Conversion to Accrual Basis Threatens Small Businesses

The House Ways and Means Chairman David Camp (R-MI) on February 26, 2014 released the 979-page “Tax Reform Act of 2014” discussion draft.  Chairman Camp’s draft proposed to lower corporate and individual tax rates, reform U.S. international tax rules, and simplify the tax Code. Chairman Camp said he hopes his draft legislation will lead to the first comprehensive repair of the U.S. tax Code since the Tax Reform Act of 1986. He stated that the draft legislation will, “fix America’s broken tax code by lowering tax rates while making the Code simpler and fairer for families and job creators.” However, the proposed accrual basis mandate for most taxpayers falls short in that respect.

The cash basis method of accounting is widely used by small to medium-size and privately held businesses largely because of its simplicity.  The cash basis method recognizes income when cash is received and expensed when cash is disbursed. Under the accrual basis method, income is recognized when the right to receive the income exists, and expenses are recorded when they are incurred.  The House Ways and Means committee argues that the accrual method provides the most accurate reflection of income. Nonetheless, mandated accounting for revenues and expenses under the accrual method for taxpayers currently using the cash method could create increased compliance costs and slow economic growth.

At this time, the cash method is available to individuals, sole proprietors, partnerships, and S corporations, with certain exceptions. A C corporation, or a partnership with a C corporation as a partner, generally cannot use the cash method unless it is a personal service corporation, is in the business of farming, or has annual gross receipts of $5 million or less. Under the House and Senate draft, the cash method would be generally restricted to individuals and businesses with under $10 million in annual gross receipts, and farming businesses.

Under the proposal, all S corporations, partnerships, and personal service corporations with over $10 million in annual gross receipts could no longer use the cash method. This would force business owners to recognize income and pay taxes on the income before cash receipt. Cash flow management becomes more complex as a result and could create the need for additional outside financing. This could put an undo financial burden on the owners of partnerships and S corporations as a result of the proposed change in accounting method for income tax purposes.

On September 11, 2014, 233 members of the bipartisan group of the House of Representatives signed a letter urging the House leadership to preserve the cash method of accounting for tax purposes rather than force a change to the accrual method for many businesses. “Those who use the cash method of accounting include many of our local job creators and professionals, including accountants, architects, attorneys, dentists, engineers, farmers, physicians and financial service professionals,” the lawmakers explained. “Importantly, the cash method of accounting is the foundation upon which these businesses have built their business models for decades.”

Likewise, the AICPA is urging Chairman Camp and his committee to consider the financial burden the proposal would place on small businesses. Furthermore, a group of 46 U.S. Senators sent a letter to the Senate Finance Committee opposing the reform. The basic theory of taxation is “the ability to pay,” and forcing taxpayers to recognize income before they receive payment violates this basic rule.

If you have any questions on how this proposal may affect your small business, please contact the tax professionals at Schneider Downs.

© 2014 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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