First off, tax accounting for the IRS and GAAP accounting for management and disclosure purposes, have always been and always will be two very different beasts. We’re talking here about tax accounting, so whether GAAP/accrual beats GAAP/cash is a conversation taking place in another room. (And the debate over the comparative virtues and vices of GAAP/accrual vs. GAAP/cash is yet another complication, which I’ll spare you for the nonce.) Congress has long made it clear that GAAP doesn’t rule in the tax world. If you want a striking example, simply consider accounting for depreciation—and how differently it’s handled in corporate financials vs. tax returns.
Financial statement reporting under GAAP/accrual produces three key documents—call them “book” accounting: (a) a P&L; (b) a balance sheet; and (c) a statement of cash flows. In corporate land, which has always been subject to GAAP/accrual, the often obvious goal is to maximize the difference between book profits and tax accounting profits. Here’s how the CFO of an AmLaw 20 to whom I posed this question replied:
In the corp world, minimizing tax is always a primary goal, and it’s not unusual for mega-corps to have huge book profits but pay nothing in tax. That happens in the corp context with things like NOL [net operating loss] carryforwards, offsetting losses within common ownership, and all sorts of other tax devices, and so a shareholder/public needs something to evaluate true “economic performance” because you would make no sense out of a corporation’s taxable income, it can vary significantly from year to year – and that’s where GAAP/accrual comes in. In the partnership/pass-thru world, we engage in an entirely different set of tax rules because we can only distribute taxable profits, and since we’re generally motivated to have the highest taxable income possible because it’s our “true earnings” and they get passed-thru, a partnership’s taxable earnings are therefore already a good barometer of “economic performance.”
My interlocutor’s point is self-evident, and the recent widely publicized adventures of worldwide corporate brands avoiding UK tax are legendary. As The Guardian recently put it:
That the world’s biggest companies avoid tax on a grand scale is no longer much of a revelation. We know only too well how Starbucks’ Dutch royalties, Amazon’s Luxembourg hub and Google’s Irish operations diminish their tax bill.
I’m also reminded of the Apple subsidiary domiciled in Ireland, constructed by diabolically and admirably clever tax and corporate lawyers, which was viewed as Caribbean-based by Irish tax law and Ireland-based by US tax law.
In short: To think that tax accounting accurately reflects economic performance is nonsense on stilts.
Second, professional service organizations are completely unlike corporations: They really have no meaningful existence in a tax code sense. They’re just pass-through conduits to the individual partners. Corporations have an ongoing existence of their own separate and apart from the comings and goings of shareholders, but partnerships (again, from the tax code perspective) really are nothing but their constituent members during any fiscal filing period.
The most enormous accounting and justice-based obstacle to the accrual method here seems to me to be the comings and goings of partners (even forgetting foreign/domestic complications), where it seems to defy basic fairness to visit economic consequences on individuals for events that occurred at a firm before they came and/or after they left. That certainly has never been the commonsensical expectation of what joining and exiting a partnership has meant.
As our friend Robert Blashek said,
“During a four-year period, partners are coming and going, and it’s not clear what happens if a partner leaves. Is he still responsible for the rest of that taxable income, or does a new partner step into that tax liability?”
This captures the unfairness argument to me: Partners should not benefit, or suffer, from activities of the firm that occurred when they just plain weren’t there.
The “accrual beats cash” camp wants to believe a desiccated abstraction trumps flesh and blood reality. I demur.
They want to believe some unstated ivory tower rationale justifies elevating an entirely synthetic juridical entity above the constituent human beings who actually give the organization life and breath. I demur.
They want to believe the shorthand phrase “elevator assets” packs no punch in the canyons of Sixth Avenue or Threadneedle Street. This is a categorical error of the first order: And if you think there will be no consequences should this proposal become law, I only wish you could conduct your academically pristine experiment in some alternate universe. I echo Woody Allen, asked his attitude towards death, who said “I have no problem with it; I just don’t want to be there when it happens.”
Shall we, finally, recur to first principles?
The AICPA issued a remarkable document in 2007 called “Guiding Principles for Tax Equity and Fairness,” which begins as follows:
The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities. (Adam Smith, 1776)
When a number of persons engage in a mutually advantageous cooperative venture according to rules . . . we are not to gain from the cooperative labors of others without doing our fair share. (John Rawls, 1971)
Their point is not abstract or academic. They are underscoring the over-riding principle of “horizontal equity,” meaning that similarly situated taxpayers should be treated similarly. A three-year-old would grasp it. But this proposal would destroy it, creating random and arbitrary differences—potentially into the tens or hundreds of thousands of dollars—for very similarly situated taxpayers—partners who joined and/or left the same firm more or less at the same time and earned very comparable compensation while there.
Can this pass the whiff test of common sense? Of fairness? Of justice? Of plain old sanity?
Well, leave it to Congress in its wisdom.
Or don’t: This is a call to arms, remember. You, and we, all of us, have a voice.