Pa. Firms: Accounting Changes Could Cost Legal Industry Billions

, The Legal Intelligencer

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While law firms are increasingly modeling their business practices after their clients’, one they have not been interested in mimicking is the accrual method of accounting. But it may be coming.

Leaders of some of Pennsylvania’s largest law firms are calling a piece of proposed tax reform legislation floating around in Congress a “gimmick” to get what one firm leader estimated was an extra $10 billion in tax revenue from the Am Law 200 firms alone, with the end result being heavy tax burdens on partners and firms being forced to borrow money.

Law firms and other professional services firms are currently exempt from having to use an accrual method of accounting, which would require them to pay taxes on accounts receivable and work in process as well as the cash they bring in. Currently they pay tax only on actual cash receipts.

Max Baucus, the former chairman of the Senate Finance Committee before leaving Congress earlier this month to serve as the U.S. ambassador to China, and Rep. Dave Camp, R-Mich., chairman of the House Ways and Means Committee, each introduced comprehensive tax reform legislation that included a requirement for professional services firms with more than $10 million in revenue to switch to an accrual method of accounting. The switch in methods would be phased in over four years.

With Baucus, a Montana Democrat, out and a midterm election coming up this year, bankers and firm leaders who spoke to The Legal said passage of a tax overhaul was unlikely in the very near future. But the bankers said firms need to prepare just in case and law firm leaders are concerned the measure would be plucked from the tax reform legislation and added into a more easily passed bill to help finance whatever that proposal may be.

K&L Gates managing partner Peter Kalis said in an email that while the proposals are aimed at businesses, they “profoundly” impact the individual owners of these businesses—the partners, who will have to pay taxes on “phantom” income they have not, and may never, receive. He said this switch would drive law firms into debt to fund operations, partner compensation and tax obligations.

“On the heels of the global financial crisis and its aftermath, it is sheer folly to drive the legal industry into a deficit position requiring massive bank borrowing to fund operations and partners’ now artificially swollen tax obligations,” Kalis said in the email. “In the nascent recovery of the legal markets, the timing of this blindsided blow to U.S. law firms and their individual partners could not be worse. There is no credible justification for causing law firms to abandon cash accounting, to single out their partners to be taxed on phantom income, and to drive them and their firms into debt.”

Dechert CEO Daniel O’Donnell said his firm joined several other law firms and the American Bar Association in opposing a switch to the accrual method.

“This appears to be a one-time revenue-raising gimmick that would impose a significant tax penalty on professions whose members are already paying tax at the highest ordinary income rates,” O’Donnell said.

Read more in an upcoming edition of The Legal.

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