Federal budget could cripple small firms

Kevin Cheung
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.

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