US law firms are facing a fundamental overhaul over the way they calculate and distribute their profits that could result in far higher short-term tax bills if controversial proposals currently before Congress are approved.
The proposals could see US firms with over $10m in revenues forced to switch their accounting model from a cash basis, under which money received in a financial year is taxable, to a UK-style accrual method, where taxable revenue includes work done but not yet billed or collected.
Such a change would create major financial and managerial challenges for US advisers and Tony Williams (pictured), principal at Jomati Consultants, told Legal Business: ‘The challenging part for the legal sector is the conversion process.’
The proposed changes will have the immediate effect of a short-term spike in the amount of tax due, with Congress expected to raise around $50bn from the legal sector as a result, according to Williams. The shift is expected to be phased over four years.
If the proposal is passed, US firms will face difficult choices with regard to funding this spike and Williams added: ‘Law firms will have three choices – to increase bank debt, delay capital distribution to its partners, or make its partners increase their capital contribution – none is favourable.’
The proposals may also require firms to make changes to adapt the way contingency or fixed fees are recorded, or any other liabilities that accrue in one period but are paid later, such as unused holiday pay or bonuses. However, it would make it easier to financially merge US and UK law firms.
Unsurprisingly the proposals are proving unpopular, with one US firm partner describing them as a ‘one-off grab by the US taxman’. Bingham McCutchen’s London managing partner James Roome said: ‘Taxation of accruals tends to result in less prudent finances. Paying tax on fees that have not yet been received increases a partnership’s working capital, and is generally financed through firm or individual partner debt.’
The accrual system can also cause firms difficulty if a client fails to pay, particularly in the case of an insolvency, and Roome added: ‘You can claw back the tax later, but by then it is often too late.’
If passed, Congress aims for the accrual method to be up and running by 2015.