A subcommittee of the House of Representatives' Committee on Small Business recently held a hearing to discuss the value of small businesses using the cash basis of accounting, and whether they should be required to use the accrual basis.

Translation: small businesses are about to be hit again as Congress looks for ways to raise taxes without changing the tax rates. Changing tax rates themselves seems to attract the attention of the media more so than less obvious ways to get more money, such as changing deductions, et cetera.

Current law allows most businesses with annual gross receipts of $5 million or less to use the cash method of accounting for tax purposes. That means income is not recognized until cash or other payment is received and deductions are not allowed until payments are made. Personal service businesses such as law firms, accounting firms, engineering firms, medical practices and others, are allowed to use the cash method of accounting regardless of their annual revenue, unless they carry inventory.

Proposals are being drafted that would change current law by raising the gross receipts cap to $10 million. On its face, that would allow more larger businesses to use cash-basis accounting. The problem lies in a parallel provision that would eliminate the existing exemption for personal service businesses.

Such a law would result in catastrophic financial and compliance burdens for those service businesses. This would force these businesses to pay taxes on accounts receivable, which has been called “phantom income,” before they actually collect it. This tax on accounts receivable would be partially offset by the fact that the taxpayer should be able to deduct accounts payable – bills the business owes but hasn’t yet paid. The problem is that for a profitable business, receivables are normally much higher than payables. Many businesses may have to borrow money to pay the taxes on receivables that they may not collect until sometime down the road, if ever. Any business owners who have tried to borrow money from a bank recently know how difficult this process is.

This could create an unfair tax burden on partners or shareholders who transition out of a partnership or a Subchapter S corporation, since they would have to pay the tax on money they will never see. Such businesses may have to split apart and avoid growth to avoid rising above the $10 million cap.

On the compliance side, businesses falling under the new rules would have to upgrade and monitor their recordkeeping. At the end of each tax year, these businesses would have to review their receivables to determine their accuracy and to adjust those that might not be collectible. Such adjustments are reflected on tax returns as “bad debt.” Since the return form has a separate line just for this, you can rest assured that this might raise questions with the IRS, resulting in a possible audit. An IRS auditor can be expected to question the taxpayer’s opinion as to why a receivable is considered “bad.”

The witnesses appearing before the Small Business Subcommittee were all in agreement that the cash method is far easier to use. Who would benefit from mandating a change to accrual accounting?

The government.

Since all the discussion on tax policy over the past few years has been on simplifying the tax code, I cannot understand why this issue is being raised. The answer can only be that certain members of Congress are seeking new revenue sources regardless of fairness. A related answer is that businesses, regardless of their size, need to be punished for their success.

Randy McIntyre is a Certified Public Accountant and a partner in McIntyre, Paradis, Wood & Company, CPAs. He has worked in public accounting since 1977, in Wilmington since 1992. His firm is built on a history of service, technical expertise, and innovative to provide the expertise of larger firms with a personal, one-on-one approach. To learn more about McIntyre, Paradis, Wood & Company, see www.mpwcpas.com. He can be reached at [email protected]  or 910-793-1181.