What Do the Cash Method of Accounting and Sausages Have in Common?

"Laws, like sausages, cease to inspire respect in proportion as we know how they are made." (Although often attributed to Otto von Bismarck (the Iron Chancellor), this maxim was actually first made by lawyer-poet John Godfrey Saxe, quoted in the University Chronicle, p. 4 (March 27, 1869).)

Perhaps this statement has never been truer than it is today. The creation of tax laws in Washington is often labor-intensive and involves members of Congress, their staffs, special-interest groups, lobbyists, and other interested stakeholders. One can assume that if tax legislation is riddled with compromise, the actual negotiation and closed-door discussions that produce the laws are unfriendly and perhaps even hostile at times. As a result, the process of drafting tax laws is generally better left unseen.

However, such negotiation and compromise are part of the process. Affected parties have perhaps not only the right but the obligation to educate those who are responsible for creating and administering the tax laws. In this light, the CPA community, both individually and through the AICPA, can play a vital role. CPAs are uniquely qualified through their expert experience to provide Congress with not only theoretical support for policy decisions but also practical knowledge for all tax law proposals.

Congress has launched a debate on comprehensive tax reform, the likes of which the country has not seen since 1986. As a result, the AICPA, in fulfilling one of its key roles as a leading professional organization, has been active in monitoring and educating Congress about the implications of various tax reform legislative proposals.

In March 2013, House Ways and Means Committee Chairman Dave Camp, R-Mich., released a tax reform draft bill, Proposed Tax Reform Act of 2013, that included Title II—Tax Reform for Businesses. The 2013 proposal included many tax reform measures that signaled the committee's desire to proceed with major tax reform in this legislative session. Among the various proposals is a troubling provision that would severely restrict individual owners of businesses from using the cash method of accounting. In early 2014, Camp modified the 2013 proposal in favor of a much more robust and comprehensive tax reform package titled the Tax Reform Act of 2014. Like its predecessor, the 2014 proposal included a similar limitation on the use of the cash method of accounting.

In the fall of 2013, former Sen. Max Baucus, D-Mont., then chairman of the Senate Finance Committee, proposed a discussion draft on cost recovery and accounting that would also restrict certain individual owners of businesses from using the cash method of accounting.

Each of these proposals would force a large number of existing cash-method businesses to adopt the accrual method of accounting.

The cash method of accounting has historically been recognized as appropriate for individuals to use in reporting their business dealings. The cash method is easier to understand and administer than the accrual method. Starting in 1986, certain entities were not allowed to use the cash method of accounting. However, many businesses could continue to use it as long as the business profits and activity would ultimately be taxable to individuals (Sec. 448(a)).

The cash method of accounting is currently permissible for businesses owned by individuals, most partnerships, and S corporations, unless the business maintains inventory (Sec. 448(a) and Regs. Sec. 1.446-1(c)(2)). A C corporation, or a partnership with a C corporation partner, generally cannot use the cash method of accounting (Secs. 448(a)(1) and (2)) unless it is a personal service corporation, has average annual gross receipts of not more than $5 million, or is in the business of farming (Sec. 448(b)).

The Camp proposal would limit the use of the cash method of accounting to only individuals conducting business as a sole proprietorship and other forms of businesses with $10 million or less in average annual gross receipts. Under the Camp proposal, however, the new rules would not apply to farming businesses, which would continue to be subject to current-law accounting rules. The Baucus proposal would limit the use of the cash method of accounting to only businesses (including sole proprietorships) with $10 million or less in average annual gross receipts. Thus, both proposals would force all directly owned businesses other than sole proprietorships, such as partnerships and S corporations, with annual gross receipts of more than $10 million, to adopt the accrual method of accounting, regardless of the nature of the business and even if it did not maintain inventory.This proposed limitation could lead businesses to alter their ownership and business structure for the primary purpose of qualifying to maintain the cash method of accounting. When income tax outcomes drive business decisions, unintended and undesirable business consequences are often quick to follow.

It is only fair to note that the proposals would double the historical annual gross receipts applicability standard. This portion of the proposals is well-reasoned and should be supported. An increase in the limit is appropriate, considering that the current threshold has not reflected any inflation factor. However, the other limitations on the use of the cash method of accounting placed on partnerships and S corporations make the overall proposal unworkable.

The proposals would produce several direct and indirect consequences harmful to U.S. businesses. They would:

• Discourage individuals from forming partnerships if doing so would cause them to be subject to the $10 million annual gross receipts test;

• Require partners and S corporation shareholders to pay tax on income they have not yet received; and

• Increase the complexity and cost of compliance by forcing these "cash only" types of businesses to adopt the more complicated accrual method of accounting.

In Washington, tax ideas often require discussion for many years before they gather enough support for passage. However, ideas that raise revenue will often be adopted more quickly as Congress seeks ways to offset proposed tax breaks with new tax revenues in current legislative proposals. According to the Joint Committee on Taxation, under a dynamic scoring model, Camp's 2014 proposal would raise $23.6 billion of new tax revenue over the next 10 years (Joint Committee on Taxation, Estimated Revenue Effects of the "Tax Reform Act of 2014" (JCX-20-14), p. 7 (Feb. 26, 2014)). The amount of projected revenue raised by this proposal is significant, even by Washington's standards. There is a real risk that the proposals could be used in future unrelated bills as an offset to fund new legislation.

To better assist lawmakers in understanding the implications of the proposals, the AICPA has sent both houses of Congress five letters (see one from August 2013) that highlight the proposals' shortcomings and unintended consequences, as well as the negative business implications. In addition, the AICPA, its volunteers, and its staff members have contacted various congressional offices to provide detailed personal explanations of how the negative consequences will affect members and their clients. On July 17, the AICPA submitted written testimony to the House Committee on Small Business's Subcommittee on Economic Growth, Tax and Capital Access.

The AICPA's advocacy efforts resulted in 71 bipartisan members of the House sending a letter to Camp and Ways and Means Committee ranking member Sander Levin, D-Mich., in November 2013, strongly discouraging them from adopting Camp's initial proposal. On Aug. 6, 2014, a bipartisan group of 46 senators sent a letter to Senate Finance Committee Chairman Ron Wyden, D-Ore., and ranking member Orrin Hatch, R-Utah, expressing concerns about the measures included in Baucus's proposal.

The AICPA will continue to provide this same education and thought leadership whenever a proposal to limit cash-basis accounting surfaces in either house of Congress in the future.

AICPA members can help by taking a more active role in informing their representatives and senators about the negative implications of the proposals. This information can be shared through phone calls, emails, and meetings with lawmakers and their staff members. CPAs can provide copies of the AICPA's comment letters and testimony and emphasize that the AICPA generally supports tax reform efforts; however, the AICPA and its members strongly oppose the limitation on cash-basis accounting.

If the AICPA and other organizations are not proactive about educating members of Congress and their staffers about the direct and indirect negative consequences of limiting the cash method of accounting, Congress could very well end up including this provision or something very similar to it in a future tax bill that becomes law.