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ABA opposes potential income-tax change for law firms

The Maryland State Bar Association has joined a national lawyers’ group in opposing draft congressional legislation that would require high-revenue law firms and other personal-services firms to pay income tax on money their clients still owe them.

A draft of the yet-to-be introduced Tax Reform Act of 2014 in the House calls for a change from the cash-receipts method of tax accounting to an accrual standard for personal-services firms with annual gross receipts over $10 million. Under Section 3301 of the draft proposal, these firms would have to treat as income any revenue they have a right to receive within the tax year.

Paul G. Marcotte Jr., who helped formulate MSBA’s opposition, derided as “unfair” such taxing of money that has not yet been paid to a firm.

“If you are a service business, you send a bill out and you don’t know if you’re going to collect that bill,” said Marcotte, a past chair of MSBA’s Taxation Section.

Firms with high gross receipts have “the same problem collecting a bill” as smaller practices, Marcotte said, adding the draft proposal’s gross-receipts threshold is not very high.

“This is going to impact a lot of firms,” said Marcotte, of Paley Rothman in Bethesda. “It’s not hard to get to $10 million if you’re a midsize firm.”

His comments followed the American Bar Association’s submission last week of written testimony in opposition to the draft legislation, which characterized it as a tax on “phantom 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 businesses operate will be turned on its head,” ABA President-Elect William C. Hubbard wrote in the testimony to the U.S. House Small Business Subcommittee on Economic Growth, Tax and Capital Access.

“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,” Hubbard wrote.

While accounts receivable are an important factor in a business’s overall financial condition, they do not necessarily reflect how much money the owners have on hand, which affects their ability to pay taxes, Marcotte and Hubbard agreed. Without ready cash when the taxes fall due, a firm could be forced to dip into its bad-debt reserve, Marcotte noted.

The proposed rule would also discourage smaller firms from expanding or merging, Hubbard wrote.

“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 service businesses by requiring them to pay tax on income they have not yet received and may never receive,” wrote Hubbard, of Nelson Mullins Riley & Scarborough LLP in Columbia, S.C.

The office of U.S. House Ways and Means Committee Chair Dave Camp, R-Mich., who drafted the proposal, did not return telephone and email messages Wednesday seeking comment on the bar associations’ objections.

In a February statement, Camp said the draft measure was intended primarily to spur discussion of reforming the U.S. Tax Code.

“I am hopeful that lawmakers on both sides of the aisle — and partners at both ends of Pennsylvania Avenue — take a close look at this plan and share their thoughts and ideas, and those of their constituents,” Camp said.

“The bottom line: Just saying ‘no’ is not the solution,” he added. “We can, and need to, work together to craft a plan that fixes our broken code and strengthens the economy so there are more jobs and bigger paychecks for hardworking taxpayers.”