Keeping the Cash Method Promotes Simplicity and Economic Growth
We know what we are, but know not what we may be.
Followers of my blogs know that I periodically write about tax reform, but it’s been a while. So, I’ve decided to dust off this quiz – here we go:
What will be the greatest driver of tax reform?
- Bipartisan compromise?
- Congressional leadership changes?
- Current events?
- Good tax policy?
Well, it does. (And there may be more than one correct answer to my quiz.) Our profession must remain vigilant on what is being discussed now to safeguard businesses (including our own) and taxpayers later on down the line.
In its current iteration, tax reform has been top of mind on Capitol Hill for about five years. Hearings, task forces, discussion drafts and bills. Lots of conversations. It’s part of the normal vetting process and quite important. It’s how we separate the wheat from the chaff and arrive at much better legislative solutions; a process that continues today even if we “know not” the result.
One proposal considered recently would limit the use of the cash method of accounting. Current law allows the use of the cash method by individuals, pass-through entities, personal service corporations, businesses with less than $5 million in gross receipts, and most farms. The specific proposal would require any business (other than individuals) with over $10 million in gross receipts to switch to the accrual method. While we applaud Congress for its efforts to reform the tax code, the AICPA strongly believes limiting the cash method would have a very serious negative impact on professional service firms and partnerships.
Most such firms and partnerships use the cash method of accounting. Regardless of how big the business is – or hopes to become – it allows them to understand the company’s finances, cash position, and to pay taxes based on money that has actually come in and what has gone out. And when tax time comes, the owners – also on the cash method – know exactly where they stand and can pay the taxes that they owe.
The accrual method of accounting has its value, too. In fact, many CPAs would argue that the accrual method is the best way to understand the overall financial health of a business. Unlike cash method financial statements, accrual method statements reflect a more complete picture of a business’s financial position and operations. Importantly, though, even accrual financial statements include a statement of cash flows so the reader can understand how the business is managing its cash.
When it comes to taxes (where financial condition is moot), however, the cash method has been an accepted method for ages. Years ago, the AICPA developed “guiding principles of good tax policy” as a framework to help analyze changes to existing tax rules. The first of the 10 guiding principles is “Equity and Fairness,” meaning that similarly situated taxpayers should be taxed similarly. Individuals doing business as sole proprietors – regardless of taxable income – may use the cash method. In essence, a partnership is merely an aggregation of individuals, and if a limitation based on the entity’s gross receipts were to be enacted, many partnerships would not qualify to use the cash method, which could drastically affect each individual owner’s taxable income.
As a result, a service provider working as a sole proprietor could have a significantly lower tax liability than a service provider in a partnership merely because of where they work. The AICPA believes that such disparate treatment is unjustifiable and penalizes owners for participating in a partnership.
It is important to remember that requiring the accrual method wouldn’t generate new revenue, but only accelerate the collection of taxes – a timing issue that has associated opportunity costs. And an accrual mandate would create severe financial ramifications related to when taxes are paid. CPAs and other service providers’ revenues may be impacted by:
- clients who don’t pay;
- long-term contracts with uncertain payments;
- fee negotiations that can result in lower than expected revenues; and
- insurance payments or structured settlements that can take a long time to resolve.
Finally, the AICPA believes a gross receipts restriction on the use of the cash method would unfairly impact accounting firms and could threaten their ability to expand. State board of accountancy rules effectively prohibit owners from obtaining outside capital to finance their businesses. We believe that the issues enumerated contradict some of the rationales for tax reform, such as growing businesses, creating jobs and making our country more competitive.
I can hear you saying, “But, Ed, you said tax reform is dead this year.” True enough; however, because a forced transition to accrual accounting would result in an immediate infusion of revenue for the U. S. Treasury, it is also an appealing option that could be picked up as a pay-for in any other legislation unrelated to tax reform.
The cash method should not be used as a pay-for in tax reform or in any other legislation. We believe the cash method should be left alone.
Edward Karl, Vice President-Taxation, American Institute of CPAs.
Compass courtesy of Shutterstock.