[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]
CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON ECONOMIC GROWTH, TAX AND CAPITAL ACCESS
OF THE
COMMITTEE ON SMALL BUSINESS
UNITED STATES
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
__________
HEARING HELD
JULY 10, 2014
__________
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
Small Business Committee Document Number 113-074
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HOUSE COMMITTEE ON SMALL BUSINESS
SAM GRAVES, Missouri, Chairman
STEVE CHABOT, Ohio
STEVE KING, Iowa
MIKE COFFMAN, Colorado
BLAINE LUETKEMEYER, Missouri
MICK MULVANEY, South Carolina
SCOTT TIPTON, Colorado
JAIME HERRERA BEUTLER, Washington
RICHARD HANNA, New York
TIM HUELSKAMP, Kansas
DAVID SCHWEIKERT, Arizona
KERRY BENTIVOLIO, Michigan
CHRIS COLLINS, New York
TOM RICE, South Carolina
NYDIA VELAZQUEZ, New York, Ranking Member
KURT SCHRADER, Oregon
YVETTE CLARKE, New York
JUDY CHU, California
JANICE HAHN, California
DONALD PAYNE, JR., New Jersey
GRACE MENG, New York
BRAD SCHNEIDER, Illinois
RON BARBER, Arizona
ANN McLANE KUSTER, New Hampshire
PATRICK MURPHY, Florida
Lori Salley, Staff Director
Paul Sass Deputy Staff Director
Barry Pineles, Chief Counsel
Michael Day, Minority Staff Director
C O N T E N T S
OPENING STATEMENT
Page
Hon. Tom Rice.................................................... 1
Hon. Judy Chu.................................................... 2
WITNESSES
Mr. Donald Williamson, Professor, Department of Accounting and
Taxation, Executive Director, Kogod Tax Center, American
University, Washington, DC..................................... 3
Ms. Sarah Windham, Senior Tax Manager, Dixon Hughes Goodman LLP,
Charleston, SC, testifying on behalf of the South Carolina Farm
Bureau......................................................... 5
Ms. Terry Durkin, Owner, Durkin Associates, Burlington, MA,
testifying on behalf of the National Association of Enrolled
Agents......................................................... 7
Mr. Stephen Mankowski, Partner, EP Caine & Associates CPA, LLC,
Bryn Mawr, PA, testifying on behalf of the National Conference
of CPA Practitioners........................................... 9
APPENDIX
Prepared Statements:
Mr. Donald Williamson, Professor, Department of Accounting
and Taxation, Executive Director, Kogod Tax Center,
American University, Washington, DC........................ 26
Ms. Sarah Windham, Senior Tax Manager, Dixon Hughes Goodman
LLP, Charleston, SC, testifying on behalf of the South
Carolina Farm Bureau....................................... 37
Ms. Terry Durkin, Owner, Durkin Associates, Burlington, MA,
testifying on behalf of the National Association of
Enrolled Agents............................................ 42
Mr. Stephen Mankowski, Partner, EP Caine & Associates CPA,
LLC, Bryn Mawr, PA, testifying on behalf of the National
Conference of CPA Practitioners............................ 46
Questions for the Record:
None.
Answers for the Record:
None.
Additional Material for the Record:
American Bar Association (ABA)............................... 52
American Council of Engineering Companies (ACEC)............. 59
American Institute of Certified Public Accountants (AICPA)... 62
CTA Statement................................................ 70
National Cattlemen's Beef Association (NCBA)................. 73
National Federation of Independent Business (NFIB)........... 76
Jeffrey Wald, Chief Executive Officer, Kennedy and Coe, LLC.. 79
CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?
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THURSDAY, JULY 10, 2014
House of Representatives,
Committee on Small Business,
Subcommittee on Economic Growth,
Tax and Capital Access,
Washington, DC.
The Subcommittee met, pursuant to call, at 10:00 a.m., in
Room 2360, Rayburn House Office Building. Hon. Tom Rice
[chairman of the subcommittee] presiding.
Present: Representatives Rice, Chabot, Mulvaney, Hanna,
Schweikert, Chu, Paine, and Schneider.
Chairman RICE. Good morning. This hearing will come to
order.
First, let me thank our witnesses for taking time to be
with us today to talk about how to help small businesses
prosper.
As a former tax attorney and CPA for nearly 30 years, I
know firsthand that tax complexity is a big problem facing
small business owners. Today, we are going to examine one way
to simplify life for small firms by looking at the issue of the
cash method of accounting, which offers a simple,
straightforward solution for entrepreneurs to record business
income and expenses. In cash accounting, a business records
incoming expenses at the time the funds are received or paid,
just like with a personal checkbook, and it makes it fairly
easy to track cash flow, the lifeblood of many entrepreneurs.
Perhaps because of this simplicity it is a preferred method of
accounting for small businesses.
The other, more complicated method, accrual accounting,
requires a business to record income at the time a sale is made
or an agreement to provide services reached, regardless of when
the payment is actually received. By the same token, expenses
are recorded when they are obligated to be paid, regardless of
when the funds were actually dispersed.
In determining which accounting method to use, small
business owners must comply with the Internal Revenue code.
Most businesses are required to use the accrual method, though
exceptions exist which permit firms of certain types and sizes
to use the cash method.
Ultimately, whichever method is used can have very real
effects on how a small business operates. Given this, it would
be in the interest of us here in Washington to ensure our
nation's job creators have the flexibility to use the
accounting method that best suits their operations and gives
them the best chance to succeed.
We are fortunate to have with us a group of leaders within
the accounting community, both industry experts and small
businesses that help other small businesses with their
accounting services. I look forward to learning firsthand how
they perceive the utility of the cash accounting for small
businesses and how we can make cash accounting even easier for
small businesses to use.
With that, I would like to thank our distinguished panel of
witnesses for being here today, and I now recognize the ranking
member for her opening statement.
Ms. CHU. Thank you, Mr. Chair.
For many, starting a successful business and seeing it grow
is the American dream. During that process, many big decisions
must be made--where to rent, what to call the business, and how
much capital is needed. Besides deciding which business
organizational structure to adopt, one of the most basic
decisions is which accounting method to use--accrual accounting
or cash basis method. On the surface, the question may seem
easy, but small business owners must learn several rules and
complicated nuances associated with each technique. These
methods primarily differ in when and how income and expenses
are reported. The cash method accounting is widely used by
small firms because it is simple to understand and makes day-
to-day recordkeeping easier. It generally requires taxpayers to
report income and expenses as they are received and paid, so it
mimics how individuals handle their own personal finances.
Simply put, income is reported when cash comes in, and expenses
are reported when cash goes out.
On the other hand, the accrual accounting method generally
requires taxpayers to report income and expenses as the
transactions are established, regardless of whether cash is
received or paid. While accrual accounting offers the
flexibility to delay or advance income and expensing to more
accurately reflect business operations. The cash method more
accurately reflects cash flow.
Most small business owners track the profitability of their
business during the year based on the balance in their checking
account, which is more in line with the cash accounting, so it
is not surprising that the National Federation of Independent
Businesses found that 41 percent of small business owners
utilize the cash method of accounting, while only 19 percent
use the accrual method. I have also heard repeatedly from small
business owners in my district how much they depend on the cash
accounting method.
Today's hearing will examine the differences between the
two accounting methods and discuss what makes the cash
accounting method more advantageous for small business owners.
We will also discuss the tax reform proposal for expanding the
cash method revenue limit and the draft language limiting its
use to certain organizational structures. The proposal was
introduced earlier this Congress by Chairman Dave Camp of the
Ways and Means Committee.
Reforms that lower the burden on small businesses by
reducing recordkeeping and paperwork help to lead to increased
entrepreneurial activity and a stronger economy. Under current
law, C corporations and certain partnerships may not use the
cash method once average gross receipts exceed five million.
However, some partnerships and S corporations are permitted to
use the cash method regardless of their level of receipts,
provided they are not required to maintain inventories. The
draft proposal generated much debate surrounding the cash
accounting method because it would expand and limit the
availability of this critical accounting scheme.
Despite increasing its use to allow businesses with up to
$10 million in gross receipts, the draft language prohibits S
corporations and partnerships that previously qualified for the
cash method from continuing to use it, and that means that
personal service corporations, like businesses performing
accounting, dentistry, and legal services would no longer
qualify if they hit the gross receipts ceiling.
This raises many questions and concerns for those small
businesses, and this hearing will highlight some of them.
Providing relief for thousands of small firms is critical to
moving forward with tax reform. However, we must be cautious as
to how that simplicity is provided. Today's hearing presents
the opportunity to have a real debate on the accounting methods
used by millions of small business owners and how certain tax
reform proposals can affect their bottom line.
I want to thank all the witnesses for being here, and I
look forward to your testimony. Thank you, and I yield back.
Chairman RICE. Okay. Just some formalities to get out of
the way.
If committee members have an opening statement, I ask that
they submit it for the record.
I would like to take a moment to explain the timing lights
for you. You will each have five minutes to deliver your
testimony. The lights will start out as green. When you have
one minute remaining, it will turn yellow. And finally, at the
end of your five minutes, it will turn red. I will ask that you
try to adhere to that time limit, although we are not going to
be very strict.
Our first witness today is Professor Donald Williamson of
the American University where he teaches and serves as the
director of Masters of Science and Taxation Program. He is also
the executive director of the Americans Kogod Tax Center. Prior
to his time at American University, he served as senior manager
for international taxation at KPMG. A certified public
accountant, Mr. Williamson is a frequent lecturer to
professional groups throughout the nation, and has published
over 50 articles in professional and academic journals.
Thank you for being here, sir. We look forward to your
testimony.
STATEMENTS OF DONALD WILLIAMSON, PROFESSOR, DEPARTMENT OF
ACCOUNTING AND TAXATION AND EXECUTIVE DIRECTOR, KOGOD TAX
CENTER, AMERICAN UNIVERSITY; SARAH WINDHAM, CERTIFIED PUBLIC
ACCOUNTANT AND SENIOR TAX MANAGER, DIXON HUGHES GOODMAN, LLC;
TERRY DURKIN, OWNER, DURKIN ASSOCIATES; STEPHEN MANKOWSKI,
PARTNER, EP CAINE AND ASSOCIATES CPA, LLC
STATEMENT OF DONALD WILLIAMSON
Mr. WILLIAMSON. Thank you, Chairman Rice.
Chairman Rice, Ranking Member Chu, and members of the
Subcommittee, thank you for the opportunity to testify on the
need to simplify the tax reporting requirements on small
businesses by means of adopting simpler methods of tax
accounting, most notably, expanding the circumstances whereby
small business may use the cash method rather than the more
burdensome accrual method of accounting.
My name is Don Williamson, and I am a professor of Taxation
at American University's Kogod School of Business, where for
the past 30 years I have directed the school's Masters in
Taxation degree program. The MST program at American offers
graduate courses in federal taxation to CPAs, experienced
accountants, attorneys, and others who wish to expand their
knowledge of our nation's tax law. Our course offerings not
only include traditional classes in subject areas such as
taxation of corporations and partnerships, but also more
specialized areas of the tax law, such as accounting periods
and methods, which is the topic of this hearing today.
As part of my responsibilities at American, I am also the
executive director of the Kogod Tax Center, which conducts
nonpartisan research on tax issues affecting small business and
entrepreneurs, and for the past 25 years, I have had my own tax
preparation and tax planning practice for small businesses in
Falls Church, Virginia.
My written testimony describes the key differences between
the cash and accrual methods of account for the reporting of
income and expenses on the tax return of a small business. For
now, let me simply say that the accrual method is undeniably
the more complex method of accounting and that it offers few
advantages to small businesses whose chief concern with regard
to their financial condition is their cash flow. It is
important to note that the method of accounting adopted by a
business, whether it be the cash method or the accrual method,
only affects the timing of when a business reports income or
deductions on its tax return. The accounting method a business
uses does not determine whether an item of income is taxable or
an expense deductible and does not affect the total income and
deductions a business will recognize over its lifetime.
However, despite the greater simplicity and better fit of
the cash method for small businesses, the Internal Revenue Code
denies the cash method to corporations with average gross
receipts exceeding $5 million. I urge Congress to increase the
current threshold for use of the cash method to $10 million.
Raising the threshold to $10 million will mean that almost 90
percent of all businesses in the United States could adopt the
cash method of accounting.
But even when the cash method is available to small
business, certain judicial doctrines, such as constructive
receipt for the recognition of income impose unnecessary
complication on a small business simply to accelerate the
reporting of income by, in most cases, a few months before the
actual cash is received. Also, the requirement that a cash
method small business may not deduct its cash outlays to
purchase inventory until that product is sold may satisfy
accounting theorists but offers no immediate tax benefit to
small businesses that expend considerable sums creating jobs.
To address these needs of small businesses, I urge Congress to
go beyond simply expanding the number of small businesses
eligible to use the cash method of accounting and consider
enacting a simplified cash method of accounting along the lines
described in my written testimony. Under this method of
accounting, a small business would be able to look at its
checkbook to determine its taxable income. It sounds simple,
and it is. Permitting small business to elect a simplified cash
method of accounting will reduce tax compliance costs, ease the
burden of tax administration, and clarify the measurement of
taxable income.
I thank the Committee again for the opportunity to testify.
I welcome any questions you may have.
Chairman RICE. Thank you, sir.
Our next witness is Sarah Windham, certified public
accountant and senior tax manager at Dixon Hughes Goodman in my
home state in Charleston, South Carolina. Mrs. Windham has been
in public practice for 15 years and has extensive experience
preparing tax returns and consulting with small business
clients, with particular expertise in the agriculture and
construction industries. She is testifying today on behalf of
the South Carolina Farm Bureau. We appreciate you being here.
You may now begin your testimony.
STATEMENT OF SARAH WINDHAM
Ms. WINDHAM. Thank you. Chairman Rice and members of the
Committee, thank you for allowing me the opportunity to testify
today.
My name is Sarah Windham, and I am a senior tax manager in
the Charleston, South Carolina office of Dixon Hughes Goodman.
We are the largest CPA firm based in the southern U.S. Our
commitment to our clients' success has led to the development
of specialized practice groups, such as agribusiness. With
nearly 60 years of experience serving the agribusiness
industry, DHG has developed a deep understanding of the
operations and issues affecting the agribusiness industry. I am
a CPA with 15 years of experience. I have extensive experience
with agriculture clients, construction and real estate clients,
as well as many other small businesses. I am here today on
behalf of South Carolina Farm Bureau.
I am testifying before you today on the potential negative
ramifications of the various proposals in Congress that would
eliminate for many taxpayers the use of cash accounting for the
purpose of calculating income tax liability. These adverse
effects include a significant increase in the time dedicated to
tax compliance, which will defer farmers and other small
businesses from focusing on making a living, as well as an
increase in the cost of tax compliance that will reduce the
profitability of many farms and small businesses who already
work on very thin margins.
Another effect would be a significant acceleration of the
tax liability without cash available to pay the uncollected,
yet taxed income. These adverse effects would fall
disproportionately on small businesses, such as farmers, and on
professionals, such as those in my farm. Most farmers do not
employ professional accountants. Many farms' books and records
are maintained by family members or the farm owners themselves.
Requiring them to switch to accrual basis accounting would
force them to hire bookkeeping assistance and/or spend
additional funds on accrual accounting systems, thus creating
additional costs in an industry that continues to face rapidly
rising production expenses.
One story I would like to share with you reflects the
strain accrual accounting can put on farms. One of our farm
clients was being asked by his financial institution to provide
accrual financial statements on a quarterly basis. As with most
farms, they keep their books and records on the cash basis.
After explaining the additional fees that a farmer would incur
to have us assist their staff in converting the books to
accrual basis, it was agreed that cash basis statements would
be a better option.
Farmers, by nature, manage risk and volatility. They are
literally at the mercy of nature, the effects and aftermath of
weather, and commodity prices. Since their income can fluctuate
wildly from year to year, accrual accounting, coupled with our
progressive tax system, would likely cause farmers to pay more
tax over time than a company in a different industry with
stable income over the same time period. Cash accounting also
allows them the option to even-out their taxable income
comparable with long-term earnings with other industries. It
gives them the ability to plan for capital investments and
large purchase of inputs without incurring debt.
An independent research firm, Informa Economics, revealed
that U.S. agriculture producers required to switch from cash to
accrual basis under the proposed new laws could pay out as much
as $4.84 billion in taxes over the next four years. According
to this study, those same farms have only 1.4 billion in cash
reserves to pay the additional taxes. If the tax proposals
associated with accrual accounting are effective in an
unprofitable year or farm owners cannot otherwise meet their
capital requirements, the farm may be forced to downsize. Over
17 percent of the U.S. workforce is employed in the agriculture
industry. The estimated 4.84 billion in tax that would be
required to be paid by farmers may cause them not to hire
additional employees or to lay off employees they already have
due to downsizing.
We have many clients required to use accrual basis
accounting for various reasons in the Internal Revenue Code. As
I mentioned in my introduction, I have expertise in
construction. Especially in today's economy, many contractors
are experiencing the pains of collecting receivables and
managing cash flow. Contractors may not receive payment until
well after they have invoiced their customers and recorded
income under accrual accounting. Oftentimes, they may be filing
their tax return well before those receivables have been
collected.
In a recent experience I had with a contractor I have been
working with, he was faced with extending his tax return
several years in a row in order to collect the revenue that he
needed from his receivables to pay the taxes, incurring
penalties and interest. After many years in public practice, I
believe that the proposals required for farm operations to use
accrual accounting would have a detrimental impact to food
producers whom it would affect and impact. These proposals
would have no additional cash available to pay tax payments,
cash that would otherwise be used to grow business, create
jobs, and serve communities in which those businesses operate.
Thank you for allowing me to testify today. I would like to
thank Chairman Rice and other members of the Committee who have
supported opposing limitations on the use of cash accounting. I
will be delighted to address any questions from any member of
the Committee today. Thank you.
Chairman RICE. Thank you, ma'am.
Our next witness is Terry Durkin, an enrolled agent and
owner of Durkin Associates, a tax preparation and
representation practice in Burlington, Massachusetts. Mrs.
Durkin started Durkin Associates in 2006, after 21 years in the
software industry, and was recently chosen as the president-
elect of the National Association of enrolled agents for 2014
and 2015. She has a B.S. degree in applied mathematics from
Yale University and an M.B.A. from New York University.
Ms. Durkin is testifying today on behalf of the National
Association of Enrolled Agents. We appreciate you being here,
and you may now begin your testimony.
STATEMENT OF TERRY DURKIN
Ms. DURKIN. Thank you, Chairman Rice, Ranking Member Chu,
and members of the Subcommittee. I am Terry Durkin, an enrolled
agent and president-elect of the National Association of
Enrolled Agents, which represents the interests of over 46,000
enrolled agents across the country. I am also a sole
proprietor. My practice is primarily focused on individuals and
on small business of less than 500,000 in gross revenues, what
I refer to as microbusinesses. Today, I share with you my
perspectives as both a tax practitioner and a small business
owner.
Over the years, it has become clear to me that the business
checking account is the focal point for most small business
bookkeeping. Small businesses use the business checking account
to measure cash flow and profits, and to a great extent is
their tax accounting. As a result, any change to the tax law
that requires small business owners to move away from the
simple checkbook accounting or cash basis accounting, has two
negative effects with increased complexity and restricted cash
flow.
As Congress begins reforming the tax code, I urge you to
keep in mind how essential cash basis accounting is to startup
businesses, especially these microbusinesses. I have six
recommendations.
First, increase expensing under section 179. Because
Congress has not enacted legislation to extend expired tax
provisions, expensing of capital purchases is currently limited
to $25,000. This is a big drop from the $500,000 deduction that
was available for the last several years. Also, the purchase
limit for section 179 property is $200,000. This, again, is a
big drop from the $2 million total purchase limit of the past
several years.
You can see the tax planning challenge we face when
taxpayers do not know in advance which provisions may or may
not be extended. I urge Congress to extend the section 179
expensing to at least $250,000, and to increase the total
purchase limit to at least one million.
Second, remove uniform capitalization rules for small
businesses. The uniform capitalization rules which were enacted
as part of the Tax Reform Act of 1986, requires certain direct
and indirect costs attributable to real or tangible personal
property produced by the taxpayer to be included in either
inventory or capitalized into the basis of such property. I
recommend that Congress consider removing this rule for small
businesses and allow them simply to expense the costs.
Third, allow small businesses to use pure cash accounting
even if they have inventory. In general, taxpayers must account
for inventories if the production, purchase, or sale of
merchandise is material to the production of income. In these
circumstances, taxpayers must maintain inventory records to
determine the cost of goods sold.
Fourth, allow small businesses to expense leasehold
improvements. While the current list of potential tax extenders
would provide some relief from having to depreciate
improvements to lease property over 39 years, I urge Congress
to allow these costs to be expensed under either section 179 or
its own specific tax code section. A 15-year depreciation is
certainly helpful but it can still be a problem for small
businesses.
Fifth, allow small businesses to deduct all startup and
organizational expenses. A taxpayer may elect to expense up to
$5,000 of startup expenditures in the tax year the business
begins. A corporation or partnership may elect to expense up to
$5,000 of organizational expenditures in the taxable year the
business begins. I urge Congress to allow all of these costs to
be expensed for small businesses.
Sixth and finally, increase the limit on repairs and
improvements. Under the new IRS rules, small businesses that
lack a applicable financial statement, such as my
microbusinesses, may expense amounts paid for property costing
less than $500, rather than depreciating that property over
several years.
Taxpayers must elect this new provision annually and must
have documented business procedures in place. You can see,
taxpayers must do a lot of paperwork here for a small benefit.
I would recommend a rule that allows small businesses to
expense these costs in the year made.
Based on my experience as a small business owner and as a
tax practitioner, I believe the above recommendations would
substantially simplify operations, ease paperwork burdens, and
improve cash flow for many businesses.
Thank you for your time and attention.
Chairman RICE. Thank you, ma'am.
I will now yield to Mrs. Chu, who will introduce our final
witness.
Ms. CHU. It is my pleasure to introduce Mr. Stephen
Mankowski, the national tax chair and national secretary for
the National Conference of CPA Practitioners. He is also a
partner at EP Caine and Associates CPA, LLC, where he advises
individuals and small businesses on issues related to
accounting, taxation, business consulting, and litigation
support services. Mr. Mankowski has a unique view of running a
small business and also representing small businesses that rely
on him for business management and accounting advice. He is a
graduate of LaSalle University.
Welcome, Mr. Mankowski.
STATEMENT OF STEPHEN MANKOWSKI
Mr. MANKOWSKI. Thank you, Mr. Chairman, and Ranking Member
Chu.
Again, my name is Stephen Mankowski, and I am a CPA. I am
the national secretary and tax policy chair of the National
Conference of CPA Practitioners, and a member of the American
Institute of CPAs.
If I were to ask the average taxpayer about the difference
between cash and accrual basis of accounting, most would not
know the answer. The same is true for today's business owners.
Several times each year I am asked to write off bad debt. It
can be written off under the accrual basis, yet not under the
cash basis. Why? Because in the cash basis of accounting, if
the income was never recorded on the books, it cannot be
written off. Part of a CPA's job is to ensure that taxpayers
comply with tax code. Many business owners do not realize that
there are other considerations to operating a business,
including keeping separate books and records, paying themselves
a salary, additional tax filings, et cetera.
LLCs have become a common business structure for new small
businesses. Often, the business owners, however, are not aware
of the tax ramifications. LLCs can be taxed as sole
proprietors, partnerships, or even S corporations. The choice
of business structure, however, does not affect the accounting
basis. I have found that small business owners simply think in
terms of cash in and cash out. Many started their businesses
after being downsized. They have lived their lives on the cash
basis, so operating their business in this fashion simply makes
sense to them. They provide us with bank statements, check
stubs, and invoices to analyze their business activities and
prepare reports that are used solely to prepare their tax
returns. These owners do not have systems in place to fully
track accounts receivables or payables. Further, they do not
have the excess funds to put the systems in place. To convert
their financial information into an accrual basis would require
adjustments for uncollected revenue, unpaid payroll and related
liabilities, prepared expenses, inventory, et cetera. The
owners will not only be responsible for knowing what
adjustments need to be made, but also their valuation.
Ultimately, despite the business owners' reliance on
accounting professionals, the fiscal responsibility still falls
on the owners. Converting to an accrual basis of accounting
might simply be a one-time benefit for the government. Once the
conversion is completed, the annual effect might not be
significant depending on the type of business. Newer entities
or entities with minimal accounts receivable or accounts
payable would likely have a small tax increase and possibly
even a tax decrease. Entities with a larger receivable base,
however, would not be so fortunate. To convert, they would need
to record all open receivables as current income and all unpaid
bills as current expenses. The impact of this added income
could propel the owners into higher tax brackets, which could
lead into phase outs of itemized deductions and personal
exemptions, phase-out of other deductions and credits,
including tuition and student loans when the increased income
is reported on their individual tax returns.
In addition, taxpayers may find themselves subjected to the
new 3.9 percent net investment income tax surtax that went into
effect this past filing season. These tax increases will not
only affect the taxpayers' federal income tax. Additional state
and local taxes may also be due because these returns usually
have to be filed on the same basis as the federal tax returns.
Further, many municipalities also impose gross receipts taxes
on all businesses.
If there is one common thread resonating from the IRS, it
has been to reduce taxpayer burden. While this can mean many
things, ultimately, I believe the IRS realizes that business
and taxes in today's economy have become even more complicated.
Requiring businesses to change their accounting method without
any specific reason would truly be in conflict to what the IRS
has been working to achieve.
In conclusion, the majority of businesses are permitted to
choose their accounting methods. With the guidance of financial
professionals, they are able to elect the most appropriate
accounting method for them. Forcing a business to use the
accrual basis not only complicates their business but also
requires the owners to take time away from operations to focus
on changing an accounting method. Ultimately, one does not
start a business simply to focus on accounting. Forcing this
change will do just that.
I would like to thank Representative Rice and the other
members of the Committee for their ongoing support in
opposition to the limitations on the cash basis of accounting.
Thank you for the opportunity to present this testimony today,
and I look forward to your questions.
Chairman RICE. Thank you, sir.
I am going to defer my questions until the end. I think we
have some members who are in a little bit of a hurry.
So Mrs. Chu, would you like to start?
Ms. CHU. Thank you, Mr. Chair.
Mr. Mankowski, the goals of our tax system should be to
encourage investment and ensure economic competitiveness while
limiting complexity. I understand that cash accounting is
easier and requires much less recordkeeping for small
businesses. Most importantly, a business owner may not need
formal training to understand how it works, and I hear this
from my constituent small business owners time and time again.
Can you describe how losing the ability to use cash accounting
will affect the small businesses that you advise?
Mr. MANKOWSKI. Certainly. I will try to be as brief as
possible with this.
Cash accounting is how many small business owners think,
and that is how they have been making their living. Their goal
is to just pay their fair share of taxes and to just manage
their business and to pay their family expenses. Losing the
ability to function under the cash basis and have to go into an
accrual basis could hinder the growth of the businesses. If
they know that adding a specific partner onto their practice
would then result in that firm having to convert to an accrual
basis of accounting could really hinder the operations of the
business and could really question if they need to add or where
their growth is really going. In essence, it would stagnate
growth, not promote growth. And ultimately, if the goal is to
be competitive, that would make the firm that has to now
account on an accrual basis of accounting, it could, in fact,
make them less competitive in the environment or in their
business environment, and ultimately, it is making their
business more complex, not less complex. And ultimately, it
would result in higher taxes to the owners of the business.
Ms. CHU. Okay. And Mr. Mankowski, Mr. Camp's draft language
proposal is raising the gross receipts limit to $10 million,
meaning any qualified personal service corporation over this
limit must use the accrual method. Can you discuss the concerns
about treating some business structures differently than others
based solely on their income level?
Mr. MANKOWSKI. By treating them based on their income
level, it will actually--again, it will really create a
situation where that business might not be competitive against
their competition. If they know that if they continue to grow
their business they are going to end up paying more taxes,
there are issues that could relate with pass-throughs to
retired partners that now may end up getting a larger tax
liability for income that the firm has not even received yet.
And further, in going through, many of the small businesses, as
was mentioned by Ms. Durkin, the small businesses do not
necessarily have ample cash flow. And when it comes time for
paying their taxes, especially newer businesses, they may not
have planned accordingly even with the assistance of their
accounting professionals for what their liabilities may be. And
ultimately, making this more complex makes it much more
convoluted for the owners and takes them away from what their
goal is, which is operating their business.
Ms. CHU. Thank you.
Ms. Windham, personal service businesses, like lawyers and
architects, often work on a contingency basis for their
clients. I understand you have personal experience working with
construction contractors whose payments are often delayed. Can
you explain how these payment structures work with both cash
and accrual accounting and which method is preferred by
businesses that you work with?
Ms. WINDHAM. Well, as I mentioned in my statement earlier,
I had the example of a client who received his receivables very
late and was forced to extend his tax return. And actually, in
his case, incurred a fair amount of interest and penalties
because he was forced to use the accrual basis of accounting.
So I think that is a perfect example of the effect it would
have. Had he used cash basis accounting, he would have waited
another year to report that income in the year that he actually
received it as opposed to having to extend his tax return and
pay the interest and penalties that were calculated due to
that. And he was in a situation where it was very close to the
filing deadline, so had he not been able to collect those in
time for the filing deadline, he may have been forced to borrow
the money to pay his tax liability under the accrual basis of
accounting.
Ms. CHU. Thank you.
Professor Williamson, in support of simplifying the cash
accounting method, your testimony detailed the differences and
difficulties that small businesses face when complying with
current cash accounting rules, such as various judicial
doctrines and exceptions to expense reporting. Does the Camp
draft proposal alleviate some of your concerns, or what
recommendations would you make to the current Camp draft
proposal?
Mr. WILLIAMSON. Representative Chu, I am here today to
represent small businesses, and our view is that small
businesses need the cash method of accounting. Period. I know
many large businesses also are on the cash method and feel very
strongly they need to stay that way despite the Camp proposals.
But I would like to emphasize that taxpayers be given as much
latitude as possible in electing their method of accounting, be
it cash or accrual method. I just see constantly my clients--I
have a practice in Falls Church--simply do not understand the
accrual method. They are cash basis people. Cash in, cash out.
It is the balance in the bank account that concerns them most
month to month, and that is what I am here to speak to today.
Ms. CHU. Thank you.
Ms. Dunkin, you suggest allowing small firms--I mean,
Durkin. You suggest allowing small firms to use pure cash
accounting even with inventories, which is currently disallowed
as inventory accounting can be complicated. How would such a
recommendation make it easier for small operations with
inventories?
Ms. DURKIN. Sure.
So I think it really is a matter of timing when you can
take the income and the expenses. So by allowing a small
business to really keep to their checkbook, what they bring in
and what they take out, whether there is inventory involved or
not, really does make it easier for them to do their
operations. So by having the ability to not have to deal with
inventory really does, although it is a matter of timing, to
make it simplified and stick with the pure cash accounting.
Ms. CHU. Thank you. I yield back.
Chairman RICE. I am going to start with Mr. Mulvaney
because I think he has some other obligations.
Mr. MULVANEY. Thank you, Mr. Chairman. I appreciate the
accommodation from you and from my fellow colleagues.
Back when I was a normal person, before I had this job, I
had experience with both cash and accrual methods. I had a
restaurant company that we used to run on a cash basis, a law
firm that was on a cash basis, and then I ran a real estate
company that was forced because of the nature of its business
and the size to run the accrual method of accounting. So I have
sort of seen it from both sides. And I remember very vividly
the ugly reality of being in the accrual business, having to
pay taxes on earnings that I had not collected yet. And I did
not care for that very much.
Ms. Windham, you have mentioned that you have got a large
Ag business, agribusiness stable of clients and it is something
that is important to me because where we are from, both Mr.
Rice and myself, we have large ag businesses in our district,
tell me what it means to a farmer, and do not talk as an
industry, because every time we talk about $4.8 billion of this
it sort of gets lost. Tell me what the individual farmer, what
it means to him or her if the law changes and they have to
change from accrual to cash. What does that mean in terms of
what they have to go through and what they have to pay?
Ms. WINDHAM. Sure. I think to address the first part what
they would have to go through, you know, we have dealt with
this with clients who have banking relationships. For example,
in my testimony, that just do not understand that farmers
operate on a cash basis and the bankers ask them to do it on an
accrual basis. It is very difficult for them to track their
work in progress or their inventory, to estimate what their
corn may be worth at the end of the year as commodity prices
fluctuate.
Mr. MULVANEY. And let me stop you there for just a second,
because you mentioned--I want to drill down on this a little
bit because you just mentioned words that make sense to you and
me but not to ordinary citizens, which is estimating your work
in process, and in this particular circumstance, what your corn
is worth at any particular time. Tell us what that involves?
Ms. WINDHAM. For example, the work in progress. Throughout
the year, as the farmer starts, usually in our state at least,
sometime in the spring, planting. So they have seed, they have
fertilizer. They are spraying throughout the year. They have
labor cost, which can be extremely high for the planting, as
well as the picking or whatever they may be doing. And that
would entail their work in progress. So throughout the year as
they spend money on the cash basis, for example, they expense
these items. On the accrual basis, they would have to track
these items throughout the year and accumulate them as
inventory and then determine as they sell their corn or their
peaches or their blueberries or whatever it may be, how much of
those expenses they have accumulated are attributable to the
blueberries or the peaches or the corn they just sold.
Mr. MULVANEY. And that is subject to be second guessed by
the IRS, is it not?
Ms. WINDHAM. Absolutely it could be. I could see it being
very difficult, for example, we will use corn because I have a
lot of farmers that are row crop farmers. If they have hundreds
of acres of corn, and they buy seed and fertilizer in large
bulk quantities, how do you determine I sold all of the corn in
these five acres today and three weeks from now I am going to
sell the corn on the other 10 acres? You know, what portion of
my seed and fertilizer did I use on these five acres versus
those 10 acres when I bought it all at the same time in March?
It could be very difficult for them.
Mr. MULVANEY. Tell me about the process, because I have
never gone through a conversion. I have never had to take a
company from cash to accrual. Tell us what that means for a
farmer.
Ms. WINDHAM. For a farmer, it means bringing someone like
me in usually, which can quickly add up, depending on what kind
of recordkeeping they already have. Most of the farms----
Mr. MULVANEY. Because the recordkeeping for the two methods
is entirely different?
Ms. WINDHAM. It is entirely different. Correct. They are
used to maintaining basically like a checkbook, which several
people have mentioned, and that is easy for them. They can know
what they start the year with in their checkbook and what they
finish the year with in their checkbook, just like we all do
with our personal checkbooks. Switching it to accrual basis can
be very costly from a standpoint of having someone assist them,
as well as just difficult in that the records do not convert
very easily and that is not how they operate their businesses.
Commodity prices fluctuating on a regular basis can make it
difficult. Which price do you use today and which price do you
use when you make the conversion three months from now? So it
can be extremely challenging, not to mention we do not have
many farms in downtown Charleston or in Washington, D.C. They
are out in very rural areas and you do not see too many CFO
controller-type people living in those rural areas. So it may
be very difficult for a farm owner to hire on staff the talent
that they need to make that conversion on a regular basis.
Mr. MULVANEY. Thank you, Ms. Windham. I appreciate the
testimony.
Ms. WINDHAM. You are welcome.
Mr. MULVANEY. Thank you, Mr. Chairman, for the opportunity.
Chairman RICE. Thank you, Mr. Mulvaney.
Mr. Schneider?
Mr. SCHNEIDER. Thank you, Chairman Rice. Thank you for
calling this hearing. It is a critically important issue.
I bring my own personal experience to this. My father is a
CPA. Had an accounting firm. At the time, it was one of the
largest ones in Denver with 35 partners. I started my career in
consulting at Price Waterhouse as I am thinking about it, 30
years ago this week, and before coming to Congress 10 years
ago, I was in consulting with what was then the largest single-
office private accounting firm in the country, a firm called
Blackman Kallick. I understand the issue on a personal level
having my own consulting firm, so thank you all for being here
and talking about this critically important issue.
Professor Williamson, I know you talked about this being an
issue for small businesses, but it is an issue for a lot of
businesses. An accounting firm, or in my case a consulting firm
that just needs a couple of partners working together quickly
exceeds $10 million, but the impact on these professional
service firms that have to book expenses and then not get paid
many times for six to 12 months later would be profound. And to
that end, I am circulating a bipartisan letter. I am pleased to
have people on both sides of the aisle working on this issue
with Congressmen Luetkemeyer, Quigley, and Hudson, and we want
to draw the attention to the importance of cost accounting. I
would invite my colleagues to all join us on that letter.
Speaking of agriculture, Ms. Windham, you know, my district
does not include a whole lot of agriculture, but we appreciate
the value of the food--the corn, the blueberries, the peaches,
that we eat. And understand that a vast majority of that still
comes from the family farm. And those farms require the ability
to do their accounting in such a way that makes sense for their
business, and that is crucial. The burden of having to transfer
from cash to accrual accounting for a farmer, for a
professional service firm, obviously is significant. Farmers
and ranchers rely on this flexibly to deal with the commodities
and weather. There is a lot of uncertainty in business. We all
deal with that regardless of the business we have. Adding
another level of uncertainty is, I think, the last thing we
should be doing. And that is why this is important.
But it is not just agriculture. It is not just consultants
and accountants. It is dentists. It is engineers. It is
architects. So many of these professional service firms,
partners working together individually rely on this, and as I
mentioned before $10 million for a group of people working
together adds up fairly quickly, but the impact on the
individual becomes severe, and oftentimes it is going to affect
retiring partners as was said before, and we need to touch on
all of those.
I guess, Ms. Windham, I will touch with you. The impact you
talked about, the cost to convert for a farm, what is the cost
to convert for an accounting firm? What would be the impact
there?
Ms. WINDHAM. I think one of the biggest costs for an
accounting firm would be, one, keeping up with the receivables
and payables, but two, as you bring partners in and out, new
owners in and out, and I believe someone mentioned it in their
testimony earlier, you could have a retiring partner who is
forced to pick up income that may be received after he leaves
the firm and retires, because it is an accounts receivable, and
I know we have experienced in the prior five or six years with
our clients struggling, you know, it may take six to 12 months
to collect a receivable as you mentioned. And then the other
side of that would be new partners coming in. It may be
difficult for them. If a new partner were potentially to come
in in a year of this conversion, they could be hit with a tax
liability that they were not expecting, not to mention, a tax
liability they do not have the cash to pay. So I think that is
one of the biggest potential challenges for an accounting firm
or a law firm or a professional service firm, is transitioning
partners in and out and then the massive amount of tax
liability that may be experienced with no additional cash. It
would take cash away from hiring new accountants or attorneys,
from creating jobs, from giving back to our communities, from
those types of things, and we just do not have the cash savings
to be able to afford to do that.
Mr. SCHNEIDER. Mr. Mankowski, you talked about competition
briefly and the challenge it is for companies to compete. If
you take two small businesses, one on a cash basis, one on an
accrual basis, what are some of the disadvantages to the cash
basis having to make the switch or compete?
Mr. MANKOWSKI. One of the advantages, or disadvantages,
rather with the business that is going to be forced to switch
over to an accrual basis is that within an accounting firm, as
an example, there is generally not a lot of accounts payable
they are going to be having, especially as you get towards
yearend. However, you could be sitting with a considerable
account of accounts receivable from some clients that may have
done their yearend or with a plethora of clients that file tax
extensions, and also clients that may have been billed for
yearend tax planning that you may not receive the funds until
the following year. The firm that is on the cash basis, they
are not recording that in as revenue, so that may potentially
allow their partners to keep those rates maybe a little bit
lower for their clients because they are not going to have to
absorb in a higher tax liability for the individual partners.
So in that situation, the firm that is now going to be
converting or has already converted into an accrual basis, the
owners may be at a disadvantage due to the receivables at the
end of the year and higher tax liabilities.
Mr. SCHNEIDER. Great. Well, I have many more questions. I
am out of time. Thank you for the extended time. I want to
thank, again, the chair and the ranking member for calling this
crucially important hearing on an issue. As our economy grows,
we need our small companies, our middle market companies to
grow, and this is important to allow them to do that.
Thank you very much.
Chairman RICE. Chairman Hanna.
Mr. HANNA. Thank you. Thank you for letting me in on this
Committee. I am not normally here.
I have never heard such unanimity in my life between
people. It is nice. And I agree with you as a guy who was in
business for many, many years.
One of the things you mentioned, Ms. Windham had mentioned
it also, Mr. Williamson, is that the possibility exists when
you make someone convert to accrual who was on a cash basis, to
actually wind up paying taxes on money, and you talk about
construction, Mr. Mankowski did and Ms. Durkin did, those
people have the possibility of actually owing money on money
they may never receive. Owing money on litigated construction
that they may ultimately win, having to go to the bank, borrow
money, pay interest, pay taxes, and find themselves holding the
bag. Because everything does not come in in a few months. Some
things come in--and then you have the conversion issue of 10
years, trying to--recapture I think is the language that you
used--built-in gains, which is a problem that a lot of people
face.
So let me start off by saying, you know, I agree with you,
but I want to understand the other side of the issue a little
bit because, Ms. Durkin, when you talk about being able to
write off inventory, one of the problems with that for the IRS
is simply if you are a growing business, all you need to do is
grow your inventory and you may never pay taxes as you grow
until you close. And Mr. Williamson made a wonderful point, and
that is that everybody ultimately winds up paying the tax they
owe, but it is all a little bit about timing, is it not? It is
a little bit about how do you manage your taxes and postpone
it? How do you, as gamblers use the word, kiting checks, you
can kite money. Right? You know what I am talking about.
So from the IRS's point of view, if you are going to take
the other perspective, because I am guessing this is about
making it a little bit easier for people to company and for
them to actually understand the nature of what you are doing.
So Mr. Williamson, what would you say if you were an IRS agent?
How would you respond?
Mr. WILLIAMSON. If I were an IRS agent I would welcome this
proposal of going more on the cash basis because some of the
nuances of the accrual method, some of the uncertainties--when
did you receive the income, when can you write it off as a bad
debt--I think going on the cash method takes so many
uncertainties that IRS agents have to interpret when they apply
the law when they go out to a client or to a taxpayer. I would
think the IRS would applaud this. And as you have already said,
Mr. Hanna, this is all about timing because over the life cycle
of the business the amount of economic income and the amount of
economic expenses will be incurred. And ultimately, the same
amount of tax will be paid under either the cash or accounting
method, no question about that. And your point is well taken.
This is about timing. And I can understand why perhaps the
Treasury Department and certain members of Congress would want
to be on the accrual method because that would, in some cases,
accelerate income into earlier years for purposes of scoring a
tax bill.
Mr. HANNA. Right. So basically, what we are saying is you
can pay now or pay later, but you are going to pay, and it is
just a matter of whether you hold your money a little longer
and the IRS gets theirs a little sooner is really----
Mr. WILLIAMSON. And as Ms. Windham pointed out, whether you
have to borrow the money to pay the tax.
Mr. HANNA. Do you agree, Ms. Windham?
Ms. WINDHAM. I do. Yes. I think it does, quite honestly,
make it easier for the IRS as well because they are attending
the same continuing education and the same training that a lot
of us are attending as CPAs. And as you are well aware, the tax
code is pretty tremendous. Even for an IRS agent knowing every
part of it can be challenging. So simplicity I think is better.
I think, as well, unless there is some type of individual
tax return that coincides with tax reform for S corps, C corps,
and partnerships, that under a progressive tax system you could
potentially pay more taxes over the same period of time as you
would even though you are going to incur the income or
expenses. For example, with farmers, it may be really high in a
good year and the next year we may have a drought and it would
be really low, and the year that they have high income, they
are going to pay a higher rate.
Mr. HANNA. And we have no more income averaging. It used to
be around. It is not anymore. So that is an issue for someone
in your business.
Ms. WINDHAM. Right. Correct.
Mr. HANNA. I want to ask you, I have just got a few seconds
left here, but the economic value of letting people keep things
simple I would say is huge, and it benefits the country
ultimately because they make more money. Do you all kind of
agree with that? Anybody?
Ms. DURKIN. I do, and I think taking some comments that
Chairman Rice has said in the past, small business owners are
America's economic engine, and we need to fuel that engine, and
cash is that fuel. So by allowing the small businesses to use
the cash accounting really does fuel that and powers the
economy.
Mr. HANNA. Thank you. My time is expired.
Chairman RICE. Mr. Schweikert?
Mr. SCHWEIKERT. Thank you, Mr. Chairman.
First, a one-off question just because of an experience we
had a couple years ago. Have any of you had the experience of
doing a conversion and someone that uses one of the online
softwares for the management of their business and having some
real troubles getting it to work in regards to bad debt, some
inventory issues? So I guess it is sort of a universal question
of for right now, any experiences, first of all, on the cash
basis, small business accounting softwares, what they do with
bad debt, and then particularly a small business that might be
using accrual?
Mr. MANKOWSKI. Mr. Schweikert, first, under the cash basis,
although many of our clients do think that they can write off
bad debt, currently, if they are filing under a cash basis,
they are not permitted to write off bad debt. As I had
mentioned in my testimony, every year I get asked the same
question by a number of clients.
Mr. SCHWEIKERT. But to that point, have you ever had
someone present to you saying here is my software and look, it
has a category for this?
Mr. MANKOWSKI. Absolutely. And I go through and I tell them
that they are not allowed to and they ask why. And I tell them,
well, you never declared the revenue, so you cannot turn around
and take the expense. We will gladly put the revenue in this
year, and it is only going to offset and you will get zero
impact from it.
Mr. SCHWEIKERT. Ms. Dunkin? Or Durkin?
Ms. DURKIN. I have had the same situation as far as
clients.
Mr. SCHWEIKERT. Hit the mic.
Ms. DURKIN. Thank you.
I have had the same situation of clients saying I never got
paid for this and then the discussion is, well, did we ever
claim it as income? No. So you are not allowed to claim that
expense.
Mr. SCHWEIKERT. And I am going to skip to the professor
because I want to come back to Ms. Windham.
Professor?
Mr. WILLIAMSON. Yeah. I think what you are illustrating,
Mr. Schweikert, is exactly the confusion that taxpayers have
and small businesses have and why we are advocating the cash
method of accounting. Why can I not take a bad debt? They did
not pay me. Well, you never recognized the income in the first
place. And I cannot tell you, and I think all of us at the
panel have had the experience with our clients where we try to
tell them this and they just do not get it. And what that
demonstrates is how we need the cash method of accounting to
show them cash in, cash out, and really eliminate the bad debt
issue entirely, other than for those firms that should be on
the accrual method.
Mr. SCHWEIKERT. Ms. Windham, because you actually
personally generated my memory of this question in a couple of
your comments in regards to difficulty in collections and
sometimes negotiated settlements on pay as this percentage of
our bill and then complete write-offs, and the difficulties
sometimes that causes for even cash accounting when you are
breaking over your year, and then the difficulties I have seen
with a couple of our personal businesses and those we have
helped on that they are using software and the software keeps
popping up. Why are you not telling us this? Am I the only one
to have experienced this?
Ms. WINDHAM. I can speak to a very similar situation
actually that has happened in the past month or two. We have a
client who has an investor who is an attorney who uses the cash
basis in his firm because he is an attorney and is allowed to.
This particular client of mine is required to be on the accrual
basis and prepares their books on an accrual basis. Well, he
has asked for a cash basis statement from my client because
that is what he understands. And in this particular situation
they are using QuickBooks, which is a software that many, many,
many clients use across the country.
Mr. SCHWEIKERT. I was trying to avoid mentioning any----
Ms. WINDHAM. Well, I started not to, but anyway, and it is
extremely common in small businesses. And because of the way my
particular client operates, and obviously, I do not want to
disclose their financials, hitting a button, so to speak, to
convert to cash basis is an option. However, because of the way
they track certain things, the software does not do it
correctly because of the way they have to input it. And it is
not a software issue, it is an input issue, and there is no
other way to input this data for it to convert correctly. So we
have been struggling with explaining to this attorney why we
cannot produce cash basis without a lot of work.
Mr. SCHWEIKERT. Have you run into the other externality
when there are other partners that you are paying out and the
problem of we have not recognized the income but----
Ms. WINDHAM. Yes. We see that a good bit where we have
questions on, for example, a partner has a tax liability on
their individual tax return because they are receiving a K1
with income from the partnership. However, they have not
received the related cash. And the first question is how can I
have income and tax if I do not have the cash? And you have to
explain to them, well, you have half a million dollars in
accounts receivable which you have yet to collect, and when you
collect those you will have the cash. And it can be a very
difficult pill for a partner in a partnership to swallow when
they have a large tax liability and no related cash to go with
it.
Mr. SCHWEIKERT. Thank you, Mr. Chairman. Having run into
some interesting issues in this sort of mechanic where a lot of
partnership agreements are written where you owe a certain rate
of return or pref on sometimes not actually realized income but
in booked income. You do end up in this kind of cascade of
problems and borrowing money to pay your partners. So with that
I yield back, Mr. Chairman. Thank you for the patience.
Chairman RICE. Thank you, sir.
Mr. Payne?
Mr. PAYNE. Thank you, Mr. Chairman.
Ms. Windham, I understand that you support the cash
accounting method, but as someone who assists small businesses,
do you also believe that some of the current cash accounting
rules are too complex and seem to unnecessarily try to match
accrual accounting as Mr. Williamson suggests? Based on your
experience, do you believe that the current Internal Revenue
Code cash codes should remain as is or need changing?
Ms. WINDHAM. I think the current cash accounting rules and
the Internal Revenue Code are pretty easy for businesses to
follow. There are quite a few exceptions and twists and turns
as with anything in the Internal Revenue Code, but for the most
part, small businesses can use a checkbook-type method of
accounting. There are some, as Ms. Durkin mentioned, some
issues in there with inventory, depreciation, repairs and
maintenance that could, quite honestly, be simplified, and I
think she made some great points in her testimony on
simplifying repairs and maintenance. There is a new regulation
written on that recently that complicated it in my opinion.
Depreciation could be made a little more simple with making it
permanent instead of extending it every couple of years and
causing uncertainty for small businesses. Inventory, obviously,
as she said, is another issue that can be a challenge for small
businesses to track their inventory and not expense it when
they actually write the checks. So I do think there are some
ways in there to simplify accounting for small businesses, and
I think her testimony spelled that out pretty accurately. But
true cash accounting needs to continue for small businesses to
allow them to be able to deal with the challenges of running
the rest of their business and not have to focus on their books
on an hourly or daily basis.
Mr. PAYNE. So it can be very easy but then you also say it
is very complex?
Ms. WINDHAM. Yes.
Mr. PAYNE. Okay. All right.
Ms. Durkin?
Ms. DURKIN. Yes. I will give you one example of a client
who became a client, who was in the theater production. He was
starting up to create a theater. He bought--leased a building
and put $300,000 into leasehold improvements. And sadly, he
thought that whole $300,000 would be depreciated in that year
because he spent it in that year, and I had to be the one to
tell him. And when he came afterwards to me to prepare the
return, well, you cannot take the whole $300,000. Some of it we
can do 15 years, some of it we have to do 39 years. So this
cash basis person all of a sudden then had these three
different ways he could take this deduction and not the
deduction that he wanted to. So you can see some challenges
like that.
Mr. PAYNE. Sure. Thank you.
Mr. Mankowski?
Mr. MANKOWSKI. Thank you, Mr. Payne.
I can agree with some of the comments. One of the things
that ultimately I think we need to look at is not just if we
are going to move the threshold from a $5 million to a $10
million, the $5 million threshold I believe went into effect
with the Tax Reform Act of 1986. Similar to many of the items
in the tax code, they have stayed there and stayed there, but
they have not been inflation indexed and now they are just
looking to come up with a number. If they are going to increase
it and actually keep a threshold, they should probably look at
some level of an indexing, starting from '86 moving forward, or
potentially even look to remove the threshold and just allow a
business to operate so that as many of us have mentioned, we
are not going to all of a sudden you have a good year, whether
you are a hedge fund or whether you are an attorney who lands a
big case, all of a sudden you need to convert to an accrual
basis the following--after you are out of that three-year
averaging. If you are now below the threshold, are you then
allowed to convert back to cash basis because you are no longer
in that threshold? There are some of the complexities that
simply doing away with any type of a revenue threshold, even on
an average basis, would really work towards simplifying and
allow the owners to do what they do best, which is operate
their business. And that is why all of us are in the accounting
profession. That is what we do best, which is help them manage
their accounting aspects so that they do not have to worry
about that part of their business.
Mr. PAYNE. Thank you. And in the interest of time, I will
yield back.
Chairman RICE. Thank you, sir.
Well, this has truly been a very interesting hearing. I
have learned a lot from you guys, and I appreciate you all
being here. My concern in all this is that here we sit six
years after the Great Recession, and we have still an economy
that is struggling, negative 2.8 percent growth in the last
quarter. Millions of people dropped off the employment--the
workforce because they find it so difficult to find employment.
American jobs, every day you turn on the TV and you see more
companies moving over to corporate inversions now, but that is
really more jobs moving overseas. And I think a lot of that
comes from anti-competitive policies that come out of
Washington, D.C. I think we make it too complicated. I think we
make it too difficult. And I think we cost businesses too much.
Too much in taxes. Too much in red tape. And I think that is
what I hear from you guys. It is one thing to not create
impediments, but it is another thing to actually throw up
impediments to hiring and expansion. And I see that in
government. And Mr. Mankowski, I think you referred to that
earlier when you said the accrual method could actually put up
impediments. Is that correct--to hiring and to expansion--is
that right?
Mr. MANKOWSKI. That is correct, sir.
Chairman RICE. Can you explain that further?
Mr. MANKOWSKI. Certainly. If you have--and I will take my
position. I recently merged my accounting practice. If we
continue--and we have been growing our practice daily with more
and more clients--if we bring on additional partners that may
bring additional revenue into our firm, expand our services, if
we get to a point where we, at this point we hit a $5 million
threshold, the firm would then have to go through converting to
an accrual basis. At that point, is it really worth bringing on
an additional partner who may kick you into having to go to
accrual basis? Or maybe go and, not that we, as accountants,
know our way around the system, but potentially spin off part
of a practice. I will stay a partner in my firm. I am going to
spin off part of the practice to one of the other partners.
That will be a separate entity, and now we are staying under
the thresholds.
Chairman RICE. And that does not add to complexity at all,
does it?
Mr. MANKOWSKI. None. It does not add to the complexity, but
it----
Chairman RICE. Oh, it does. When you maintain separate
entities.
Mr. MANKOWSKI. But in that case, it is keeping you out of
the thresholds which is not what we want to do.
Chairman RICE. Does that make you more productive?
Mr. MANKOWSKI. Absolutely not.
Chairman RICE. All you are trying to do is work through
some loophole. Is that correct?
Mr. MANKOWSKI. Unfortunately, that is what it comes down
to.
Chairman RICE. Ms. Windham, do you agree that this law,
forcing people to apply with the accrual method, that that
actually makes firms consider not expanding and not hiring and
not bringing on new employees?
Ms. WINDHAM. Yes, absolutely. I mean, some of the
statistics I have seen with taxes that would have to be paid
without the lack of additional cash, obviously, that prohibits
firms, attorneys, accountants, whoever, from taking that cash
that they have been reserving for growth, expansion. It may be
in the case of a farm, building a new building or purchasing a
large piece of equipment or adding a production line. They are
going to use that cash to pay tax instead of growing jobs,
growing the economy, and growing their business.
Chairman RICE. And I know this is a hot button topic, but
the Affordable Care Act forces people to limit their workers to
30 hours a week, forces them to stay under the 50-person
threshold. So you see these policies out of Washington who
everybody stands up here and says we are for jobs, but what
they do is something different. The policies that come out of
Washington actually stifle expansion and stifle job growth.
Do you agree with that, Ms. Durkin?
Ms. DURKIN. Yes. The example of the new IRS regulation
about the repairs versus capitalization, for the small
businesses, they have to do a considerable amount of paperwork,
declare a capitalization policy, and put it on their return
each year for $500. I had a client who had a rental property
and he bought an $800 washing machine, so he did all this
paperwork and he still could not use it for this purpose, so
there are--the intention is a good one, but practically when it
gets down to it, some of the thresholds are just too low.
Chairman RICE. There have been reports coming through this
Committee that fairly routinely say the cost per--small
businesses employ 70 percent of the people in the United
States, and the cost per employee to a small business in terms
of regulatory costs, which includes tax compliance, is like
$10,000 per employee. It far exceeds the tax liability.
Professor Williamson, do you see this as a meaningful----
Mr. WILLIAMSON. As I hear you speak and the other panelists
speak, what I think is going on here from an academic
perspective is our advocation of the cash accounting method
does indeed violate the matching principle of accounting, which
is somewhat of a catechism, that you want to match your
revenues with your costs, and that is the basis of the accrual
method. And people in the Academy would agree that the accrual
method is a more accurate method for keeping track of your
books and records.
That said, for small business, as we have said, all of us
here in our testimony, it is about the cash. And we can set
different thresholds--$5 million, $10 million. I even hear some
rumblings that maybe it should be even higher. And for small
businesses, it is all about the cash and it is not about some
theoretical matching principle of revenue with cost.
And with respect to the repair regs, we advocated in the
Tax Center that $500 be $5,000, which they gave to the large
businesses, but not to you and me.
Chairman RICE. I hear you. And I agree with you. But the
average small business guy, he does not know what you just
said. And the average person out there watching C-SPAN does not
know what you just said. So my bottom-line crux issue is the
effect on American competitiveness and jobs. And my theory is
that the complexity created by Washington, and the accrual
method being one of those, decreases our competitiveness and
puts burdens on job creators. Do you agree with that?
Mr. WILLIAMSON. Absolutely. For small businesses, no
question.
Chairman RICE. Okay.
Mr. WILLIAMSON. They can hire Ms. Windham or they can hire
a new employee.
Chairman RICE. What I am worried about is my sons and my
grandsons and my granddaughters getting jobs. And what I want
to do is put us in a position that makes them more competitive
in the world.
Mr. WILLIAMSON. Absolutely.
Chairman RICE. This is just one more addition, one more
burden on farmers and small businesses. Is that correct?
Mr. WILLIAMSON. Yes. Or advocacy here with the cash method
of accounting is lighting a candle. We have heard some candles
about cursing the darkness. We are advocating here, we are
lighting one candle to ease the burden upon small business with
respect to the method of accounting they choose in their
business.
Chairman RICE. Let me ask you this. The Ways and Means
proposal, Dave Camp's proposal they referred to earlier, does
that simplify the burden on small businesses or does that
exacerbate the burden on small businesses?
Mr. WILLIAMSON. As I understand it, it enables small
businesses to continue the cash method of accounting.
Chairman RICE. And it increases the threshold generally?
Mr. WILLIAMSON. Yes.
Chairman RICE. Ms. Windham, do you agree with that?
Ms. WINDHAM. It does increase the threshold. I think it
could have some consequences that people may not be aware of
though. For example, farms would be a great example of that.
You know, farms are traditionally passed down from one
generation to the next, and obviously, as you continue to pass
down, you may be adding more family members, so there may be
other businesses that are created, especially with the movement
across the U.S. for farm to table and those kinds of things,
you may create a retail market or a restaurant or a processing
component. And if you have a related party that owns the farm
as well as some of these other businesses, you may be forced to
pull in the revenue for all the businesses together to
calculate your gross revenue. So the farm may be, for example,
forced to switch to the accrual basis of accounting which was
not intended because the farm owner's sister happens to have a
retail market and they are forced to include revenues from
both.
Chairman RICE. Okay. So the way I understand what you just
said is Camp's, the Ways and Means proposal, actually expands
the availability of the cash method but there are some
particulars that you would like to see changed to make it even
more available?
Ms. WINDHAM. Well, in his proposal specifically, the $10
million threshold, currently there is no limit on most farms,
and that would obviously put a limit on farms specifically. So
in both sides of it, putting a limit on farms, as well as
putting a limit on other businesses who may be forced to use
these aggregation rules to include multiple lines of their
businesses because they are related family members or owners.
Chairman RICE. Thank you.
Mr. Mankowski, you said something at the very beginning of
your testimony, and I do not want to mischaracterize it, and I
do not think you meant it this way. It almost sounded like you
said the accrual method had an advantage and that you could
write off bad debt. But under the cash method, that money would
never have been taken in income anyway. So the net result is
zero under either method. Is that correct?
Mr. MANKOWSKI. Yes, sir. That is correct.
Chairman RICE. All right. Well, unless anybody else has any
additional questions they want to ask.
Ms. CHU. I would just like to enter into the record the
written statement from the American Bar Association, which lays
out their concerns on how the draft tax reform proposals would
affect these small law firms throughout the country.
And I would simply like to thank the panelists. I was
impressed by the unanimity of your statements and also your
very vivid examples of how this would affect small business.
Chairman RICE. And I appreciate your specific
recommendations for how we can make things better, you know,
your list of items, Ms. Durkin, you listed in yours;
particularly, Professor Williamson, so.
Mr. SCHWEIKERT. Mr. Chairman, if I can, as well, I would
like to enter into the record testimony of Jeffrey Wald, who is
the CEO of an accounting firm, Kennedy and Coe, LLC, that
specializes working with agriculture businesses and understands
and says I think very--clearly states some of the challenges
these businesses face and the advantage of the cash accounting
method.
Chairman RICE. Thank you, sir.
Okay. Thank you all for participating today. While tax and
recordkeeping complexity causes concern for so many small
business owners, it is clear that the use of the cash
accounting promotes simplicity. Moving forward, we must ensure
that our nation's job creators have the flexibility to utilize
the accounting method that allows them to thrive. Today's
testimony will be helpful as Congress looks for ways to make
our tax policies more simple, predictable, and rational. It has
been an honor for me and the other members of the Subcommittee
to hear from this group of industry leaders and small business
owners.
I ask unanimous consent that the members have five
legislative days to submit statements and supporting material
for the record.
Without objection, so ordered.
The hearing is now adjourned.
[Whereupon, at 11:16 a.m., the Subcommittee was adjourned.]
A P P E N D I X
Testimony of
Professor Donald T. Williamson
Howard S. Dvorkin Faculty Fellow
Executive Director, Kogod Tax Center
Kogod School of Business American University
Washington, D.C.
Committee on Small Business
Subcommittee on Economic Growth,
Tax and Capital Access
United States House of Representatives
Hearing on
``Cash Accounting: A Simpler Method for Small Firms?''
July 10, 2014
Chairman Rice, Ranking Member Chu and Members of the
Subcommittee, thank you for the opportunity to testify on the
need to simplify the tax reporting requirements on small
businesses by means of adopting simpler methods of tax
accounting.
My name is Don Williamson and I am a professor of taxation
at American University's Kogod School of Business where for the
past thirty years I have been the Director of the School's
Masters in Taxation degree program. The MST program at American
University offers graduate courses in federal taxation to CPAs,
experienced accountants, attorneys and others who wish to
expand their knowledge of our nation's tax law. Our course
offerings not only include traditional classes in subject areas
such as the taxation of corporations and partnerships,
international taxation and tax policy but also more specialized
areas of the tax law such as accounting periods and methods
which is the topic of this hearing today. As part of my
responsibilities at American University, I am the Executive
Director of the Kogod Tax Center which conducts nonpartisan
research on tax issues affecting small business and
entrepreneurs. For the past 25 years, I have had my own tax
preparation and planning practice for small businesses in Falls
Church, Virginia.
The Kogod Tax Center has previously testified before the
House Small Business Committee on the most burdensome tax
problems faced by small businesses. Today I would like to focus
my remarks on one area in the Internal Revenue Code that can
easily be changed to substantially reduce the record keeping
and tax compliance burdens on small businesses namely,
liberalizing the law to permit more small businesses to adopt
the cash method of accounting rather than being required to use
the more burdensome accrual method.
My testimony will describe and highlight the burden placed
upon small businesses when the Internal Revenue Code requires
them to be on the accrual method of accounting. However, even
where the law permits a small business to use the simpler cash
method of accounting, the general requirement to maintain
inventory records creates burdens that may only influence by
only a few months the timing of a small business's taxable
income. Therefore, we urge Congress to not only expand the
number of businesses eligible to use the cash method of
accounting but to also enact a ``simplified'' cash method of
accounting for small businesses that would further reduce
unnecessary record keeping and compliance burdens. We believe
such simplification will neither adversely affect the accuracy
of tax returns nor impact the ability of the IRS to collect
tax.
I. Cash Method vs. Accrual Methods of Accounting
Before describing our proposal for a simplified cash
method, I would like to explain, for the benefit of the members
of the subcommittee who may not be familiar with tax accounting
rules, the two major tax accounting methods used by businesses,
i.e. the cash method and the accrual method. I believe this
explanation will highlight why for small businesses the accrual
method is more burdensome than the cash method; and
demonstrates that while the accrual method may in some cases
more accurately measure economic net income, why the complexity
and cost of any additional precision is unnecessary and
ultimately provides no greater tax revenue for the IRS.
Once a business adopts a tax year, and for most small
businesses this will be the calendar year, it must adopt an
accounting method which determine the time at which the
business recognizes an item of income or may deduct an expense.
It is important to note that a business's accounting method
only affects the timing of when a business reports income or
deductions on a tax return. The accounting method a business
uses does not determine whether an item of income is taxable or
an expense deductible and does not affect the total income and
deductions a business will recognize over its lifetime.
Publicly traded corporations and many large businesses
generate financial statements for the SEC or commercial banks
based on generally accepted accounting principles (GAAP). Small
businesses usually do not keep their books and records in
accordance with GAAP, almost always relying upon their tax
returns to provide lenders and owners with sufficient
information to determine the success and credit worthiness of
the business.
Under the Internal Revenue Code a small business is only
required to choose an accounting method that ``clearly reflects
income'' and apply that method consistently from year to year.
Consistent with this requirement, most small businesses adopt
the cash method of accounting unless the law requires them to
use the accrual method.
A. Cash Method
A business adopting the cash method of accounting
recognizes income when it receives actual payment for the goods
or services sold, regardless of when the business sells the
good or performs the service. Similarly, a cash method business
is entitled to a deduction on its tax return only when payment
for an ordinary and necessary business expense is actually
made. However, even cash method businesses may not deduct
certain types of payments when made. For example, a cash
expenditure that creates an asset of the business with a useful
life of more than one year but rather must ``capitalize'' the
cost and depreciate (deduct) the cost over a prescribed
``recovery period'' in which the tax law presumes the asset
will be consumed in the business. There are other types of cash
payments subject to similar treatment. Thus, even the cash
method adopts certain principles of the accrual method
described below resulting in a mismatch of the time an
expenditure is made and the time at which it can be deducted.
1. Judicial Doctrines of Income
In addition to requirements to capitalize certain
expenditures there are several other technical requirements for
a business computing taxable income under the cash method that
are unnecessarily complex. Under the judicial doctrine of
``constructive'' receipt, a cash basis taxpayer must recognize
income even when cash has not come into the physical possession
of the business but is merely available to the business at its
discretion. Similarly, the mere receipt of a promise results in
recognizable income under the cash method if the promise is
convertible to cash before it matures, in which case the fair
market value (that is, the ``cash equivalent'') of the
obligation is recognized at the time of receipt of the promise.
Finally, under the ``economic benefit'' doctrine, a cash method
business must immediately recognize income on the receipt of
property whenever the business's right to the property is
absolute, even if not immediately assignable and even though it
cannot be immediately converted to cash.
Such judicial theories that require a business using the
cash method to pay tax on income deemed received prior to the
receipt of cash unnecessarily imposes a severe cash flow
problem on small businesses--a problem that creates only a
marginal timing benefit to the IRS, since small businesses
would most certainly receive the cash shortly after
constructive receipt, economic benefit, or a cash equivalent
arises. While these concepts offer comfort to theorists, small
businesses must pay next month's bills, and the acceleration of
any taxable income before the receipt of cash under these
theories requires small businesses to use their operating cash
to pay tax on amounts they have not yet received instead of
using that cash to run their businesses.
2. Accounting for Expenses
An even more challenging problem encountered by small
businesses using the cash method of accounting is the
compliance costs and complexity associated with computing
deductible expenses. Generally, the cash method permits a
deduction for ordinary and necessary business expenses when
actual payment is made. Thus, a promise to pay is not
deductible until payment is actually made.
Although there may be confusion surrounding when and if a
payment has been made, small businesses confront even greater
difficulties when computing allowable deductions under the cash
method because of four exceptions to the general rule that a
deduction is permitted when payment is made, i.e. prepayments,
depreciation, inventory and capitalization of some expenses.
Prepayments for property or services are not deductible if the
goods or services are provided more than one year after the
prepayment. Costs exceeding $5,000 associated with creating a
new business are not deducted when paid but amortized over 15
years. For inventory, the costs of its acquisition or
production are deducted only when the inventory is sold.
Similarly, property with a useful life of more than one year is
generally subject to depreciation, requiring its deduction be
spread over recovery periods ranging from three to 39 years.
These examples demonstrate that the current cash method of
accounting is too often not based upon cash receipts and
disbursements, but rather on principles that attempt to match
costs with income similar to the accrual method. For small
businesses that have no government regulators to whom financial
statements must be submitted and have no banks or other
creditors in need of profit and loss determinations that
conform to the rules of GAAP, tax rules based on the accrual
method serve no practical purpose when economic success and
taxable income can simply be measured on cash receipts and
expenditures--that is, cash flow. In short, while the current
cash method is substantially simpler than the accrual method,
certain refinements to the current rules could make the cash
method even simpler and more easily enable allow small
businesses to comply with tax record keeping and reporting
requirements without the loss of accuracy on their tax returns.
B. Accrual Method
The other major accounting method, the accrual method,
attempts to determine the time at which ``all events'' occur
that give rise to the right to income and the amount of that
income can be determined with reasonable accuracy. Similarly,
an expense may be deducted when the obligation to pay an
expense is fixed, the amount of that obligation can be
determined with reasonable accuracy and economic performance
has occurred. Thus, businesses must report income on their tax
returns when earned and may deduct expenses when incurred
without regard to the receipt or payment of cash.
The accrual method and its ``all events'' test creates
substantial complexity in an effort to better identify the
financial success or failure of a business. This complexity
calls for small businesses, whose every day well being centers
upon its cash position, to determine its financial well-being
in a manner that adds no value to its success. From the
perspective of the IRS, while the timing of income and expense
reported under the accrual method may provide some acceleration
of tax upon income that must be recognized before any cash is
received, such acceleration is clearly unfair if the cash is
never received, and may only accelerate tax collection by no
more than one year if the cash is subsequently receive shortly
after the accrual.
The complexity of the accrual method is illustrated by
prepayments. In the case of prepaid rent or interest received,
income must be reported immediately upon receipt even if ``all
events'' entitling the business to the income have not
occurred. Similarly, where goods or services have not been
delivered but cash payment has been received, the general rule
under the accrual method that delays reporting the cash
receipts on the business's tax return until ``all events'' have
occurred, i.e. the goods are delivered or services performed,
is disregarded. Thus, in the case of prepayments a business
otherwise on the accrual method finds itself using the cash
method for prepayments. Not an easy concept for a small
business owner to understand.
Another complexity of the accrual method is the necessity
to account for bad debts when a business reports as income an
account receivable for which it never receives actual payment.
Each year businesses on the accrual method must determine which
previously reported receivables are uncollectible and claim
them as tax deductions. This can be a time consuming, confusing
and expensive process. Businesses using the cash method do not
deduct bad debts because they do not include receivables in
taxable income.
Finally, even when a business on the accrual method meets
the ``all events'' test with respect to an expense, a deduction
may be claimed only when ``economic performance'' occurs.
Therefore, in the case of receiving goods and/or services from
another party, the business may deduct the obligation to pay
the other party only as the goods or services are received
regardless of when the business pays for the goods or services,
subject to an exception permitting deduction in the year of
prepayment if the other party provides the goods or services
within three and one-half months of the next taxable year.
Again, not such an easy concept for small businesses to
understand.
The above illustrations of some of the complexity required
by the accrual method of accounting demonstrates that in the
case of small businesses the technical accuracy resulting from
these rules offers no practical benefit to the business in
measuring its economic performance, and over the life cycle of
the business, offers no additional tax revenue to the
government.
II. Tax Accounting for Inventories
Regardless of whether a business is on the cash or accrual
method of accounting, if inventory is a material income
producing factor, the business must account for gross profit,
i.e. sales minus cost of goods sold, using the accrual method,
even if they have adopted the cash method as their overall
accounting method. Thus, a business cannot deduct the cost of
the inventory (finished goods) to the extent it has not sold
the product by the end of the business's taxable year.
Businesses selling inventory must maintain records documenting
their cost of unsold, finished goods, partially finished goods
and ``raw'' materials on hand that will be used in the future
to manufacture or produce inventory. In addition, inventory
cost accounting principles call for the deduction of indirect
costs (overhead) associated with manufacturing or producing the
inventory only when the inventory is sold.
In determining its cost of inventory, a business must adopt
an inventory costing method, i.e. the first-in, first-out
(FIFO) method, the last-in, last-out (LIFO) method or the
specific identification method. The FIFO and LIFO methods
relieve businesses of the need to keep track of the cost of
each item its sells, but where the items are unique or
relatively high-cost, low volume products (e.g., jewelry,
antiques, cars, etc.) the specific identification method is
used.
As an exception to the requirement to maintain inventory
accounts, the IRS (not the Internal Revenue Code) permits a
cash method business to use the cash method to account for
their gross profit from the sale of inventory if the business's
average annual gross receipts for the three year period prior
to the current year do not exceed $10,000,000 and the
business's primary activity is to provide services to customers
but also offers a product for sale incidental to the
performance of services. Thus, a veterinarian using the cash
method of accounting need not use the accrual method to account
for the sale of medicines or other goods associated with the
business of caring for animals because such sales are
incidental to the veterinarian's professional practices. But
when the average gross receipts of the business exceeds
$10,000,000, businesses must not only account for inventory
using the accrual method, but also must apply certain ``uniform
cost capitalization'' (UNICAP) rules that require an allocation
to inventory of an array of indirect costs beyond those
ordinarily associated with producing goods. Thus, under the
UNICAP rules, a business must add to the cost of inventory a
portion of compensation paid to employees who may not be
involved in producing the inventory but may merely indirectly
support the production process.
A final illustration of the complexity of the accrual
method deals with the perceived abuse of an accrual method
business accruing (deducting) an amount owed to a related party
using the cash method. In this case the business using the
accrual method may not deduct the amount owed to the related
party until the amount is actually paid and recognized as
taxable income by the cash method party. This issue frequently
arises where a business employs the owner or a relative of an
owner. Related parties, for this purpose, include family
members and certain businesses owned by the same individual(s).
III. Comparison of Cash and Accrual Methods
As the above descriptions demonstrate, the primary
advantages of the cash method over the accrual method are its
clarity and flexibility in measuring income and expenses and
its less cumbersome bookkeeping and record keeping
requirements. While the accrual method is generally considered
a more accurate reflection of a business's financial condition,
the price of this accuracy is mind numbing complexity and
inevitably increased compliance and record keeping costs.
However, the Internal Revenue Code limits the adoption of
the cash method to the following businesses: (1) sole
proprietorships; (2) S corporations; (3) certain corporations
engaged predominantly in the performance of services by their
owners; (4) corporations with average gross receipts over the
preceding three years of $5,000,000; (5) partnerships with no
corporate shareholder whose gross receipts exceed $5,000,000;
and (6) farms.
Suggestions for simplifying and liberalizing the use of the
cash method were made by the Treasury Department in 2007, and
by the Bowles-Simpson Commission in 2010. These studies
concluded that simplifying the reporting of income and expenses
on tax returns filed by small businesses would result in the
reallocation of resources to more productive purposes,
ultimately stimulating job growth. In addition, the IRS
Taxpayer Advocate has consistently recommended simplifying
accounting methods for small business as a way to ease
compliance burdens and reduce tax administration.
IV. Simplified Cash Method of Accounting (``SCM'') - The
``Checkbook'' Method
Based on this brief description of the accounting methods
available to small businesses and the observations of Treasury,
IRS and independent tax reform studies, I believe that small
businesses need and deserve legislative relief in measuring and
reporting their taxable income and deductible expenses. In my
view, the Internal Revenue Code should be amended to not only
permit the adoption of the cash method by more small
businesses, but also the adoption of a ``simplified cash method
of accounting'' (``SCM''). This proposed simplification of the
existing cash method of accounting will reduce time-consuming,
expensive administrative burdens on small businesses in keeping
records and reporting their income and expenses on their
returns, thereby unleashing resources that will create more
productive, job creating activities.
Besides reducing compliance costs the SCM will enable small
businesses to better understand their tax returns, thereby
reducing the general public's cynicism that the Internal
Revenue Code is replete with loopholes only accessible to
businesses with resources to employ expensive tax
professionals. In short, I believe that simplifying reporting
on tax returns will increase compliance, ease the burden of tax
administration, increase tax revenue and ultimately reduce the
gap between what taxpayers should pay and what the IRS actually
collects.
Under the SCM the computation of taxable income is reduced
to the following formula:
Cash Receipts
Less: Cash Expenses including:
Inventory
Prepayments
Materials/Supplies
Depreciable Property
Taxable Income
In short, the derivation of taxable income is based solely
on amounts actually received or paid during the tax year, by
means of examining the business's checkbook for when checks
were cut and deposits made. Under SCM, income consists only of
cash, property or services received during the tax year without
regard to imputed income under the constructive receipt, cash
equivalence, or economic benefit doctrines. While determining
and valuing the receipt of in-kind goods and services would
continue to be a problem, small businesses would otherwise be
able to arrive at their income by adding up their bank deposits
for the year. Any timing advantage to businesses from not being
subject to the judicial doctrines just mentioned would be
minimal given that small businesses cannot, as a practical
matter, defer recognition of cash by more than a few months
without creating severe cash flow problems for the payment of
their own bills. The complexity of the judicial doctrines does
not warrant their application to small businesses.
SCM offers even greater simplification for the
determination of deductible expenses. Under SCM, all current
expenditures, including those for the acquisition or
construction of inventory, would be deducted when paid.
Although a technical violation of GAAP's matching principle of
accounting, GAAP is not a particularly useful concept in
measuring the ability of a small business to pay tax, or even
stay in business. More than one small business that had a
profit under GAAP has failed because of cash flow problems.
Allowing for the immediate deduction of the cost of inventory
simplifies small business record keeping at relatively little
cost to the government. For a small business to stay in
business, inventory paid for and deducted in one year likely
will be sold no later than the next year to ensure sufficient
cash flow for business operations. Also, permitting the
expensing of inventory before its sale recognizes the fact that
by the IRS's own admission, small businesses are not following
the rules for the computation of cost of goods sold, in that
audits reveal more than 50 percent of cost of goods sold
calculations are incorrect.
Finally, permitting the immediate expensing of depreciable
property simply continues 100 percent bonus depreciation
approach for acquired property with a useful life in excess of
one year and the current section 179 expense allowance for
purchased depreciable property. Thresholds and limitations
similar to the present $10,000,000 limitation for uniform
capitalization rules and the current IRS allowance for the cash
method may be adopted to restrict SCM to small businesses.
Exhibit 1 compares the treatment of many items under the
current cash and accrual methods with the SCM.
With a $10 million threshold for the general adoption of
the cash method coupled with an election to adopt the SCM,
simplification would be available to approximately 99% of all
businesses in the United States, thereby reducing the tax
compliance burden for almost every person owning and operating
a business in America.
IV. Conclusion
The cash method of accounting is undeniably simpler than
the accrual method of accounting. Expanding the number of
businesses eligible to use the cash method by substituting the
current statutory limits on its use with a $10 million gross
receipts threshold would benefit not only small businesses but
the overall economy.
In addition, codification of the SCM would reduce the tax
record keeping and compliance burdens faced by small businesses
even further and improve the ability of small businesses to
maintain their own accounting records and prepare their own tax
returns eliminating the need to retain expensive tax
professionals. Such a reduction in the reliance on tax
accountants and lawyers will foster a greater appreciation by
average Americans that the tax law is not benefitting only
special interests but is, in fact, attempting to measure a
business's true economic net income. In short, I believe that a
simplified cash method of accounting such as the SCM will
improve tax compliance at lower cost to businesses with little
or no loss of tax revenue.
Thank you for the opportunity to testify today. I welcome
any questions from any Member of the Committee or its staff.
[GRAPHIC] [TIFF OMITTED] T8718.001
Testimony of
Sarah Windham, CPA
Senior Manager
Dixon Hughes Goodman LLP
Charleston, South Carolina
Committee on Small Business
Subcommittee on Economic Growth, Tax and Capital Access
United States House of Representatives
Hearing on
Cash Accounting: A Simpler Method for Small Firms?
July 10, 2014
Chairman Rice and Members of the Committee, thank you for
the opportunity to testify on Cash Accounting: A Simpler Method
for Small Firms?
My name is Sarah Windham. I am a Senior Tax Manager in the
Charleston, South Carolina office of Dixon Hughes Goodman LLP.
With over 1,800 people located throughout the region, we are
the largest CPA firm based in the Southern United States. Our
commitment to our clients' success has led to the development
of specialized practice groups, each dedicated to a specific
industry and offering comprehensive solutions. One of the
firm's professional service areas is Agribusiness. With nearly
60 years of experience serving the agribusiness industry, Dixon
Hughes Goodman has developed a deep understanding of the
operations and issues affecting various agribusinesses such as
food processors, growers, industry associations, cotton ginners
and co-ops.
I am a Certified Public Accountant with 15 years of
experience. I have extensive experience with agriculture
clients, construction and real estate clients, as well as many
other small businesses.
I am here today on behalf of the South Carolina Farm
Bureau. The South Carolina Farm Bureau is a grassroots, non-
profit organization celebrating and supporting family farmers,
locally grown food and our rural lands throughout legislative
advocacy, education and community outreach.
I am testifying before you today on the potential negative
ramifications of the various proposals in Congress that would
eliminate, for many taxpayers, the use of cash accounting for
the purpose of calculating income tax liability. These adverse
effects include a significant increase in the time dedicated to
tax compliance, which will deter farmers and other small
business owners from focusing on making a living, as well as,
an increase in the cost of tax compliance that would reduce the
profitability of many farmers and small businesses who already
work with very thin margins. Another effect would be a
significant acceleration of tax liability without the cash
available to pay the taxes on uncollected, yet taxed, income.
These adverse effects would fall disproportionately on small
businesses, such as farmers and professionals engaged in the
fields of law, accounting, engineering, architecture, health,
actuarial science, performing arts, or consulting.
Almost all farmers use the simple, straightforward cash
method of accounting in which income is not recognized until
cash or other payment is actually received and expenses are not
taken into account until they are actually paid. This method is
used in determining profitability because it most accurately
reflects the true financial picture of a farming operation.
Currently the tax code (Internal Revenue Code Section 446)
recognizes that to require a separate method of accounting
solely for calculating income tax liability is an unnecessary
burden and states that income tax liability ``shall be computed
under the method of accounting on the basis of which the
taxpayer regularly computes his income in keeping his books.''
Section 446 goes on to specifically provide that the cash
method is a permissible method of calculating tax liability.
Many taxpayers today, especially small businesses, find
complying with the Internal Revenue Code burdensome. The cost
of tax compliance for small businesses is 67% higher than that
of a large business according to the National Federation of
Independent Business. Agriculture is an industry that would be
negatively impacted by the proposed changes to require accrual
basis accounting. Farms, regardless of acreage, are perfect
examples of small businesses. The definition of a small farm
has changed dramatically due to advances in science and
technology. According to the USDA, in 1945, 100 bushels of corn
was produced on 2 acres of land. In 2002, that same 100 bushels
of corn were produced on less than 1 acre. As you can see,
fewer farmers produce more food on less acreage meaning many
family farms may have larger gross revenue but not necessarily
larger profits. The gross receipts thresholds proposed for
accrual accounting would increase the cost of a family farm's
compliance burden in an industry that is facing over increasing
input costs each year. Our nation may see further rises in our
food prices passed along to the consumer by these growers.
Why cash accounting? Cash accounting is a simple method of
record keeping. As illustrated in its most simple and basic
definition, the differences between cash versus accrual
accounting is a matter of timing. For example, if Farmer Brown
sold a bushel of corn in November with the understanding that
he would be paid in January, under the cash method, Farmer
Brown would record the payment in January when he received
payment from his customer. Any expenses associated with growing
and preparing the corn for market would be recorded when Farmer
Brown paid his suppliers. This method is not dissimilar to
maintaining and reconciling a simple checking account.
Most farmers do not employ professional accountants or
bookkeeping staff. Many farming operations are in rural
communities that do not have a large population from which to
draw high level CFOs, controllers or even accountants. Many
farms' books and records are maintained by a family member or
the farms' owners themselves. They are already saddled with the
burden of hiring professionals to prepare payroll and tax
returns as well as financial statements. Requiring them to
switch to accrual basis would force them to hire bookkeeping
assistance and/or spend additional funds on accrual accounting
systems, thus creating additional costs in an industry facing
rapidly rising production expenses. The simplicity of the cash
accounting method can also offer a ready window into tracking
cash on hand and current profitability. One story I would like
to share with you reflects the financial strain accrual
accounting can put on farms. One of our farm clients was being
asked by his financial institution to provide accrual basis
financial statements on a quarterly basis. As with most farms,
they keep their records on the cash basis. After explaining the
additional fees the farmer would incur to have us assist their
staff in converting the books to accrual basis it was agreed
that cash basis statements were a better option.
Farmers by nature must manage risk and volatility. It's
endemic to their industry. They are literally at the mercy of
nature, the effects and aftermath of weather, and commodity
prices. ``Whether caused by unpredictable weather that affects
crop yields or uncontrollable markets that set the price of
goods sold, it is not uncommon for farmers and ranchers to have
years with little or no taxable income,'' Farm Bureau wrote to
Senate Finance Committee Chairman Max Baucus (D-Mont.) and
Ranking Member Orrin Hatch (R-Utah). Since their income can
fluctuate widely from year to year, accrual accounting, coupled
with our progressive tax system, would likely cause farmers to
pay more taxes over time than a company in a different industry
with stable income over the same time period. Cash accounting
allows them to accelerate expenses or defer income giving farms
the option to even out their taxable income comparable with
long-term earnings of other industries. This also gives then
the ability to plan for capital investments and the large
purchases of inputs based on improved cash flow without
incurring debt.
Most farmers and ranchers consider themselves to be small
operations. Their operations are often divided into multiple
businesses where some family members operate the farm while
other family members may operate a related business, such as a
processing facility or a retail market. Often times the farm
may not have high gross receipts compared to the related
business. Some proposals would decrease the threshold for
switching to accrual accounting from $25 million to $10 million
of gross receipts for C corporations and would also apply to S
corporations, partnerships and sole-proprietorships that
currently do not have a gross receipts limitation. Under the
aggregation rules, the related businesses under common control
would be combined. When combined, each of these related
businesses, including the farm, would be required to use the
accrual method of accounting. Most farms are structured as S
corporations, partnerships or sole-proprietorships and would be
subject to accrual accounting under these proposals. It may
also be argued that the transition from the cash to the accrual
method of accounting may be unfair to current owners of an
enterprise if the switch to accrual penalizes current owners
and compels them to pay for the benefits received by a previous
owner.
As stated previously, the differences between cash versus
accrual accounting is a matter of timing. Using the same
scenario, if Farmer Brown sold a bushel of corn in November
with the understanding that he would be paid in January, under
the accrual method, Farmer Brown would record the income on his
November books even though he's received no money. Farmer Brown
also would incur the tax liability on this income even though
he's received no money. Though receivables are definitely an
asset that is an important measure in determining financial
posture, only cash--and not receivables--can be used to pay
income tax.
An independent research firm, Informa Economics, revealed
that U.S. agriculture producers required to switch from cash-
basis to accrual-basis accounting under proposed new laws would
have to pay out as much as $4.84 billion in taxes during the
next four years. Additionally, borrowing capacity of these
operations would decrease by another $7.26 billion over the
same time period. According to the study, these farms have less
than $1.4 billion in current cash on hand to pay the additional
taxes. If the tax proposals associated with cash accounting are
effective in an unprofitable farm year or if growers cannot
otherwise meet the capital requirements, the farmer may have to
downsize to survive. Over 24 million people, or 17% of the US
work force, are employed in agriculture industries. The
estimated $4.84 billion in tax that would be required to be
paid by farms could very easily limit the ability of those
farms to hire additional employees or may cause them to lay off
employees if they are forced to downsize.
We have many clients that are required to use accrual basis
accounting for various reason in the Internal Revenue Code. As
I mentioned in my introduction, I also have expertise in the
construction industry. I have many examples of clients in this
industry that have felt the challenges and burdens of accrual
basis accounting. Especially in today's economy, many
contractors are experiencing the pains of spending much of
their time and effort collecting accounts receivable and
managing related cash flow instead of growing their business or
building buildings and homes. Many contractors may not receive
payment until well after they have invoiced their customers and
recorded the income under the accrual method of accounting.
Often times, they may be filing tax returns and paying tax on
those receivables before the cash has been collected. In a
recent experience, a small contractor who I work with has been
faced with extending his tax return for several years in a row
and incurring penalties and interest until he was able to
collect the receivables needed to pay his income taxes. Under
the cash basis of accounting, these hardships are less likely
to happen since the taxpayer would not pay income tax on the
money until it was received.
Summary
The proposed requirement that farm operations use the
accrual accounting method for tax purposes introduces
complexity and expense to an industry that is already hobbled
by gross receipts that do not necessarily indicate an increase
in profitability. Producers operate at very low margins,
usually under 20%.
After many years in public practice, I believe that the
proposals that would require farm operations to use accrual
accounting would be determined to the food producers whom it
will affect and impact. Under these proposals no additional
cash would be available to make tax payments--cash that would
otherwise be used to grow business, create more jobs and serve
the communities in which businesses operate.
In addition to being a CPA, I am the mother of two small
children. The $4.84 billion in taxes that I referenced earlier
from the projection made by the independent research firm,
Informa Economics, reminds me of the fable I have read to my
children--The Goose that Laid the Golden Egg. $4.84 billion
dollars is, indeed, a golden egg. Unfortunately, in its
pursuit, the forced switch to accrual-basis accounting may kill
or do irreparable harm to the very enterprise that feeds the
U.S. and the world. Golden eggs can be replaced. The goose,
once dead, is gone.
Thank you for allowing me to testify today. I would like to
thank Chairman Rice and the other members of the committee who
have supported opposing limitations to the use of cash basis
accounting. I would be delighted to address any questions from
any Member of the Committee or your staff today. I, and others
at Dixon Hughes Goodman LLP, would be pleased to address any
further questions with you at any future date.
Statement of Terry Durkin, EA
President-Elect National Association of Enrolled Agents
Before the U.S. House of Representatives Committee on Small Business,
Subcommittee on Economic Growth, Tax and Capital Access
July 10, 2014
Thank you, Chairman Rice, Ranking Member Chu, and members
of the Subcommittee, for asking me to testify today. I am an
enrolled agent (EA) and President-Elect of the National
Association of Enrolled Agents (NAEA), which represents the
interests of over 46,000 enrolled agents across the country.
The enrolled agent license is the highest credential granted by
the Department of Treasury. EAs are the only tax practitioners
who are directly approved by the Department of Treasury for
competency and ethical behavior.
I am also a sole proprietor. My practice is primarily
focused on individuals and on small businesses of less than
$500,000 gross revenues--what I refer to as
``microbusinesses.'' Today I share with you my perspectives as
both a tax practitioner and a small business owner. While I am
testifying as an officer of NAEA, the opinions I express in
this testimony are mine alone.
Over the years, it has become clear to me that the business
checking account is the focal point for most small business
bookkeeping. Small businesses use the business checking account
to measure cash flow and profits, and to a great extent it is
the basis for their tax accounting as well. As a result, any
change to the tax law that requires small business owners to
move away from simple checkbook accounting, or cash basis
accounting, has two negative effects:
1. Increased complexity: Other methods of accounting, for
example accrual or hybrid, create complexity by forcing small
businesses to track certain expenses and capital outlays
separately from their basic income and expense ledgers. For
less sophisticated taxpayers, these separate accounting systems
can be counter-intuitive and create expensive paperwork
requirements.
2. Restricted cash flow: Small businesses are commonly
undercapitalized, which results in severe cash flow problems
when they make payments but are unable to expense them for tax
purposes in the same calendar year. A common complaint I hear
in my practice is, ``How do I owe taxes when I do not have any
cash in my business checking account?''
As Congress begins reforming the tax code, I urge you to
keep in mind how essential cash basis accounting is to startup
businesses, especially micro businesses. I believe Congress can
do more to help them. Both Chairman Camp and former Senator
Baucus's proposals are good first steps, but I strongly
recommend that Congress go even further. I have several
recommendations:
First, increase expensing under section 179. Because
Congress has not enacted legislation to extend expired
tax provisions, expensing of capital purchases is
currently limited to $25,000. This is a big drop from
the $500,000 deduction that was available for the last
several years under the provisions that expired. Also,
the purchase limit for section 179 property has dropped
to $200,000. This, again, is a big drop from the
$2,000,000 total purchase limit of the past several
years. I have a client in the medical field who is a
sole proprietor (single member LLC) and planning to
purchase a $100,000 piece of equipment this year. With
the current rules, she will not be able to take the
whole $100,000 amount as a section 179 expense. Given
her situation, she needs to pay estimated taxes to
account for the limited expenses she can take this
year. However, if she were able to take a section 179
expense on the whole purchase, her tax liability and
thus estimated tax payments would be much less. You can
see the tax planning challenges we face when taxpayers
do not know in advance which provisions might or might
not be extended. I urge Congress to increase the
section 179 expensing to at least $250,000 and to
increase the total purchase limit to at least
$1,000,000. Section 179 is essential to creating a true
cash basis system for small businesses.
Second, remove uniform capitalization rules for small
businesses. The uniform capitalization rules, which
were enacted as part of the Tax Reform Act of 1986,
require certain direct and indirect costs allocable to
real or tangible personal property produced by the
taxpayer to be included in either inventory or
capitalized into the basis of such property, as
applicable. I recommend that Congress consider removing
this rule for small businesses and allow them simply to
expense these costs.
Third, allow small businesses to use pure cash
accounting even if they have inventory. In general,
taxpayers must account for inventories if the
production, purchase, or sale of merchandise is
material to the production of income.
In those circumstances in which a taxpayer is
required to account for inventory, the taxpayer must
maintain inventory records to determine the cost of
goods sold during the taxable period. Cost of goods
sold generally is determined by adding the taxpayer's
inventory at the beginning of the period to the
purchases made during the period and subtracting from
that sum the taxpayer's inventory at the end of the
period. I recommend that Congress allow small
businesses to use pure cash accounting for their
operations, even if they have inventory.
Fourth, allow small businesses to expense leasehold
improvements. While the current list of tax extenders
provides some relief from depreciating improvements to
leased property over 39 years, I urge Congress to allow
these outlays to be expensed, under either section 179
or its own specific tax code section. For example,
under the currently expired provisions, leasehold
improvements were allowed fifteen-year treatment for
qualified property. This treatment covers qualified
leasehold improvements, retail improvements, and
restaurant property. I represent a small business owner
that leased part of a building to create a performing
arts theatre. He made $300,000 worth of leasehold
improvements to the building. Sadly, he did this before
consulting anyone and thought he would be able to write
off the whole $300,000 in one year since he spent it in
that year. Being able to expense these costs in the
year spent or at the very least to depreciate the
$300,000 over 15 years would be much more palatable and
better for his cash flow than depreciating it over 39
years.
Fifth, allow small businesses to deduct all start-up
and organizational expenses. A taxpayer may elect to
expense up to $5,000 of start-up expenditures in the
tax year in which the active trade or business begins.
A corporation or a partnership may elect to expense up
to $5,000 of organizational expenditures in the taxable
year in which the active trade or business begins. I
urge Congress to allow all of these costs to be
expensed for small businesses. When one of my clients
starts a business, he or she inevitably asks, ``I spent
much more money on the business than I received in
income. How can I still owe taxes?'' I try to explain
that some of the expenses cannot be written off in the
year they are expended, even though the client is on a
cash accounting system. As you can imagine, this does
not go over well for microbusinesses.
Sixth and finally, increase the limit on repairs and
improvements. Under rules created by the IRS, smaller
businesses that lack an applicable financial statement,
such as my microbusinesses, may expense amounts paid
for property costing less than $500 rather than
depreciating the property over several years. Taxpayers
elect this new provision annually by including a
statement on the tax return. In addition, taxpayers
must have in place appropriate and documented business
procedures. Although the idea is a good one, taxpayers
must do a lot of paperwork for a small benefit. I would
recommend a rule that allowed small businesses to
expense these costs in the year made.
I had a client with several rental properties
document his intentions to use this new regulation, but
his question to me was, ``When I buy a washer for the
rental unit this year for $600, I cannot take advantage
of this new regulation and will have to depreciate it
anyway, right? What good is it to have the `under $500'
threshold?'' I had to agree with him. He would see more
benefits from this regulation if he could expense his
$600 washing machine purchase or his $1,000 dryer
purchase.
Based on my experience as a small business owner and as a
tax practitioner, I believe the above recommendations would
substantially simplify operations, ease paperwork burdens, and
improve cash flow for many businesses.
In closing, I would like to draw the Subcommittee's
attention to the recommendations of President George W. Bush's
Advisory Panel of Federal Tax Reform:
The Panel recommends that most small businesses file
taxes the same way they pay their bills--with their
checkbook. Under the Panel's options, most small
businesses would report income as cash receipts minus
cash business expenses. This rule reduces compliance
costs by relieving small businesses from keeping a
second (or sometimes even a third) set of books for tax
reasons and allowing them to use records they already
keep for their businesses.
President Bush's panel of experts clearly saw the advantage
of simplification and the importance of cash flow for small
business owners.
Thank you for your time and attention.
[GRAPHIC] [TIFF OMITTED] T8718.002
Mr. Chairman and members of the Committee, thank you for
inviting me to testify today. My name is Stephen Mankowski. I
am a Certified Public Accountant, member of the American
Institute of CPAs and the National Secretary and National Tax
Policy Chair of the National Conference of CPA Practitioners,
(NCCPAP), as well as the Vice President of the Delaware Valley
Chapter of NCCPAP. NCCPAP is a professional organization that
advocates on issues that affect Certified Public Accountants in
public practice and their small business and individual clients
located throughout the United States. NCCPAP members serve more
than one million business and individual clients and are in
continual communication with regulatory bodies to keep them
apprised of the needs of the local CPA practitioner.
Accompanying me is Mr. Edward Caine, President of NCCPAP.
We recently merged our practices.
We have been preparing tax returns for over 30 years. Our
firm annually prepares well over 1,100 small business and
individual tax returns as well as sales tax and payroll tax
returns. As a result, we are in the trenches with clients
discussing their tax, financial and personal issues, and the
impact of events on them. Although our clients are mostly in
the Pennsylvania, New Jersey and Delaware area, we have clients
in New York, South Carolina, Ohio, Florida, Michigan, Alabama,
California, Massachusetts, Nebraska, Tennessee and Washington,
DC. In total, our firm files serves clients in over 30 states
and also services clients in Canada and Europe. In this respect
our practice is the same as many members of NCCPAP and other
smaller CPA firms throughout the United States.
Discussions surrounding the proper basis of accounting most
likely began the moment a second basis was developed. Today, we
not only have the two primary bases--cash and accrual--but also
others including tax, regulatory and ``other''. Any basis other
than accrual method is referred to as an ``Other Comprehensive
Basis of Accounting (OCBOA)''. For purposes of this testimony,
I will be discussing the cash and accrual bases of accounting.
To further complicate the discussion, there are two
distinct cash bases of accounting--cash and modified cash. Pure
cash presentations in financial statements are very rare
because cash receipts would not only include sales receipts but
also proceeds from debt and fixed asset sales, and cash
disbursements would include expenses, purchases of fixed
assets, and loan repayments. This approach does not provide
useful or realistic financial statements. Rather, a modified
presentation has evolved to address these concerns. Therefore,
when the term ``cash basis of accounting'' is used, the
presenter is truly using the modified cash basis of accounting.
As such, when discussing the cash basis of accounting, it is
really a Modified Cash Basis, but hereinafter will be referred
to as ``cash basis''.
Under the cash basis of accounting, a taxpayer can defer
income until cash is received but must also wait to deduct
expenses until the amounts have actually been paid. Currently
the cash basis of accounting is available for businesses
operating as sole proprietors, S Corporations, partnerships
that do not have a ``C'' Corporation as a partner, and personal
service corporations (PSCs). A PSC performs activities in the
fields of health, law, engineering, accounting, etc. whereby
substantially all of the stock of the corporation is owned by
employees performing services for the corporation in connection
with those activities. In addition, some C Corporations and
partnerships with C Corporation as partners can use the cash
method if their average annual sales for the previous three
years are less than $5 million.
Accrual accounting is considered to be the standard
accounting method for most other companies. The accrual method
provides a more accurate picture of the company's current
financial condition, but its relative complexity makes it more
expensive to implement. Generally, a small business that
receives income from producing, purchasing or selling
merchandise must computer its inventory and use the accrual
method of accounting. However, a small business with average
annual receipts of $1 million or less can still use the cash
method and account for inventory as materials and supplies. The
costs of these materials and supplies would be deducted in the
year the business sells the merchandise or pays for the items,
whichever is later. Resellers with gross receipts of $10
million or less are not required to use the accrual method of
accounting.
Currently, if a small business has sales that require an
accrual method of accounting or if the business simply wishes
to convert from the cash method to the accrual method they must
file IRS Form 3115, Application for Change in Accounting
Method. The filing of this form is a request for a change in
accounting method, not a guarantee. In preparing this form, the
taxpayer must take into account any and all changes required to
convert to an accrual basis as well as pay a filing fee.
The need for the accrual method arose out of the increasing
complexity of business transactions and a desire for more
accurate financial information. Selling on credit and projects
that provide revenue streams over a long period of time affect
the company's financial condition at the point of the
transaction. Therefore, it usually makes sense that such events
should also be reflected on the financial statements during the
same reporting period that these transactions occur.
The form to request a Federal Employer ID number (EIN)
requires that an accounting method for the business must be
selected. This form is completed prior to the business opening.
Often, the primary understanding of accounting and record
keeping of the business owner(s) falls under the cash basis of
accounting. Throughout their adult lives, as individuals they
have received W2s, 1099s, 1098s, and/or real estate bills. All
of these documents were prepared under the cash basis of
accounting. In fact, almost all personal tax returns are
prepared on a cash basis of accounting. Therefore, when opening
a business or even purchasing a rental property, the cash basis
of accounting is the initial thought that comes to mind for the
taxpayer.
In establishing a business, hopefully the business owners
have consulted with professionals--attorneys to incorporate the
entity, if applicable, and CPAs to ensure the proper business
structure. Part of a CPA's job is to ensure that taxpayers
comply with the tax codes so that they pay their fair share of
taxes. Many business owners went to incorporate their business
believing that there are special tax advantages, such as fewer
tax audits. They don't realize that there are other
considerations including keeping separate books and records,
paying themselves a salary as an incorporated business is
required to do, additional tax files, and the list goes on.
In recent years, Limited Liability Companies (LLCs) have
become a common choice of business structure of the new small
business. Often, however, the business owner is not aware of
the various tax ramifications. If there is only one owner, the
business is taxed as a sole proprietor and all of the business
activity will be reported on Schedule C of the owner's
individual tax return. With multiple owners, the entity would
be taxed as a partnership. The entity can elect to be taxed as
an S-Corporation regardless of the number of owners provided
that none of the owners are corporations. Under the rules of S
Corporations, owners with greater than a five percent ownership
interest are required to draw reasonable compensation in the
form of a salary where the tax withholdings can be sufficient
to remove the burden of making quarterly estimated tax payments
as individuals.
Regardless of whether the entity is taxed as an S
corporation or partnership, the owners are subject to pass-
through income based upon their ownership interest or
partnership agreement. Often, this income relates to fund that
are not always immediately available for distribution to the
owner(s), which may be another challenge to taxpayers who have
to follow accrual based accounting as this may trigger phantom
income. Owner(s) may choose to keep the net income in the
business to help fund expansion, debt service or unpaid bills.
Countless times during tax season after the owner(s) receive
Form K-1 from their partnership or S corporation, we have to
explain to business owners why they are paying taxes on
business income that they have not received. This is what is
referred to as pass-through income of the business and is taxed
at the individual level--frequently at lower tax rates than if
taxed at corporate levels. Further complicating pass-through
income is the fact that most partnership income is also subject
to self-employment taxes.
Many small businesses still operate under the cash basis
for tax purposes but opt to prepare accrual basis financial
statements, as this MAY show them in a better financial
position. This is often the case when there is a need for
financing. In addition, many banks prefer an accrual basis as
it provides them a more comprehensive view of the financial
position of the entity because of the inclusion of accounts
receivable and accounts payable in the financial statements.
Often business owners do not have the accounting background
to properly and adequately track and report revenue and
expenses in any manner other than cash basis without the
assistance of CPAs, EAs, accountants and bookkeepers. Many
owners simply think on the basis of cash in and cash out and
give their accountants their bank statements, check stubs and
invoices to prepare their financial books which are used solely
to prepare their tax returns. Many small business owners do not
have systems in place to fully track accounts receivable or
accounts payable. Once the financial activity is recorded,
small business owners would then need to adjust these
statements into an accrual basis. These adjustments can include
uncollected revenue, unpaid payroll and related liabilities,
prepaid expenses, inventory, etc. Not only will the owners be
responsible for knowing what adjustments need to be made, they
also must be able to determine the valuation of these
adjustments.
Despite the business owner's reliance on accounting
professionals, the fiscal responsibility still falls on the
owners. The business owners are and will remain responsible for
all of the information that appears on their tax returns. The
fact that their tax returns are professionally prepared does
not alleviate the taxpayer responsibility for the accuracy of
the data contained in the tax returns, but many business owners
may not have the financial background to make this
determination using the accrual basis of accounting.
If small businesses were required to convert their
accounting method to the accrual basis, the overall impact
might simply be a ``one-time'' hit. Meaning, once the
conversion is complete, the annual effect might not be as
significant as one might expect. The ``one-time'' hit, however,
could be very significant depending on the business. Newer
entities or entities with minimal accounts receivable or
accounts payable would likely have a small tax increase and
possibly even a tax decrease. Entities with a larger receivable
base, however, would not be so fortunate. To properly convert,
they would need to report ALL open receivables as current
income and all unpaid bills as current expenses. The impact of
this added income could propel the owners into higher tax
brackets, which in turn could lead to the phase-outs of
itemized deductions and personal exemptions, phase-outs of
other deductions and credits including tuition and student
loans when the increased income is reported on their individual
income tax returns. In addition, taxpayers may find themselves
subject to the 3.9% Net Investment Income surtax that became
effective last year.
These tax increases will not just affect the taxpayer's
federal income tax. Rather, additional state and local taxes
may also be due because state and local tax returns usually
have to be filed on the same basis as the federal tax returns.
Further, many municipalities also impose a tax on gross
receipts of all businesses.
As discussed throughout the testimony, taxpayers often are
unaware of the differences in accounting methods. If they were
required to convert, this obviously creates a major business
opportunity for CPAs, EA, bookkeepers, etc. Unfortunately, this
will also open the door for unregulated preparers to take
advantage of unknowing taxpayers and utilize creative
accounting.
Over the last few years, I have attended many IRS meetings,
including National Public Liaison (NPL) and Working Together
Forums. If there is one common thread that has been resonating
from the IRS, it has been to reduce taxpayer burden. While this
can mean many things, ultimately I believe that the IRS
realizes that business and taxes in today's economy have gotten
even more complicated. The current tax codes makes compliance
even more complicated. In working to reduce the tax compliance
burden, the IRS representatives have stressed the importance of
e-Filing tax returns and have improved upon this every tax
season, added additional features to their website such as
``where's my amended return'' that allows taxpayers to track
the processing of amended tax returns. Further, discussions
have also centered on what can be done to ease the stress of
taxpayers from regular tax filings and to respond to IRS
notices that are sent. Requiring taxpayers to change their
accounting methods without any specific reasons would truly be
in conflict to what the IRS has been working to achieve.
In conclusion, after reviewing the facts surrounding the
differences between cash and accrual basis accounting, I feel
that the use of cash basis for small firms remains of great
importance and should be continued. It is a method that is
consistent with how the owners have been taxed throughout their
lives on their personal tax returns and how they realistically
live. Converting to an accrual basis would add an additional
burden onto them--financial. They would need to retain
accounting professionals to guide them in this process. The
Federal Government would achieve what can best be described as
a ``one-time'' boost of tax revenue from the conversion.
Taxpayers would be paying taxes on net income that neither they
nor the business has received and this tax increase will
include federal, state and local taxes. If the taxpayer has
uncollectable aged accounts receivable, the taxpayer will be
able to then write off this revenue and potentially send
cancellation of debt notices (a 1099C) to those who owe money
to the business. If the business subsequently pays the old
accounts receivable, the income would be reported at that time
and a method would have to be developed to reverse the
cancellation of debt notice. The end result would be that the
taxpayer has reduced his or her tax burden and the effect of
the conversion to accrual basis is further diminished.
All businesses have the opportunity to elect to track their
accounting on an accrual basis. Not all have the opportunity to
account on a cash basis. Some larger entities and many of those
with inventory are required to account on an accrual basis.
However, the majority of businesses are permitted to choose
their accounting method. With the guidance of financial
professionals, they are able to elect the most appropriate
accounting method for their specific business. Forcing a
business to use the accrual basis not only complicates their
business but also requires the owners to take time away from
operations to focus on changing an accounting method.
Ultimately, one does not start a business to focus on
accounting. Forcing this change will do just that.
Thank you for the opportunity to present this testimony.
[GRAPHIC] [TIFF OMITTED] T8718.003
Mr. Chairman and Members of the Subcommittee:
My name is William Hubbard, and I am the President-Elect of
the American Bar Association (``ABA'') and a partner at Nelson
Mullins Riley & Scarborough LLP in Columbia, South Carolina,
where I practice in the area of business litigation. On behalf
of the ABA, which has almost 400,000 members, thank you for the
opportunity to express our views regarding the advantages of
the traditional cash method of accounting utilized by most law
firms, as well as our concerns over draft legislation prepared
by House Ways & Means Committee Chairman Dave Camp (R-MI) that
would substantially limit the continued use of cash accounting.
We request that this statement be made part of the hearing
record.
The proposed legislation, contained in Section 3301 of
Chairman Camp's draft ``Tax Reform Act of 2014,'' would impose
substantial new financial burdens and hardships on many law
firms and other types of personal service businesses throughout
the country by fundamentally changing the manner in which they
must pay their taxes.\1\ In particular, the provision would
require all law firms and other personal service businesses
with annual gross receipts over $10 million to switch from the
traditional cash receipts and disbursement method of accounting
to the much more complex accrual method of accounting. As a
result, many small and medium sized businesses--including many
thousands of law firms, accounting firms, medical firms, and
other professional service providers--would be forced to pay
taxes on income long before it is actually received.
---------------------------------------------------------------------------
\1\ The text of the draft ``Tax Reform Act of 2014'' is available
on the House Ways & Means Committee's website at http://
waysandmeans.house.gov/uploadedfiles/
statutory--text--tax--reform--
act--of--2014--discussion--d
raft--0226214.pdf.
Although we commend Chairman Camp and the Ways & Means
Committee staff for their efforts to craft legislation aimed at
simplifying the tax laws--an objective that the ABA and its
Section of Taxation have long supported--we are concerned that
Section 3301 of his bill would have the opposite effect and
cause other negative unintended consequences. This far-reaching
provision would create unnecessary complexity in the tax law by
disallowing the use of the cash method; increase compliance
costs and corresponding risk of manipulation; and cause
substantial hardship to many law firms and other personal
services businesses by requiring them to pay tax on income they
---------------------------------------------------------------------------
have not yet received and many never receive.
While the ABA has expressed its views on many different
policy issues during the 113th Congress, this particular issue
has become one of the most important issues to our members--and
many state and local bars throughout the country \2\--because
of the serious negative effects that the proposed legislation
would have on practicing lawyers, their law firms, and their
clients. In addition, many other leading associations and other
entities have expressed serious concerns regarding this and
other proposals to impose substantial new limits on the use of
cash accounting.\3\ Therefore, the ABA appreciates this
Subcommittee's efforts to highlight the benefits of cash
accounting and the very serious effects that mandatory accrual
accounting would have on law firms and many other types of
small and medium sized businesses throughout the nation.
---------------------------------------------------------------------------
\2\ At least 21 state and local bars have expressed opposition to
the mandatory accrual accounting legislation, including those in
Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan,
Minnesota, Missouri, Mississippi, Nebraska, New Jersey, North Carolina,
Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, and Wisconsin. A
complete list of the national, specialty, state and local bars opposing
the proposal and other resources on this issue are available at: http:/
/www.americanbar.org/advocacy/
governmental--legislative--work/
priorities--policy/
independence--of--the--legal--
profession/mandatory-accrual-for-law-firms.html.
\3\ The ABA has been working in close cooperation with a broad and
diverse coalition of organizations including the American Institute of
CPAs, American Council of Engineering Companies, American Dental
Association, American Farm Bureau Federation, American Institute of
Architects, American Association for Justice, Americans for Tax Reform,
and over 50 law firms, accounting firms, and other entities in an
effort to raise awareness of the proposed mandatory accrual accounting
legislation and its unintended harmful consequences.
---------------------------------------------------------------------------
Advantages of the Cash Method of Accounting
Under current law, businesses are permitted to use the
simple, straightforward cash method of accounting--in which
income is not recognized until cash or other payment is
actually received and expenses are not taken into account until
they are actually paid--if they are individuals or pass-through
entities (e.g., partnerships or subchapter S corporations), or
their average annual gross receipts for a three year period are
$5 million or less. In addition, all personal service
businesses--including those engaged in the field of law,
accounting, engineering, architecture, health, actuarial
science, performing arts, or consulting--whether organized as
sole proprietorships, partnerships, limited liability
companies, or S corporations, are exempt from the revenue cap
and can use the cash method of accounting irrespective of their
annual revenues, unless they have inventory.
Partnerships, S corporations, personal service corporations
and other pass-through entities favor the cash method because
it is simple and generally correlates with the manner in which
these business owners operate their businesses--i.e., on a cash
basis. Simplicity is important from a compliance perspective
because it enables taxpayers to better understand the tax
consequences of transactions in which they engage or plan to
engage. In this regard, simplicity helps to mitigate compliance
costs--which already are significant--and to improve compliance
with the Tax Code.
In addition to promoting simplicity, the cash method of
accounting also produces a sound and fair result because it
properly recognizes that the cash a business actually receives
in return for the services it provides--not the business'
accounts receivable--is the proper measure of its true income.
While accounts receivable clearly are important in determining
the overall financial condition of the business and assessing
its future prospects, they do not accurately reflect what is
available for the business' owners to spend (or their present
ability to pay taxes on their income). If the tax rules are
changed to disconnect cash collections from how income is
taxed, the very business model upon which many law firms and
other personal service business operate will be turned on its
head.
Mandatory Accrual Accounting for Personal Service Businesses Would Be a
Major Change to Current Law and Would Increase, Not Decrease, the
Complexity of the Tax Code
Section 3301 of the Chairman Camp's draft legislation would
dramatically change current law by raising the gross receipts
cap to $10 million while eliminating the existing exemption for
law firms and other personal service businesses and for other
partnerships and S corporations. Therefore, if this proposal is
enacted into law, all law firms and other personal service
businesses with annual gross receipts over $10 million would be
required to use the accrual method of accounting, in which
income is recognized when the right to receive the income is
present and expenses are recorded when they are fixed,
determinable and economically performed, both aspects of which
present complications.
Although Chairman Camp's proposal would allow certain small
business taxpayers with annual gross receipts in the $5 million
to $10 million range to switch to--and thereby enjoy the
benefits of--the cash method of accounting (a concept that the
ABA does not oppose), the proposal would significantly
complicate tax compliance for a far greater number of small
business taxpayers, including many law firms and other personal
service businesses, by forcing them to use the accrual method
of accounting.
For example, while law firms using the cash method of
accounting simply pay taxes on the income that they actually
receive, law firms that are required to use the accrual method
will be forced to calculate and then pay taxes on multiple
types of accrued income, including work in progress and other
unbilled work, accounts receivable (where the work has been
done and billed but not yet paid for), and accounts paid (where
the work has been done, billed, and paid for).\4\ In order to
meet these requirements, law firms and other affected
businesses will need to keep much more detailed work and
billing records and hire additional accounting and support
staff. As a result, the proposal would substantially raise
compliance costs for many law firms and other personal service
businesses while greatly increasing the risk of noncompliance
with the Tax Code.
---------------------------------------------------------------------------
\4\ For a detailed discussion of the specific effects that
mandatory accrual accounting legislation would have on law firms, see
PwC's Law Firm Services, Congressional Proposals Requiring Law Firms to
Report Taxable Income on the Accrual Method of Accounting (December,
2013), available at: http://legaltimes.typepad.com/files/cash-to-
accrual-white-paper.pdf.
---------------------------------------------------------------------------
Other ABA Concerns Regarding the Legislation
In addition to creating unnecessary complexity and
compliance costs, Chairman Camp's proposal would lead to
economic distortions that would adversely affect all personal
service businesses that currently use the cash method of
accounting and those who retain them, including many law firms
and their clients, in several ways.
First, the proposal would impose substantial new financial
burden on many thousands of personal service businesses
throughout the country--including many law firms--by requiring
them to pay taxes on income they have not yet received and may
never receive. Unlike the current law, where law firms and
other personal service businesses need only pay taxes on income
they have actually received, the proposal would require many of
these firms to pay tax on ``phantom income'' that they have not
yet received, including work in progress, other unbilled work,
and accounts receivable. As a result, many firms would have to
borrow money or use their scarce capital just to pay their
accelerated tax obligations. In either event, the proposal
would impose a serious financial burden and hardship on many of
these firms.
Second, the proposal would cause the legal profession to
suffer even greater financial hardships than other professions
because many lawyers and law firms are not paid by their
clients until long after the work is performed. Many types of
lawyers--such as business lawyers working on complex
transactions and litigators involved in lengthy trials or
appeals--often are not paid until the end of the case or
project, which can be years after the work is performed. This
sets lawyers and law firms apart from many other types of
professionals--such as doctors, dentists, and accountants--who
typically work on a pay-as-you-go basis. Therefore, requiring
personal service providers to pay taxes on income that has
accrued but not yet been received will create special hardships
for many in the legal profession.
The proposal also would disproportionately affect
professional service providers that practice in regulated
professions, like lawyers, because many of these professionals
are subject to special rules that significantly limit their
ability to raise capital. For example, lawyers must comply with
state court ethics requirements that generally prohibit them
from forming a law firm partnership with a non-lawyer \5\ or
allowing a non-lawyer to own any interest in a law firm
partnership.\6\ As a result, many law firms must be capitalized
solely by the individual lawyers who together own those firms
and they are unable to raise equity capital from outside non-
lawyer investors. Therefore, forcing these law firms to pay tax
on income that has not yet been received and which may never be
received could place a major strain on lawyers' ability to
properly capitalize and operate their firms.
---------------------------------------------------------------------------
\5\ Rule 5.4(b) of the ABA Model Rule of Professional Conduct
(``ABA Model Rules'') provides that ``a lawyer shall not form a
partnership with a nonlawyer if any of the activities of the
partnership consist of the practice of law.'' See also Charts Comparing
Individual Professional Conduct Rules as Adopted or Proposed by States
to ABA Model Rules, available at http://www.americanbar.org/groups/
professional--responsibility/policy.html.
\6\ ABA Model Rule 5.4(d)(1) provides that ``a lawyer shall not
practice with or in the form of a professional corporation or
association authorized to practice law for a profit, if...a nonlawyer
owns any interest therein, except that a fiduciary representative of
the estate of a lawyer may hold the stock or interest of the lawyer for
a reasonable time during administration.'' Similarly, in many states,
accounting firms may not have any passive (i.e., investor) ownership
and a majority of the owners must hold active CPA licenses.
Third, the mandatory accrual accounting proposal could
adversely affect clients, interfere with the lawyer-client
relationship, and reduce the availability of legal services in
various ways. Under the traditional hourly billing model
followed by many law firms, individual lawyers within the firm
typically perform any necessary legal services for the client
throughout the month and the firm then bills the client on a
monthly (or quarterly, or some other periodic) basis. In other
cases, law firms may agree to handle a client's case on a
contingency fee basis, in which a fee (typically a percentage
of the total recovery, plus actual expenses) is only charged if
the client prevails. In still other cases, a law firm may agree
to represent a start-up company in return for an equity
interest in the new business instead of a traditional legal
fee. Many law firms also agree to represent a certain number of
indigent clients on a pro bono basis in which no fee of any
---------------------------------------------------------------------------
kind is charged.
Unfortunately, if the proposed legislation is enacted and
many law firms that currently use the cash method of accounting
are forced to use the accrual method and pay taxes on income
they have not yet received, the resulting financial pressures
will force many firms charging on an hourly basis to collect
their legal fees immediately after the legal services are
provided to the clients (or at least much sooner than they
currently do). In addition, many firms will no longer be able
to represent as many accident victims, start-up companies, or
other clients on a contingent fee basis as they currently do
because the taxes on contingent fee income could become due
once the court judgments or settlements become final, even if
the firm does not actually collect the income for months or
even years later. Perhaps worst of all, the serious cash flow
and other financial pressures caused by the acceleration of
their tax liabilities will force many firms to reduce the
amount of free, pro bono legal services that they currently
provide to the poor.
Finally, the ABA opposes the mandatory accrual accounting
proposal because it would constitute a major tax increase on
small and medium sized businesses and would discourage economic
growth. According to the Joint Committee on Taxation, the
accrual accounting mandate in Section 3301 of Chairman Camp's
bill would generate $23.6 billion in new taxes over ten years
\7\ by requiring the affected businesses to pay taxes on
phantom income up to a year or more before it is actually
received (if it is ever received). Because this acceleration of
a firm's tax liability would be permanent and continue year
after year, it would constitute a major permanent tax increase
for the firm, when compared to the taxes the firm currently
pays under the cash method, until the firm eventually
dissolves, merges with another firm, or otherwise ceases to
exist.
---------------------------------------------------------------------------
\7\ See Tax Reform Act of 2014 Discussion Draft, Section-by-Section
Summary at page 88, available at: http://waysandmeans.house.gov/
uploadedfiles/
ways--and--means--section--b
y--section--summary--final--
022614.pdf
In addition, the proposal would discourage professional
service providers from joining with other providers to create
or expand a firm, even if it made economic sense and would
benefit their clients, because4 it could trigger the accrual
accounting requirement in the bill. For example, solo
practitioner lawyers would be discouraged from entering into
law firm partnerships--and many existing law firms would be
discouraged from growing or expanding--because once a firm
exceeds $10 million in annual gross receipts, it would be
required to switch from cash to accrual accounting, thereby
accelerating its tax payments. Sound tax policy should
encourage--not discourage--the growth of small and medium sized
businesses, including those providing personal services such as
law firms, especially in today's difficult economic
---------------------------------------------------------------------------
environment.
Conclusion
In sum, while the simple cash method of accounting more
accurately reflects the true income of most businesses and
offers many other advantages, mandatory accrual accounting
proposals such as Section 3301 of the draft Tax Reform Act of
2014 would likely cause numerous harmful unintended
consequences. These include unnecessary new complexity in the
tax law, increased compliance costs, and significant new
financial burdens and hardships for the many law firms and
other personal service businesses throughout the country that
will be required to pay tax on phantom income that has not yet
been received and may never be received. In addition, the
proposal would harm the economy and discourage growth, without
providing any corresponding benefits.
To avoid these harmful results, the ABA urges you and your
colleagues to protect the ability of personal service
businesses to use the simple cash method of accounting and to
oppose provisions like Section 3301 that would require many of
these businesses to utilize the more complex and costly accrual
method of accounting.
Thank you again for the opportunity to express the ABA's
views on this important issue.
[GRAPHIC] [TIFF OMITTED] T8718.004
The American Council of Engineering Companies (ACEC)--the
business association of the nation's engineering industry--is
pleased to submit this statement to the Subcommittee on
Economic Growth, Tax, and Capital Access of the House Small
Business Committee for its hearing on the cash method of
accounting.
ACEC members--numbering more than 5,000 firms representing
hundreds of thousands of engineers and other specialists
throughout the country--are engaged in a wide range of
engineering works that propel the nation's economy, and enhance
and safeguard America's quality of life. The Council represents
engineering businesses of all sizes, from those with a single
professional engineer to firms that employ tens of thousands of
professionals working in the United States and throughout the
world.
A proposal is being discussed in Congress that would change
the rules regarding the use of the cash method of accounting.
The Tax Reform Act of 1986 requires most businesses,
particularly those that have inventories, to use the accrual
method of accounting. However, professional services firms of
all sizes, including engineering firms, are generally allowed
to use cash accounting for tax purposes, either under the QPSC
exception or because they are organized as S corporations or
partnerships. In addition, the law provides a general allowance
in the use of cash accounting for any small firm with revenues
below $5 million, as well as farmers.
The proposal under consideration would change these long-
standing rules and limit the use of cash accounting only to
sole proprietorships and firms with less than $10 million in
gross receipts. While increasing the basic small firm threshold
from $5 million to $10 million makes sense, the larger impact
of forcing engineering firms with revenues over $10 million to
switch to accrual accounting presents major problems.
At the outset, we would note an immediate contradiction in
policy, as the current small business size standard for
engineering firms is $14 million. Should the proposal become
law, some firms that are classified as small by the Small
Business Administration would be considered large under the
Internal Revenue Code.
The proposal presents more fundamental problems, however.
Engineering firms normally carry large balances of accounts
receivable and work in progress, representing work performed
for clients for which they have not yet been paid. The primary
cost for engineering firms is labor, and approximately 85
percent of a typical firm's expenses can be attributed to
payroll, benefits, and similar regular expenses. Engineering
firms generally have to wait at least 120 days to be paid for
services rendered to their clients, and at the same time must
pay their employees every two weeks. While this situation can
create cash flow challenges for firms, the use of cash
accounting helps to mitigate those challenges by allowing firms
to make tax payments after receiving payment for their
services.
By contrast, forcing firms to switch to accrual accounting
would require firms to use debt financing to cover the delta
between expenses and receipts, which is much harder for small
and mid-size firms to access today. The cash flow challenges
that would result from a switch to accrual accounting would
create additional negative consequences, including workforce
downsizing among some firms, delayed expansion plans, and
decreased shareholder distributions. In fact, many S
corporations utilize shareholder distributions to facilitate
ownership transition, and any reduction could have a
detrimental impact on a firm's long-term viability. All of
these outcomes would take money out of the productive economy,
jeopardize well-paying jobs, and burden firms that continue to
struggle in the soft economy.
The simple premise of cash accounting allows engineering
firms to pay income taxes on their revenue when they are
actually paid, rather than when they submit an invoice.
Conversely, they are not allowed to take deductions for
expenses when they are incurred, but when the expense is
actually paid. Once again, we believe this approach is fair for
an industry whose product is intellectual capital, not hard
physical inventory.
For these reasons, ACEC strongly recommends that Congress
continue to allow engineering firms and other similar
businesses to use cash accounting as they have done for
decades.
On behalf of the nation's engineering industry, we thank
the Subcommittee on Economic Growth, Tax, and Capital Access of
the House Small Business Committee for the opportunity to
submit a statement on this important issue.
[GRAPHIC] [TIFF OMITTED] T8718.005
[GRAPHIC] [TIFF OMITTED] T8718.006
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
WRITTEN STATEMENT
For the Record of the
July 10, 2014 Hearing
of the
UNITED STATES HOUSE OF REPRESENTATIVES
COMMITTEE ON SMALL BUSINESS
SUBCOMMITTEE ON ECONOMIC GROWTH, TAX AND CAPITAL ACCESS
on
CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?
Introduction
The AICPA commends Chairman Rice, Ranking Member Chu, and
the Subcommittee on Economic Growth, Tax and Capital Access for
examining cash accounting, its utilization by small businesses,
and whether the current policies should be changed to allow
small firms more flexibility in choice of accounting methods.
We wholly support the expansion of the number of taxpayers
that may use the cash method of accounting. The cash method of
accounting is simpler in application, has fewer compliance
costs, and does not require taxpayers to pay tax before
receiving the income being taxed. For these same reasons, we
are extremely concerned with, and oppose, any limitations on
the use of the cash method for small and service businesses,
including those businesses whose income is taxed directly on
their owners' individual returns, such as S corporations and
partnerships. Requiring these businesses to switch to the
accrual method upon reaching a gross receipts threshold would
unnecessarily discourage small business growth.
The AICPA is the world's largest member association
representing the accounting profession, with more than 394,000
members in 128 countries and a 125-year heritage of serving the
public interest. Our members advise clients on Federal, state
and international tax matters and prepare income and other tax
returns for millions of Americans. Our members provide services
to individuals, not-for-profit organizations, small and medium-
sized businesses, as well as America's largest businesses.
Background
1. General Rules
In general, a taxpayer may use any method of accounting
that clearly reflects income (including the cash method) unless
the taxpayer is required by the Internal Revenue Code or Income
Tax Regulations to use a specific method of accounting (e.g.,
the accrual method of accounting, the percentage of completion
method for long-term contracts, etc.).\1\
---------------------------------------------------------------------------
\1\ See section 446(c).
For example, the following taxpayers are generally
---------------------------------------------------------------------------
permitted to use the cash method of accounting:
1. Sole proprietors; \2\
---------------------------------------------------------------------------
\2\ See section 446(c).
---------------------------------------------------------------------------
2. Pass-through entities (e.g., partnerships and S
corporations); \3\
---------------------------------------------------------------------------
\3\ See section 446(c).
---------------------------------------------------------------------------
3. Entities that engage in a farming business; \4\
---------------------------------------------------------------------------
\4\ See limitation, however, under section 447.
---------------------------------------------------------------------------
4. Entities that primarily perform services by their
owners; \5\ and
---------------------------------------------------------------------------
\5\ See section 448(b).
---------------------------------------------------------------------------
5. Entities that satisfy a $5 million gross receipts
test (and do not maintain inventory).\6\
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\6\ See section 448(b)(3).
Currently, the Internal Revenue Code and Income Tax
Regulations require certain taxpayers to adopt a specific
method of accounting (e.g., the accrual method of accounting,
the percentage of completion method for long-term contracts,
etc.). For example, C corporations (as well as partnerships
that have a C corporation as a partner) and tax shelters are
not allowed to use the cash method of accounting (subject to
exceptions),\7\ and a taxpayer must also generally use the
accrual method of accounting if the taxpayer purchases,
produces, or sells merchandise.\8\
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\7\ See section 448(a) and 448(b)(3).
\8\ See Treas. Reg. Sec. 1.446-1(c)(2)(i).
On the other hand, the Internal Revenue Service (IRS), by
administrative action, has allowed certain ``small'' taxpayers
(e.g., qualifying taxpayers \9\ and qualifying small business
taxpayers \10\) to use the cash method even if inventories are
maintained.
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\9\ According to Rev. Proc. 2001-10, a qualifying taxpayer is an
entity with average annual gross receipts for each prior tax year
ending on or after December 17, 1998, of $1 million or less.
\10\ According to Rev. Proc. 2002-28, a qualifying small business
taxpayer is an entity with average annual gross receipts for each prior
tax year ending on or after December 31, 2000, of more than $1 million
but not more than $10 million, and is not otherwise prohibited from
using the cash method under section 448(a).
In other words, most types of entities (e.g., sole
proprietorships, partnerships, and S corporations) may use the
cash basis method of accounting regardless of whether they
maintain inventory, if they have average annual gross receipts
of less than $10 million. As mentioned above, this threshold is
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lowered to $5 million for C corporations.
In general, a taxpayer who changes its accounting method
(e.g., from the cash method to the accrual method) is required
to compute an adjustment (section 481(a) adjustment) to prevent
items of income or expense from being duplicated or entirely
omitted from the taxpayer's taxable income. If the accounting
method change is made with the permission of the Commissioner
and results in a positive section 481(a) adjustment (increase
in income), the adjustment is included in taxable income
ratably over four taxable years. Whereas, a negative section
481(a) adjustment (decrease in income) is taken into account
entirely in the year of change.\11\
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\11\ See Section 481(a); Rev. Proc. 97-27, 1997-1 C.B. 680.
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12. Recent Proposals
On February 21, 2014, House Ways and Means Committee
Chairman Dave Camp released the Tax Reform Act of 2014, which
provides that the cash method of accounting is available for
natural persons (in other words, ``individuals'') and any other
taxpayer who meets the gross receipts test and is otherwise
eligible to use the cash method. Under the proposal, a taxpayer
would satisfy the gross receipts test if the taxpayer's average
annual gross receipts for a three taxable-year period are $10
million or less. The proposal effectively would require certain
pass-through entities (e.g., partnerships and S corporations)
and personal service corporations with average annual gross
receipts in excess of $10 million to use the accrual method of
accounting. The proposal also would provide that a positive
section 481(a) adjustment from an accounting change from the
cash method to the accrual method is accounted over a four-year
stepped period within eight years.
On November 21, 2013, the former Senate Finance Committee
Chairman Max Baucus released the 2013 Cost Recovery and
Accounting Staff Discussion Legislative Language, which
provides that the cash method of accounting is only available
by taxpayers who meet the gross receipts test and are otherwise
eligible to use the cash method. Under the proposal, a taxpayer
would satisfy the gross receipts test if the taxpayer's average
annual gross receipts for a three taxable-year period are $10
million or less. The proposal effectively would require certain
individuals, farmers, pass-through entities (e.g., partnerships
and S corporations), and personal service corporations with
average annual gross receipts in excess of $10 million to use
the accrual method of accounting. However, the proposal would
permit a taxpayer to use the cash basis method of accounting,
if the gross receipts threshold is satisfied, regardless of
whether it maintains inventory.
In summary, if enacted, these proposals would both expand
and limit the availability of the cash method of accounting for
small businesses by increasing the gross receipts threshold
from $5 to $10 million and requiring pass-through entities and
personal service operations with average annual gross receipts
in excess of $10 million to use the accrual method of
accounting.
Analysis
Increased burden in adopting the accrual method of
accounting
The AICPA believes that requiring small and service
businesses, including those businesses whose income is taxed
directly on their owners' individual returns, such as S
corporations and partnerships, to adopt and use the accrual
method of accounting imposes complexities and increases burden.
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.
Therefore, determining taxable income using the cash method is
much simpler in application. Thus, many small businesses,
including the service industry, prefer using the cash method of
accounting.
Under the accrual method, income is recognized when the
right to receive the income is fixed and the amount is
determinable with reasonable accuracy,\12\ and expenses are
deductible when they are fixed, determinable, and economically
performed \13\ (e.g., the ``all-events test''). These tests
require analysis that is more complex than under the cash
method. For example, under the accrual method, a taxpayer must
determine the fact and amount of liability and determine if the
property or service to which the accrual relates is actually
provided or used. Therefore, determining taxable income under
the accrual method is far more difficult in application,
resulting in increases in the cost of compliance compared with
the cash method. Thus, many small businesses oppose any
requirement that the accrual method of accounting be used.
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\12\ See section 451.
\13\ See section 461.
Given that the cash method remains a far simpler method of
accounting, the AICPA believes that simplicity justifies its
continued use by non-natural persons (e.g., pass-through
entities and personal service corporations), regardless of
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their gross receipts.
Discouraging business growth
The AICPA believes that limiting the use of the cash method
of accounting by businesses (e.g., sole proprietors, farmers,
and pass-through entities) would discourage their natural
business growth.
Every business hopes to grow. Businesses may grow
organically, or by combining with similar businesses. As a
result, although many businesses start out as a sole
proprietorship, most eventually convert to a pass-through
entity (e.g., general partnerships, limited liability
partnerships, limited liability companies, and S corporations)
to join forces and expand their operations.
Under Chairman Camp's proposal, many pass-through entities
would need to change to the accrual method of accounting once
their average annual gross receipts exceeded a $10 million
threshold, inhibiting both organic growth and growth through
combination. For example, assume a sole proprietor is currently
operating a successful business with more than $10 million of
gross receipts. If the sole proprietor rewards an employee by
making the employee a partner in the business, the business is
no longer operating as a natural person (sole proprietor) and
therefore, would be ineligible to continue to use the cash
basis method of accounting--providing a disincentive to expand
the business.
Similarly, if two firms (each with $5.5 million gross
receipts) intend to combine to share resources and expertise
and better serve their clients, the combined firm would exceed
the proposed threshold and be subject to the mandatory use of
the accrual method of accounting--again, creating a
disincentive to gain efficiencies through combination. In other
words, a business's inability to use the cash method of
accounting would create an artificial obstacle to joint
ventures or the joining of two or more owners or businesses.
In addition, limiting the use of the cash method of
accounting would slow down (even stop) business growth. As
noted above, requiring businesses to adopt the accrual method
would increase the cost of compliance. This increase would
force these businesses to stop hiring and planning for future
expansions. In other words, instead of these businesses
focusing on their growth (e.g., hiring more employees,
expanding to new markets), they would be required to shift
their resources to comply with the requirement.
Small businesses play a key role to the economic growth in
the United States. According to the Small Business
Administration, small businesses ``accounted for 63 percent of
the net new jobs created between 1993 and mid-2013 (or 14.3
million of the 22.9 million net new jobs).'' The AICPA believes
that small businesses need a sound tax policy and business
environment that promotes simplicity and economic growth. The
cash method of accounting provides simplification and allows
small businesses to focus on their expansion and growth.
Financial burden on individual owners of service businesses
The AICPA believes that limiting the use of the cash method
of accounting for service businesses and pass-through
businesses would impose an undue financial burden on their
individual owners.
These businesses should not be required to use the accrual
method of accounting. Such a requirement would accelerate the
taxable income of many professional service firm owners (e.g.,
CPAs, attorneys, engineers), resulting in an increased tax
liability on earnings they have not yet received. In order to
pay this accelerated tax, some businesses would be forced to
make cash distributions to their owners from other sources
(e.g., new loans, reduction in workforce, slowing growth
initiatives, etc.), potentially threatening their operations
due to a tightening of cash flow. Other businesses would force
their owners to deal with the financial burden regardless of
the individuals' ability to pay.
Additionally, the acceleration of income may result in the
only reason that a partner is taxed at a higher marginal tax
rate. Under the current U.S. tax system, income is taxed at
progressively higher rates.\14\ For example, the top marginal
rate of 39.6 percent applies to taxable income over $400,000
for a partner filing as a single person. Thus, the acceleration
of income of a partner could be taxed at the highest marginal
rate that would otherwise be taxed at a lower rate (e.g., 35,
33, 28, 25, 15, or 10 percent). In addition to paying the
highest tax rate, the partner could lose some of the benefit of
itemizing certain deductions. For example, itemized deductions
(e.g., mortgage interest deduction, charitable deduction) of a
partner with an adjusted gross income of $250,000 would be
reduced by the lesser of 3 percent of the excess of adjusted
gross income (AGI) over $250,000 or 80 percent of the itemized
deduction.\15\ Thus, the partner is likely to have a higher
overall tax liability with the acceleration of income.
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\14\ IRS 2013 Form 1040 Instructions, page 101.
\15\ See section 68(a).
For those professional service firms that are subject to
state regulations limiting ownership to individuals who
actively participate in the business, the potential hardship
created by restricting use of the cash method by pass-through
entities would increase significantly. For example, in many
states, a firm engaged in the practice of accountancy is
specifically prohibited from allowing any passive (investor)
ownership and a majority of the owners must hold active CPA
licenses. As a result, many accounting firms must raise capital
solely by the individual professionals who together own the
firm; they cannot raise capital from outside investors. As a
result, 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
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maintain capital in their firms.
We believe that a transition from the cash to the accrual
method imposes undue financial burden and would have a negative
impact on both a new owner's ability to finance entrance into a
partnership and a firm's ability to grow either independently
or through merging with another firm.
Conclusion
The AICPA supports expansion of the number of taxpayers who
may use the cash method of accounting. As we have discussed,
the cash method of accounting is simpler in application, has
fewer compliance costs, and does not require taxpayers to pay
tax before receiving the cash.
However, we strongly believe that Congress should not
restrict the use of the long-standing cash method of accounting
for the thousands of U.S. businesses that rely on it. We have
confidence that forcing more businesses to use the accrual
method of accounting for tax purposes would increase their
administrative burden, discourage business growth in the U.S.
economy, and unnecessarily impose financial hardship on cash-
strapped businesses.
Statement for the Record
Cash Accounting: A Simpler Method for Small Firms?
July 10, 2014
Subcommittee on Economic Growth, Tax and Capital Access
Committee on Small Business
House of Representatives
We, the undersigned, wish to thank Chairman Rice, Ranking
Member Chu and Members of the Subcommittee for convening this
hearing to examine whether current tax policies should be
changed to allow small businesses more flexibility in using the
cash method of accounting. We represent a diverse group of
service businesses who rely on the cash method to simply and
accurately report income and expenses. As Congress examines the
merits of the cash method of accounting and considers whether
to expand its availability to more small businesses, we urge
you to oppose any proposal that would force businesses
currently allowed to use the cash method to switch to accrual
accounting.
For several decades, Congress has recognized that the cash
method is a simple, accurate, and transparent method of
reporting when income is received and when expenses are paid.
The cash method is used extensively by American service
providers representing a wide array of large and small
businesses, many family-owned, including medical, dental,
accounting, law, architectural, engineering, landscaping,
horticultural, financial services, and consulting firms.
Limiting the use of the cash accounting method would impose a
significant tax and compliance burden on these businesses--and
the individuals who own them--and undermine a tried and tested
method of measuring and verifying a company's income and
expenses.
Under current law, the cash method of accounting may be
used by individuals, most farmers, and service providers
operating as partnerships, S corporations and professional
service corporations, regardless of size. Certain C
corporations with gross receipts up to $5 million also may use
the cash method. The House Ways and Means and Senate Finance
Committees have released tax reform proposals that would allow
more businesses with gross receipts up to $10 million to use
cash accounting. However, their proposals also would require
partnerships, S corporations, and personal service corporations
with gross receipts over $10 million to switch from the cash
method to the accrual method of accounting; the Senate version
also includes individuals and farmers.
While we do not oppose measures expanding the use of cash
accounting to benefit the smallest businesses, we do oppose
measures that would prohibit us from continuing to use the cash
method and that could result in significant hardship and
negative consequences. The cash method is good for all sizes of
service businesses with common concerns about economic growth,
job creation and competitiveness. Proposals to restrict its use
are without any policy justification and are used solely for
the purpose of raising revenue to pay for tax reform.
Such proposals would force businesses to switch from a
simple ``cash-in/cash-out'' method of accounting for income and
expenses to the much more complicated accrual method of
accounting. Further, accrual accounting requires taxpayers to
pay tax on accounts receivable and work-in-progress--phantom
income that hasn't been collected and may never be collected--
creating cash flow issues and forcing some taxpayers to go into
debt just to pay their tax bill. Compliance costs would
escalate, adding to the already, overwhelming recordkeeping
burdens and costs faced by many of these businesses.
Ultimately, because most of these businesses are pass-throughs,
the cash to accrual proposal is an immediate and unfair tax
increase on individuals.
There is no policy justification to force service
businesses to switch from cash to accrual accounting. There is
no evidence or allegation of abuse of the cash method by the
taxpayers who use it. Further, the impact of the proposal is
not consistent with the stated principles of tax reform,
including fairness, simplicity, certainty, economic growth, job
creation and enhanced competitiveness. Indeed, banning a tried
and true method of tracking income to arbitrarily pay for tax
reform is entirely inconsistent with these principles.
Thank you for the opportunity to provide these comments. We
are pleased to serve as a resource to the Congress, the
Committee, and the Subcommittee, and we look forward to our
continued work together on this important matter.
Adams and Reese LLP
American Council of Engineering Companies
American Institute of Architects
Americans for Tax Reform
Covington & Burling LLP
Cozen O'Connor
Federal Communications Bar Association
Fisher & Phillips LLP
Gardere Wynne Sewell LLP
Investment Adviser Association
Jackson Walker LLP
K&L Gates LLP
Littler Mendelson, P.C.
McKenna Long & Aldridge LLP
Miles & Stockbridge
Mitchell Silberberg & Knupp LLP
Nelson Mullins Riley & Scarborough LLP
Ogletree Deakins
Pierce Atwood LLP
Richards, Layton & Finger, P.A.
State Bar of South Dakota
White & Case LLP
Wiley Rein LLP
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The National Federation of Independent Business (NFIB)
appreciates the opportunity to submit this statement for the
record to the Committee on Small Business for the hearing
entitled ``Cash Accounting: A Simpler Method for Small Firms?''
NFIB is the nation's leading small business advocacy
organization representing over 350,000 small business owners
across the country, and we appreciate the opportunity to
provide our perspective on this issue. NFIB represents small
businesses in every region and every industry in the country.
Accordingly, NFIB has a unique insight into the concerns of the
small business community, and can speak with authority on these
concerns.
NFIB applauds the Committee for having this hearing today.
Small business' ability to use cash accounting can greatly
simplify the time and costs associated with tax preparation by
small business owners. But while the availability of cash
accounting has been gradually expanded over the years,
significant limitations to its availability remain that limit
the ability of small business owners to take advantage of this
simplified accounting method.
Small Business' Ability to Use Cash Accounting
Cash accounting, when receipts are recorded during the
period they are actually or constructively received, and
expenses are recorded in the period in which they are actually
paid, is the preferred method of accounting for small
businesses. Forty-one percent of small businesses report using
the cash method of accounting according to a 2006 NFIB National
Small Business Poll. Small business owners prefer the cash
accounting method because it is much easier for them to follow
and more closely matches the way that small business owners
maintain their books. However, the availability of cash
accounting is not applied evenly by the tax code or the
Internal Revenue Service (IRS). Depending on a firm's entity-
type, size (by revenue), and industry-type, cash accounting may
be unavailable to a number of small businesses.
The Internal Revenue Code (the code) contains significant
limitations to the ability of small business' to use cash
accounting. Section 448(c) allows C corporations and
partnerships with less than $5 million in gross receipts to use
cash accounting. This provision, however, does not include S
corporations, which are one of the most frequently used types
of business entity used by small business owners, Further, any
taxpayer who maintains inventories is prohibited from using
cash accounting regardless of their gross receipts. This
prevents any small business owner who purchases and sells
merchandise, such as retailers or wholesalers, from using the
cash accounting method. Finally, the code prohibits taxpayers
who manufacture goods for resale from using cash accounting.
Since 2000, the IRS has taken meaningful steps to expand
the availability of cash accounting to small businesses. IRS
Revenue Procedure 2000-22 permits small businesses with gross
receipts of $1 million or less (based on the preceding three-
year period) to use cash accounting where the business
otherwise would have to use accrual accounting because it is
required to account for inventories. Revenue Procedure 2002-28
permits qualifying small businesses with gross receipts of $10
million or less (based on the preceding three-year period) to
use cash accounting. However, Revenue Procedure 2002-28
precludes many industries, such as manufacturing, wholesale
trade, retail trade and mining. The procedure also does not
apply to C corporations or partnerships with a C corporation
partner.
Due to these statutory and administrative limitations, many
small businesses cannot use cash accounting. Many of these
businesses would benefit from an expanded ability to use cash
accounting for tax purposes. Permitting more businesses with
higher gross receipts to use cash accounting helps small
businesses to manage cash flow because it better reflects the
business owner's ability to pay taxes. This expansion is also
logical given efforts by the IRS to expand the availability of
cash accounting.
Allowing any business entity with gross receipts of less
than $10 million meaningfully expands the availability of cash
accounting for small business owners. Because of the large
number of small businesses that maintain inventories, any
expansion of cash accounting should also apply to these types
of taxpayers.
Conclusion
NFIB greatly appreciates the efforts of the Committee to
shed light on the importance of cash accounting for small
business owners. Current law is overly complicated and fails to
adequately reach many small business owners who might otherwise
be able to lower their tax compliance burden. Expanding its
availability would go a long way towards simplifying tax
compliance and preparation for small business owners. However,
expanding cash accounting is just one aspect of tax reform and
it does not replace the need to reduce individual tax rates and
ensure a level playing field between pass-through entities and
C corporations.
Testimony of Jeffrey Wald
Chief Executive Officer, Kennedy and Coe, LLC
To the House of Representatives Committee On Small Business,
Subcommittee on Economic Growth, Tax and Capital Access
Cash Accounting: A Simpler Method for Small Firms?
July 10, 2014
Kennedy and Coe commends Chairman Rice, Ranking Member Chu
and the entire House Committee on Small Business for examining
the value of the cash method of accounting to U.S. small
businesses.
As CEO of Kennedy and Coe, one of the nation's largest
accounting firms specializing in food and agriculture
businesses, I can tell you first hand that the cash basis of
accounting is critical for agriculture.
The agriculture sector, unlike many other sectors of our
economy, is still driven by the small and family business.
According to USDA's 2012 Census of Agriculture, nearly 88
percent of the 2.1 million farm businesses are considered small
businesses. Without question, this makes the agriculture
industry among the most reliant on the success or failure of
the small business owner.
Kennedy and Coe works with farmers and ranchers in nearly
every state. And regardless of region or commodity type, our
accountants find that the cash basis of accounting helps small
farmers grow their businesses. We see three primary reasons for
this:
1. Cash accounting is simpler and requires less
administrative work.
2. Cash accounting helps farmers and ranchers manage
volatile commodity and input prices; and
3. Cash accounting ensures that taxes do not have to
be paid until after income has been received.
While these benefits may be universal among anyone
utilizing cash accounting, the impact is particularly acute in
the agriculture sector.
Cash Accounting is simpler and requires less administrative
work
For those of us in the farming industry, we know just how
wrong some perceptions of agriculture can be. Take the idea
that our food and fiber comes from corporate farms, for
instance. In reality, 97.6 percent of all U.S. farms are family
owned and operated. These farms are responsible for 85 percent
of all U.S. farm production.
Look a little closer and we get an even clearer picture of
just who is growing our food:
-62 percent of farmers in the U.S. are over the age
of 55;
-77 percent have worked their land for more than 10
years
Put simply: these operations are not large enough to employ
an army of accountants and lawyers capable of navigating a
complex tax code. These are family businesses that have to
consider the trade-offs of maintaining complex accounting
records. Because the more time most farmers spend doing their
books, the less time they can spend on their farms and with
their families.
What farmers need is a reasonably easy, common sense way to
accurately keep track of receipts and expenses. The cash basis
of accounting provides just that.
Cash Accounting Helps Farmers Manage Volatile Commodity and
Input Prices
The agriculture sector is widely recognized for its slim
margins and extreme volatility. But just because these
characteristics are inherent, doesn't mean they are easy to
deal with.
Running a successful agricultural operation requires
constant planning to adapt to wide swings in the cost of
critical inputs such as energy, fertilizer, or animal feed.
On the other end of the equation, farm operators need to be
prepared for considerable changes in annual production volumes
from factors such as weather or disease. They also need to
prepare for major shifts in the prices they receive, as things
like drought or policy changes can have a major impact on
commodity markets.
The cash basis of accounting is the one critical tool that
farmers and ranchers can use to deal with this volatility.
Under the cash basis, income is not realized until the
business receives payment for its product; and expenses are not
realized until that expense is paid. With this flexibility,
farm businesses can elect to withhold a portion of their crop
until prices improve. Or, they can elect to purchase large
volumes of feed or fuel when prices are low, even if it will be
used across multiple tax-years.
The value of this flexibility cannot be overstated--this
carried inventory or reduced expense is often what makes the
difference between making and losing money in a given tax year.
Cash accounting ensures that taxes do not have to be paid
until after income has been received.
Due to the commoditization of the agriculture business, and
the vast amount of capital it takes to break into the food
processing business, many farmers do not sell their products
directly into the market. Instead, they sell to intermediaries
who often only pay a fraction of the price up front, and
provide the remainder of the compensation after the product has
been sold.
While such arrangements may effectively diffuse market
risk, such an arrangement only makes sense under a system of
cash accounting. Because under cash accounting, the farm
operator is only responsible for paying taxes on the income he
or she has received.
Should farmers lose the ability to use cash accounting,
many would have to pay taxes on income they have yet to
receive. In the asset-rich but cash-poor agriculture industry,
this arrangement simply is not feasible.
The phrase ``not feasible,'' isn't just rhetoric. After the
House Ways and Means Committee and Senate Finance Committee
floated the idea of forcing farms with more than $10 million in
revenue to use accrual accounting instead of cash accounting,
Kennedy and Coe commissioned Informa Economics to study the
potential impacts of the policy change. As the study shows, the
results would be catastrophic.
Informa Economics concluded that U.S. agricultural
producers forced to switch from cash-basis to accrual-basis
accounting under the draft tax bill would have to accelerate
payment on as much as $4.84 billion in taxes over the next four
years. Additionally, the borrowing capacity of these operations
would decrease by another $7.26 billion over the same time
period.
To put that $12.1 billion loss in working capital in
context, Informa estimates that the combined liquid capital of
impacted farms is only $1.8 billion. This means that losing
cash accounting would likely force farmers and ranchers to
either sell assets or go to the bank, just to pay their taxes,
in many cases on products for which they have yet to receive
payment.
The Informa study quantified what we'd heard from producers
across the U.S.--losing cash accounting would have a major
negative effect on American agriculture. Meeting the immediate
tax burden is going to be very difficult or impossible for
producers who simply do not have the cash flow to pay taxes
before they sell their products.
Conclusion
I want to close by once again expressing my appreciation
for the leadership of the many champions of small business and
family farms on this Committee. The cash basis of accounting
provides the lifeblood of rural America--our agriculture
industry--with the ability to thrive even in today's
challenging market environment.
Mr. Chairman, Madam Ranking Member, Members of the
Committee, I am grateful for the opportunity to share the
perspective of the agriculture community. I appreciate your
efforts to call attention to the need to simplify and expand
the use of cash accounting, and look forward to working with
you to ensure that this expansion benefits our nation's farmers
and ranchers.