[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]



 
           CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?

=======================================================================

                                HEARING

                               before the

        SUBCOMMITTEE ON ECONOMIC GROWTH, TAX AND CAPITAL ACCESS

                                 OF THE

                      COMMITTEE ON SMALL BUSINESS
                             UNITED STATES
                        HOUSE OF REPRESENTATIVES

                    ONE HUNDRED THIRTEENTH CONGRESS

                             SECOND SESSION

                               __________

                              HEARING HELD
                             JULY 10, 2014

                               __________

                               [GRAPHIC] [TIFF OMITTED] TONGRESS.#13
                               

            Small Business Committee Document Number 113-074
              Available via the GPO Website: www.fdsys.gov

                                 ______

                   U.S. GOVERNMENT PRINTING OFFICE 
88-718                     WASHINGTON : 2014
____________________________________________________________________________ 
For sale by the Superintendent of Documents, U.S. Government Printing Office, 
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202ï¿½09512ï¿½091800, or 866ï¿½09512ï¿½091800 (toll-free). E-mail, [email protected].  


                   HOUSE COMMITTEE ON SMALL BUSINESS

                     SAM GRAVES, Missouri, Chairman
                           STEVE CHABOT, Ohio
                            STEVE KING, Iowa
                         MIKE COFFMAN, Colorado
                      BLAINE LUETKEMEYER, Missouri
                     MICK MULVANEY, South Carolina
                         SCOTT TIPTON, Colorado
                   JAIME HERRERA BEUTLER, Washington
                        RICHARD HANNA, New York
                         TIM HUELSKAMP, Kansas
                       DAVID SCHWEIKERT, Arizona
                       KERRY BENTIVOLIO, Michigan
                        CHRIS COLLINS, New York
                        TOM RICE, South Carolina
               NYDIA VELAZQUEZ, New York, Ranking Member
                         KURT SCHRADER, Oregon
                        YVETTE CLARKE, New York
                          JUDY CHU, California
                        JANICE HAHN, California
                     DONALD PAYNE, JR., New Jersey
                          GRACE MENG, New York
                        BRAD SCHNEIDER, Illinois
                          RON BARBER, Arizona
                    ANN McLANE KUSTER, New Hampshire
                        PATRICK MURPHY, Florida

                      Lori Salley, Staff Director
                    Paul Sass Deputy Staff Director
                      Barry Pineles, Chief Counsel
                  Michael Day, Minority Staff Director


                            C O N T E N T S

                           OPENING STATEMENT

                                                                   Page
Hon. Tom Rice....................................................     1
Hon. Judy Chu....................................................     2

                               WITNESSES

Mr. Donald Williamson, Professor, Department of Accounting and 
  Taxation, Executive Director, Kogod Tax Center, American 
  University, Washington, DC.....................................     3
Ms. Sarah Windham, Senior Tax Manager, Dixon Hughes Goodman LLP, 
  Charleston, SC, testifying on behalf of the South Carolina Farm 
  Bureau.........................................................     5
Ms. Terry Durkin, Owner, Durkin Associates, Burlington, MA, 
  testifying on behalf of the National Association of Enrolled 
  Agents.........................................................     7
Mr. Stephen Mankowski, Partner, EP Caine & Associates CPA, LLC, 
  Bryn Mawr, PA, testifying on behalf of the National Conference 
  of CPA Practitioners...........................................     9

                                APPENDIX

Prepared Statements:
    Mr. Donald Williamson, Professor, Department of Accounting 
      and Taxation, Executive Director, Kogod Tax Center, 
      American University, Washington, DC........................    26
    Ms. Sarah Windham, Senior Tax Manager, Dixon Hughes Goodman 
      LLP, Charleston, SC, testifying on behalf of the South 
      Carolina Farm Bureau.......................................    37
    Ms. Terry Durkin, Owner, Durkin Associates, Burlington, MA, 
      testifying on behalf of the National Association of 
      Enrolled Agents............................................    42
    Mr. Stephen Mankowski, Partner, EP Caine & Associates CPA, 
      LLC, Bryn Mawr, PA, testifying on behalf of the National 
      Conference of CPA Practitioners............................    46
Questions for the Record:
    None.
Answers for the Record:
    None.
Additional Material for the Record:
    American Bar Association (ABA)...............................    52
    American Council of Engineering Companies (ACEC).............    59
    American Institute of Certified Public Accountants (AICPA)...    62
    CTA Statement................................................    70
    National Cattlemen's Beef Association (NCBA).................    73
    National Federation of Independent Business (NFIB)...........    76
    Jeffrey Wald, Chief Executive Officer, Kennedy and Coe, LLC..    79


           CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?

                              ----------                              


                        THURSDAY, JULY 10, 2014

                  House of Representatives,
               Committee on Small Business,
                   Subcommittee on Economic Growth,
                                    Tax and Capital Access,
                                                    Washington, DC.
    The Subcommittee met, pursuant to call, at 10:00 a.m., in 
Room 2360, Rayburn House Office Building. Hon. Tom Rice 
[chairman of the subcommittee] presiding.
    Present: Representatives Rice, Chabot, Mulvaney, Hanna, 
Schweikert, Chu, Paine, and Schneider.
    Chairman RICE. Good morning. This hearing will come to 
order.
    First, let me thank our witnesses for taking time to be 
with us today to talk about how to help small businesses 
prosper.
    As a former tax attorney and CPA for nearly 30 years, I 
know firsthand that tax complexity is a big problem facing 
small business owners. Today, we are going to examine one way 
to simplify life for small firms by looking at the issue of the 
cash method of accounting, which offers a simple, 
straightforward solution for entrepreneurs to record business 
income and expenses. In cash accounting, a business records 
incoming expenses at the time the funds are received or paid, 
just like with a personal checkbook, and it makes it fairly 
easy to track cash flow, the lifeblood of many entrepreneurs. 
Perhaps because of this simplicity it is a preferred method of 
accounting for small businesses.
    The other, more complicated method, accrual accounting, 
requires a business to record income at the time a sale is made 
or an agreement to provide services reached, regardless of when 
the payment is actually received. By the same token, expenses 
are recorded when they are obligated to be paid, regardless of 
when the funds were actually dispersed.
    In determining which accounting method to use, small 
business owners must comply with the Internal Revenue code. 
Most businesses are required to use the accrual method, though 
exceptions exist which permit firms of certain types and sizes 
to use the cash method.
    Ultimately, whichever method is used can have very real 
effects on how a small business operates. Given this, it would 
be in the interest of us here in Washington to ensure our 
nation's job creators have the flexibility to use the 
accounting method that best suits their operations and gives 
them the best chance to succeed.
    We are fortunate to have with us a group of leaders within 
the accounting community, both industry experts and small 
businesses that help other small businesses with their 
accounting services. I look forward to learning firsthand how 
they perceive the utility of the cash accounting for small 
businesses and how we can make cash accounting even easier for 
small businesses to use.
    With that, I would like to thank our distinguished panel of 
witnesses for being here today, and I now recognize the ranking 
member for her opening statement.
    Ms. CHU. Thank you, Mr. Chair.
    For many, starting a successful business and seeing it grow 
is the American dream. During that process, many big decisions 
must be made--where to rent, what to call the business, and how 
much capital is needed. Besides deciding which business 
organizational structure to adopt, one of the most basic 
decisions is which accounting method to use--accrual accounting 
or cash basis method. On the surface, the question may seem 
easy, but small business owners must learn several rules and 
complicated nuances associated with each technique. These 
methods primarily differ in when and how income and expenses 
are reported. The cash method accounting is widely used by 
small firms because it is simple to understand and makes day-
to-day recordkeeping easier. It generally requires taxpayers to 
report income and expenses as they are received and paid, so it 
mimics how individuals handle their own personal finances. 
Simply put, income is reported when cash comes in, and expenses 
are reported when cash goes out.
    On the other hand, the accrual accounting method generally 
requires taxpayers to report income and expenses as the 
transactions are established, regardless of whether cash is 
received or paid. While accrual accounting offers the 
flexibility to delay or advance income and expensing to more 
accurately reflect business operations. The cash method more 
accurately reflects cash flow.
    Most small business owners track the profitability of their 
business during the year based on the balance in their checking 
account, which is more in line with the cash accounting, so it 
is not surprising that the National Federation of Independent 
Businesses found that 41 percent of small business owners 
utilize the cash method of accounting, while only 19 percent 
use the accrual method. I have also heard repeatedly from small 
business owners in my district how much they depend on the cash 
accounting method.
    Today's hearing will examine the differences between the 
two accounting methods and discuss what makes the cash 
accounting method more advantageous for small business owners. 
We will also discuss the tax reform proposal for expanding the 
cash method revenue limit and the draft language limiting its 
use to certain organizational structures. The proposal was 
introduced earlier this Congress by Chairman Dave Camp of the 
Ways and Means Committee.
    Reforms that lower the burden on small businesses by 
reducing recordkeeping and paperwork help to lead to increased 
entrepreneurial activity and a stronger economy. Under current 
law, C corporations and certain partnerships may not use the 
cash method once average gross receipts exceed five million. 
However, some partnerships and S corporations are permitted to 
use the cash method regardless of their level of receipts, 
provided they are not required to maintain inventories. The 
draft proposal generated much debate surrounding the cash 
accounting method because it would expand and limit the 
availability of this critical accounting scheme.
    Despite increasing its use to allow businesses with up to 
$10 million in gross receipts, the draft language prohibits S 
corporations and partnerships that previously qualified for the 
cash method from continuing to use it, and that means that 
personal service corporations, like businesses performing 
accounting, dentistry, and legal services would no longer 
qualify if they hit the gross receipts ceiling.
    This raises many questions and concerns for those small 
businesses, and this hearing will highlight some of them. 
Providing relief for thousands of small firms is critical to 
moving forward with tax reform. However, we must be cautious as 
to how that simplicity is provided. Today's hearing presents 
the opportunity to have a real debate on the accounting methods 
used by millions of small business owners and how certain tax 
reform proposals can affect their bottom line.
    I want to thank all the witnesses for being here, and I 
look forward to your testimony. Thank you, and I yield back.
    Chairman RICE. Okay. Just some formalities to get out of 
the way.
    If committee members have an opening statement, I ask that 
they submit it for the record.
    I would like to take a moment to explain the timing lights 
for you. You will each have five minutes to deliver your 
testimony. The lights will start out as green. When you have 
one minute remaining, it will turn yellow. And finally, at the 
end of your five minutes, it will turn red. I will ask that you 
try to adhere to that time limit, although we are not going to 
be very strict.
    Our first witness today is Professor Donald Williamson of 
the American University where he teaches and serves as the 
director of Masters of Science and Taxation Program. He is also 
the executive director of the Americans Kogod Tax Center. Prior 
to his time at American University, he served as senior manager 
for international taxation at KPMG. A certified public 
accountant, Mr. Williamson is a frequent lecturer to 
professional groups throughout the nation, and has published 
over 50 articles in professional and academic journals.
    Thank you for being here, sir. We look forward to your 
testimony.

   STATEMENTS OF DONALD WILLIAMSON, PROFESSOR, DEPARTMENT OF 
   ACCOUNTING AND TAXATION AND EXECUTIVE DIRECTOR, KOGOD TAX 
 CENTER, AMERICAN UNIVERSITY; SARAH WINDHAM, CERTIFIED PUBLIC 
 ACCOUNTANT AND SENIOR TAX MANAGER, DIXON HUGHES GOODMAN, LLC; 
  TERRY DURKIN, OWNER, DURKIN ASSOCIATES; STEPHEN MANKOWSKI, 
           PARTNER, EP CAINE AND ASSOCIATES CPA, LLC

                 STATEMENT OF DONALD WILLIAMSON

    Mr. WILLIAMSON. Thank you, Chairman Rice.
    Chairman Rice, Ranking Member Chu, and members of the 
Subcommittee, thank you for the opportunity to testify on the 
need to simplify the tax reporting requirements on small 
businesses by means of adopting simpler methods of tax 
accounting, most notably, expanding the circumstances whereby 
small business may use the cash method rather than the more 
burdensome accrual method of accounting.
    My name is Don Williamson, and I am a professor of Taxation 
at American University's Kogod School of Business, where for 
the past 30 years I have directed the school's Masters in 
Taxation degree program. The MST program at American offers 
graduate courses in federal taxation to CPAs, experienced 
accountants, attorneys, and others who wish to expand their 
knowledge of our nation's tax law. Our course offerings not 
only include traditional classes in subject areas such as 
taxation of corporations and partnerships, but also more 
specialized areas of the tax law, such as accounting periods 
and methods, which is the topic of this hearing today.
    As part of my responsibilities at American, I am also the 
executive director of the Kogod Tax Center, which conducts 
nonpartisan research on tax issues affecting small business and 
entrepreneurs, and for the past 25 years, I have had my own tax 
preparation and tax planning practice for small businesses in 
Falls Church, Virginia.
    My written testimony describes the key differences between 
the cash and accrual methods of account for the reporting of 
income and expenses on the tax return of a small business. For 
now, let me simply say that the accrual method is undeniably 
the more complex method of accounting and that it offers few 
advantages to small businesses whose chief concern with regard 
to their financial condition is their cash flow. It is 
important to note that the method of accounting adopted by a 
business, whether it be the cash method or the accrual method, 
only affects the timing of when a business reports income or 
deductions on its tax return. The accounting method a business 
uses does not determine whether an item of income is taxable or 
an expense deductible and does not affect the total income and 
deductions a business will recognize over its lifetime.
    However, despite the greater simplicity and better fit of 
the cash method for small businesses, the Internal Revenue Code 
denies the cash method to corporations with average gross 
receipts exceeding $5 million. I urge Congress to increase the 
current threshold for use of the cash method to $10 million. 
Raising the threshold to $10 million will mean that almost 90 
percent of all businesses in the United States could adopt the 
cash method of accounting.
    But even when the cash method is available to small 
business, certain judicial doctrines, such as constructive 
receipt for the recognition of income impose unnecessary 
complication on a small business simply to accelerate the 
reporting of income by, in most cases, a few months before the 
actual cash is received. Also, the requirement that a cash 
method small business may not deduct its cash outlays to 
purchase inventory until that product is sold may satisfy 
accounting theorists but offers no immediate tax benefit to 
small businesses that expend considerable sums creating jobs. 
To address these needs of small businesses, I urge Congress to 
go beyond simply expanding the number of small businesses 
eligible to use the cash method of accounting and consider 
enacting a simplified cash method of accounting along the lines 
described in my written testimony. Under this method of 
accounting, a small business would be able to look at its 
checkbook to determine its taxable income. It sounds simple, 
and it is. Permitting small business to elect a simplified cash 
method of accounting will reduce tax compliance costs, ease the 
burden of tax administration, and clarify the measurement of 
taxable income.
    I thank the Committee again for the opportunity to testify. 
I welcome any questions you may have.
    Chairman RICE. Thank you, sir.
    Our next witness is Sarah Windham, certified public 
accountant and senior tax manager at Dixon Hughes Goodman in my 
home state in Charleston, South Carolina. Mrs. Windham has been 
in public practice for 15 years and has extensive experience 
preparing tax returns and consulting with small business 
clients, with particular expertise in the agriculture and 
construction industries. She is testifying today on behalf of 
the South Carolina Farm Bureau. We appreciate you being here. 
You may now begin your testimony.

                   STATEMENT OF SARAH WINDHAM

    Ms. WINDHAM. Thank you. Chairman Rice and members of the 
Committee, thank you for allowing me the opportunity to testify 
today.
    My name is Sarah Windham, and I am a senior tax manager in 
the Charleston, South Carolina office of Dixon Hughes Goodman. 
We are the largest CPA firm based in the southern U.S. Our 
commitment to our clients' success has led to the development 
of specialized practice groups, such as agribusiness. With 
nearly 60 years of experience serving the agribusiness 
industry, DHG has developed a deep understanding of the 
operations and issues affecting the agribusiness industry. I am 
a CPA with 15 years of experience. I have extensive experience 
with agriculture clients, construction and real estate clients, 
as well as many other small businesses. I am here today on 
behalf of South Carolina Farm Bureau.
    I am testifying before you today on the potential negative 
ramifications of the various proposals in Congress that would 
eliminate for many taxpayers the use of cash accounting for the 
purpose of calculating income tax liability. These adverse 
effects include a significant increase in the time dedicated to 
tax compliance, which will defer farmers and other small 
businesses from focusing on making a living, as well as an 
increase in the cost of tax compliance that will reduce the 
profitability of many farms and small businesses who already 
work on very thin margins.
    Another effect would be a significant acceleration of the 
tax liability without cash available to pay the uncollected, 
yet taxed income. These adverse effects would fall 
disproportionately on small businesses, such as farmers, and on 
professionals, such as those in my farm. Most farmers do not 
employ professional accountants. Many farms' books and records 
are maintained by family members or the farm owners themselves. 
Requiring them to switch to accrual basis accounting would 
force them to hire bookkeeping assistance and/or spend 
additional funds on accrual accounting systems, thus creating 
additional costs in an industry that continues to face rapidly 
rising production expenses.
    One story I would like to share with you reflects the 
strain accrual accounting can put on farms. One of our farm 
clients was being asked by his financial institution to provide 
accrual financial statements on a quarterly basis. As with most 
farms, they keep their books and records on the cash basis. 
After explaining the additional fees that a farmer would incur 
to have us assist their staff in converting the books to 
accrual basis, it was agreed that cash basis statements would 
be a better option.
    Farmers, by nature, manage risk and volatility. They are 
literally at the mercy of nature, the effects and aftermath of 
weather, and commodity prices. Since their income can fluctuate 
wildly from year to year, accrual accounting, coupled with our 
progressive tax system, would likely cause farmers to pay more 
tax over time than a company in a different industry with 
stable income over the same time period. Cash accounting also 
allows them the option to even-out their taxable income 
comparable with long-term earnings with other industries. It 
gives them the ability to plan for capital investments and 
large purchase of inputs without incurring debt.
    An independent research firm, Informa Economics, revealed 
that U.S. agriculture producers required to switch from cash to 
accrual basis under the proposed new laws could pay out as much 
as $4.84 billion in taxes over the next four years. According 
to this study, those same farms have only 1.4 billion in cash 
reserves to pay the additional taxes. If the tax proposals 
associated with accrual accounting are effective in an 
unprofitable year or farm owners cannot otherwise meet their 
capital requirements, the farm may be forced to downsize. Over 
17 percent of the U.S. workforce is employed in the agriculture 
industry. The estimated 4.84 billion in tax that would be 
required to be paid by farmers may cause them not to hire 
additional employees or to lay off employees they already have 
due to downsizing.
    We have many clients required to use accrual basis 
accounting for various reasons in the Internal Revenue Code. As 
I mentioned in my introduction, I have expertise in 
construction. Especially in today's economy, many contractors 
are experiencing the pains of collecting receivables and 
managing cash flow. Contractors may not receive payment until 
well after they have invoiced their customers and recorded 
income under accrual accounting. Oftentimes, they may be filing 
their tax return well before those receivables have been 
collected.
    In a recent experience I had with a contractor I have been 
working with, he was faced with extending his tax return 
several years in a row in order to collect the revenue that he 
needed from his receivables to pay the taxes, incurring 
penalties and interest. After many years in public practice, I 
believe that the proposals required for farm operations to use 
accrual accounting would have a detrimental impact to food 
producers whom it would affect and impact. These proposals 
would have no additional cash available to pay tax payments, 
cash that would otherwise be used to grow business, create 
jobs, and serve communities in which those businesses operate.
    Thank you for allowing me to testify today. I would like to 
thank Chairman Rice and other members of the Committee who have 
supported opposing limitations on the use of cash accounting. I 
will be delighted to address any questions from any member of 
the Committee today. Thank you.
    Chairman RICE. Thank you, ma'am.
    Our next witness is Terry Durkin, an enrolled agent and 
owner of Durkin Associates, a tax preparation and 
representation practice in Burlington, Massachusetts. Mrs. 
Durkin started Durkin Associates in 2006, after 21 years in the 
software industry, and was recently chosen as the president-
elect of the National Association of enrolled agents for 2014 
and 2015. She has a B.S. degree in applied mathematics from 
Yale University and an M.B.A. from New York University.
    Ms. Durkin is testifying today on behalf of the National 
Association of Enrolled Agents. We appreciate you being here, 
and you may now begin your testimony.

                   STATEMENT OF TERRY DURKIN

    Ms. DURKIN. Thank you, Chairman Rice, Ranking Member Chu, 
and members of the Subcommittee. I am Terry Durkin, an enrolled 
agent and president-elect of the National Association of 
Enrolled Agents, which represents the interests of over 46,000 
enrolled agents across the country. I am also a sole 
proprietor. My practice is primarily focused on individuals and 
on small business of less than 500,000 in gross revenues, what 
I refer to as microbusinesses. Today, I share with you my 
perspectives as both a tax practitioner and a small business 
owner.
    Over the years, it has become clear to me that the business 
checking account is the focal point for most small business 
bookkeeping. Small businesses use the business checking account 
to measure cash flow and profits, and to a great extent is 
their tax accounting. As a result, any change to the tax law 
that requires small business owners to move away from the 
simple checkbook accounting or cash basis accounting, has two 
negative effects with increased complexity and restricted cash 
flow.
    As Congress begins reforming the tax code, I urge you to 
keep in mind how essential cash basis accounting is to startup 
businesses, especially these microbusinesses. I have six 
recommendations.
    First, increase expensing under section 179. Because 
Congress has not enacted legislation to extend expired tax 
provisions, expensing of capital purchases is currently limited 
to $25,000. This is a big drop from the $500,000 deduction that 
was available for the last several years. Also, the purchase 
limit for section 179 property is $200,000. This, again, is a 
big drop from the $2 million total purchase limit of the past 
several years.
    You can see the tax planning challenge we face when 
taxpayers do not know in advance which provisions may or may 
not be extended. I urge Congress to extend the section 179 
expensing to at least $250,000, and to increase the total 
purchase limit to at least one million.
    Second, remove uniform capitalization rules for small 
businesses. The uniform capitalization rules which were enacted 
as part of the Tax Reform Act of 1986, requires certain direct 
and indirect costs attributable to real or tangible personal 
property produced by the taxpayer to be included in either 
inventory or capitalized into the basis of such property. I 
recommend that Congress consider removing this rule for small 
businesses and allow them simply to expense the costs.
    Third, allow small businesses to use pure cash accounting 
even if they have inventory. In general, taxpayers must account 
for inventories if the production, purchase, or sale of 
merchandise is material to the production of income. In these 
circumstances, taxpayers must maintain inventory records to 
determine the cost of goods sold.
    Fourth, allow small businesses to expense leasehold 
improvements. While the current list of potential tax extenders 
would provide some relief from having to depreciate 
improvements to lease property over 39 years, I urge Congress 
to allow these costs to be expensed under either section 179 or 
its own specific tax code section. A 15-year depreciation is 
certainly helpful but it can still be a problem for small 
businesses.
    Fifth, allow small businesses to deduct all startup and 
organizational expenses. A taxpayer may elect to expense up to 
$5,000 of startup expenditures in the tax year the business 
begins. A corporation or partnership may elect to expense up to 
$5,000 of organizational expenditures in the taxable year the 
business begins. I urge Congress to allow all of these costs to 
be expensed for small businesses.
    Sixth and finally, increase the limit on repairs and 
improvements. Under the new IRS rules, small businesses that 
lack a applicable financial statement, such as my 
microbusinesses, may expense amounts paid for property costing 
less than $500, rather than depreciating that property over 
several years.
    Taxpayers must elect this new provision annually and must 
have documented business procedures in place. You can see, 
taxpayers must do a lot of paperwork here for a small benefit. 
I would recommend a rule that allows small businesses to 
expense these costs in the year made.
    Based on my experience as a small business owner and as a 
tax practitioner, I believe the above recommendations would 
substantially simplify operations, ease paperwork burdens, and 
improve cash flow for many businesses.
    Thank you for your time and attention.
    Chairman RICE. Thank you, ma'am.
    I will now yield to Mrs. Chu, who will introduce our final 
witness.
    Ms. CHU. It is my pleasure to introduce Mr. Stephen 
Mankowski, the national tax chair and national secretary for 
the National Conference of CPA Practitioners. He is also a 
partner at EP Caine and Associates CPA, LLC, where he advises 
individuals and small businesses on issues related to 
accounting, taxation, business consulting, and litigation 
support services. Mr. Mankowski has a unique view of running a 
small business and also representing small businesses that rely 
on him for business management and accounting advice. He is a 
graduate of LaSalle University.
    Welcome, Mr. Mankowski.

                 STATEMENT OF STEPHEN MANKOWSKI

    Mr. MANKOWSKI. Thank you, Mr. Chairman, and Ranking Member 
Chu.
    Again, my name is Stephen Mankowski, and I am a CPA. I am 
the national secretary and tax policy chair of the National 
Conference of CPA Practitioners, and a member of the American 
Institute of CPAs.
    If I were to ask the average taxpayer about the difference 
between cash and accrual basis of accounting, most would not 
know the answer. The same is true for today's business owners. 
Several times each year I am asked to write off bad debt. It 
can be written off under the accrual basis, yet not under the 
cash basis. Why? Because in the cash basis of accounting, if 
the income was never recorded on the books, it cannot be 
written off. Part of a CPA's job is to ensure that taxpayers 
comply with tax code. Many business owners do not realize that 
there are other considerations to operating a business, 
including keeping separate books and records, paying themselves 
a salary, additional tax filings, et cetera.
    LLCs have become a common business structure for new small 
businesses. Often, the business owners, however, are not aware 
of the tax ramifications. LLCs can be taxed as sole 
proprietors, partnerships, or even S corporations. The choice 
of business structure, however, does not affect the accounting 
basis. I have found that small business owners simply think in 
terms of cash in and cash out. Many started their businesses 
after being downsized. They have lived their lives on the cash 
basis, so operating their business in this fashion simply makes 
sense to them. They provide us with bank statements, check 
stubs, and invoices to analyze their business activities and 
prepare reports that are used solely to prepare their tax 
returns. These owners do not have systems in place to fully 
track accounts receivables or payables. Further, they do not 
have the excess funds to put the systems in place. To convert 
their financial information into an accrual basis would require 
adjustments for uncollected revenue, unpaid payroll and related 
liabilities, prepared expenses, inventory, et cetera. The 
owners will not only be responsible for knowing what 
adjustments need to be made, but also their valuation.
    Ultimately, despite the business owners' reliance on 
accounting professionals, the fiscal responsibility still falls 
on the owners. Converting to an accrual basis of accounting 
might simply be a one-time benefit for the government. Once the 
conversion is completed, the annual effect might not be 
significant depending on the type of business. Newer entities 
or entities with minimal accounts receivable or accounts 
payable would likely have a small tax increase and possibly 
even a tax decrease. Entities with a larger receivable base, 
however, would not be so fortunate. To convert, they would need 
to record all open receivables as current income and all unpaid 
bills as current expenses. The impact of this added income 
could propel the owners into higher tax brackets, which could 
lead into phase outs of itemized deductions and personal 
exemptions, phase-out of other deductions and credits, 
including tuition and student loans when the increased income 
is reported on their individual tax returns.
    In addition, taxpayers may find themselves subjected to the 
new 3.9 percent net investment income tax surtax that went into 
effect this past filing season. These tax increases will not 
only affect the taxpayers' federal income tax. Additional state 
and local taxes may also be due because these returns usually 
have to be filed on the same basis as the federal tax returns. 
Further, many municipalities also impose gross receipts taxes 
on all businesses.
    If there is one common thread resonating from the IRS, it 
has been to reduce taxpayer burden. While this can mean many 
things, ultimately, I believe the IRS realizes that business 
and taxes in today's economy have become even more complicated. 
Requiring businesses to change their accounting method without 
any specific reason would truly be in conflict to what the IRS 
has been working to achieve.
    In conclusion, the majority of businesses are permitted to 
choose their accounting methods. With the guidance of financial 
professionals, they are able to elect the most appropriate 
accounting method for them. Forcing a business to use the 
accrual basis not only complicates their business but also 
requires the owners to take time away from operations to focus 
on changing an accounting method. Ultimately, one does not 
start a business simply to focus on accounting. Forcing this 
change will do just that.
    I would like to thank Representative Rice and the other 
members of the Committee for their ongoing support in 
opposition to the limitations on the cash basis of accounting. 
Thank you for the opportunity to present this testimony today, 
and I look forward to your questions.
    Chairman RICE. Thank you, sir.
    I am going to defer my questions until the end. I think we 
have some members who are in a little bit of a hurry.
    So Mrs. Chu, would you like to start?
    Ms. CHU. Thank you, Mr. Chair.
    Mr. Mankowski, the goals of our tax system should be to 
encourage investment and ensure economic competitiveness while 
limiting complexity. I understand that cash accounting is 
easier and requires much less recordkeeping for small 
businesses. Most importantly, a business owner may not need 
formal training to understand how it works, and I hear this 
from my constituent small business owners time and time again. 
Can you describe how losing the ability to use cash accounting 
will affect the small businesses that you advise?
    Mr. MANKOWSKI. Certainly. I will try to be as brief as 
possible with this.
    Cash accounting is how many small business owners think, 
and that is how they have been making their living. Their goal 
is to just pay their fair share of taxes and to just manage 
their business and to pay their family expenses. Losing the 
ability to function under the cash basis and have to go into an 
accrual basis could hinder the growth of the businesses. If 
they know that adding a specific partner onto their practice 
would then result in that firm having to convert to an accrual 
basis of accounting could really hinder the operations of the 
business and could really question if they need to add or where 
their growth is really going. In essence, it would stagnate 
growth, not promote growth. And ultimately, if the goal is to 
be competitive, that would make the firm that has to now 
account on an accrual basis of accounting, it could, in fact, 
make them less competitive in the environment or in their 
business environment, and ultimately, it is making their 
business more complex, not less complex. And ultimately, it 
would result in higher taxes to the owners of the business.
    Ms. CHU. Okay. And Mr. Mankowski, Mr. Camp's draft language 
proposal is raising the gross receipts limit to $10 million, 
meaning any qualified personal service corporation over this 
limit must use the accrual method. Can you discuss the concerns 
about treating some business structures differently than others 
based solely on their income level?
    Mr. MANKOWSKI. By treating them based on their income 
level, it will actually--again, it will really create a 
situation where that business might not be competitive against 
their competition. If they know that if they continue to grow 
their business they are going to end up paying more taxes, 
there are issues that could relate with pass-throughs to 
retired partners that now may end up getting a larger tax 
liability for income that the firm has not even received yet. 
And further, in going through, many of the small businesses, as 
was mentioned by Ms. Durkin, the small businesses do not 
necessarily have ample cash flow. And when it comes time for 
paying their taxes, especially newer businesses, they may not 
have planned accordingly even with the assistance of their 
accounting professionals for what their liabilities may be. And 
ultimately, making this more complex makes it much more 
convoluted for the owners and takes them away from what their 
goal is, which is operating their business.
    Ms. CHU. Thank you.
    Ms. Windham, personal service businesses, like lawyers and 
architects, often work on a contingency basis for their 
clients. I understand you have personal experience working with 
construction contractors whose payments are often delayed. Can 
you explain how these payment structures work with both cash 
and accrual accounting and which method is preferred by 
businesses that you work with?
    Ms. WINDHAM. Well, as I mentioned in my statement earlier, 
I had the example of a client who received his receivables very 
late and was forced to extend his tax return. And actually, in 
his case, incurred a fair amount of interest and penalties 
because he was forced to use the accrual basis of accounting. 
So I think that is a perfect example of the effect it would 
have. Had he used cash basis accounting, he would have waited 
another year to report that income in the year that he actually 
received it as opposed to having to extend his tax return and 
pay the interest and penalties that were calculated due to 
that. And he was in a situation where it was very close to the 
filing deadline, so had he not been able to collect those in 
time for the filing deadline, he may have been forced to borrow 
the money to pay his tax liability under the accrual basis of 
accounting.
    Ms. CHU. Thank you.
    Professor Williamson, in support of simplifying the cash 
accounting method, your testimony detailed the differences and 
difficulties that small businesses face when complying with 
current cash accounting rules, such as various judicial 
doctrines and exceptions to expense reporting. Does the Camp 
draft proposal alleviate some of your concerns, or what 
recommendations would you make to the current Camp draft 
proposal?
    Mr. WILLIAMSON. Representative Chu, I am here today to 
represent small businesses, and our view is that small 
businesses need the cash method of accounting. Period. I know 
many large businesses also are on the cash method and feel very 
strongly they need to stay that way despite the Camp proposals. 
But I would like to emphasize that taxpayers be given as much 
latitude as possible in electing their method of accounting, be 
it cash or accrual method. I just see constantly my clients--I 
have a practice in Falls Church--simply do not understand the 
accrual method. They are cash basis people. Cash in, cash out. 
It is the balance in the bank account that concerns them most 
month to month, and that is what I am here to speak to today.
    Ms. CHU. Thank you.
    Ms. Dunkin, you suggest allowing small firms--I mean, 
Durkin. You suggest allowing small firms to use pure cash 
accounting even with inventories, which is currently disallowed 
as inventory accounting can be complicated. How would such a 
recommendation make it easier for small operations with 
inventories?
    Ms. DURKIN. Sure.
    So I think it really is a matter of timing when you can 
take the income and the expenses. So by allowing a small 
business to really keep to their checkbook, what they bring in 
and what they take out, whether there is inventory involved or 
not, really does make it easier for them to do their 
operations. So by having the ability to not have to deal with 
inventory really does, although it is a matter of timing, to 
make it simplified and stick with the pure cash accounting.
    Ms. CHU. Thank you. I yield back.
    Chairman RICE. I am going to start with Mr. Mulvaney 
because I think he has some other obligations.
    Mr. MULVANEY. Thank you, Mr. Chairman. I appreciate the 
accommodation from you and from my fellow colleagues.
    Back when I was a normal person, before I had this job, I 
had experience with both cash and accrual methods. I had a 
restaurant company that we used to run on a cash basis, a law 
firm that was on a cash basis, and then I ran a real estate 
company that was forced because of the nature of its business 
and the size to run the accrual method of accounting. So I have 
sort of seen it from both sides. And I remember very vividly 
the ugly reality of being in the accrual business, having to 
pay taxes on earnings that I had not collected yet. And I did 
not care for that very much.
    Ms. Windham, you have mentioned that you have got a large 
Ag business, agribusiness stable of clients and it is something 
that is important to me because where we are from, both Mr. 
Rice and myself, we have large ag businesses in our district, 
tell me what it means to a farmer, and do not talk as an 
industry, because every time we talk about $4.8 billion of this 
it sort of gets lost. Tell me what the individual farmer, what 
it means to him or her if the law changes and they have to 
change from accrual to cash. What does that mean in terms of 
what they have to go through and what they have to pay?
    Ms. WINDHAM. Sure. I think to address the first part what 
they would have to go through, you know, we have dealt with 
this with clients who have banking relationships. For example, 
in my testimony, that just do not understand that farmers 
operate on a cash basis and the bankers ask them to do it on an 
accrual basis. It is very difficult for them to track their 
work in progress or their inventory, to estimate what their 
corn may be worth at the end of the year as commodity prices 
fluctuate.
    Mr. MULVANEY. And let me stop you there for just a second, 
because you mentioned--I want to drill down on this a little 
bit because you just mentioned words that make sense to you and 
me but not to ordinary citizens, which is estimating your work 
in process, and in this particular circumstance, what your corn 
is worth at any particular time. Tell us what that involves?
    Ms. WINDHAM. For example, the work in progress. Throughout 
the year, as the farmer starts, usually in our state at least, 
sometime in the spring, planting. So they have seed, they have 
fertilizer. They are spraying throughout the year. They have 
labor cost, which can be extremely high for the planting, as 
well as the picking or whatever they may be doing. And that 
would entail their work in progress. So throughout the year as 
they spend money on the cash basis, for example, they expense 
these items. On the accrual basis, they would have to track 
these items throughout the year and accumulate them as 
inventory and then determine as they sell their corn or their 
peaches or their blueberries or whatever it may be, how much of 
those expenses they have accumulated are attributable to the 
blueberries or the peaches or the corn they just sold.
    Mr. MULVANEY. And that is subject to be second guessed by 
the IRS, is it not?
    Ms. WINDHAM. Absolutely it could be. I could see it being 
very difficult, for example, we will use corn because I have a 
lot of farmers that are row crop farmers. If they have hundreds 
of acres of corn, and they buy seed and fertilizer in large 
bulk quantities, how do you determine I sold all of the corn in 
these five acres today and three weeks from now I am going to 
sell the corn on the other 10 acres? You know, what portion of 
my seed and fertilizer did I use on these five acres versus 
those 10 acres when I bought it all at the same time in March? 
It could be very difficult for them.
    Mr. MULVANEY. Tell me about the process, because I have 
never gone through a conversion. I have never had to take a 
company from cash to accrual. Tell us what that means for a 
farmer.
    Ms. WINDHAM. For a farmer, it means bringing someone like 
me in usually, which can quickly add up, depending on what kind 
of recordkeeping they already have. Most of the farms----
    Mr. MULVANEY. Because the recordkeeping for the two methods 
is entirely different?
    Ms. WINDHAM. It is entirely different. Correct. They are 
used to maintaining basically like a checkbook, which several 
people have mentioned, and that is easy for them. They can know 
what they start the year with in their checkbook and what they 
finish the year with in their checkbook, just like we all do 
with our personal checkbooks. Switching it to accrual basis can 
be very costly from a standpoint of having someone assist them, 
as well as just difficult in that the records do not convert 
very easily and that is not how they operate their businesses. 
Commodity prices fluctuating on a regular basis can make it 
difficult. Which price do you use today and which price do you 
use when you make the conversion three months from now? So it 
can be extremely challenging, not to mention we do not have 
many farms in downtown Charleston or in Washington, D.C. They 
are out in very rural areas and you do not see too many CFO 
controller-type people living in those rural areas. So it may 
be very difficult for a farm owner to hire on staff the talent 
that they need to make that conversion on a regular basis.
    Mr. MULVANEY. Thank you, Ms. Windham. I appreciate the 
testimony.
    Ms. WINDHAM. You are welcome.
    Mr. MULVANEY. Thank you, Mr. Chairman, for the opportunity.
    Chairman RICE. Thank you, Mr. Mulvaney.
    Mr. Schneider?
    Mr. SCHNEIDER. Thank you, Chairman Rice. Thank you for 
calling this hearing. It is a critically important issue.
    I bring my own personal experience to this. My father is a 
CPA. Had an accounting firm. At the time, it was one of the 
largest ones in Denver with 35 partners. I started my career in 
consulting at Price Waterhouse as I am thinking about it, 30 
years ago this week, and before coming to Congress 10 years 
ago, I was in consulting with what was then the largest single-
office private accounting firm in the country, a firm called 
Blackman Kallick. I understand the issue on a personal level 
having my own consulting firm, so thank you all for being here 
and talking about this critically important issue.
    Professor Williamson, I know you talked about this being an 
issue for small businesses, but it is an issue for a lot of 
businesses. An accounting firm, or in my case a consulting firm 
that just needs a couple of partners working together quickly 
exceeds $10 million, but the impact on these professional 
service firms that have to book expenses and then not get paid 
many times for six to 12 months later would be profound. And to 
that end, I am circulating a bipartisan letter. I am pleased to 
have people on both sides of the aisle working on this issue 
with Congressmen Luetkemeyer, Quigley, and Hudson, and we want 
to draw the attention to the importance of cost accounting. I 
would invite my colleagues to all join us on that letter.
    Speaking of agriculture, Ms. Windham, you know, my district 
does not include a whole lot of agriculture, but we appreciate 
the value of the food--the corn, the blueberries, the peaches, 
that we eat. And understand that a vast majority of that still 
comes from the family farm. And those farms require the ability 
to do their accounting in such a way that makes sense for their 
business, and that is crucial. The burden of having to transfer 
from cash to accrual accounting for a farmer, for a 
professional service firm, obviously is significant. Farmers 
and ranchers rely on this flexibly to deal with the commodities 
and weather. There is a lot of uncertainty in business. We all 
deal with that regardless of the business we have. Adding 
another level of uncertainty is, I think, the last thing we 
should be doing. And that is why this is important.
    But it is not just agriculture. It is not just consultants 
and accountants. It is dentists. It is engineers. It is 
architects. So many of these professional service firms, 
partners working together individually rely on this, and as I 
mentioned before $10 million for a group of people working 
together adds up fairly quickly, but the impact on the 
individual becomes severe, and oftentimes it is going to affect 
retiring partners as was said before, and we need to touch on 
all of those.
    I guess, Ms. Windham, I will touch with you. The impact you 
talked about, the cost to convert for a farm, what is the cost 
to convert for an accounting firm? What would be the impact 
there?
    Ms. WINDHAM. I think one of the biggest costs for an 
accounting firm would be, one, keeping up with the receivables 
and payables, but two, as you bring partners in and out, new 
owners in and out, and I believe someone mentioned it in their 
testimony earlier, you could have a retiring partner who is 
forced to pick up income that may be received after he leaves 
the firm and retires, because it is an accounts receivable, and 
I know we have experienced in the prior five or six years with 
our clients struggling, you know, it may take six to 12 months 
to collect a receivable as you mentioned. And then the other 
side of that would be new partners coming in. It may be 
difficult for them. If a new partner were potentially to come 
in in a year of this conversion, they could be hit with a tax 
liability that they were not expecting, not to mention, a tax 
liability they do not have the cash to pay. So I think that is 
one of the biggest potential challenges for an accounting firm 
or a law firm or a professional service firm, is transitioning 
partners in and out and then the massive amount of tax 
liability that may be experienced with no additional cash. It 
would take cash away from hiring new accountants or attorneys, 
from creating jobs, from giving back to our communities, from 
those types of things, and we just do not have the cash savings 
to be able to afford to do that.
    Mr. SCHNEIDER. Mr. Mankowski, you talked about competition 
briefly and the challenge it is for companies to compete. If 
you take two small businesses, one on a cash basis, one on an 
accrual basis, what are some of the disadvantages to the cash 
basis having to make the switch or compete?
    Mr. MANKOWSKI. One of the advantages, or disadvantages, 
rather with the business that is going to be forced to switch 
over to an accrual basis is that within an accounting firm, as 
an example, there is generally not a lot of accounts payable 
they are going to be having, especially as you get towards 
yearend. However, you could be sitting with a considerable 
account of accounts receivable from some clients that may have 
done their yearend or with a plethora of clients that file tax 
extensions, and also clients that may have been billed for 
yearend tax planning that you may not receive the funds until 
the following year. The firm that is on the cash basis, they 
are not recording that in as revenue, so that may potentially 
allow their partners to keep those rates maybe a little bit 
lower for their clients because they are not going to have to 
absorb in a higher tax liability for the individual partners. 
So in that situation, the firm that is now going to be 
converting or has already converted into an accrual basis, the 
owners may be at a disadvantage due to the receivables at the 
end of the year and higher tax liabilities.
    Mr. SCHNEIDER. Great. Well, I have many more questions. I 
am out of time. Thank you for the extended time. I want to 
thank, again, the chair and the ranking member for calling this 
crucially important hearing on an issue. As our economy grows, 
we need our small companies, our middle market companies to 
grow, and this is important to allow them to do that.
    Thank you very much.
    Chairman RICE. Chairman Hanna.
    Mr. HANNA. Thank you. Thank you for letting me in on this 
Committee. I am not normally here.
    I have never heard such unanimity in my life between 
people. It is nice. And I agree with you as a guy who was in 
business for many, many years.
    One of the things you mentioned, Ms. Windham had mentioned 
it also, Mr. Williamson, is that the possibility exists when 
you make someone convert to accrual who was on a cash basis, to 
actually wind up paying taxes on money, and you talk about 
construction, Mr. Mankowski did and Ms. Durkin did, those 
people have the possibility of actually owing money on money 
they may never receive. Owing money on litigated construction 
that they may ultimately win, having to go to the bank, borrow 
money, pay interest, pay taxes, and find themselves holding the 
bag. Because everything does not come in in a few months. Some 
things come in--and then you have the conversion issue of 10 
years, trying to--recapture I think is the language that you 
used--built-in gains, which is a problem that a lot of people 
face.
    So let me start off by saying, you know, I agree with you, 
but I want to understand the other side of the issue a little 
bit because, Ms. Durkin, when you talk about being able to 
write off inventory, one of the problems with that for the IRS 
is simply if you are a growing business, all you need to do is 
grow your inventory and you may never pay taxes as you grow 
until you close. And Mr. Williamson made a wonderful point, and 
that is that everybody ultimately winds up paying the tax they 
owe, but it is all a little bit about timing, is it not? It is 
a little bit about how do you manage your taxes and postpone 
it? How do you, as gamblers use the word, kiting checks, you 
can kite money. Right? You know what I am talking about.
    So from the IRS's point of view, if you are going to take 
the other perspective, because I am guessing this is about 
making it a little bit easier for people to company and for 
them to actually understand the nature of what you are doing. 
So Mr. Williamson, what would you say if you were an IRS agent? 
How would you respond?
    Mr. WILLIAMSON. If I were an IRS agent I would welcome this 
proposal of going more on the cash basis because some of the 
nuances of the accrual method, some of the uncertainties--when 
did you receive the income, when can you write it off as a bad 
debt--I think going on the cash method takes so many 
uncertainties that IRS agents have to interpret when they apply 
the law when they go out to a client or to a taxpayer. I would 
think the IRS would applaud this. And as you have already said, 
Mr. Hanna, this is all about timing because over the life cycle 
of the business the amount of economic income and the amount of 
economic expenses will be incurred. And ultimately, the same 
amount of tax will be paid under either the cash or accounting 
method, no question about that. And your point is well taken. 
This is about timing. And I can understand why perhaps the 
Treasury Department and certain members of Congress would want 
to be on the accrual method because that would, in some cases, 
accelerate income into earlier years for purposes of scoring a 
tax bill.
    Mr. HANNA. Right. So basically, what we are saying is you 
can pay now or pay later, but you are going to pay, and it is 
just a matter of whether you hold your money a little longer 
and the IRS gets theirs a little sooner is really----
    Mr. WILLIAMSON. And as Ms. Windham pointed out, whether you 
have to borrow the money to pay the tax.
    Mr. HANNA. Do you agree, Ms. Windham?
    Ms. WINDHAM. I do. Yes. I think it does, quite honestly, 
make it easier for the IRS as well because they are attending 
the same continuing education and the same training that a lot 
of us are attending as CPAs. And as you are well aware, the tax 
code is pretty tremendous. Even for an IRS agent knowing every 
part of it can be challenging. So simplicity I think is better.
    I think, as well, unless there is some type of individual 
tax return that coincides with tax reform for S corps, C corps, 
and partnerships, that under a progressive tax system you could 
potentially pay more taxes over the same period of time as you 
would even though you are going to incur the income or 
expenses. For example, with farmers, it may be really high in a 
good year and the next year we may have a drought and it would 
be really low, and the year that they have high income, they 
are going to pay a higher rate.
    Mr. HANNA. And we have no more income averaging. It used to 
be around. It is not anymore. So that is an issue for someone 
in your business.
    Ms. WINDHAM. Right. Correct.
    Mr. HANNA. I want to ask you, I have just got a few seconds 
left here, but the economic value of letting people keep things 
simple I would say is huge, and it benefits the country 
ultimately because they make more money. Do you all kind of 
agree with that? Anybody?
    Ms. DURKIN. I do, and I think taking some comments that 
Chairman Rice has said in the past, small business owners are 
America's economic engine, and we need to fuel that engine, and 
cash is that fuel. So by allowing the small businesses to use 
the cash accounting really does fuel that and powers the 
economy.
    Mr. HANNA. Thank you. My time is expired.
    Chairman RICE. Mr. Schweikert?
    Mr. SCHWEIKERT. Thank you, Mr. Chairman.
    First, a one-off question just because of an experience we 
had a couple years ago. Have any of you had the experience of 
doing a conversion and someone that uses one of the online 
softwares for the management of their business and having some 
real troubles getting it to work in regards to bad debt, some 
inventory issues? So I guess it is sort of a universal question 
of for right now, any experiences, first of all, on the cash 
basis, small business accounting softwares, what they do with 
bad debt, and then particularly a small business that might be 
using accrual?
    Mr. MANKOWSKI. Mr. Schweikert, first, under the cash basis, 
although many of our clients do think that they can write off 
bad debt, currently, if they are filing under a cash basis, 
they are not permitted to write off bad debt. As I had 
mentioned in my testimony, every year I get asked the same 
question by a number of clients.
    Mr. SCHWEIKERT. But to that point, have you ever had 
someone present to you saying here is my software and look, it 
has a category for this?
    Mr. MANKOWSKI. Absolutely. And I go through and I tell them 
that they are not allowed to and they ask why. And I tell them, 
well, you never declared the revenue, so you cannot turn around 
and take the expense. We will gladly put the revenue in this 
year, and it is only going to offset and you will get zero 
impact from it.
    Mr. SCHWEIKERT. Ms. Dunkin? Or Durkin?
    Ms. DURKIN. I have had the same situation as far as 
clients.
    Mr. SCHWEIKERT. Hit the mic.
    Ms. DURKIN. Thank you.
    I have had the same situation of clients saying I never got 
paid for this and then the discussion is, well, did we ever 
claim it as income? No. So you are not allowed to claim that 
expense.
    Mr. SCHWEIKERT. And I am going to skip to the professor 
because I want to come back to Ms. Windham.
    Professor?
    Mr. WILLIAMSON. Yeah. I think what you are illustrating, 
Mr. Schweikert, is exactly the confusion that taxpayers have 
and small businesses have and why we are advocating the cash 
method of accounting. Why can I not take a bad debt? They did 
not pay me. Well, you never recognized the income in the first 
place. And I cannot tell you, and I think all of us at the 
panel have had the experience with our clients where we try to 
tell them this and they just do not get it. And what that 
demonstrates is how we need the cash method of accounting to 
show them cash in, cash out, and really eliminate the bad debt 
issue entirely, other than for those firms that should be on 
the accrual method.
    Mr. SCHWEIKERT. Ms. Windham, because you actually 
personally generated my memory of this question in a couple of 
your comments in regards to difficulty in collections and 
sometimes negotiated settlements on pay as this percentage of 
our bill and then complete write-offs, and the difficulties 
sometimes that causes for even cash accounting when you are 
breaking over your year, and then the difficulties I have seen 
with a couple of our personal businesses and those we have 
helped on that they are using software and the software keeps 
popping up. Why are you not telling us this? Am I the only one 
to have experienced this?
    Ms. WINDHAM. I can speak to a very similar situation 
actually that has happened in the past month or two. We have a 
client who has an investor who is an attorney who uses the cash 
basis in his firm because he is an attorney and is allowed to. 
This particular client of mine is required to be on the accrual 
basis and prepares their books on an accrual basis. Well, he 
has asked for a cash basis statement from my client because 
that is what he understands. And in this particular situation 
they are using QuickBooks, which is a software that many, many, 
many clients use across the country.
    Mr. SCHWEIKERT. I was trying to avoid mentioning any----
    Ms. WINDHAM. Well, I started not to, but anyway, and it is 
extremely common in small businesses. And because of the way my 
particular client operates, and obviously, I do not want to 
disclose their financials, hitting a button, so to speak, to 
convert to cash basis is an option. However, because of the way 
they track certain things, the software does not do it 
correctly because of the way they have to input it. And it is 
not a software issue, it is an input issue, and there is no 
other way to input this data for it to convert correctly. So we 
have been struggling with explaining to this attorney why we 
cannot produce cash basis without a lot of work.
    Mr. SCHWEIKERT. Have you run into the other externality 
when there are other partners that you are paying out and the 
problem of we have not recognized the income but----
    Ms. WINDHAM. Yes. We see that a good bit where we have 
questions on, for example, a partner has a tax liability on 
their individual tax return because they are receiving a K1 
with income from the partnership. However, they have not 
received the related cash. And the first question is how can I 
have income and tax if I do not have the cash? And you have to 
explain to them, well, you have half a million dollars in 
accounts receivable which you have yet to collect, and when you 
collect those you will have the cash. And it can be a very 
difficult pill for a partner in a partnership to swallow when 
they have a large tax liability and no related cash to go with 
it.
    Mr. SCHWEIKERT. Thank you, Mr. Chairman. Having run into 
some interesting issues in this sort of mechanic where a lot of 
partnership agreements are written where you owe a certain rate 
of return or pref on sometimes not actually realized income but 
in booked income. You do end up in this kind of cascade of 
problems and borrowing money to pay your partners. So with that 
I yield back, Mr. Chairman. Thank you for the patience.
    Chairman RICE. Thank you, sir.
    Mr. Payne?
    Mr. PAYNE. Thank you, Mr. Chairman.
    Ms. Windham, I understand that you support the cash 
accounting method, but as someone who assists small businesses, 
do you also believe that some of the current cash accounting 
rules are too complex and seem to unnecessarily try to match 
accrual accounting as Mr. Williamson suggests? Based on your 
experience, do you believe that the current Internal Revenue 
Code cash codes should remain as is or need changing?
    Ms. WINDHAM. I think the current cash accounting rules and 
the Internal Revenue Code are pretty easy for businesses to 
follow. There are quite a few exceptions and twists and turns 
as with anything in the Internal Revenue Code, but for the most 
part, small businesses can use a checkbook-type method of 
accounting. There are some, as Ms. Durkin mentioned, some 
issues in there with inventory, depreciation, repairs and 
maintenance that could, quite honestly, be simplified, and I 
think she made some great points in her testimony on 
simplifying repairs and maintenance. There is a new regulation 
written on that recently that complicated it in my opinion. 
Depreciation could be made a little more simple with making it 
permanent instead of extending it every couple of years and 
causing uncertainty for small businesses. Inventory, obviously, 
as she said, is another issue that can be a challenge for small 
businesses to track their inventory and not expense it when 
they actually write the checks. So I do think there are some 
ways in there to simplify accounting for small businesses, and 
I think her testimony spelled that out pretty accurately. But 
true cash accounting needs to continue for small businesses to 
allow them to be able to deal with the challenges of running 
the rest of their business and not have to focus on their books 
on an hourly or daily basis.
    Mr. PAYNE. So it can be very easy but then you also say it 
is very complex?
    Ms. WINDHAM. Yes.
    Mr. PAYNE. Okay. All right.
    Ms. Durkin?
    Ms. DURKIN. Yes. I will give you one example of a client 
who became a client, who was in the theater production. He was 
starting up to create a theater. He bought--leased a building 
and put $300,000 into leasehold improvements. And sadly, he 
thought that whole $300,000 would be depreciated in that year 
because he spent it in that year, and I had to be the one to 
tell him. And when he came afterwards to me to prepare the 
return, well, you cannot take the whole $300,000. Some of it we 
can do 15 years, some of it we have to do 39 years. So this 
cash basis person all of a sudden then had these three 
different ways he could take this deduction and not the 
deduction that he wanted to. So you can see some challenges 
like that.
    Mr. PAYNE. Sure. Thank you.
    Mr. Mankowski?
    Mr. MANKOWSKI. Thank you, Mr. Payne.
    I can agree with some of the comments. One of the things 
that ultimately I think we need to look at is not just if we 
are going to move the threshold from a $5 million to a $10 
million, the $5 million threshold I believe went into effect 
with the Tax Reform Act of 1986. Similar to many of the items 
in the tax code, they have stayed there and stayed there, but 
they have not been inflation indexed and now they are just 
looking to come up with a number. If they are going to increase 
it and actually keep a threshold, they should probably look at 
some level of an indexing, starting from '86 moving forward, or 
potentially even look to remove the threshold and just allow a 
business to operate so that as many of us have mentioned, we 
are not going to all of a sudden you have a good year, whether 
you are a hedge fund or whether you are an attorney who lands a 
big case, all of a sudden you need to convert to an accrual 
basis the following--after you are out of that three-year 
averaging. If you are now below the threshold, are you then 
allowed to convert back to cash basis because you are no longer 
in that threshold? There are some of the complexities that 
simply doing away with any type of a revenue threshold, even on 
an average basis, would really work towards simplifying and 
allow the owners to do what they do best, which is operate 
their business. And that is why all of us are in the accounting 
profession. That is what we do best, which is help them manage 
their accounting aspects so that they do not have to worry 
about that part of their business.
    Mr. PAYNE. Thank you. And in the interest of time, I will 
yield back.
    Chairman RICE. Thank you, sir.
    Well, this has truly been a very interesting hearing. I 
have learned a lot from you guys, and I appreciate you all 
being here. My concern in all this is that here we sit six 
years after the Great Recession, and we have still an economy 
that is struggling, negative 2.8 percent growth in the last 
quarter. Millions of people dropped off the employment--the 
workforce because they find it so difficult to find employment. 
American jobs, every day you turn on the TV and you see more 
companies moving over to corporate inversions now, but that is 
really more jobs moving overseas. And I think a lot of that 
comes from anti-competitive policies that come out of 
Washington, D.C. I think we make it too complicated. I think we 
make it too difficult. And I think we cost businesses too much. 
Too much in taxes. Too much in red tape. And I think that is 
what I hear from you guys. It is one thing to not create 
impediments, but it is another thing to actually throw up 
impediments to hiring and expansion. And I see that in 
government. And Mr. Mankowski, I think you referred to that 
earlier when you said the accrual method could actually put up 
impediments. Is that correct--to hiring and to expansion--is 
that right?
    Mr. MANKOWSKI. That is correct, sir.
    Chairman RICE. Can you explain that further?
    Mr. MANKOWSKI. Certainly. If you have--and I will take my 
position. I recently merged my accounting practice. If we 
continue--and we have been growing our practice daily with more 
and more clients--if we bring on additional partners that may 
bring additional revenue into our firm, expand our services, if 
we get to a point where we, at this point we hit a $5 million 
threshold, the firm would then have to go through converting to 
an accrual basis. At that point, is it really worth bringing on 
an additional partner who may kick you into having to go to 
accrual basis? Or maybe go and, not that we, as accountants, 
know our way around the system, but potentially spin off part 
of a practice. I will stay a partner in my firm. I am going to 
spin off part of the practice to one of the other partners. 
That will be a separate entity, and now we are staying under 
the thresholds.
    Chairman RICE. And that does not add to complexity at all, 
does it?
    Mr. MANKOWSKI. None. It does not add to the complexity, but 
it----
    Chairman RICE. Oh, it does. When you maintain separate 
entities.
    Mr. MANKOWSKI. But in that case, it is keeping you out of 
the thresholds which is not what we want to do.
    Chairman RICE. Does that make you more productive?
    Mr. MANKOWSKI. Absolutely not.
    Chairman RICE. All you are trying to do is work through 
some loophole. Is that correct?
    Mr. MANKOWSKI. Unfortunately, that is what it comes down 
to.
    Chairman RICE. Ms. Windham, do you agree that this law, 
forcing people to apply with the accrual method, that that 
actually makes firms consider not expanding and not hiring and 
not bringing on new employees?
    Ms. WINDHAM. Yes, absolutely. I mean, some of the 
statistics I have seen with taxes that would have to be paid 
without the lack of additional cash, obviously, that prohibits 
firms, attorneys, accountants, whoever, from taking that cash 
that they have been reserving for growth, expansion. It may be 
in the case of a farm, building a new building or purchasing a 
large piece of equipment or adding a production line. They are 
going to use that cash to pay tax instead of growing jobs, 
growing the economy, and growing their business.
    Chairman RICE. And I know this is a hot button topic, but 
the Affordable Care Act forces people to limit their workers to 
30 hours a week, forces them to stay under the 50-person 
threshold. So you see these policies out of Washington who 
everybody stands up here and says we are for jobs, but what 
they do is something different. The policies that come out of 
Washington actually stifle expansion and stifle job growth.
    Do you agree with that, Ms. Durkin?
    Ms. DURKIN. Yes. The example of the new IRS regulation 
about the repairs versus capitalization, for the small 
businesses, they have to do a considerable amount of paperwork, 
declare a capitalization policy, and put it on their return 
each year for $500. I had a client who had a rental property 
and he bought an $800 washing machine, so he did all this 
paperwork and he still could not use it for this purpose, so 
there are--the intention is a good one, but practically when it 
gets down to it, some of the thresholds are just too low.
    Chairman RICE. There have been reports coming through this 
Committee that fairly routinely say the cost per--small 
businesses employ 70 percent of the people in the United 
States, and the cost per employee to a small business in terms 
of regulatory costs, which includes tax compliance, is like 
$10,000 per employee. It far exceeds the tax liability.
    Professor Williamson, do you see this as a meaningful----
    Mr. WILLIAMSON. As I hear you speak and the other panelists 
speak, what I think is going on here from an academic 
perspective is our advocation of the cash accounting method 
does indeed violate the matching principle of accounting, which 
is somewhat of a catechism, that you want to match your 
revenues with your costs, and that is the basis of the accrual 
method. And people in the Academy would agree that the accrual 
method is a more accurate method for keeping track of your 
books and records.
    That said, for small business, as we have said, all of us 
here in our testimony, it is about the cash. And we can set 
different thresholds--$5 million, $10 million. I even hear some 
rumblings that maybe it should be even higher. And for small 
businesses, it is all about the cash and it is not about some 
theoretical matching principle of revenue with cost.
    And with respect to the repair regs, we advocated in the 
Tax Center that $500 be $5,000, which they gave to the large 
businesses, but not to you and me.
    Chairman RICE. I hear you. And I agree with you. But the 
average small business guy, he does not know what you just 
said. And the average person out there watching C-SPAN does not 
know what you just said. So my bottom-line crux issue is the 
effect on American competitiveness and jobs. And my theory is 
that the complexity created by Washington, and the accrual 
method being one of those, decreases our competitiveness and 
puts burdens on job creators. Do you agree with that?
    Mr. WILLIAMSON. Absolutely. For small businesses, no 
question.
    Chairman RICE. Okay.
    Mr. WILLIAMSON. They can hire Ms. Windham or they can hire 
a new employee.
    Chairman RICE. What I am worried about is my sons and my 
grandsons and my granddaughters getting jobs. And what I want 
to do is put us in a position that makes them more competitive 
in the world.
    Mr. WILLIAMSON. Absolutely.
    Chairman RICE. This is just one more addition, one more 
burden on farmers and small businesses. Is that correct?
    Mr. WILLIAMSON. Yes. Or advocacy here with the cash method 
of accounting is lighting a candle. We have heard some candles 
about cursing the darkness. We are advocating here, we are 
lighting one candle to ease the burden upon small business with 
respect to the method of accounting they choose in their 
business.
    Chairman RICE. Let me ask you this. The Ways and Means 
proposal, Dave Camp's proposal they referred to earlier, does 
that simplify the burden on small businesses or does that 
exacerbate the burden on small businesses?
    Mr. WILLIAMSON. As I understand it, it enables small 
businesses to continue the cash method of accounting.
    Chairman RICE. And it increases the threshold generally?
    Mr. WILLIAMSON. Yes.
    Chairman RICE. Ms. Windham, do you agree with that?
    Ms. WINDHAM. It does increase the threshold. I think it 
could have some consequences that people may not be aware of 
though. For example, farms would be a great example of that. 
You know, farms are traditionally passed down from one 
generation to the next, and obviously, as you continue to pass 
down, you may be adding more family members, so there may be 
other businesses that are created, especially with the movement 
across the U.S. for farm to table and those kinds of things, 
you may create a retail market or a restaurant or a processing 
component. And if you have a related party that owns the farm 
as well as some of these other businesses, you may be forced to 
pull in the revenue for all the businesses together to 
calculate your gross revenue. So the farm may be, for example, 
forced to switch to the accrual basis of accounting which was 
not intended because the farm owner's sister happens to have a 
retail market and they are forced to include revenues from 
both.
    Chairman RICE. Okay. So the way I understand what you just 
said is Camp's, the Ways and Means proposal, actually expands 
the availability of the cash method but there are some 
particulars that you would like to see changed to make it even 
more available?
    Ms. WINDHAM. Well, in his proposal specifically, the $10 
million threshold, currently there is no limit on most farms, 
and that would obviously put a limit on farms specifically. So 
in both sides of it, putting a limit on farms, as well as 
putting a limit on other businesses who may be forced to use 
these aggregation rules to include multiple lines of their 
businesses because they are related family members or owners.
    Chairman RICE. Thank you.
    Mr. Mankowski, you said something at the very beginning of 
your testimony, and I do not want to mischaracterize it, and I 
do not think you meant it this way. It almost sounded like you 
said the accrual method had an advantage and that you could 
write off bad debt. But under the cash method, that money would 
never have been taken in income anyway. So the net result is 
zero under either method. Is that correct?
    Mr. MANKOWSKI. Yes, sir. That is correct.
    Chairman RICE. All right. Well, unless anybody else has any 
additional questions they want to ask.
    Ms. CHU. I would just like to enter into the record the 
written statement from the American Bar Association, which lays 
out their concerns on how the draft tax reform proposals would 
affect these small law firms throughout the country.
    And I would simply like to thank the panelists. I was 
impressed by the unanimity of your statements and also your 
very vivid examples of how this would affect small business.
    Chairman RICE. And I appreciate your specific 
recommendations for how we can make things better, you know, 
your list of items, Ms. Durkin, you listed in yours; 
particularly, Professor Williamson, so.
    Mr. SCHWEIKERT. Mr. Chairman, if I can, as well, I would 
like to enter into the record testimony of Jeffrey Wald, who is 
the CEO of an accounting firm, Kennedy and Coe, LLC, that 
specializes working with agriculture businesses and understands 
and says I think very--clearly states some of the challenges 
these businesses face and the advantage of the cash accounting 
method.
    Chairman RICE. Thank you, sir.
    Okay. Thank you all for participating today. While tax and 
recordkeeping complexity causes concern for so many small 
business owners, it is clear that the use of the cash 
accounting promotes simplicity. Moving forward, we must ensure 
that our nation's job creators have the flexibility to utilize 
the accounting method that allows them to thrive. Today's 
testimony will be helpful as Congress looks for ways to make 
our tax policies more simple, predictable, and rational. It has 
been an honor for me and the other members of the Subcommittee 
to hear from this group of industry leaders and small business 
owners.
    I ask unanimous consent that the members have five 
legislative days to submit statements and supporting material 
for the record.
    Without objection, so ordered.
    The hearing is now adjourned.
    [Whereupon, at 11:16 a.m., the Subcommittee was adjourned.]


                            A P P E N D I X


                              Testimony of


                     Professor Donald T. Williamson


                    Howard S. Dvorkin Faculty Fellow


                  Executive Director, Kogod Tax Center


              Kogod School of Business American University


                            Washington, D.C.


                      Committee on Small Business


                    Subcommittee on Economic Growth,


                         Tax and Capital Access


                 United States House of Representatives


                               Hearing on


         ``Cash Accounting: A Simpler Method for Small Firms?''


                             July 10, 2014

    Chairman Rice, Ranking Member Chu and Members of the 
Subcommittee, thank you for the opportunity to testify on the 
need to simplify the tax reporting requirements on small 
businesses by means of adopting simpler methods of tax 
accounting.

    My name is Don Williamson and I am a professor of taxation 
at American University's Kogod School of Business where for the 
past thirty years I have been the Director of the School's 
Masters in Taxation degree program. The MST program at American 
University offers graduate courses in federal taxation to CPAs, 
experienced accountants, attorneys and others who wish to 
expand their knowledge of our nation's tax law. Our course 
offerings not only include traditional classes in subject areas 
such as the taxation of corporations and partnerships, 
international taxation and tax policy but also more specialized 
areas of the tax law such as accounting periods and methods 
which is the topic of this hearing today. As part of my 
responsibilities at American University, I am the Executive 
Director of the Kogod Tax Center which conducts nonpartisan 
research on tax issues affecting small business and 
entrepreneurs. For the past 25 years, I have had my own tax 
preparation and planning practice for small businesses in Falls 
Church, Virginia.

    The Kogod Tax Center has previously testified before the 
House Small Business Committee on the most burdensome tax 
problems faced by small businesses. Today I would like to focus 
my remarks on one area in the Internal Revenue Code that can 
easily be changed to substantially reduce the record keeping 
and tax compliance burdens on small businesses namely, 
liberalizing the law to permit more small businesses to adopt 
the cash method of accounting rather than being required to use 
the more burdensome accrual method.

    My testimony will describe and highlight the burden placed 
upon small businesses when the Internal Revenue Code requires 
them to be on the accrual method of accounting. However, even 
where the law permits a small business to use the simpler cash 
method of accounting, the general requirement to maintain 
inventory records creates burdens that may only influence by 
only a few months the timing of a small business's taxable 
income. Therefore, we urge Congress to not only expand the 
number of businesses eligible to use the cash method of 
accounting but to also enact a ``simplified'' cash method of 
accounting for small businesses that would further reduce 
unnecessary record keeping and compliance burdens. We believe 
such simplification will neither adversely affect the accuracy 
of tax returns nor impact the ability of the IRS to collect 
tax.

    I. Cash Method vs. Accrual Methods of Accounting

    Before describing our proposal for a simplified cash 
method, I would like to explain, for the benefit of the members 
of the subcommittee who may not be familiar with tax accounting 
rules, the two major tax accounting methods used by businesses, 
i.e. the cash method and the accrual method. I believe this 
explanation will highlight why for small businesses the accrual 
method is more burdensome than the cash method; and 
demonstrates that while the accrual method may in some cases 
more accurately measure economic net income, why the complexity 
and cost of any additional precision is unnecessary and 
ultimately provides no greater tax revenue for the IRS.

    Once a business adopts a tax year, and for most small 
businesses this will be the calendar year, it must adopt an 
accounting method which determine the time at which the 
business recognizes an item of income or may deduct an expense. 
It is important to note that a business's accounting method 
only affects the timing of when a business reports income or 
deductions on a tax return. The accounting method a business 
uses does not determine whether an item of income is taxable or 
an expense deductible and does not affect the total income and 
deductions a business will recognize over its lifetime.

    Publicly traded corporations and many large businesses 
generate financial statements for the SEC or commercial banks 
based on generally accepted accounting principles (GAAP). Small 
businesses usually do not keep their books and records in 
accordance with GAAP, almost always relying upon their tax 
returns to provide lenders and owners with sufficient 
information to determine the success and credit worthiness of 
the business.

    Under the Internal Revenue Code a small business is only 
required to choose an accounting method that ``clearly reflects 
income'' and apply that method consistently from year to year. 
Consistent with this requirement, most small businesses adopt 
the cash method of accounting unless the law requires them to 
use the accrual method.

    A. Cash Method

    A business adopting the cash method of accounting 
recognizes income when it receives actual payment for the goods 
or services sold, regardless of when the business sells the 
good or performs the service. Similarly, a cash method business 
is entitled to a deduction on its tax return only when payment 
for an ordinary and necessary business expense is actually 
made. However, even cash method businesses may not deduct 
certain types of payments when made. For example, a cash 
expenditure that creates an asset of the business with a useful 
life of more than one year but rather must ``capitalize'' the 
cost and depreciate (deduct) the cost over a prescribed 
``recovery period'' in which the tax law presumes the asset 
will be consumed in the business. There are other types of cash 
payments subject to similar treatment. Thus, even the cash 
method adopts certain principles of the accrual method 
described below resulting in a mismatch of the time an 
expenditure is made and the time at which it can be deducted.

    1. Judicial Doctrines of Income

    In addition to requirements to capitalize certain 
expenditures there are several other technical requirements for 
a business computing taxable income under the cash method that 
are unnecessarily complex. Under the judicial doctrine of 
``constructive'' receipt, a cash basis taxpayer must recognize 
income even when cash has not come into the physical possession 
of the business but is merely available to the business at its 
discretion. Similarly, the mere receipt of a promise results in 
recognizable income under the cash method if the promise is 
convertible to cash before it matures, in which case the fair 
market value (that is, the ``cash equivalent'') of the 
obligation is recognized at the time of receipt of the promise. 
Finally, under the ``economic benefit'' doctrine, a cash method 
business must immediately recognize income on the receipt of 
property whenever the business's right to the property is 
absolute, even if not immediately assignable and even though it 
cannot be immediately converted to cash.

    Such judicial theories that require a business using the 
cash method to pay tax on income deemed received prior to the 
receipt of cash unnecessarily imposes a severe cash flow 
problem on small businesses--a problem that creates only a 
marginal timing benefit to the IRS, since small businesses 
would most certainly receive the cash shortly after 
constructive receipt, economic benefit, or a cash equivalent 
arises. While these concepts offer comfort to theorists, small 
businesses must pay next month's bills, and the acceleration of 
any taxable income before the receipt of cash under these 
theories requires small businesses to use their operating cash 
to pay tax on amounts they have not yet received instead of 
using that cash to run their businesses.

    2. Accounting for Expenses

    An even more challenging problem encountered by small 
businesses using the cash method of accounting is the 
compliance costs and complexity associated with computing 
deductible expenses. Generally, the cash method permits a 
deduction for ordinary and necessary business expenses when 
actual payment is made. Thus, a promise to pay is not 
deductible until payment is actually made.

    Although there may be confusion surrounding when and if a 
payment has been made, small businesses confront even greater 
difficulties when computing allowable deductions under the cash 
method because of four exceptions to the general rule that a 
deduction is permitted when payment is made, i.e. prepayments, 
depreciation, inventory and capitalization of some expenses. 
Prepayments for property or services are not deductible if the 
goods or services are provided more than one year after the 
prepayment. Costs exceeding $5,000 associated with creating a 
new business are not deducted when paid but amortized over 15 
years. For inventory, the costs of its acquisition or 
production are deducted only when the inventory is sold. 
Similarly, property with a useful life of more than one year is 
generally subject to depreciation, requiring its deduction be 
spread over recovery periods ranging from three to 39 years.

    These examples demonstrate that the current cash method of 
accounting is too often not based upon cash receipts and 
disbursements, but rather on principles that attempt to match 
costs with income similar to the accrual method. For small 
businesses that have no government regulators to whom financial 
statements must be submitted and have no banks or other 
creditors in need of profit and loss determinations that 
conform to the rules of GAAP, tax rules based on the accrual 
method serve no practical purpose when economic success and 
taxable income can simply be measured on cash receipts and 
expenditures--that is, cash flow. In short, while the current 
cash method is substantially simpler than the accrual method, 
certain refinements to the current rules could make the cash 
method even simpler and more easily enable allow small 
businesses to comply with tax record keeping and reporting 
requirements without the loss of accuracy on their tax returns.

    B. Accrual Method

    The other major accounting method, the accrual method, 
attempts to determine the time at which ``all events'' occur 
that give rise to the right to income and the amount of that 
income can be determined with reasonable accuracy. Similarly, 
an expense may be deducted when the obligation to pay an 
expense is fixed, the amount of that obligation can be 
determined with reasonable accuracy and economic performance 
has occurred. Thus, businesses must report income on their tax 
returns when earned and may deduct expenses when incurred 
without regard to the receipt or payment of cash.

    The accrual method and its ``all events'' test creates 
substantial complexity in an effort to better identify the 
financial success or failure of a business. This complexity 
calls for small businesses, whose every day well being centers 
upon its cash position, to determine its financial well-being 
in a manner that adds no value to its success. From the 
perspective of the IRS, while the timing of income and expense 
reported under the accrual method may provide some acceleration 
of tax upon income that must be recognized before any cash is 
received, such acceleration is clearly unfair if the cash is 
never received, and may only accelerate tax collection by no 
more than one year if the cash is subsequently receive shortly 
after the accrual.

    The complexity of the accrual method is illustrated by 
prepayments. In the case of prepaid rent or interest received, 
income must be reported immediately upon receipt even if ``all 
events'' entitling the business to the income have not 
occurred. Similarly, where goods or services have not been 
delivered but cash payment has been received, the general rule 
under the accrual method that delays reporting the cash 
receipts on the business's tax return until ``all events'' have 
occurred, i.e. the goods are delivered or services performed, 
is disregarded. Thus, in the case of prepayments a business 
otherwise on the accrual method finds itself using the cash 
method for prepayments. Not an easy concept for a small 
business owner to understand.

    Another complexity of the accrual method is the necessity 
to account for bad debts when a business reports as income an 
account receivable for which it never receives actual payment. 
Each year businesses on the accrual method must determine which 
previously reported receivables are uncollectible and claim 
them as tax deductions. This can be a time consuming, confusing 
and expensive process. Businesses using the cash method do not 
deduct bad debts because they do not include receivables in 
taxable income.

    Finally, even when a business on the accrual method meets 
the ``all events'' test with respect to an expense, a deduction 
may be claimed only when ``economic performance'' occurs. 
Therefore, in the case of receiving goods and/or services from 
another party, the business may deduct the obligation to pay 
the other party only as the goods or services are received 
regardless of when the business pays for the goods or services, 
subject to an exception permitting deduction in the year of 
prepayment if the other party provides the goods or services 
within three and one-half months of the next taxable year. 
Again, not such an easy concept for small businesses to 
understand.

    The above illustrations of some of the complexity required 
by the accrual method of accounting demonstrates that in the 
case of small businesses the technical accuracy resulting from 
these rules offers no practical benefit to the business in 
measuring its economic performance, and over the life cycle of 
the business, offers no additional tax revenue to the 
government.

    II. Tax Accounting for Inventories

    Regardless of whether a business is on the cash or accrual 
method of accounting, if inventory is a material income 
producing factor, the business must account for gross profit, 
i.e. sales minus cost of goods sold, using the accrual method, 
even if they have adopted the cash method as their overall 
accounting method. Thus, a business cannot deduct the cost of 
the inventory (finished goods) to the extent it has not sold 
the product by the end of the business's taxable year. 
Businesses selling inventory must maintain records documenting 
their cost of unsold, finished goods, partially finished goods 
and ``raw'' materials on hand that will be used in the future 
to manufacture or produce inventory. In addition, inventory 
cost accounting principles call for the deduction of indirect 
costs (overhead) associated with manufacturing or producing the 
inventory only when the inventory is sold.

    In determining its cost of inventory, a business must adopt 
an inventory costing method, i.e. the first-in, first-out 
(FIFO) method, the last-in, last-out (LIFO) method or the 
specific identification method. The FIFO and LIFO methods 
relieve businesses of the need to keep track of the cost of 
each item its sells, but where the items are unique or 
relatively high-cost, low volume products (e.g., jewelry, 
antiques, cars, etc.) the specific identification method is 
used.

    As an exception to the requirement to maintain inventory 
accounts, the IRS (not the Internal Revenue Code) permits a 
cash method business to use the cash method to account for 
their gross profit from the sale of inventory if the business's 
average annual gross receipts for the three year period prior 
to the current year do not exceed $10,000,000 and the 
business's primary activity is to provide services to customers 
but also offers a product for sale incidental to the 
performance of services. Thus, a veterinarian using the cash 
method of accounting need not use the accrual method to account 
for the sale of medicines or other goods associated with the 
business of caring for animals because such sales are 
incidental to the veterinarian's professional practices. But 
when the average gross receipts of the business exceeds 
$10,000,000, businesses must not only account for inventory 
using the accrual method, but also must apply certain ``uniform 
cost capitalization'' (UNICAP) rules that require an allocation 
to inventory of an array of indirect costs beyond those 
ordinarily associated with producing goods. Thus, under the 
UNICAP rules, a business must add to the cost of inventory a 
portion of compensation paid to employees who may not be 
involved in producing the inventory but may merely indirectly 
support the production process.

    A final illustration of the complexity of the accrual 
method deals with the perceived abuse of an accrual method 
business accruing (deducting) an amount owed to a related party 
using the cash method. In this case the business using the 
accrual method may not deduct the amount owed to the related 
party until the amount is actually paid and recognized as 
taxable income by the cash method party. This issue frequently 
arises where a business employs the owner or a relative of an 
owner. Related parties, for this purpose, include family 
members and certain businesses owned by the same individual(s).

    III. Comparison of Cash and Accrual Methods

    As the above descriptions demonstrate, the primary 
advantages of the cash method over the accrual method are its 
clarity and flexibility in measuring income and expenses and 
its less cumbersome bookkeeping and record keeping 
requirements. While the accrual method is generally considered 
a more accurate reflection of a business's financial condition, 
the price of this accuracy is mind numbing complexity and 
inevitably increased compliance and record keeping costs.

    However, the Internal Revenue Code limits the adoption of 
the cash method to the following businesses: (1) sole 
proprietorships; (2) S corporations; (3) certain corporations 
engaged predominantly in the performance of services by their 
owners; (4) corporations with average gross receipts over the 
preceding three years of $5,000,000; (5) partnerships with no 
corporate shareholder whose gross receipts exceed $5,000,000; 
and (6) farms.

    Suggestions for simplifying and liberalizing the use of the 
cash method were made by the Treasury Department in 2007, and 
by the Bowles-Simpson Commission in 2010. These studies 
concluded that simplifying the reporting of income and expenses 
on tax returns filed by small businesses would result in the 
reallocation of resources to more productive purposes, 
ultimately stimulating job growth. In addition, the IRS 
Taxpayer Advocate has consistently recommended simplifying 
accounting methods for small business as a way to ease 
compliance burdens and reduce tax administration.

    IV. Simplified Cash Method of Accounting (``SCM'') - The 
``Checkbook'' Method

    Based on this brief description of the accounting methods 
available to small businesses and the observations of Treasury, 
IRS and independent tax reform studies, I believe that small 
businesses need and deserve legislative relief in measuring and 
reporting their taxable income and deductible expenses. In my 
view, the Internal Revenue Code should be amended to not only 
permit the adoption of the cash method by more small 
businesses, but also the adoption of a ``simplified cash method 
of accounting'' (``SCM''). This proposed simplification of the 
existing cash method of accounting will reduce time-consuming, 
expensive administrative burdens on small businesses in keeping 
records and reporting their income and expenses on their 
returns, thereby unleashing resources that will create more 
productive, job creating activities.

    Besides reducing compliance costs the SCM will enable small 
businesses to better understand their tax returns, thereby 
reducing the general public's cynicism that the Internal 
Revenue Code is replete with loopholes only accessible to 
businesses with resources to employ expensive tax 
professionals. In short, I believe that simplifying reporting 
on tax returns will increase compliance, ease the burden of tax 
administration, increase tax revenue and ultimately reduce the 
gap between what taxpayers should pay and what the IRS actually 
collects.

    Under the SCM the computation of taxable income is reduced 
to the following formula:

    Cash Receipts

    Less: Cash Expenses including:

           Inventory

           Prepayments

           Materials/Supplies

           Depreciable Property

    Taxable Income

    In short, the derivation of taxable income is based solely 
on amounts actually received or paid during the tax year, by 
means of examining the business's checkbook for when checks 
were cut and deposits made. Under SCM, income consists only of 
cash, property or services received during the tax year without 
regard to imputed income under the constructive receipt, cash 
equivalence, or economic benefit doctrines. While determining 
and valuing the receipt of in-kind goods and services would 
continue to be a problem, small businesses would otherwise be 
able to arrive at their income by adding up their bank deposits 
for the year. Any timing advantage to businesses from not being 
subject to the judicial doctrines just mentioned would be 
minimal given that small businesses cannot, as a practical 
matter, defer recognition of cash by more than a few months 
without creating severe cash flow problems for the payment of 
their own bills. The complexity of the judicial doctrines does 
not warrant their application to small businesses.

    SCM offers even greater simplification for the 
determination of deductible expenses. Under SCM, all current 
expenditures, including those for the acquisition or 
construction of inventory, would be deducted when paid. 
Although a technical violation of GAAP's matching principle of 
accounting, GAAP is not a particularly useful concept in 
measuring the ability of a small business to pay tax, or even 
stay in business. More than one small business that had a 
profit under GAAP has failed because of cash flow problems. 
Allowing for the immediate deduction of the cost of inventory 
simplifies small business record keeping at relatively little 
cost to the government. For a small business to stay in 
business, inventory paid for and deducted in one year likely 
will be sold no later than the next year to ensure sufficient 
cash flow for business operations. Also, permitting the 
expensing of inventory before its sale recognizes the fact that 
by the IRS's own admission, small businesses are not following 
the rules for the computation of cost of goods sold, in that 
audits reveal more than 50 percent of cost of goods sold 
calculations are incorrect.

    Finally, permitting the immediate expensing of depreciable 
property simply continues 100 percent bonus depreciation 
approach for acquired property with a useful life in excess of 
one year and the current section 179 expense allowance for 
purchased depreciable property. Thresholds and limitations 
similar to the present $10,000,000 limitation for uniform 
capitalization rules and the current IRS allowance for the cash 
method may be adopted to restrict SCM to small businesses. 
Exhibit 1 compares the treatment of many items under the 
current cash and accrual methods with the SCM.

    With a $10 million threshold for the general adoption of 
the cash method coupled with an election to adopt the SCM, 
simplification would be available to approximately 99% of all 
businesses in the United States, thereby reducing the tax 
compliance burden for almost every person owning and operating 
a business in America.

    IV. Conclusion

    The cash method of accounting is undeniably simpler than 
the accrual method of accounting. Expanding the number of 
businesses eligible to use the cash method by substituting the 
current statutory limits on its use with a $10 million gross 
receipts threshold would benefit not only small businesses but 
the overall economy.

    In addition, codification of the SCM would reduce the tax 
record keeping and compliance burdens faced by small businesses 
even further and improve the ability of small businesses to 
maintain their own accounting records and prepare their own tax 
returns eliminating the need to retain expensive tax 
professionals. Such a reduction in the reliance on tax 
accountants and lawyers will foster a greater appreciation by 
average Americans that the tax law is not benefitting only 
special interests but is, in fact, attempting to measure a 
business's true economic net income. In short, I believe that a 
simplified cash method of accounting such as the SCM will 
improve tax compliance at lower cost to businesses with little 
or no loss of tax revenue.

    Thank you for the opportunity to testify today. I welcome 
any questions from any Member of the Committee or its staff.
[GRAPHIC] [TIFF OMITTED] T8718.001

                              Testimony of


                           Sarah Windham, CPA


                             Senior Manager


                        Dixon Hughes Goodman LLP


                       Charleston, South Carolina


                      Committee on Small Business


        Subcommittee on Economic Growth, Tax and Capital Access


                 United States House of Representatives


                               Hearing on


           Cash Accounting: A Simpler Method for Small Firms?


                             July 10, 2014


    Chairman Rice and Members of the Committee, thank you for 
the opportunity to testify on Cash Accounting: A Simpler Method 
for Small Firms?

    My name is Sarah Windham. I am a Senior Tax Manager in the 
Charleston, South Carolina office of Dixon Hughes Goodman LLP. 
With over 1,800 people located throughout the region, we are 
the largest CPA firm based in the Southern United States. Our 
commitment to our clients' success has led to the development 
of specialized practice groups, each dedicated to a specific 
industry and offering comprehensive solutions. One of the 
firm's professional service areas is Agribusiness. With nearly 
60 years of experience serving the agribusiness industry, Dixon 
Hughes Goodman has developed a deep understanding of the 
operations and issues affecting various agribusinesses such as 
food processors, growers, industry associations, cotton ginners 
and co-ops.

    I am a Certified Public Accountant with 15 years of 
experience. I have extensive experience with agriculture 
clients, construction and real estate clients, as well as many 
other small businesses.

    I am here today on behalf of the South Carolina Farm 
Bureau. The South Carolina Farm Bureau is a grassroots, non-
profit organization celebrating and supporting family farmers, 
locally grown food and our rural lands throughout legislative 
advocacy, education and community outreach.

    I am testifying before you today on the potential negative 
ramifications of the various proposals in Congress that would 
eliminate, for many taxpayers, the use of cash accounting for 
the purpose of calculating income tax liability. These adverse 
effects include a significant increase in the time dedicated to 
tax compliance, which will deter farmers and other small 
business owners from focusing on making a living, as well as, 
an increase in the cost of tax compliance that would reduce the 
profitability of many farmers and small businesses who already 
work with very thin margins. Another effect would be a 
significant acceleration of tax liability without the cash 
available to pay the taxes on uncollected, yet taxed, income. 
These adverse effects would fall disproportionately on small 
businesses, such as farmers and professionals engaged in the 
fields of law, accounting, engineering, architecture, health, 
actuarial science, performing arts, or consulting.

    Almost all farmers use the simple, straightforward cash 
method of accounting in which income is not recognized until 
cash or other payment is actually received and expenses are not 
taken into account until they are actually paid. This method is 
used in determining profitability because it most accurately 
reflects the true financial picture of a farming operation. 
Currently the tax code (Internal Revenue Code Section 446) 
recognizes that to require a separate method of accounting 
solely for calculating income tax liability is an unnecessary 
burden and states that income tax liability ``shall be computed 
under the method of accounting on the basis of which the 
taxpayer regularly computes his income in keeping his books.'' 
Section 446 goes on to specifically provide that the cash 
method is a permissible method of calculating tax liability.

    Many taxpayers today, especially small businesses, find 
complying with the Internal Revenue Code burdensome. The cost 
of tax compliance for small businesses is 67% higher than that 
of a large business according to the National Federation of 
Independent Business. Agriculture is an industry that would be 
negatively impacted by the proposed changes to require accrual 
basis accounting. Farms, regardless of acreage, are perfect 
examples of small businesses. The definition of a small farm 
has changed dramatically due to advances in science and 
technology. According to the USDA, in 1945, 100 bushels of corn 
was produced on 2 acres of land. In 2002, that same 100 bushels 
of corn were produced on less than 1 acre. As you can see, 
fewer farmers produce more food on less acreage meaning many 
family farms may have larger gross revenue but not necessarily 
larger profits. The gross receipts thresholds proposed for 
accrual accounting would increase the cost of a family farm's 
compliance burden in an industry that is facing over increasing 
input costs each year. Our nation may see further rises in our 
food prices passed along to the consumer by these growers.

    Why cash accounting? Cash accounting is a simple method of 
record keeping. As illustrated in its most simple and basic 
definition, the differences between cash versus accrual 
accounting is a matter of timing. For example, if Farmer Brown 
sold a bushel of corn in November with the understanding that 
he would be paid in January, under the cash method, Farmer 
Brown would record the payment in January when he received 
payment from his customer. Any expenses associated with growing 
and preparing the corn for market would be recorded when Farmer 
Brown paid his suppliers. This method is not dissimilar to 
maintaining and reconciling a simple checking account.

    Most farmers do not employ professional accountants or 
bookkeeping staff. Many farming operations are in rural 
communities that do not have a large population from which to 
draw high level CFOs, controllers or even accountants. Many 
farms' books and records are maintained by a family member or 
the farms' owners themselves. They are already saddled with the 
burden of hiring professionals to prepare payroll and tax 
returns as well as financial statements. Requiring them to 
switch to accrual basis would force them to hire bookkeeping 
assistance and/or spend additional funds on accrual accounting 
systems, thus creating additional costs in an industry facing 
rapidly rising production expenses. The simplicity of the cash 
accounting method can also offer a ready window into tracking 
cash on hand and current profitability. One story I would like 
to share with you reflects the financial strain accrual 
accounting can put on farms. One of our farm clients was being 
asked by his financial institution to provide accrual basis 
financial statements on a quarterly basis. As with most farms, 
they keep their records on the cash basis. After explaining the 
additional fees the farmer would incur to have us assist their 
staff in converting the books to accrual basis it was agreed 
that cash basis statements were a better option.

    Farmers by nature must manage risk and volatility. It's 
endemic to their industry. They are literally at the mercy of 
nature, the effects and aftermath of weather, and commodity 
prices. ``Whether caused by unpredictable weather that affects 
crop yields or uncontrollable markets that set the price of 
goods sold, it is not uncommon for farmers and ranchers to have 
years with little or no taxable income,'' Farm Bureau wrote to 
Senate Finance Committee Chairman Max Baucus (D-Mont.) and 
Ranking Member Orrin Hatch (R-Utah). Since their income can 
fluctuate widely from year to year, accrual accounting, coupled 
with our progressive tax system, would likely cause farmers to 
pay more taxes over time than a company in a different industry 
with stable income over the same time period. Cash accounting 
allows them to accelerate expenses or defer income giving farms 
the option to even out their taxable income comparable with 
long-term earnings of other industries. This also gives then 
the ability to plan for capital investments and the large 
purchases of inputs based on improved cash flow without 
incurring debt.

    Most farmers and ranchers consider themselves to be small 
operations. Their operations are often divided into multiple 
businesses where some family members operate the farm while 
other family members may operate a related business, such as a 
processing facility or a retail market. Often times the farm 
may not have high gross receipts compared to the related 
business. Some proposals would decrease the threshold for 
switching to accrual accounting from $25 million to $10 million 
of gross receipts for C corporations and would also apply to S 
corporations, partnerships and sole-proprietorships that 
currently do not have a gross receipts limitation. Under the 
aggregation rules, the related businesses under common control 
would be combined. When combined, each of these related 
businesses, including the farm, would be required to use the 
accrual method of accounting. Most farms are structured as S 
corporations, partnerships or sole-proprietorships and would be 
subject to accrual accounting under these proposals. It may 
also be argued that the transition from the cash to the accrual 
method of accounting may be unfair to current owners of an 
enterprise if the switch to accrual penalizes current owners 
and compels them to pay for the benefits received by a previous 
owner.

    As stated previously, the differences between cash versus 
accrual accounting is a matter of timing. Using the same 
scenario, if Farmer Brown sold a bushel of corn in November 
with the understanding that he would be paid in January, under 
the accrual method, Farmer Brown would record the income on his 
November books even though he's received no money. Farmer Brown 
also would incur the tax liability on this income even though 
he's received no money. Though receivables are definitely an 
asset that is an important measure in determining financial 
posture, only cash--and not receivables--can be used to pay 
income tax.

    An independent research firm, Informa Economics, revealed 
that U.S. agriculture producers required to switch from cash-
basis to accrual-basis accounting under proposed new laws would 
have to pay out as much as $4.84 billion in taxes during the 
next four years. Additionally, borrowing capacity of these 
operations would decrease by another $7.26 billion over the 
same time period. According to the study, these farms have less 
than $1.4 billion in current cash on hand to pay the additional 
taxes. If the tax proposals associated with cash accounting are 
effective in an unprofitable farm year or if growers cannot 
otherwise meet the capital requirements, the farmer may have to 
downsize to survive. Over 24 million people, or 17% of the US 
work force, are employed in agriculture industries. The 
estimated $4.84 billion in tax that would be required to be 
paid by farms could very easily limit the ability of those 
farms to hire additional employees or may cause them to lay off 
employees if they are forced to downsize.

    We have many clients that are required to use accrual basis 
accounting for various reason in the Internal Revenue Code. As 
I mentioned in my introduction, I also have expertise in the 
construction industry. I have many examples of clients in this 
industry that have felt the challenges and burdens of accrual 
basis accounting. Especially in today's economy, many 
contractors are experiencing the pains of spending much of 
their time and effort collecting accounts receivable and 
managing related cash flow instead of growing their business or 
building buildings and homes. Many contractors may not receive 
payment until well after they have invoiced their customers and 
recorded the income under the accrual method of accounting. 
Often times, they may be filing tax returns and paying tax on 
those receivables before the cash has been collected. In a 
recent experience, a small contractor who I work with has been 
faced with extending his tax return for several years in a row 
and incurring penalties and interest until he was able to 
collect the receivables needed to pay his income taxes. Under 
the cash basis of accounting, these hardships are less likely 
to happen since the taxpayer would not pay income tax on the 
money until it was received.

    Summary

    The proposed requirement that farm operations use the 
accrual accounting method for tax purposes introduces 
complexity and expense to an industry that is already hobbled 
by gross receipts that do not necessarily indicate an increase 
in profitability. Producers operate at very low margins, 
usually under 20%.

    After many years in public practice, I believe that the 
proposals that would require farm operations to use accrual 
accounting would be determined to the food producers whom it 
will affect and impact. Under these proposals no additional 
cash would be available to make tax payments--cash that would 
otherwise be used to grow business, create more jobs and serve 
the communities in which businesses operate.

    In addition to being a CPA, I am the mother of two small 
children. The $4.84 billion in taxes that I referenced earlier 
from the projection made by the independent research firm, 
Informa Economics, reminds me of the fable I have read to my 
children--The Goose that Laid the Golden Egg. $4.84 billion 
dollars is, indeed, a golden egg. Unfortunately, in its 
pursuit, the forced switch to accrual-basis accounting may kill 
or do irreparable harm to the very enterprise that feeds the 
U.S. and the world. Golden eggs can be replaced. The goose, 
once dead, is gone.

    Thank you for allowing me to testify today. I would like to 
thank Chairman Rice and the other members of the committee who 
have supported opposing limitations to the use of cash basis 
accounting. I would be delighted to address any questions from 
any Member of the Committee or your staff today. I, and others 
at Dixon Hughes Goodman LLP, would be pleased to address any 
further questions with you at any future date.
                     Statement of Terry Durkin, EA


        President-Elect National Association of Enrolled Agents


 Before the U.S. House of Representatives Committee on Small Business,


        Subcommittee on Economic Growth, Tax and Capital Access


                             July 10, 2014


    Thank you, Chairman Rice, Ranking Member Chu, and members 
of the Subcommittee, for asking me to testify today. I am an 
enrolled agent (EA) and President-Elect of the National 
Association of Enrolled Agents (NAEA), which represents the 
interests of over 46,000 enrolled agents across the country. 
The enrolled agent license is the highest credential granted by 
the Department of Treasury. EAs are the only tax practitioners 
who are directly approved by the Department of Treasury for 
competency and ethical behavior.

    I am also a sole proprietor. My practice is primarily 
focused on individuals and on small businesses of less than 
$500,000 gross revenues--what I refer to as 
``microbusinesses.'' Today I share with you my perspectives as 
both a tax practitioner and a small business owner. While I am 
testifying as an officer of NAEA, the opinions I express in 
this testimony are mine alone.

    Over the years, it has become clear to me that the business 
checking account is the focal point for most small business 
bookkeeping. Small businesses use the business checking account 
to measure cash flow and profits, and to a great extent it is 
the basis for their tax accounting as well. As a result, any 
change to the tax law that requires small business owners to 
move away from simple checkbook accounting, or cash basis 
accounting, has two negative effects:

    1. Increased complexity: Other methods of accounting, for 
example accrual or hybrid, create complexity by forcing small 
businesses to track certain expenses and capital outlays 
separately from their basic income and expense ledgers. For 
less sophisticated taxpayers, these separate accounting systems 
can be counter-intuitive and create expensive paperwork 
requirements.

    2. Restricted cash flow: Small businesses are commonly 
undercapitalized, which results in severe cash flow problems 
when they make payments but are unable to expense them for tax 
purposes in the same calendar year. A common complaint I hear 
in my practice is, ``How do I owe taxes when I do not have any 
cash in my business checking account?''

    As Congress begins reforming the tax code, I urge you to 
keep in mind how essential cash basis accounting is to startup 
businesses, especially micro businesses. I believe Congress can 
do more to help them. Both Chairman Camp and former Senator 
Baucus's proposals are good first steps, but I strongly 
recommend that Congress go even further. I have several 
recommendations:

          First, increase expensing under section 179. Because 
        Congress has not enacted legislation to extend expired 
        tax provisions, expensing of capital purchases is 
        currently limited to $25,000. This is a big drop from 
        the $500,000 deduction that was available for the last 
        several years under the provisions that expired. Also, 
        the purchase limit for section 179 property has dropped 
        to $200,000. This, again, is a big drop from the 
        $2,000,000 total purchase limit of the past several 
        years. I have a client in the medical field who is a 
        sole proprietor (single member LLC) and planning to 
        purchase a $100,000 piece of equipment this year. With 
        the current rules, she will not be able to take the 
        whole $100,000 amount as a section 179 expense. Given 
        her situation, she needs to pay estimated taxes to 
        account for the limited expenses she can take this 
        year. However, if she were able to take a section 179 
        expense on the whole purchase, her tax liability and 
        thus estimated tax payments would be much less. You can 
        see the tax planning challenges we face when taxpayers 
        do not know in advance which provisions might or might 
        not be extended. I urge Congress to increase the 
        section 179 expensing to at least $250,000 and to 
        increase the total purchase limit to at least 
        $1,000,000. Section 179 is essential to creating a true 
        cash basis system for small businesses.

          Second, remove uniform capitalization rules for small 
        businesses. The uniform capitalization rules, which 
        were enacted as part of the Tax Reform Act of 1986, 
        require certain direct and indirect costs allocable to 
        real or tangible personal property produced by the 
        taxpayer to be included in either inventory or 
        capitalized into the basis of such property, as 
        applicable. I recommend that Congress consider removing 
        this rule for small businesses and allow them simply to 
        expense these costs.

          Third, allow small businesses to use pure cash 
        accounting even if they have inventory. In general, 
        taxpayers must account for inventories if the 
        production, purchase, or sale of merchandise is 
        material to the production of income.

          In those circumstances in which a taxpayer is 
        required to account for inventory, the taxpayer must 
        maintain inventory records to determine the cost of 
        goods sold during the taxable period. Cost of goods 
        sold generally is determined by adding the taxpayer's 
        inventory at the beginning of the period to the 
        purchases made during the period and subtracting from 
        that sum the taxpayer's inventory at the end of the 
        period. I recommend that Congress allow small 
        businesses to use pure cash accounting for their 
        operations, even if they have inventory.

          Fourth, allow small businesses to expense leasehold 
        improvements. While the current list of tax extenders 
        provides some relief from depreciating improvements to 
        leased property over 39 years, I urge Congress to allow 
        these outlays to be expensed, under either section 179 
        or its own specific tax code section. For example, 
        under the currently expired provisions, leasehold 
        improvements were allowed fifteen-year treatment for 
        qualified property. This treatment covers qualified 
        leasehold improvements, retail improvements, and 
        restaurant property. I represent a small business owner 
        that leased part of a building to create a performing 
        arts theatre. He made $300,000 worth of leasehold 
        improvements to the building. Sadly, he did this before 
        consulting anyone and thought he would be able to write 
        off the whole $300,000 in one year since he spent it in 
        that year. Being able to expense these costs in the 
        year spent or at the very least to depreciate the 
        $300,000 over 15 years would be much more palatable and 
        better for his cash flow than depreciating it over 39 
        years.

          Fifth, allow small businesses to deduct all start-up 
        and organizational expenses. A taxpayer may elect to 
        expense up to $5,000 of start-up expenditures in the 
        tax year in which the active trade or business begins. 
        A corporation or a partnership may elect to expense up 
        to $5,000 of organizational expenditures in the taxable 
        year in which the active trade or business begins. I 
        urge Congress to allow all of these costs to be 
        expensed for small businesses. When one of my clients 
        starts a business, he or she inevitably asks, ``I spent 
        much more money on the business than I received in 
        income. How can I still owe taxes?'' I try to explain 
        that some of the expenses cannot be written off in the 
        year they are expended, even though the client is on a 
        cash accounting system. As you can imagine, this does 
        not go over well for microbusinesses.

          Sixth and finally, increase the limit on repairs and 
        improvements. Under rules created by the IRS, smaller 
        businesses that lack an applicable financial statement, 
        such as my microbusinesses, may expense amounts paid 
        for property costing less than $500 rather than 
        depreciating the property over several years. Taxpayers 
        elect this new provision annually by including a 
        statement on the tax return. In addition, taxpayers 
        must have in place appropriate and documented business 
        procedures. Although the idea is a good one, taxpayers 
        must do a lot of paperwork for a small benefit. I would 
        recommend a rule that allowed small businesses to 
        expense these costs in the year made.

          I had a client with several rental properties 
        document his intentions to use this new regulation, but 
        his question to me was, ``When I buy a washer for the 
        rental unit this year for $600, I cannot take advantage 
        of this new regulation and will have to depreciate it 
        anyway, right? What good is it to have the `under $500' 
        threshold?'' I had to agree with him. He would see more 
        benefits from this regulation if he could expense his 
        $600 washing machine purchase or his $1,000 dryer 
        purchase.

    Based on my experience as a small business owner and as a 
tax practitioner, I believe the above recommendations would 
substantially simplify operations, ease paperwork burdens, and 
improve cash flow for many businesses.

    In closing, I would like to draw the Subcommittee's 
attention to the recommendations of President George W. Bush's 
Advisory Panel of Federal Tax Reform:

          The Panel recommends that most small businesses file 
        taxes the same way they pay their bills--with their 
        checkbook. Under the Panel's options, most small 
        businesses would report income as cash receipts minus 
        cash business expenses. This rule reduces compliance 
        costs by relieving small businesses from keeping a 
        second (or sometimes even a third) set of books for tax 
        reasons and allowing them to use records they already 
        keep for their businesses.

    President Bush's panel of experts clearly saw the advantage 
of simplification and the importance of cash flow for small 
business owners.

    Thank you for your time and attention.

    [GRAPHIC] [TIFF OMITTED] T8718.002
    
    Mr. Chairman and members of the Committee, thank you for 
inviting me to testify today. My name is Stephen Mankowski. I 
am a Certified Public Accountant, member of the American 
Institute of CPAs and the National Secretary and National Tax 
Policy Chair of the National Conference of CPA Practitioners, 
(NCCPAP), as well as the Vice President of the Delaware Valley 
Chapter of NCCPAP. NCCPAP is a professional organization that 
advocates on issues that affect Certified Public Accountants in 
public practice and their small business and individual clients 
located throughout the United States. NCCPAP members serve more 
than one million business and individual clients and are in 
continual communication with regulatory bodies to keep them 
apprised of the needs of the local CPA practitioner.

    Accompanying me is Mr. Edward Caine, President of NCCPAP. 
We recently merged our practices.

    We have been preparing tax returns for over 30 years. Our 
firm annually prepares well over 1,100 small business and 
individual tax returns as well as sales tax and payroll tax 
returns. As a result, we are in the trenches with clients 
discussing their tax, financial and personal issues, and the 
impact of events on them. Although our clients are mostly in 
the Pennsylvania, New Jersey and Delaware area, we have clients 
in New York, South Carolina, Ohio, Florida, Michigan, Alabama, 
California, Massachusetts, Nebraska, Tennessee and Washington, 
DC. In total, our firm files serves clients in over 30 states 
and also services clients in Canada and Europe. In this respect 
our practice is the same as many members of NCCPAP and other 
smaller CPA firms throughout the United States.

    Discussions surrounding the proper basis of accounting most 
likely began the moment a second basis was developed. Today, we 
not only have the two primary bases--cash and accrual--but also 
others including tax, regulatory and ``other''. Any basis other 
than accrual method is referred to as an ``Other Comprehensive 
Basis of Accounting (OCBOA)''. For purposes of this testimony, 
I will be discussing the cash and accrual bases of accounting.

    To further complicate the discussion, there are two 
distinct cash bases of accounting--cash and modified cash. Pure 
cash presentations in financial statements are very rare 
because cash receipts would not only include sales receipts but 
also proceeds from debt and fixed asset sales, and cash 
disbursements would include expenses, purchases of fixed 
assets, and loan repayments. This approach does not provide 
useful or realistic financial statements. Rather, a modified 
presentation has evolved to address these concerns. Therefore, 
when the term ``cash basis of accounting'' is used, the 
presenter is truly using the modified cash basis of accounting. 
As such, when discussing the cash basis of accounting, it is 
really a Modified Cash Basis, but hereinafter will be referred 
to as ``cash basis''.

    Under the cash basis of accounting, a taxpayer can defer 
income until cash is received but must also wait to deduct 
expenses until the amounts have actually been paid. Currently 
the cash basis of accounting is available for businesses 
operating as sole proprietors, S Corporations, partnerships 
that do not have a ``C'' Corporation as a partner, and personal 
service corporations (PSCs). A PSC performs activities in the 
fields of health, law, engineering, accounting, etc. whereby 
substantially all of the stock of the corporation is owned by 
employees performing services for the corporation in connection 
with those activities. In addition, some C Corporations and 
partnerships with C Corporation as partners can use the cash 
method if their average annual sales for the previous three 
years are less than $5 million.

    Accrual accounting is considered to be the standard 
accounting method for most other companies. The accrual method 
provides a more accurate picture of the company's current 
financial condition, but its relative complexity makes it more 
expensive to implement. Generally, a small business that 
receives income from producing, purchasing or selling 
merchandise must computer its inventory and use the accrual 
method of accounting. However, a small business with average 
annual receipts of $1 million or less can still use the cash 
method and account for inventory as materials and supplies. The 
costs of these materials and supplies would be deducted in the 
year the business sells the merchandise or pays for the items, 
whichever is later. Resellers with gross receipts of $10 
million or less are not required to use the accrual method of 
accounting.

    Currently, if a small business has sales that require an 
accrual method of accounting or if the business simply wishes 
to convert from the cash method to the accrual method they must 
file IRS Form 3115, Application for Change in Accounting 
Method. The filing of this form is a request for a change in 
accounting method, not a guarantee. In preparing this form, the 
taxpayer must take into account any and all changes required to 
convert to an accrual basis as well as pay a filing fee.

    The need for the accrual method arose out of the increasing 
complexity of business transactions and a desire for more 
accurate financial information. Selling on credit and projects 
that provide revenue streams over a long period of time affect 
the company's financial condition at the point of the 
transaction. Therefore, it usually makes sense that such events 
should also be reflected on the financial statements during the 
same reporting period that these transactions occur.

    The form to request a Federal Employer ID number (EIN) 
requires that an accounting method for the business must be 
selected. This form is completed prior to the business opening. 
Often, the primary understanding of accounting and record 
keeping of the business owner(s) falls under the cash basis of 
accounting. Throughout their adult lives, as individuals they 
have received W2s, 1099s, 1098s, and/or real estate bills. All 
of these documents were prepared under the cash basis of 
accounting. In fact, almost all personal tax returns are 
prepared on a cash basis of accounting. Therefore, when opening 
a business or even purchasing a rental property, the cash basis 
of accounting is the initial thought that comes to mind for the 
taxpayer.

    In establishing a business, hopefully the business owners 
have consulted with professionals--attorneys to incorporate the 
entity, if applicable, and CPAs to ensure the proper business 
structure. Part of a CPA's job is to ensure that taxpayers 
comply with the tax codes so that they pay their fair share of 
taxes. Many business owners went to incorporate their business 
believing that there are special tax advantages, such as fewer 
tax audits. They don't realize that there are other 
considerations including keeping separate books and records, 
paying themselves a salary as an incorporated business is 
required to do, additional tax files, and the list goes on.

    In recent years, Limited Liability Companies (LLCs) have 
become a common choice of business structure of the new small 
business. Often, however, the business owner is not aware of 
the various tax ramifications. If there is only one owner, the 
business is taxed as a sole proprietor and all of the business 
activity will be reported on Schedule C of the owner's 
individual tax return. With multiple owners, the entity would 
be taxed as a partnership. The entity can elect to be taxed as 
an S-Corporation regardless of the number of owners provided 
that none of the owners are corporations. Under the rules of S 
Corporations, owners with greater than a five percent ownership 
interest are required to draw reasonable compensation in the 
form of a salary where the tax withholdings can be sufficient 
to remove the burden of making quarterly estimated tax payments 
as individuals.

    Regardless of whether the entity is taxed as an S 
corporation or partnership, the owners are subject to pass-
through income based upon their ownership interest or 
partnership agreement. Often, this income relates to fund that 
are not always immediately available for distribution to the 
owner(s), which may be another challenge to taxpayers who have 
to follow accrual based accounting as this may trigger phantom 
income. Owner(s) may choose to keep the net income in the 
business to help fund expansion, debt service or unpaid bills. 
Countless times during tax season after the owner(s) receive 
Form K-1 from their partnership or S corporation, we have to 
explain to business owners why they are paying taxes on 
business income that they have not received. This is what is 
referred to as pass-through income of the business and is taxed 
at the individual level--frequently at lower tax rates than if 
taxed at corporate levels. Further complicating pass-through 
income is the fact that most partnership income is also subject 
to self-employment taxes.

    Many small businesses still operate under the cash basis 
for tax purposes but opt to prepare accrual basis financial 
statements, as this MAY show them in a better financial 
position. This is often the case when there is a need for 
financing. In addition, many banks prefer an accrual basis as 
it provides them a more comprehensive view of the financial 
position of the entity because of the inclusion of accounts 
receivable and accounts payable in the financial statements.

    Often business owners do not have the accounting background 
to properly and adequately track and report revenue and 
expenses in any manner other than cash basis without the 
assistance of CPAs, EAs, accountants and bookkeepers. Many 
owners simply think on the basis of cash in and cash out and 
give their accountants their bank statements, check stubs and 
invoices to prepare their financial books which are used solely 
to prepare their tax returns. Many small business owners do not 
have systems in place to fully track accounts receivable or 
accounts payable. Once the financial activity is recorded, 
small business owners would then need to adjust these 
statements into an accrual basis. These adjustments can include 
uncollected revenue, unpaid payroll and related liabilities, 
prepaid expenses, inventory, etc. Not only will the owners be 
responsible for knowing what adjustments need to be made, they 
also must be able to determine the valuation of these 
adjustments.

    Despite the business owner's reliance on accounting 
professionals, the fiscal responsibility still falls on the 
owners. The business owners are and will remain responsible for 
all of the information that appears on their tax returns. The 
fact that their tax returns are professionally prepared does 
not alleviate the taxpayer responsibility for the accuracy of 
the data contained in the tax returns, but many business owners 
may not have the financial background to make this 
determination using the accrual basis of accounting.

    If small businesses were required to convert their 
accounting method to the accrual basis, the overall impact 
might simply be a ``one-time'' hit. Meaning, once the 
conversion is complete, the annual effect might not be as 
significant as one might expect. The ``one-time'' hit, however, 
could be very significant depending on the business. Newer 
entities or entities with minimal accounts receivable or 
accounts payable would likely have a small tax increase and 
possibly even a tax decrease. Entities with a larger receivable 
base, however, would not be so fortunate. To properly convert, 
they would need to report ALL open receivables as current 
income and all unpaid bills as current expenses. The impact of 
this added income could propel the owners into higher tax 
brackets, which in turn could lead to the phase-outs of 
itemized deductions and personal exemptions, phase-outs of 
other deductions and credits including tuition and student 
loans when the increased income is reported on their individual 
income tax returns. In addition, taxpayers may find themselves 
subject to the 3.9% Net Investment Income surtax that became 
effective last year.

    These tax increases will not just affect the taxpayer's 
federal income tax. Rather, additional state and local taxes 
may also be due because state and local tax returns usually 
have to be filed on the same basis as the federal tax returns. 
Further, many municipalities also impose a tax on gross 
receipts of all businesses.

    As discussed throughout the testimony, taxpayers often are 
unaware of the differences in accounting methods. If they were 
required to convert, this obviously creates a major business 
opportunity for CPAs, EA, bookkeepers, etc. Unfortunately, this 
will also open the door for unregulated preparers to take 
advantage of unknowing taxpayers and utilize creative 
accounting.

    Over the last few years, I have attended many IRS meetings, 
including National Public Liaison (NPL) and Working Together 
Forums. If there is one common thread that has been resonating 
from the IRS, it has been to reduce taxpayer burden. While this 
can mean many things, ultimately I believe that the IRS 
realizes that business and taxes in today's economy have gotten 
even more complicated. The current tax codes makes compliance 
even more complicated. In working to reduce the tax compliance 
burden, the IRS representatives have stressed the importance of 
e-Filing tax returns and have improved upon this every tax 
season, added additional features to their website such as 
``where's my amended return'' that allows taxpayers to track 
the processing of amended tax returns. Further, discussions 
have also centered on what can be done to ease the stress of 
taxpayers from regular tax filings and to respond to IRS 
notices that are sent. Requiring taxpayers to change their 
accounting methods without any specific reasons would truly be 
in conflict to what the IRS has been working to achieve.

    In conclusion, after reviewing the facts surrounding the 
differences between cash and accrual basis accounting, I feel 
that the use of cash basis for small firms remains of great 
importance and should be continued. It is a method that is 
consistent with how the owners have been taxed throughout their 
lives on their personal tax returns and how they realistically 
live. Converting to an accrual basis would add an additional 
burden onto them--financial. They would need to retain 
accounting professionals to guide them in this process. The 
Federal Government would achieve what can best be described as 
a ``one-time'' boost of tax revenue from the conversion. 
Taxpayers would be paying taxes on net income that neither they 
nor the business has received and this tax increase will 
include federal, state and local taxes. If the taxpayer has 
uncollectable aged accounts receivable, the taxpayer will be 
able to then write off this revenue and potentially send 
cancellation of debt notices (a 1099C) to those who owe money 
to the business. If the business subsequently pays the old 
accounts receivable, the income would be reported at that time 
and a method would have to be developed to reverse the 
cancellation of debt notice. The end result would be that the 
taxpayer has reduced his or her tax burden and the effect of 
the conversion to accrual basis is further diminished.

    All businesses have the opportunity to elect to track their 
accounting on an accrual basis. Not all have the opportunity to 
account on a cash basis. Some larger entities and many of those 
with inventory are required to account on an accrual basis. 
However, the majority of businesses are permitted to choose 
their accounting method. With the guidance of financial 
professionals, they are able to elect the most appropriate 
accounting method for their specific business. Forcing a 
business to use the accrual basis not only complicates their 
business but also requires the owners to take time away from 
operations to focus on changing an accounting method. 
Ultimately, one does not start a business to focus on 
accounting. Forcing this change will do just that.

    Thank you for the opportunity to present this testimony.

    [GRAPHIC] [TIFF OMITTED] T8718.003
    
    Mr. Chairman and Members of the Subcommittee:

    My name is William Hubbard, and I am the President-Elect of 
the American Bar Association (``ABA'') and a partner at Nelson 
Mullins Riley & Scarborough LLP in Columbia, South Carolina, 
where I practice in the area of business litigation. On behalf 
of the ABA, which has almost 400,000 members, thank you for the 
opportunity to express our views regarding the advantages of 
the traditional cash method of accounting utilized by most law 
firms, as well as our concerns over draft legislation prepared 
by House Ways & Means Committee Chairman Dave Camp (R-MI) that 
would substantially limit the continued use of cash accounting. 
We request that this statement be made part of the hearing 
record.

    The proposed legislation, contained in Section 3301 of 
Chairman Camp's draft ``Tax Reform Act of 2014,'' would impose 
substantial new financial burdens and hardships on many law 
firms and other types of personal service businesses throughout 
the country by fundamentally changing the manner in which they 
must pay their taxes.\1\ In particular, the provision would 
require all law firms and other personal service businesses 
with annual gross receipts over $10 million to switch from the 
traditional cash receipts and disbursement method of accounting 
to the much more complex accrual method of accounting. As a 
result, many small and medium sized businesses--including many 
thousands of law firms, accounting firms, medical firms, and 
other professional service providers--would be forced to pay 
taxes on income long before it is actually received.
---------------------------------------------------------------------------
    \1\ The text of the draft ``Tax Reform Act of 2014'' is available 
on the House Ways & Means Committee's website at http://
waysandmeans.house.gov/uploadedfiles/
statutory--text--tax--reform--
act--of--2014--discussion--d
raft--0226214.pdf.

    Although we commend Chairman Camp and the Ways & Means 
Committee staff for their efforts to craft legislation aimed at 
simplifying the tax laws--an objective that the ABA and its 
Section of Taxation have long supported--we are concerned that 
Section 3301 of his bill would have the opposite effect and 
cause other negative unintended consequences. 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 
services businesses by requiring them to pay tax on income they 
---------------------------------------------------------------------------
have not yet received and many never receive.

    While the ABA has expressed its views on many different 
policy issues during the 113th Congress, this particular issue 
has become one of the most important issues to our members--and 
many state and local bars throughout the country \2\--because 
of the serious negative effects that the proposed legislation 
would have on practicing lawyers, their law firms, and their 
clients. In addition, many other leading associations and other 
entities have expressed serious concerns regarding this and 
other proposals to impose substantial new limits on the use of 
cash accounting.\3\ Therefore, the ABA appreciates this 
Subcommittee's efforts to highlight the benefits of cash 
accounting and the very serious effects that mandatory accrual 
accounting would have on law firms and many other types of 
small and medium sized businesses throughout the nation.
---------------------------------------------------------------------------
    \2\ At least 21 state and local bars have expressed opposition to 
the mandatory accrual accounting legislation, including those in 
Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, 
Minnesota, Missouri, Mississippi, Nebraska, New Jersey, North Carolina, 
Ohio, Oregon, Pennsylvania, South Carolina, Tennessee, and Wisconsin. A 
complete list of the national, specialty, state and local bars opposing 
the proposal and other resources on this issue are available at: http:/
/www.americanbar.org/advocacy/
governmental--legislative--work/
priorities--policy/
independence--of--the--legal--
profession/mandatory-accrual-for-law-firms.html.
    \3\ The ABA has been working in close cooperation with a broad and 
diverse coalition of organizations including the American Institute of 
CPAs, American Council of Engineering Companies, American Dental 
Association, American Farm Bureau Federation, American Institute of 
Architects, American Association for Justice, Americans for Tax Reform, 
and over 50 law firms, accounting firms, and other entities in an 
effort to raise awareness of the proposed mandatory accrual accounting 
legislation and its unintended harmful consequences.

---------------------------------------------------------------------------
              Advantages of the Cash Method of Accounting


    Under current law, businesses are permitted to use the 
simple, straightforward cash method of accounting--in which 
income is not recognized until cash or other payment is 
actually received and expenses are not taken into account until 
they are actually paid--if they are individuals or pass-through 
entities (e.g., partnerships or subchapter S corporations), or 
their average annual gross receipts for a three year period are 
$5 million or less. In addition, all personal service 
businesses--including those engaged in the field of law, 
accounting, engineering, architecture, health, actuarial 
science, performing arts, or consulting--whether organized as 
sole proprietorships, partnerships, limited liability 
companies, or S corporations, are exempt from the revenue cap 
and can use the cash method of accounting irrespective of their 
annual revenues, unless they have inventory.

    Partnerships, S corporations, personal service corporations 
and other pass-through entities favor the cash method because 
it is simple and generally correlates with the manner in which 
these business owners operate their businesses--i.e., on a cash 
basis. Simplicity is important from a compliance perspective 
because it enables taxpayers to better understand the tax 
consequences of transactions in which they engage or plan to 
engage. In this regard, simplicity helps to mitigate compliance 
costs--which already are significant--and to improve compliance 
with the Tax Code.

    In addition to promoting simplicity, the cash method of 
accounting also produces a sound and fair result because it 
properly recognizes that the cash a business actually receives 
in return for the services it provides--not the business' 
accounts receivable--is the proper measure of its true income. 
While accounts receivable clearly are important in determining 
the overall financial condition of the business and assessing 
its future prospects, they do not accurately reflect what is 
available for the business' owners to spend (or their present 
ability to pay taxes on their 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 business operate will be turned on its 
head.

Mandatory Accrual Accounting for Personal Service Businesses Would Be a 
   Major Change to Current Law and Would Increase, Not Decrease, the 
                       Complexity of the Tax Code


    Section 3301 of the Chairman Camp's draft legislation would 
dramatically change current law by raising the gross receipts 
cap to $10 million while eliminating the existing exemption for 
law firms and other personal service businesses and for other 
partnerships and S corporations. Therefore, if this proposal is 
enacted into law, all law firms and other personal service 
businesses with annual gross receipts over $10 million would be 
required to use the accrual method of accounting, in which 
income is recognized when the right to receive the income is 
present and expenses are recorded when they are fixed, 
determinable and economically performed, both aspects of which 
present complications.

    Although Chairman Camp's proposal would allow certain small 
business taxpayers with annual gross receipts in the $5 million 
to $10 million range to switch to--and thereby enjoy the 
benefits of--the cash method of accounting (a concept that the 
ABA does not oppose), the proposal would significantly 
complicate tax compliance for a far greater number of small 
business taxpayers, including many law firms and other personal 
service businesses, by forcing them to use the accrual method 
of accounting.

    For example, while law firms using the cash method of 
accounting simply pay taxes on the income that they actually 
receive, law firms that are required to use the accrual method 
will be forced to calculate and then pay taxes on multiple 
types of accrued income, including work in progress and other 
unbilled work, accounts receivable (where the work has been 
done and billed but not yet paid for), and accounts paid (where 
the work has been done, billed, and paid for).\4\ In order to 
meet these requirements, law firms and other affected 
businesses will need to keep much more detailed work and 
billing records and hire additional accounting and support 
staff. As a result, the proposal would substantially raise 
compliance costs for many law firms and other personal service 
businesses while greatly increasing the risk of noncompliance 
with the Tax Code.
---------------------------------------------------------------------------
    \4\ For a detailed discussion of the specific effects that 
mandatory accrual accounting legislation would have on law firms, see 
PwC's Law Firm Services, Congressional Proposals Requiring Law Firms to 
Report Taxable Income on the Accrual Method of Accounting (December, 
2013), available at: http://legaltimes.typepad.com/files/cash-to-
accrual-white-paper.pdf.

---------------------------------------------------------------------------
              Other ABA Concerns Regarding the Legislation


    In addition to creating unnecessary complexity and 
compliance costs, Chairman Camp's proposal would lead to 
economic distortions that would adversely affect all personal 
service businesses that currently use the cash method of 
accounting and those who retain them, including many law firms 
and their clients, in several ways.

    First, the proposal would impose substantial new financial 
burden on many thousands of personal service businesses 
throughout the country--including many law firms--by requiring 
them to pay taxes on income they have not yet received and may 
never receive. Unlike the current law, where law firms and 
other personal service businesses need only pay taxes on income 
they have actually received, the proposal would require many of 
these firms to pay tax on ``phantom income'' that they have not 
yet received, including work in progress, other unbilled work, 
and accounts receivable. As a result, many firms would have to 
borrow money or use their scarce capital just to pay their 
accelerated tax obligations. In either event, the proposal 
would impose a serious financial burden and hardship on many of 
these firms.

    Second, the proposal would cause the legal profession to 
suffer even greater financial hardships than other professions 
because many lawyers and law firms are not paid by their 
clients until long after the work is performed. 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. This 
sets lawyers and law firms apart from many other types of 
professionals--such as doctors, dentists, and accountants--who 
typically work on a pay-as-you-go basis. Therefore, requiring 
personal service providers to pay taxes on income that has 
accrued but not yet been received will create special hardships 
for many in the legal profession.

    The proposal also would disproportionately affect 
professional service providers that practice in regulated 
professions, like lawyers, because many of these professionals 
are subject to special rules that significantly limit their 
ability to raise capital. For example, lawyers must comply with 
state court ethics requirements that generally prohibit them 
from forming a law firm partnership with a non-lawyer \5\ or 
allowing a non-lawyer to own any interest in a law firm 
partnership.\6\ As a result, many law firms must be capitalized 
solely by the individual lawyers who together own those firms 
and they are unable to raise equity capital from outside non-
lawyer investors. Therefore, forcing these law firms to pay tax 
on income that has not yet been received and which may never be 
received could place a major strain on lawyers' ability to 
properly capitalize and operate their firms.
---------------------------------------------------------------------------
    \5\ Rule 5.4(b) of the ABA Model Rule of Professional Conduct 
(``ABA Model Rules'') provides that ``a lawyer shall not form a 
partnership with a nonlawyer if any of the activities of the 
partnership consist of the practice of law.'' See also Charts Comparing 
Individual Professional Conduct Rules as Adopted or Proposed by States 
to ABA Model Rules, available at http://www.americanbar.org/groups/
professional--responsibility/policy.html.
    \6\ ABA Model Rule 5.4(d)(1) provides that ``a lawyer shall not 
practice with or in the form of a professional corporation or 
association authorized to practice law for a profit, if...a nonlawyer 
owns any interest therein, except that a fiduciary representative of 
the estate of a lawyer may hold the stock or interest of the lawyer for 
a reasonable time during administration.'' Similarly, in many states, 
accounting firms may not have any passive (i.e., investor) ownership 
and a majority of the owners must hold active CPA licenses.

    Third, the mandatory accrual accounting proposal could 
adversely affect clients, interfere with the lawyer-client 
relationship, and reduce the availability of legal services in 
various ways. Under the traditional hourly billing model 
followed by many law firms, individual lawyers within the firm 
typically perform any necessary legal services for the client 
throughout the month and the firm then bills the client on a 
monthly (or quarterly, or some other periodic) basis. In other 
cases, law firms may agree to handle a client's case on a 
contingency fee basis, in which a fee (typically a percentage 
of the total recovery, plus actual expenses) is only charged if 
the client prevails. In still other cases, a law firm may agree 
to represent a start-up company in return for an equity 
interest in the new business instead of a traditional legal 
fee. Many law firms also agree to represent a certain number of 
indigent clients on a pro bono basis in which no fee of any 
---------------------------------------------------------------------------
kind is charged.

    Unfortunately, if the proposed legislation is enacted and 
many law firms that currently use the cash method of accounting 
are forced to use the accrual method and pay taxes on income 
they have not yet received, the resulting financial pressures 
will force many firms charging on an hourly basis to collect 
their legal fees immediately after the legal services are 
provided to the clients (or at least much sooner than they 
currently do). In addition, many firms will no longer be able 
to represent as many accident victims, start-up companies, or 
other clients on a contingent fee basis as they currently do 
because the taxes on contingent fee income could become due 
once the court judgments or settlements become final, even if 
the firm does not actually collect the income for months or 
even years later. Perhaps worst of all, the serious cash flow 
and other financial pressures caused by the acceleration of 
their tax liabilities will force many firms to reduce the 
amount of free, pro bono legal services that they currently 
provide to the poor.

    Finally, the ABA opposes the mandatory accrual accounting 
proposal because it would constitute a major tax increase on 
small and medium sized businesses and would discourage economic 
growth. According to the Joint Committee on Taxation, the 
accrual accounting mandate in Section 3301 of Chairman Camp's 
bill would generate $23.6 billion in new taxes over ten years 
\7\ by requiring the affected businesses to pay taxes on 
phantom income up to a year or more before it is actually 
received (if it is ever received). Because this acceleration of 
a firm's tax liability would be permanent and continue year 
after year, it would constitute a major permanent tax increase 
for the firm, when compared to the taxes the firm currently 
pays under the cash method, until the firm eventually 
dissolves, merges with another firm, or otherwise ceases to 
exist.
---------------------------------------------------------------------------
    \7\ See Tax Reform Act of 2014 Discussion Draft, Section-by-Section 
Summary at page 88, available at: http://waysandmeans.house.gov/
uploadedfiles/
ways--and--means--section--b
y--section--summary--final--
022614.pdf

    In addition, the proposal would discourage professional 
service providers from joining with other providers to create 
or expand a firm, even if it made economic sense and would 
benefit their clients, because4 it could trigger the accrual 
accounting requirement in the bill. For example, solo 
practitioner lawyers would be discouraged from entering into 
law firm partnerships--and many existing law firms would be 
discouraged from growing or expanding--because once a firm 
exceeds $10 million in annual gross receipts, it would be 
required to switch from cash to accrual accounting, thereby 
accelerating its tax payments. Sound tax policy should 
encourage--not discourage--the growth of small and medium sized 
businesses, including those providing personal services such as 
law firms, especially in today's difficult economic 
---------------------------------------------------------------------------
environment.

                               Conclusion


    In sum, while the simple cash method of accounting more 
accurately reflects the true income of most businesses and 
offers many other advantages, mandatory accrual accounting 
proposals such as Section 3301 of the draft Tax Reform Act of 
2014 would likely cause numerous harmful unintended 
consequences. These include unnecessary new complexity in the 
tax law, increased compliance costs, and significant new 
financial burdens and hardships for the many law firms and 
other personal service businesses throughout the country that 
will be required to pay tax on phantom income that has not yet 
been received and may never be received. In addition, the 
proposal would harm the economy and discourage growth, without 
providing any corresponding benefits.

    To avoid these harmful results, the ABA urges you and your 
colleagues to protect the ability of personal service 
businesses to use the simple cash method of accounting and to 
oppose provisions like Section 3301 that would require many of 
these businesses to utilize the more complex and costly accrual 
method of accounting.

    Thank you again for the opportunity to express the ABA's 
views on this important issue.

[GRAPHIC] [TIFF OMITTED] T8718.004

    The American Council of Engineering Companies (ACEC)--the 
business association of the nation's engineering industry--is 
pleased to submit this statement to the Subcommittee on 
Economic Growth, Tax, and Capital Access of the House Small 
Business Committee for its hearing on the cash method of 
accounting.

    ACEC members--numbering more than 5,000 firms representing 
hundreds of thousands of engineers and other specialists 
throughout the country--are engaged in a wide range of 
engineering works that propel the nation's economy, and enhance 
and safeguard America's quality of life. The Council represents 
engineering businesses of all sizes, from those with a single 
professional engineer to firms that employ tens of thousands of 
professionals working in the United States and throughout the 
world.

    A proposal is being discussed in Congress that would change 
the rules regarding the use of the cash method of accounting. 
The Tax Reform Act of 1986 requires most businesses, 
particularly those that have inventories, to use the accrual 
method of accounting. However, professional services firms of 
all sizes, including engineering firms, are generally allowed 
to use cash accounting for tax purposes, either under the QPSC 
exception or because they are organized as S corporations or 
partnerships. In addition, the law provides a general allowance 
in the use of cash accounting for any small firm with revenues 
below $5 million, as well as farmers.

    The proposal under consideration would change these long-
standing rules and limit the use of cash accounting only to 
sole proprietorships and firms with less than $10 million in 
gross receipts. While increasing the basic small firm threshold 
from $5 million to $10 million makes sense, the larger impact 
of forcing engineering firms with revenues over $10 million to 
switch to accrual accounting presents major problems.

    At the outset, we would note an immediate contradiction in 
policy, as the current small business size standard for 
engineering firms is $14 million. Should the proposal become 
law, some firms that are classified as small by the Small 
Business Administration would be considered large under the 
Internal Revenue Code.

    The proposal presents more fundamental problems, however. 
Engineering firms normally carry large balances of accounts 
receivable and work in progress, representing work performed 
for clients for which they have not yet been paid. The primary 
cost for engineering firms is labor, and approximately 85 
percent of a typical firm's expenses can be attributed to 
payroll, benefits, and similar regular expenses. Engineering 
firms generally have to wait at least 120 days to be paid for 
services rendered to their clients, and at the same time must 
pay their employees every two weeks. While this situation can 
create cash flow challenges for firms, the use of cash 
accounting helps to mitigate those challenges by allowing firms 
to make tax payments after receiving payment for their 
services.

    By contrast, forcing firms to switch to accrual accounting 
would require firms to use debt financing to cover the delta 
between expenses and receipts, which is much harder for small 
and mid-size firms to access today. The cash flow challenges 
that would result from a switch to accrual accounting would 
create additional negative consequences, including workforce 
downsizing among some firms, delayed expansion plans, and 
decreased shareholder distributions. In fact, many S 
corporations utilize shareholder distributions to facilitate 
ownership transition, and any reduction could have a 
detrimental impact on a firm's long-term viability. All of 
these outcomes would take money out of the productive economy, 
jeopardize well-paying jobs, and burden firms that continue to 
struggle in the soft economy.

    The simple premise of cash accounting allows engineering 
firms to pay income taxes on their revenue when they are 
actually paid, rather than when they submit an invoice. 
Conversely, they are not allowed to take deductions for 
expenses when they are incurred, but when the expense is 
actually paid. Once again, we believe this approach is fair for 
an industry whose product is intellectual capital, not hard 
physical inventory.

    For these reasons, ACEC strongly recommends that Congress 
continue to allow engineering firms and other similar 
businesses to use cash accounting as they have done for 
decades.

    On behalf of the nation's engineering industry, we thank 
the Subcommittee on Economic Growth, Tax, and Capital Access of 
the House Small Business Committee for the opportunity to 
submit a statement on this important issue.

[GRAPHIC] [TIFF OMITTED] T8718.005

[GRAPHIC] [TIFF OMITTED] T8718.006

           AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS


                           WRITTEN STATEMENT


                         For the Record of the


                         July 10, 2014 Hearing


                                 of the


                 UNITED STATES HOUSE OF REPRESENTATIVES


                      COMMITTEE ON SMALL BUSINESS


        SUBCOMMITTEE ON ECONOMIC GROWTH, TAX AND CAPITAL ACCESS


                                   on


           CASH ACCOUNTING: A SIMPLER METHOD FOR SMALL FIRMS?


    Introduction

    The AICPA commends Chairman Rice, Ranking Member Chu, and 
the Subcommittee on Economic Growth, Tax and Capital Access for 
examining cash accounting, its utilization by small businesses, 
and whether the current policies should be changed to allow 
small firms more flexibility in choice of accounting methods.

    We wholly support the expansion of the number of taxpayers 
that may use the cash method of accounting. The cash method of 
accounting is simpler in application, has fewer compliance 
costs, and does not require taxpayers to pay tax before 
receiving the income being taxed. For these same reasons, we 
are extremely concerned with, and oppose, any limitations on 
the use of the cash method for small and service businesses, 
including those businesses whose income is taxed directly on 
their owners' individual returns, such as S corporations and 
partnerships. Requiring these businesses to switch to the 
accrual method upon reaching a gross receipts threshold would 
unnecessarily discourage small business growth.

    The AICPA is the world's largest member association 
representing the accounting profession, with more than 394,000 
members in 128 countries and a 125-year heritage of serving the 
public interest. Our members advise clients on Federal, state 
and international tax matters and prepare income and other tax 
returns for millions of Americans. Our members provide services 
to individuals, not-for-profit organizations, small and medium-
sized businesses, as well as America's largest businesses.

    Background

          1. General Rules

    In general, a taxpayer may use any method of accounting 
that clearly reflects income (including the cash method) unless 
the taxpayer is required by the Internal Revenue Code or Income 
Tax Regulations to use a specific method of accounting (e.g., 
the accrual method of accounting, the percentage of completion 
method for long-term contracts, etc.).\1\
---------------------------------------------------------------------------
    \1\ See section 446(c).

    For example, the following taxpayers are generally 
---------------------------------------------------------------------------
permitted to use the cash method of accounting:

          1. Sole proprietors; \2\
---------------------------------------------------------------------------
    \2\ See section 446(c).
---------------------------------------------------------------------------
          2. Pass-through entities (e.g., partnerships and S 
        corporations); \3\
---------------------------------------------------------------------------
    \3\ See section 446(c).
---------------------------------------------------------------------------
          3. Entities that engage in a farming business; \4\
---------------------------------------------------------------------------
    \4\ See limitation, however, under section 447.
---------------------------------------------------------------------------
          4. Entities that primarily perform services by their 
        owners; \5\ and
---------------------------------------------------------------------------
    \5\ See section 448(b).
---------------------------------------------------------------------------
          5. Entities that satisfy a $5 million gross receipts 
        test (and do not maintain inventory).\6\
---------------------------------------------------------------------------
    \6\ See section 448(b)(3).

    Currently, the Internal Revenue Code and Income Tax 
Regulations require certain taxpayers to adopt a specific 
method of accounting (e.g., the accrual method of accounting, 
the percentage of completion method for long-term contracts, 
etc.). For example, C corporations (as well as partnerships 
that have a C corporation as a partner) and tax shelters are 
not allowed to use the cash method of accounting (subject to 
exceptions),\7\ and a taxpayer must also generally use the 
accrual method of accounting if the taxpayer purchases, 
produces, or sells merchandise.\8\
---------------------------------------------------------------------------
    \7\ See section 448(a) and 448(b)(3).
    \8\ See Treas. Reg. Sec. 1.446-1(c)(2)(i).

    On the other hand, the Internal Revenue Service (IRS), by 
administrative action, has allowed certain ``small'' taxpayers 
(e.g., qualifying taxpayers \9\ and qualifying small business 
taxpayers \10\) to use the cash method even if inventories are 
maintained.
---------------------------------------------------------------------------
    \9\ According to Rev. Proc. 2001-10, a qualifying taxpayer is an 
entity with average annual gross receipts for each prior tax year 
ending on or after December 17, 1998, of $1 million or less.
    \10\ According to Rev. Proc. 2002-28, a qualifying small business 
taxpayer is an entity with average annual gross receipts for each prior 
tax year ending on or after December 31, 2000, of more than $1 million 
but not more than $10 million, and is not otherwise prohibited from 
using the cash method under section 448(a).

    In other words, most types of entities (e.g., sole 
proprietorships, partnerships, and S corporations) may use the 
cash basis method of accounting regardless of whether they 
maintain inventory, if they have average annual gross receipts 
of less than $10 million. As mentioned above, this threshold is 
---------------------------------------------------------------------------
lowered to $5 million for C corporations.

    In general, a taxpayer who changes its accounting method 
(e.g., from the cash method to the accrual method) is required 
to compute an adjustment (section 481(a) adjustment) to prevent 
items of income or expense from being duplicated or entirely 
omitted from the taxpayer's taxable income. If the accounting 
method change is made with the permission of the Commissioner 
and results in a positive section 481(a) adjustment (increase 
in income), the adjustment is included in taxable income 
ratably over four taxable years. Whereas, a negative section 
481(a) adjustment (decrease in income) is taken into account 
entirely in the year of change.\11\
---------------------------------------------------------------------------
    \11\ See Section 481(a); Rev. Proc. 97-27, 1997-1 C.B. 680.

---------------------------------------------------------------------------
    12. Recent Proposals

    On February 21, 2014, House Ways and Means Committee 
Chairman Dave Camp released the Tax Reform Act of 2014, which 
provides that the cash method of accounting is available for 
natural persons (in other words, ``individuals'') and any other 
taxpayer who meets the gross receipts test and is otherwise 
eligible to use the cash method. Under the proposal, a taxpayer 
would satisfy the gross receipts test if the taxpayer's average 
annual gross receipts for a three taxable-year period are $10 
million or less. The proposal effectively would require certain 
pass-through entities (e.g., partnerships and S corporations) 
and personal service corporations with average annual gross 
receipts in excess of $10 million to use the accrual method of 
accounting. The proposal also would provide that a positive 
section 481(a) adjustment from an accounting change from the 
cash method to the accrual method is accounted over a four-year 
stepped period within eight years.

    On November 21, 2013, the former Senate Finance Committee 
Chairman Max Baucus released the 2013 Cost Recovery and 
Accounting Staff Discussion Legislative Language, which 
provides that the cash method of accounting is only available 
by taxpayers who meet the gross receipts test and are otherwise 
eligible to use the cash method. Under the proposal, a taxpayer 
would satisfy the gross receipts test if the taxpayer's average 
annual gross receipts for a three taxable-year period are $10 
million or less. The proposal effectively would require certain 
individuals, farmers, pass-through entities (e.g., partnerships 
and S corporations), and personal service corporations with 
average annual gross receipts in excess of $10 million to use 
the accrual method of accounting. However, the proposal would 
permit a taxpayer to use the cash basis method of accounting, 
if the gross receipts threshold is satisfied, regardless of 
whether it maintains inventory.

    In summary, if enacted, these proposals would both expand 
and limit the availability of the cash method of accounting for 
small businesses by increasing the gross receipts threshold 
from $5 to $10 million and requiring pass-through entities and 
personal service operations with average annual gross receipts 
in excess of $10 million to use the accrual method of 
accounting.

    Analysis

    Increased burden in adopting the accrual method of 
accounting

    The AICPA believes that requiring small and service 
businesses, including those businesses whose income is taxed 
directly on their owners' individual returns, such as S 
corporations and partnerships, to adopt and use the accrual 
method of accounting imposes complexities and increases burden.

    Under the cash method, income is recognized when it is 
actually or constructively received, and expenses are recorded 
when paid. These are straightforward and easily applied tests. 
Therefore, determining taxable income using the cash method is 
much simpler in application. Thus, many small businesses, 
including the service industry, prefer using the cash method of 
accounting.

    Under the accrual method, income is recognized when the 
right to receive the income is fixed and the amount is 
determinable with reasonable accuracy,\12\ and expenses are 
deductible when they are fixed, determinable, and economically 
performed \13\ (e.g., the ``all-events test''). These tests 
require analysis that is more complex than under the cash 
method. For example, under the accrual method, a taxpayer must 
determine the fact and amount of liability and determine if the 
property or service to which the accrual relates is actually 
provided or used. Therefore, determining taxable income under 
the accrual method is far more difficult in application, 
resulting in increases in the cost of compliance compared with 
the cash method. Thus, many small businesses oppose any 
requirement that the accrual method of accounting be used.
---------------------------------------------------------------------------
    \12\ See section 451.
    \13\ See section 461.

    Given that the cash method remains a far simpler method of 
accounting, the AICPA believes that simplicity justifies its 
continued use by non-natural persons (e.g., pass-through 
entities and personal service corporations), regardless of 
---------------------------------------------------------------------------
their gross receipts.

    Discouraging business growth

    The AICPA believes that limiting the use of the cash method 
of accounting by businesses (e.g., sole proprietors, farmers, 
and pass-through entities) would discourage their natural 
business growth.

    Every business hopes to grow. Businesses may grow 
organically, or by combining with similar businesses. As a 
result, although many businesses start out as a sole 
proprietorship, most eventually convert to a pass-through 
entity (e.g., general partnerships, limited liability 
partnerships, limited liability companies, and S corporations) 
to join forces and expand their operations.

    Under Chairman Camp's proposal, many pass-through entities 
would need to change to the accrual method of accounting once 
their average annual gross receipts exceeded a $10 million 
threshold, inhibiting both organic growth and growth through 
combination. For example, assume a sole proprietor is currently 
operating a successful business with more than $10 million of 
gross receipts. If the sole proprietor rewards an employee by 
making the employee a partner in the business, the business is 
no longer operating as a natural person (sole proprietor) and 
therefore, would be ineligible to continue to use the cash 
basis method of accounting--providing a disincentive to expand 
the business.

    Similarly, if two firms (each with $5.5 million gross 
receipts) intend to combine to share resources and expertise 
and better serve their clients, the combined firm would exceed 
the proposed threshold and be subject to the mandatory use of 
the accrual method of accounting--again, creating a 
disincentive to gain efficiencies through combination. In other 
words, a business's inability to use the cash method of 
accounting would create an artificial obstacle to joint 
ventures or the joining of two or more owners or businesses.

    In addition, limiting the use of the cash method of 
accounting would slow down (even stop) business growth. As 
noted above, requiring businesses to adopt the accrual method 
would increase the cost of compliance. This increase would 
force these businesses to stop hiring and planning for future 
expansions. In other words, instead of these businesses 
focusing on their growth (e.g., hiring more employees, 
expanding to new markets), they would be required to shift 
their resources to comply with the requirement.

    Small businesses play a key role to the economic growth in 
the United States. According to the Small Business 
Administration, small businesses ``accounted for 63 percent of 
the net new jobs created between 1993 and mid-2013 (or 14.3 
million of the 22.9 million net new jobs).'' The AICPA believes 
that small businesses need a sound tax policy and business 
environment that promotes simplicity and economic growth. The 
cash method of accounting provides simplification and allows 
small businesses to focus on their expansion and growth.

    Financial burden on individual owners of service businesses

    The AICPA believes that limiting the use of the cash method 
of accounting for service businesses and pass-through 
businesses would impose an undue financial burden on their 
individual owners.

    These businesses should not be required to use the accrual 
method of accounting. Such a requirement would accelerate the 
taxable income of many professional service firm owners (e.g., 
CPAs, attorneys, engineers), resulting in an increased tax 
liability on earnings they have not yet received. In order to 
pay this accelerated tax, some businesses would be forced to 
make cash distributions to their owners from other sources 
(e.g., new loans, reduction in workforce, slowing growth 
initiatives, etc.), potentially threatening their operations 
due to a tightening of cash flow. Other businesses would force 
their owners to deal with the financial burden regardless of 
the individuals' ability to pay.

    Additionally, the acceleration of income may result in the 
only reason that a partner is taxed at a higher marginal tax 
rate. Under the current U.S. tax system, income is taxed at 
progressively higher rates.\14\ For example, the top marginal 
rate of 39.6 percent applies to taxable income over $400,000 
for a partner filing as a single person. Thus, the acceleration 
of income of a partner could be taxed at the highest marginal 
rate that would otherwise be taxed at a lower rate (e.g., 35, 
33, 28, 25, 15, or 10 percent). In addition to paying the 
highest tax rate, the partner could lose some of the benefit of 
itemizing certain deductions. For example, itemized deductions 
(e.g., mortgage interest deduction, charitable deduction) of a 
partner with an adjusted gross income of $250,000 would be 
reduced by the lesser of 3 percent of the excess of adjusted 
gross income (AGI) over $250,000 or 80 percent of the itemized 
deduction.\15\ Thus, the partner is likely to have a higher 
overall tax liability with the acceleration of income.
---------------------------------------------------------------------------
    \14\ IRS 2013 Form 1040 Instructions, page 101.
    \15\ See section 68(a).

    For those professional service firms that are subject to 
state regulations limiting ownership to individuals who 
actively participate in the business, the potential hardship 
created by restricting use of the cash method by pass-through 
entities would increase significantly. For example, in many 
states, a firm engaged in the practice of accountancy is 
specifically prohibited from allowing any passive (investor) 
ownership and a majority of the owners must hold active CPA 
licenses. As a result, many accounting firms must raise capital 
solely by the individual professionals who together own the 
firm; they cannot raise capital from outside investors. As a 
result, an acceleration of tax on income that has not actually 
been collected in cash would place a strain on the ability of 
such professional owner-operators to properly capitalize and 
---------------------------------------------------------------------------
maintain capital in their firms.

    We believe that a transition from the cash to the accrual 
method imposes undue financial burden and would have a negative 
impact on both a new owner's ability to finance entrance into a 
partnership and a firm's ability to grow either independently 
or through merging with another firm.

    Conclusion

    The AICPA supports expansion of the number of taxpayers who 
may use the cash method of accounting. As we have discussed, 
the cash method of accounting is simpler in application, has 
fewer compliance costs, and does not require taxpayers to pay 
tax before receiving the cash.

    However, we strongly believe that Congress should not 
restrict the use of the long-standing cash method of accounting 
for the thousands of U.S. businesses that rely on it. We have 
confidence that forcing more businesses to use the accrual 
method of accounting for tax purposes would increase their 
administrative burden, discourage business growth in the U.S. 
economy, and unnecessarily impose financial hardship on cash-
strapped businesses.
                    Statement for the Record

       Cash Accounting: A Simpler Method for Small Firms?

                         July 10, 2014

    Subcommittee on Economic Growth, Tax and Capital Access

                  Committee on Small Business

                    House of Representatives

    We, the undersigned, wish to thank Chairman Rice, Ranking 
Member Chu and Members of the Subcommittee for convening this 
hearing to examine whether current tax policies should be 
changed to allow small businesses more flexibility in using the 
cash method of accounting. We represent a diverse group of 
service businesses who rely on the cash method to simply and 
accurately report income and expenses. As Congress examines the 
merits of the cash method of accounting and considers whether 
to expand its availability to more small businesses, we urge 
you to oppose any proposal that would force businesses 
currently allowed to use the cash method to switch to accrual 
accounting.

    For several decades, Congress has recognized that the cash 
method is a simple, accurate, and transparent method of 
reporting when income is received and when expenses are paid. 
The cash method is used extensively by American service 
providers representing a wide array of large and small 
businesses, many family-owned, including medical, dental, 
accounting, law, architectural, engineering, landscaping, 
horticultural, financial services, and consulting firms. 
Limiting the use of the cash accounting method would impose a 
significant tax and compliance burden on these businesses--and 
the individuals who own them--and undermine a tried and tested 
method of measuring and verifying a company's income and 
expenses.

    Under current law, the cash method of accounting may be 
used by individuals, most farmers, and service providers 
operating as partnerships, S corporations and professional 
service corporations, regardless of size. Certain C 
corporations with gross receipts up to $5 million also may use 
the cash method. The House Ways and Means and Senate Finance 
Committees have released tax reform proposals that would allow 
more businesses with gross receipts up to $10 million to use 
cash accounting. However, their proposals also would require 
partnerships, S corporations, and personal service corporations 
with gross receipts over $10 million to switch from the cash 
method to the accrual method of accounting; the Senate version 
also includes individuals and farmers.

    While we do not oppose measures expanding the use of cash 
accounting to benefit the smallest businesses, we do oppose 
measures that would prohibit us from continuing to use the cash 
method and that could result in significant hardship and 
negative consequences. The cash method is good for all sizes of 
service businesses with common concerns about economic growth, 
job creation and competitiveness. Proposals to restrict its use 
are without any policy justification and are used solely for 
the purpose of raising revenue to pay for tax reform.

    Such proposals would force businesses to switch from a 
simple ``cash-in/cash-out'' method of accounting for income and 
expenses to the much more complicated accrual method of 
accounting. Further, accrual accounting requires taxpayers to 
pay tax on accounts receivable and work-in-progress--phantom 
income that hasn't been collected and may never be collected--
creating cash flow issues and forcing some taxpayers to go into 
debt just to pay their tax bill. Compliance costs would 
escalate, adding to the already, overwhelming recordkeeping 
burdens and costs faced by many of these businesses. 
Ultimately, because most of these businesses are pass-throughs, 
the cash to accrual proposal is an immediate and unfair tax 
increase on individuals.

    There is no policy justification to force service 
businesses to switch from cash to accrual accounting. There is 
no evidence or allegation of abuse of the cash method by the 
taxpayers who use it. Further, the impact of the proposal is 
not consistent with the stated principles of tax reform, 
including fairness, simplicity, certainty, economic growth, job 
creation and enhanced competitiveness. Indeed, banning a tried 
and true method of tracking income to arbitrarily pay for tax 
reform is entirely inconsistent with these principles.

    Thank you for the opportunity to provide these comments. We 
are pleased to serve as a resource to the Congress, the 
Committee, and the Subcommittee, and we look forward to our 
continued work together on this important matter.

    Adams and Reese LLP

    American Council of Engineering Companies

    American Institute of Architects

    Americans for Tax Reform

    Covington & Burling LLP

    Cozen O'Connor

    Federal Communications Bar Association

    Fisher & Phillips LLP

    Gardere Wynne Sewell LLP

    Investment Adviser Association

    Jackson Walker LLP

    K&L Gates LLP

    Littler Mendelson, P.C.

    McKenna Long & Aldridge LLP

    Miles & Stockbridge

    Mitchell Silberberg & Knupp LLP

    Nelson Mullins Riley & Scarborough LLP

    Ogletree Deakins

    Pierce Atwood LLP

    Richards, Layton & Finger, P.A.

    State Bar of South Dakota

    White & Case LLP

    Wiley Rein LLP

    [GRAPHIC] [TIFF OMITTED] T8718.007
    
    [GRAPHIC] [TIFF OMITTED] T8718.008
    
    [GRAPHIC] [TIFF OMITTED] T8718.009
    
    [GRAPHIC] [TIFF OMITTED] T8718.010
    
    The National Federation of Independent Business (NFIB) 
appreciates the opportunity to submit this statement for the 
record to the Committee on Small Business for the hearing 
entitled ``Cash Accounting: A Simpler Method for Small Firms?'' 
NFIB is the nation's leading small business advocacy 
organization representing over 350,000 small business owners 
across the country, and we appreciate the opportunity to 
provide our perspective on this issue. NFIB represents small 
businesses in every region and every industry in the country. 
Accordingly, NFIB has a unique insight into the concerns of the 
small business community, and can speak with authority on these 
concerns.

    NFIB applauds the Committee for having this hearing today. 
Small business' ability to use cash accounting can greatly 
simplify the time and costs associated with tax preparation by 
small business owners. But while the availability of cash 
accounting has been gradually expanded over the years, 
significant limitations to its availability remain that limit 
the ability of small business owners to take advantage of this 
simplified accounting method.

    Small Business' Ability to Use Cash Accounting

    Cash accounting, when receipts are recorded during the 
period they are actually or constructively received, and 
expenses are recorded in the period in which they are actually 
paid, is the preferred method of accounting for small 
businesses. Forty-one percent of small businesses report using 
the cash method of accounting according to a 2006 NFIB National 
Small Business Poll. Small business owners prefer the cash 
accounting method because it is much easier for them to follow 
and more closely matches the way that small business owners 
maintain their books. However, the availability of cash 
accounting is not applied evenly by the tax code or the 
Internal Revenue Service (IRS). Depending on a firm's entity-
type, size (by revenue), and industry-type, cash accounting may 
be unavailable to a number of small businesses.

    The Internal Revenue Code (the code) contains significant 
limitations to the ability of small business' to use cash 
accounting. Section 448(c) allows C corporations and 
partnerships with less than $5 million in gross receipts to use 
cash accounting. This provision, however, does not include S 
corporations, which are one of the most frequently used types 
of business entity used by small business owners, Further, any 
taxpayer who maintains inventories is prohibited from using 
cash accounting regardless of their gross receipts. This 
prevents any small business owner who purchases and sells 
merchandise, such as retailers or wholesalers, from using the 
cash accounting method. Finally, the code prohibits taxpayers 
who manufacture goods for resale from using cash accounting.

    Since 2000, the IRS has taken meaningful steps to expand 
the availability of cash accounting to small businesses. IRS 
Revenue Procedure 2000-22 permits small businesses with gross 
receipts of $1 million or less (based on the preceding three-
year period) to use cash accounting where the business 
otherwise would have to use accrual accounting because it is 
required to account for inventories. Revenue Procedure 2002-28 
permits qualifying small businesses with gross receipts of $10 
million or less (based on the preceding three-year period) to 
use cash accounting. However, Revenue Procedure 2002-28 
precludes many industries, such as manufacturing, wholesale 
trade, retail trade and mining. The procedure also does not 
apply to C corporations or partnerships with a C corporation 
partner.

    Due to these statutory and administrative limitations, many 
small businesses cannot use cash accounting. Many of these 
businesses would benefit from an expanded ability to use cash 
accounting for tax purposes. Permitting more businesses with 
higher gross receipts to use cash accounting helps small 
businesses to manage cash flow because it better reflects the 
business owner's ability to pay taxes. This expansion is also 
logical given efforts by the IRS to expand the availability of 
cash accounting.

    Allowing any business entity with gross receipts of less 
than $10 million meaningfully expands the availability of cash 
accounting for small business owners. Because of the large 
number of small businesses that maintain inventories, any 
expansion of cash accounting should also apply to these types 
of taxpayers.

    Conclusion

    NFIB greatly appreciates the efforts of the Committee to 
shed light on the importance of cash accounting for small 
business owners. Current law is overly complicated and fails to 
adequately reach many small business owners who might otherwise 
be able to lower their tax compliance burden. Expanding its 
availability would go a long way towards simplifying tax 
compliance and preparation for small business owners. However, 
expanding cash accounting is just one aspect of tax reform and 
it does not replace the need to reduce individual tax rates and 
ensure a level playing field between pass-through entities and 
C corporations.
                       Testimony of Jeffrey Wald


             Chief Executive Officer, Kennedy and Coe, LLC


      To the House of Representatives Committee On Small Business,


        Subcommittee on Economic Growth, Tax and Capital Access


           Cash Accounting: A Simpler Method for Small Firms?


                             July 10, 2014


    Kennedy and Coe commends Chairman Rice, Ranking Member Chu 
and the entire House Committee on Small Business for examining 
the value of the cash method of accounting to U.S. small 
businesses.

    As CEO of Kennedy and Coe, one of the nation's largest 
accounting firms specializing in food and agriculture 
businesses, I can tell you first hand that the cash basis of 
accounting is critical for agriculture.

    The agriculture sector, unlike many other sectors of our 
economy, is still driven by the small and family business. 
According to USDA's 2012 Census of Agriculture, nearly 88 
percent of the 2.1 million farm businesses are considered small 
businesses. Without question, this makes the agriculture 
industry among the most reliant on the success or failure of 
the small business owner.

    Kennedy and Coe works with farmers and ranchers in nearly 
every state. And regardless of region or commodity type, our 
accountants find that the cash basis of accounting helps small 
farmers grow their businesses. We see three primary reasons for 
this:

          1. Cash accounting is simpler and requires less 
        administrative work.

          2. Cash accounting helps farmers and ranchers manage 
        volatile commodity and input prices; and

          3. Cash accounting ensures that taxes do not have to 
        be paid until after income has been received.

    While these benefits may be universal among anyone 
utilizing cash accounting, the impact is particularly acute in 
the agriculture sector.

    Cash Accounting is simpler and requires less administrative 
work

    For those of us in the farming industry, we know just how 
wrong some perceptions of agriculture can be. Take the idea 
that our food and fiber comes from corporate farms, for 
instance. In reality, 97.6 percent of all U.S. farms are family 
owned and operated. These farms are responsible for 85 percent 
of all U.S. farm production.

    Look a little closer and we get an even clearer picture of 
just who is growing our food:

          -62 percent of farmers in the U.S. are over the age 
        of 55;
          -77 percent have worked their land for more than 10 
        years

    Put simply: these operations are not large enough to employ 
an army of accountants and lawyers capable of navigating a 
complex tax code. These are family businesses that have to 
consider the trade-offs of maintaining complex accounting 
records. Because the more time most farmers spend doing their 
books, the less time they can spend on their farms and with 
their families.

    What farmers need is a reasonably easy, common sense way to 
accurately keep track of receipts and expenses. The cash basis 
of accounting provides just that.

    Cash Accounting Helps Farmers Manage Volatile Commodity and 
Input Prices

    The agriculture sector is widely recognized for its slim 
margins and extreme volatility. But just because these 
characteristics are inherent, doesn't mean they are easy to 
deal with.

    Running a successful agricultural operation requires 
constant planning to adapt to wide swings in the cost of 
critical inputs such as energy, fertilizer, or animal feed.

    On the other end of the equation, farm operators need to be 
prepared for considerable changes in annual production volumes 
from factors such as weather or disease. They also need to 
prepare for major shifts in the prices they receive, as things 
like drought or policy changes can have a major impact on 
commodity markets.

    The cash basis of accounting is the one critical tool that 
farmers and ranchers can use to deal with this volatility.

    Under the cash basis, income is not realized until the 
business receives payment for its product; and expenses are not 
realized until that expense is paid. With this flexibility, 
farm businesses can elect to withhold a portion of their crop 
until prices improve. Or, they can elect to purchase large 
volumes of feed or fuel when prices are low, even if it will be 
used across multiple tax-years.

    The value of this flexibility cannot be overstated--this 
carried inventory or reduced expense is often what makes the 
difference between making and losing money in a given tax year.

    Cash accounting ensures that taxes do not have to be paid 
until after income has been received.

    Due to the commoditization of the agriculture business, and 
the vast amount of capital it takes to break into the food 
processing business, many farmers do not sell their products 
directly into the market. Instead, they sell to intermediaries 
who often only pay a fraction of the price up front, and 
provide the remainder of the compensation after the product has 
been sold.

    While such arrangements may effectively diffuse market 
risk, such an arrangement only makes sense under a system of 
cash accounting. Because under cash accounting, the farm 
operator is only responsible for paying taxes on the income he 
or she has received.

    Should farmers lose the ability to use cash accounting, 
many would have to pay taxes on income they have yet to 
receive. In the asset-rich but cash-poor agriculture industry, 
this arrangement simply is not feasible.

    The phrase ``not feasible,'' isn't just rhetoric. After the 
House Ways and Means Committee and Senate Finance Committee 
floated the idea of forcing farms with more than $10 million in 
revenue to use accrual accounting instead of cash accounting, 
Kennedy and Coe commissioned Informa Economics to study the 
potential impacts of the policy change. As the study shows, the 
results would be catastrophic.

    Informa Economics concluded that U.S. agricultural 
producers forced to switch from cash-basis to accrual-basis 
accounting under the draft tax bill would have to accelerate 
payment on as much as $4.84 billion in taxes over the next four 
years. Additionally, the borrowing capacity of these operations 
would decrease by another $7.26 billion over the same time 
period.

    To put that $12.1 billion loss in working capital in 
context, Informa estimates that the combined liquid capital of 
impacted farms is only $1.8 billion. This means that losing 
cash accounting would likely force farmers and ranchers to 
either sell assets or go to the bank, just to pay their taxes, 
in many cases on products for which they have yet to receive 
payment.

    The Informa study quantified what we'd heard from producers 
across the U.S.--losing cash accounting would have a major 
negative effect on American agriculture. Meeting the immediate 
tax burden is going to be very difficult or impossible for 
producers who simply do not have the cash flow to pay taxes 
before they sell their products.

    Conclusion

    I want to close by once again expressing my appreciation 
for the leadership of the many champions of small business and 
family farms on this Committee. The cash basis of accounting 
provides the lifeblood of rural America--our agriculture 
industry--with the ability to thrive even in today's 
challenging market environment.

    Mr. Chairman, Madam Ranking Member, Members of the 
Committee, I am grateful for the opportunity to share the 
perspective of the agriculture community. I appreciate your 
efforts to call attention to the need to simplify and expand 
the use of cash accounting, and look forward to working with 
you to ensure that this expansion benefits our nation's farmers 
and ranchers.

                                 
