A Call to Arms: III

Thursday, February 6, 2014

The first installment in this series presented the background and basic ramifications of the proposal now pending in Congress to require law firms and other professional service firms with annual revenue over $10-million to adopt the accrual accounting basis and not the cash basis. The second installment outlined the financial repercussions in dollars and cents, including the PwC estimate of a one-time, unfunded transitional tax liability for all affected firms of $50-billion. (“Unfunded” in the sense that the members of those firms would be paying tax on income they had not actually received in cash.) I also included back-of-the-envelope calculations estimating the impact on the 350 largest law firms in the US at $11.85-billion.

Today I’d like to wrap up the series with more policy- and equity-driven arguments about why this could have dire consequences for law firms and their partners—with the double whammy of no countervailing benefit.

  • There’s not even a fig leaf of justification for it. My Capitol Hill lobbying friends involved in this may think they’ve seen everything, but according to them, this proposal sets a new low-water-mark for a naked revenue grab without any policy justification whatsoever. Even staffers seem a bit abashed when asked about the rationale, and generally resort to making transparently implausible noises about “simplification.”
  • Cash accounting is much simpler and far less prone to optimistic judgment calls than accrual. I think this is pretty much undisputed. Cash is cash, but revenue and expense recognition depend on a host of assumptions about the future state of the world, including the often unknowable intentions of one’s counter-party. If you doubt the wiles even “modified cash” accounting can dangle in front of those prepared to be so tempted, I have one word for you: Dewey.
  • Cash accounting isn’t a “loophole.” This strikes me as important, but gets little visibility in the overall discussion. One would hope that when Congress undertook substantive tax reform it would be, if not to achieve a positive socioeconomic objective, then at the very least to close down an abusive practice. Cash accounting is no such thing, and in fact it’s the bedrock basis on which households have been filing their taxes for close to a century.
  • The four-year transitional period puts US-based firms at a competitive disadvantage to UK-based firms with no phantom income overhang. Why should US-firm partners who are mobile and have choices not decamp? It will put material amounts of money in their pockets without changing how hard they work or what they do. In today’s profoundly globalized world, this matters. Congress does plenty of things to compromise US competitiveness as it is, but this seems almost spiteful.
  • The ongoing costs of compliance are substantial, in terms of financial systems, controls, and headcount, outside auditor expenses, a greater frequency of amended and re-stated K-1’s, and more.
  • Besides the upfront financial costs, firms will have to amend their partnership agreements and probably the terms of every future engagement letter (perhaps even some applying to matters already underway).
  • AFA’s become distinctly unattractive and a minefield for the unwary. Certainly any AFA where fees are fixed upfront but paid over time after the bulk of the work has been performed will accelerate tax liability on much if not all of the agreed-upon fee. Structured settlements where amounts, including legal fees, are also fixed upfront but paid over time will also entail immediate tax liability for the entire amount with no corresponding amount of cash in hand as an offset.
  • Contingency fees become exercises in high stakes debt financing. This is true in spades for our good friends in the plaintiffs’ bar, but many AmLaw and NLJ firms enter into contingency fee agreements as well.
  • The bright line $10-million annual revenue rule invites widespread unintended consequences. You want to combine your $6-M firm with my $7-M firm? Not so fast. Last year your revenue was $9.5-M. Do you really want to continue growing? Etc. Congress must think taxpayers are idiots.

No, we’re not done.

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  1. Barry Wilkinson, 2 years ago Reply

    Re your arguments
    •The four-year transitional period puts US-based firms at a competitive disadvantage to UK-based firms with no phantom income overhang.

    The UK based firms have had accrual accounting for many years. And the UK tax authorities adoption of FRS 5 (Long term Contract WIP) for revenue recognition has created an even greater absurdity.

    I sympathise with you, but this justification does not pass muster

    • Bruce, 2 years ago Reply

      Hi, Brian, and thanks for this.

      Perhaps I’m missing something, but my intended point was that during the four year transition period US-firm partners would be paying for the overhang while UK-firm partners have no such liability.

      The differential only exists during the four years; if everyone had always been on accrual your point would be utterly correct and my argument empty. But four years is a long time!

  2. Ted, 2 years ago Reply

    How many Congressmen came out of Big Law Firms? How many expect to retire into a big firm? Some senators seem to make that move, but not too many congressmen. Seems like big firm lawyers going into government service land on a federal bench.

    How receptive will they be to the issues so well defined here?

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