For many professionals who run their own practice, March's federal budget could mean paying more taxes upfront that will strain their cash flow.
The government has proposed to eliminate the ability of designated professionals, such as lawyers, accountants, dentists, veterinarians, and chiropractors, to use so-called billed-basis accounting, which allows them to exclude the value of work in progress (WIP) when calculating their income.
WIP is the amount of money your company expects to earn from projects that are in progress but not yet completed at the end of the tax year. Lawyers, accountants, and consultants typically quote upfront the number of billable hours they are likely to spend on a particular case or project and work toward that number of hours.
Section 34 of the Income Tax Act has allowed professionals to defer taxes on income for work completed over months or years until the whole project is completed and billed. At the moment, about 20 per cent to 35 per cent of total gross billings of the professionals I work with use billed-basis accounting.
With the elimination of the ability to defer taxes on costs associated with work in progress, professionals will have to pay taxes upfront for the work in progress billed during that year, even though the project has not been completed and receivables have not been paid in full.
Cash-flow hit to professionals
This could be problematic to many professionals. Lawyers, for instance, could help clients settle a $500,000 suit and charge 50 per cent of the settlement amount as legal fees over time. This complicated suit can involve a lot of WIP progress over many years.
The current rules would have allowed them to exclude this WIP from taxable income until the case was settled and the firm was paid. But with the federal budget proposal, they'll have to pay taxes upfront on WIP for each fiscal year, and risk overpayment of taxes in case the suit gets settled for a lesser amount and the firm ends up collecting less – say $100,000, instead of the full $250,000 in expected legal fees.
This also applies to accountants. If an auditor performed $5,000 worth of preparation work in 2016 but the bulk of the assignment, say $25,000, was completed in 2017, the auditor would have to pay taxes upfront for the $5,000 considered as WIP in 2016, instead of having the ability to defer paying taxes until the work is completed in 2017.
But what if the funds are never recovered? Professionals will have to value their WIP at the end of each fiscal year at the lower of cost or fair-market value based on their best estimate of collecting on debt. For the accounting and legal community, this may be a big cash-flow hit.
Another issue that may arise is that some smaller firms/professionals do not use billed-basis accounting; they generate a bill at the end of the assignment. The change would force them to make changes to how they estimate, track, and record their WIP so they would be tax-compliant based on this new policy change.
To lessen the blow of the federal government's new policy, here are some options for small business practitioners:
- Change WIP calculation: They can minimize or defer taxes by being more conservative in estimating WIP at year-end and/or by reducing WIP accounted for over time. For example, they may have to write down their WIP if they determine that a client has financial difficulties and they know they will not be able to collect the full amount. They may also want to be more conservative in their WIP estimate at the outset knowing that they may reduce the final billing or may want to push more of the WIP into the next year. In addition, practitioners should revise their WIP records to only include items that they feel can be reasonably recovered. Some might have old entries in their WIP going back to, say, 2012, which they had hoped to recover on future jobs. Now, they will have to assess if they need to delete these old entries so they are not paying tax on income they will not receive.
- Incorporate your practice: Professionals who are incorporated will be able to keep the net income of their business under the small business deduction rate. In Ontario alone, paying tax on the WIP at corporate taxes as opposed to personal tax rates means paying 26.5 per cent instead of 53.5 per cent.
- Create a holding company for excess cash: Once professionals have taken the excess funds out of their business, they can move it to a separate holding company that could have themselves and their family members as shareholders. They and their family members can get paid with dividends as partial owners of the holding company.
- Split income with family members: This tax-planning technique allows business owners to shift their income to their spouse and children who work in their company and are paying tax at a lower rate.
While the government is offering a transitional period for the first taxation year, it's important for affected professionals to sit down with their accountants and financial advisers to plan ahead and consider their options.
The new rules in calculating WIP could be just the tip of the iceberg – with the ongoing review by the federal government on how businesses use private corporations to knock down taxes, more tax changes are ahead for professionals and small business owners.
Rick Umbrio is an investment adviser at IPC Securities Corp.