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Federal budget could cripple small firms

Last year, the federal government’s budget took aim at small businesses by clamping down on ways to maximize the small business deduction. This affected incorporated lawyers operating in a partnership. This year, the budget, tabled on March 22, takes aim at long-standing tax deferral opportunities afforded to certain professionals, including lawyers, accountants, dentists, medical doctors, veterinarians and chiropractors.    

The budget proposes to eliminate the ability to elect billed-basis accounting for the listed professionals. This could have a devastating effect on law firms, particularly small firms with a large number of contingency or set-fee files.

Billed-basis accounting allows the value of work in progress (WIP) to be excluded from taxable income in a given year while permitting the deduction of costs associated with WIP. This effectively defers tax until WIP is included as taxable income (when it is billed). Section 34 of the Income Tax Act allows certain professionals, including lawyers, to elect billed-basis accounting. This was originally adopted by the government as it recognized the difficulties in valuing WIP for listed professionals.  

Eliminating the option to elect billed-basis accounting forces lawyers to pay tax on WIP in the year the work is done, not the year in which the work is billed. For small firms with a large number of files on contingency or set fee, this can put them out of business.

While there is a two-year transition period to ease the pain for taxpayers, taxing WIP before it is billed will have a negative impact on a firm’s cash flow. The firm may not have enough cash to pay the taxes owing, creating even bigger problems for them. Small firms may not have the luxury of cash flow from other areas of practice to pay tax on WIP.  

Firms working on contingency may be forced to move to hourly billing arrangements to ensure they have sufficient cash flow to pay taxes. This creates a significant problem for personal injury victims with no sources of income, as most personal injury files are on a contingency fee basis. By extension, this could create an access-to-justice crisis in the personal injury field.

The same would apply for class actions.     

Eliminating the ability to select billed-basis accounting may also impact exit strategies for retiring lawyers. Older lawyers may have planned on deferring taxes on WIP into their retirement. Due to being forced to pay taxes on current- and previous-year WIP, the retiring lawyer will need to generate a significant amount of cash to pay this tax that they had thought would be paid in retirement.    

Law firms will need to take significant steps to ensure compliance if the budget is approved as proposed. Accounting systems and practices will need to be updated. Many small firms do not record WIP as there is no impact on the net effect for tax purposes. Moreover, and what was recognized in the original legislative intent, firms may have trouble valuing WIP, especially risky litigation files.

It may make financial sense for unincorporated lawyers to incorporate their practice. This would allow them to pay WIP at corporate tax rates rather than personal tax rates.

The proposed budget has a significant impact on lawyers. It is unclear whether the federal government put its mind to the impact on access to justice when drafting this budget. The elimination of billed-basis accounting does not increase tax revenue for the government; it simply reduces the wait time for collection. What is clear is that the change will have a dramatic impact on the way law firms, small and large, do business.

  • Managing Partner

    Shael Eisen
    Eliminating billing based accounting will put my law firm out of business.

    I typically get a small retainer and then get paid at the end. Files on average take a year to resolve, and while I keep track of wip through PClaw, it is a rare file where I get 100% of my wip into a bill, and a further rarity that I get 100% of an outstanding account.

    Shael Eisen
  • FCPA FCA TEP

    Hugh Neilson
    I'm curious how many people who expect their firms will go bankrupt have read the Budget proposal.

    WIP is an inventory. It is not the "fully billed out chargeout rate WIP", but the lower of value and cost.

    While there remains some uncertainty in these determinations, older (1992; 1981/82) commentary suggests staff costs, variable overheads and recoverable disbursements. All of those documents indicate partner/proprietor time would have no cost.

    This is not "tax your full bill in advance", but "defer deduction of your costs until revenues are reported" - much like a home builder does not get to deduct the costs of land or construction before recognizing revenues from sale of the building.

    The video referenced in another comment discusses uncertainties on "cost" in some detail.
  • FCPA FCA TEP

    Hugh Neilson
    I'm not a lawyer. I will point out that the reasons advanced in 1981/82 when this provision was proposed to vanish (we went down this road before) have since largely been legislated away, so reminding Finance of reasons that no longer exist may be less than helpful.

    If a homebuilder builds a house on spec, he does not get to deduct the costs incurred in doing so until he sells the house. I am challenged to explain why my, or your, WIP is different from his.

    I would also note that most of us carry WIP in our financial records at "amount we expect to bill in future". The proposal does not require that be included as income, but that the costs of that WIP (disbursements; professional time; the extent is unclear at present) be deferred from deduction until the work is billed.

    If you have 15 minutes to kill, you can check out Video Tax News' discussion of the proposal at https://vimeo.com/210792535 (I am a member of the Board of Editors).
  • lawyer

    Micheal Simaan
    It is rather unfair. It is hard enough paying income tax on billed files that you haven't yet collected (and in some cases may not collect at all). But paying income tax on files that may not generate any income for years (if ever) is ridiculous.
  • Lawyer

    Craig McLeod
    I would expect the national and provincial law societies, bar associations, and other lawyers' organizations, as well as the associations of other professionals affected by this, will strongly lobby the government, the CRA, and individual members of Parliament as soon as possible to make them aware of the reasons the exclusion of WIP was allowed in the first place and of the serious effects this change in taxation will have.
  • Lawyer

    Allisa Wu
    I agree with Craig; however, lawyers should not only rely on law societies or association to make the push. The law societies and associations are always asking for lawyers input and submissions. This will have to be a collective effort.
  • Accountant

    S. G.
    Great article Kevin. It is unfortunate when a government that is supposed to be supporting the middle class hammer on small business. As a small business owner, we can not move as quickly as the proposed legislation and the unfortunate reality - the only way I can generate enough cash to pay this tax early is a staff member will need to be let go. I would hazard to guess that the last 2 liberal budgets eliminated many jobs for young professionals - way to go Justin.
  • FCPA FCA TEP

    Hugh Neilson
    I'm not sure there are a lot of firms, small or large, carrying an extra professional or two they don't really need to deliver client service because they can deduct their WIP costs on jobs in progress at year end. I suspect gathering the stats on that might be challenging, though.

    Have their been mass layoffs with the SBD restrictions on partnerships coming into force?
  • Accountant

    S. G.
    Not sure if there have been mass layoffs but just speaking from our own firm's perspective; SBD changes hit us $140K and now the WIP (another $110K or so over 2 years), we can not change our business model quickly enough for that type of cash hit.

    We also have 2 retired shareholders that are being bought out over time that consult for us on the odd job - it is unfortunate that they are not allow access to the SBD. We now need to incur additional costs to restructure their deals so we are back to where we should be. The Liberal changes are destructive and hurting the so called "middle class" and business owners.
  • FCPA FCA TEP

    Hugh Neilson
    Obviously I have no insights to your business structure, but you must be running a public practice to be hit with the WIP provisions. The SBD changes are considerably more broad, and have hit a lot of businesses beyond what I read as their target (being a single business getting access to multiple small business deduction limits).

    Given the spread between the SBD rate and the general corporate rate is about 14%, a $140k hit implies you were previously getting SBD on $1.5 million, and are now restricted to a single $500k business limit across whatever number of partners are in your firm – presumably, at least 3.

    As the SBD is only a deferral, you must be able to leave $1.5 million in the corporations after your personal cash flow needs. How much income does one earn before being considered above “middle class”? How much income does a business generate and still qualify as “small”? These are definitions the Government seems unwilling to disclose.
  • Accountant

    S. G.
    When there are several owners that must split the $1.5 and are taking home under $200K it is painful. What about re-investment and debt servicing? You invest in your business assuming some stability of earnings/taxes; then in 1 year the government hits you with a $70,000 extra tax bill. What about new partners leveraging to buy-in; there expected debt servicing cash just disappeared. The changes are crippling to many businesses and devastating to many families.

    It is not necessarily a matter of how much is small or what is middle class - it is a government that continues to say they have not raised income taxes, yet have hammered small business owners (professionals in particular). If tax changes are going to occur the government should at least give some time for business owners to react. Significant tax changes of this nature create major cash flow issues for owners; the only option left for many owners is to layoff staff or delay hiring.
  • FCPA FCA TEP

    Hugh Neilson
    Among the first actions of the Liberals was to raise tax rates, so I don't think they deny that. That $70k extra tax implies loss of SBD on income of $500,000 - over and above any compensation taken for personal cash requirements. That's significant, but so is the income earned.

    Assuming that Finance would continue to ignore SBD multiplication seems like a pretty optimistic belief to me. I think it was always clear that the policy intent was for a single business to access a single business limit. From that perspective, Finance closed a loophole.

    All businesses got at least a year's warning, and most professionals got 21 months as professional partnerships are generally required to have Dec 31 year ends. Is that enough time to plan? Debatable - but how much notice of a change is reasonable?
  • FCPA FCA TEP

    Hugh Neilson
    I find it hard to believe anyone familiar with the old Specified Partnership Rules would be surprised that a full SBD limit for each partner was outside the policy intent. The Corporate rules went well beyond that policy. I am hopeful they will be corrected (& disappointed it isn't already done).

    Perhaps we should show government how professionals reinvest their tax savings into their businesses and create new employment, more so than capital-intensive businesses that quickly lose SBD access due to the taxable capital rules. Would our financial statements demonstrate that reinvestment?

    In 1982 when the WIP deduction was retained for the “six professions”, they did not qualify for the same SBD. They do now. Many decided “one limit per business” should instead be “one limit per owner”. If we as professionals are hit especially hard by the limit being tightened, perhaps that is because we were especially eager to circumvent the tax policy that limited access.

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