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.
According to coverage in The Daily Journal, Robert Blashek, a tax partner at O’Melveny & Myers, said the impact could hit law firms, particularly large ones, very hard. One of the most potentially explosive repercussions would be an across-the-board increase in law firm debt, assuming (quite reasonably, I believe) that market pressures would force firms to advance the money to partners to pay their unfunded tax liability. For an AmLaw 25 firm, this could easily amount to $50-$100-million of additional debt. For firms who have already pledged a large proportion of their WIP and A/R, it’s not clear under what terms, if at all, banks would be willing to lend such amounts.
Said David Roberts, partner in charge of RBZ LLP, an LA-based public accounting firm, “To say this could be the death [knell] for many law firm’s wouldn’t be too far fetched.” Elliot Freier, a tax law specialist at Irell & Manella, took a similarly harsh view: Firms would have to “jump a high hurdle” to provide that certain income would never be received, showing that there was some “identifiable event” making it clear that it wouldn’t be able to collect from a client.
“In the meantime the government has your money and you haven’t seen a dime; it’s a rather unpleasant situation.”
And Freier is also not optimistic that Congress will hold its fire until it can mount a concerted effort at comprehensive tax reform: “With Congress, anything can happen. I have seen the most amazing things done in the name of generating revenue.”
Finally, let me address head-on an undercurrent of commentary that has arisen to defend the supposed merits of accrual accounting as a superior measure of an organization’s true economic performance. This view, as well-intentioned as it may be, is just plain wrong for a few critical reasons. Let us not succumb to the temptation of getting bogged down in the “cash beats accrual/accrual beats cash” debate and lose sight of the one enormous issue here.
Why are the accrual acolytes wrong-headed?
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.