By Jason Bramwell, Staff Writer
A proposal made last month by US Senate Committee on Finance Chairman Max Baucus (D-MT) that would require companies to use the accrual method of accounting instead of the cash method of accounting under certain circumstances would "restrict the use of the long-standing cash method of accounting for the thousands of US businesses that rely on it", according to the American Institute of CPAs (AICPA).
Baucus, who is retiring from Congress at the end of 2014, released a series of comprehensive tax reform proposals over a three-day span in late November. Specifically, the three drafts cover a restructuring of the international tax system, tax administration and fraud prevention techniques, and cost recovery deductions.
Under Baucus' tax accounting proposal, businesses with average annual gross receipts for a three-year taxable period of $10 million or less could elect to adopt either the cash method of accounting or the accrual method of accounting",regardless of whether inventory is a material income-producing factor in the business", according to the senator.
However, businesses – including farmers and personal business corporations – that do not meet the three-year gross receipts threshold would be required to adopt the accrual method.
In a letter sent to Baucus and Senate Committee on Finance Ranking Member Orrin Hatch (R-UT) on December 5, the AICPA stated its opposition to the proposed limitations on the use of the cash method of accounting. The simplicity of the cash method "justifies its continued use by natural persons [sole proprietors], certain pass-through entities, personal service corporations, and farmers, regardless of their gross receipts", the letter stated.
"The AICPA believes tax reform should promote simplicity and economic growth but should not create unnecessary administrative and financial burdens on taxpayers or impede the productive capacity of the economy", wrote Jeffrey Porter, CPA, chair of the AICPA Tax Executive Committee. "Simplicity is important both to improve the compliance process and to enable taxpayers to better understand the tax consequences of transactions in which they engage in or plan to engage. However, we believe Section 51 of the Proposal, as drafted, would impose undue burdens on many of these taxpayers by requiring significant additional planning to prepare for, and comply with, the new requirements."
According to Porter, under current law, businesses are permitted to use the cash method of accounting – regardless of their gross receipts – unless they have inventory.
"Under the cash method, income is recognized when it is actually or constructively received, and expenses are recorded when paid. These are straightforward and easily applied tests", he wrote. "Under the accrual method, income is recognized when the right to receive the income exists, and expenses are recorded when they are fixed, determinable, and economically performed (i.e., all-events test). All-events tests are more complex, do not track the financial accounting concepts of the accrual method, and increase costs of compliance."
If enacted, the proposal would place a financial burden on many businesses, according to the AICPA.
"The accumulated prior year amounts are reported in the initial year when the change in accounting method is reported. Even under current law, which allows taxpayers to pay the tax associated with such change over four years, this substantial increase in taxes will place a significant financial burden on businesses", Porter wrote. "It is also important to note that the increase in taxes is not limited to the first four years. In a growing economy, the acceleration of income would continue every year.
"In order to cover this accelerated need to pay taxes, some businesses would be forced to make cash distributions to their owners from other sources, potentially threatening their operations due to a tightening of cash flow", he continued. "Other businesses would force their owners to deal with the financial burden regardless of their ability to pay. We believe either scenario would result in an unjustifiable burden."
Restricting the use of the cash method of accounting by pass-through entities would also increase potential hardships for professional service firms, the letter stated.
"For example, in many states, a firm engaged in the practice of accountancy is specifically prohibited from obtaining any passive (investor) ownership, and a majority of the owners must hold active CPA licenses", Porter wrote. "We believe that similar restrictions also exist for firms engaged in the practice of law. As a result, many accounting and law firms must raise capital solely by the individual professionals who together own the firm, and cannot raise capital from outside investors. Because of these limitations, an acceleration of tax on income that has not actually been collected in cash would place a strain on the ability of such professional owner-operators to properly capitalize and maintain capital in their firms."
The AICPA also believes Baucus' proposal would discourage natural business growth because exceeding $10 million in annual receipts "would trigger an accounting change."
"In other words, a business' inability to use the cash method of accounting would create an artificial obstacle to the acquisition of or merger with another service firm", Porter wrote.
The letter concluded by asking the two lawmakers to consider the potential negative impact the tax accounting change could have on capital markets.
"By virtue of their education, training, and skill set, CPA firm partners have a variety of career options. By mandating the use of accrual accounting by partnerships, Congress is essentially penalizing those individuals solely for being part of a partnership", Porter wrote. "It could have the unintended consequence of driving many of these individuals out of accounting firms. Thinning the ranks of those individuals who perform public company audits could weaken investor confidence in our capital markets."