stays in the partnership with the then current partners? Moreover, how partners are compensated by the firm may need to be revisited if this proposal is enacted. For example, partners may be compensated based on income generated, which has historically equated to cash collected. But the shift from the cash to accrual method of accounting for US tax purposes could prompt the firm to modify its partnership agreement to be more specific. If the tax law is changed, the agreement may need to clearly state that partner compensation is based on cash collected and not the firm s income computed using the US federal income tax rules. PwC 1
Other modifications to the partnership agreement may also need to occur should the proposal be enacted. It will be important to consider the process of making such changes will a supermajority of partners need to approve? How much time would be necessary? How such changes are developed, communicated, and reflected in the partnership agreement could have a positive or negative impact on the firm s culture and its partners. 2. How should financing the upfront tax liability be addressed? This upfront US federal tax liability promises to place a considerable financial burden on the partners and potentially the firm, depending upon what type of assistance the firm is willing to provide. Under just about any scenario, financing likely will need to be sought by either the partners or the firm. The key issues are who will borrow, who will be ultimately responsible for the cost, and how the loan would be structured. The devil is in the details and this financing could take time to arrange regardless of whether the borrowing is at the firm or partner level. This financing would be unique and firms may find themselves in unchartered waters. If enacted, Congress may have an opportunity to embed this proposal into the law in a way that could help alleviate some of its financial and administrative burdens. For example, perhaps the firm could have the option to pay the US federal tax on behalf of the partners as a whole from the entity level in the form of a deposit (under current rules, this does not occur as the entity is not treated as a separate taxpayer.) This may not eliminate the need for financing but could help with the complexity noted above with respect to identifying and tracking which partners are liable for the resulting tax, how it impacts their capital account, and the need for partnership agreement changes. 3. What communication plan should the firm have? Firm management should consider what communication plan to implement in the short and long term. First, firms should alert their partners to the existence of this proposal and how the firm plans to evaluate the best course of action. If a firm has already done this, partners may be asking how the firm plans to address this proposal if enacted. Should there be a communication to the partners now about the firm s position and any potential preparatory actions? Should there be communications to other teams such as HR, who may already be receiving questions about this issue from partner candidates? One consideration is to form a committee or working group that could help formulate a plan for all affected stakeholders, if action is required. The importance of a communication plan should not be underestimated. The ability of a firm to embody a sense of transparency and fairness in their organization can be an important differentiator for the firm in the eyes of its partners and employees. How well management communicates within the firm can have a strong impact on the firm s overall culture an important element to retaining and attracting talent. 4. What resources should be deployed and when? If enacted, these proposals will mandate that large law firms immediately evaluate and pursue necessary changes to their policies, procedures, and systems. Firms will also need to evaluate whether they need to dedicate additional resources in-house or external in order to address the issues. Firm management should consider what amount of contingency planning should be done now, i.e., to pinpoint what actions it will need to pursue based on their particular circumstances. There will likely be two categories of actions and resources needed. The first is the upfront changes to systems, policies, and procedures. For example, systems that track accounts receivable may need to have a more sophisticated capability for tracking income to help firms more efficiently comply with the accrual based rules for tax purposes. Second, additional staffing resources will likely be needed as the rules for determining taxable income will be more complex, generally requiring more manual oversight even if PwC 2
accounting systems are altered. How a firm plans to allocate its tax accrual-based income and how partners will be paid could also have an impact on needed staffing levels. The decision of what resources to deploy and when is challenging. Firms may not wish to incur costs to engage in contingency planning where it is not certain that the proposal will be enacted. However, if no contingency planning is performed and the proposal is enacted, a firm may be left scrambling to craft a plan and act quickly in order to comply. Each firm must evaluate their own circumstances, risk profile, culture, and adaptability for change in order to effectively answer this question. Many external stakeholders, including trade associations and professional firms, have publically voiced concerns that these proposals could yield significant challenges. 5. How would this proposal, if enacted, impact the longer term strategy of the firm? The cash to accrual method proposal could have an impact on the overall strategy of the firm in the longer term. Where does the firm want to be in five to ten years in terms of number of partners and employees, revenue growth, and areas of practice? Firm management should think about what impact, if any, the proposal could have on their specific circumstances. For example, perhaps the firm has aggressive growth goals, i.e., it wishes to break out of its mold as a more regional law firm into a larger firm with a broader geographical reach. It may plan to reach this goal by initiating an aggressive lateral hiring plan. This proposal could impact this hiring plan those firms asking lateral hires to share in the payment of the resulting US federal tax liabilities noted above may have trouble attracting candidates. The proposal could also cause other impacts, such as the early retirement of partners who wish to avoid the potential US federal income tax liability. 6. What role should the firm play in the public opposition? Many external stakeholders, including trade associations and professional firms, have publically voiced concerns that these proposals could yield significant challenges. However, for various business and public relations reasons, some law firms may not wish to publically advocate for their own interests. Firm management should determine whether or not the firm should pursue a more public profile to oppose these proposals. Let s talk For more information about this issue and how it can affect your business, please contact: Stanley Kolodziejczak Co-leader, Law Firm Services Practice +1 646 471 3160 stanley.kolodziejczak@us.pwc.com David E. Gaulin Co-leader, Law Firm Services Practice +1 646 471 1810 david.gaulin@us.pwc.com Brian Meighan Tax Partner, Washington National Tax Services +1 202 414 1790 brian.meighan@us.pwc.com PwC 3
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