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Written by: Lyndon Braun, CPA, CA
As detailed in the March 21, 2017 Federal Budget, there has been a significant change to the way in which professional corporations are required to calculate their taxable income. This change will have a significant impact over the short term for many professional businesses and may significantly affect cash flows as taxes increase under the new rules.
The rule changes impact how the inventory or work in progress of a professional is taxed. As professional corporations generally charge either their clients or patients for their time, many of these corporations record the time spent on clients and patients as work in progress commonly referred to as “WIP”. This WIP is tracked as inventory until it is billed to the client and is usually recorded at the professional’s normal market charge out rates.
For taxation years beginning prior to March 21, 2017, incorporated professionals including accountants, lawyers, dentists, medical doctors, veterinarians, and chiropractors were entitled to deduct this WIP for income tax purposes. Previously these rules were in place due to the fact that these professionals carried their inventory on the books in a way that included some nominal profit that had not yet been billed or received.
This is easier understood in an example:
Accounting firm Debit & Credit LLP prepares a Personal Tax Return for $1,200 fee. The time or WIP incurred to prepare the return at their normal charge out rates is $1,200. The tax return is prepared at April 30, 2017 but not billed until July 1, 2017. D & C LLP has a June 30th corporate year-end. Assume embedded profit is 20%.
In this example, Debit & Credit LLP would record its time of $1,200 at year-end as inventory or WIP and this would include not only the actual wages/cost of performing the services but also an embedded profit component.
In this example the profit would be $240 and would be taxed even though it wasn’t billed at year-end. This would appear to be an unfair result.
As a result the old rules allowed a deduction of the WIP effectively removing the embedded profit (which had not been billed to a client yet) from taxation until the following year. The old rules also allowed the deduction of expenses/costs related to unbilled income to be deducted in the current year and the recognition of income in the subsequent year when billed. This provided significant advantages to professionals in deferring their taxes to a later taxation year.
Again, the previous tax rules took into account the common business and accounting practices that professionals utilized to record their inventory and tried to work within that framework. It recognized that they accounted for their inventory in a manner different from many businesses.
Unfortunately this recognition and streamlining of tax reporting has now been eliminated.
For taxation years commencing after March 21, 2017 the rules have been altered to remove the ability of professionals to deduct WIP at year-end for taxation purposes. The legislation has been removed that recognizes the special manner in which professionals record their inventory.
Instead, professionals will be required to (at least for taxation purposes) account for their inventory/WIP in a manner consistent with other businesses. That is, professionals will no longer be able to record their inventory at their standard charge out rates. Instead they will have to record their inventory/WIP at the lower of cost and net realizable value.
As a result, to take into account these changes professionals will need to evaluate what their “cost” of providing their services actually is. This can be a complicated and complex analysis to try to determine all the cost factors that go into their services.
Certainly wages and contract fees will be included along with some reasonable allocation of overhead costs. How about the time provided by the Partners of a professional firm? Arguably there is no cost of providing a service by a Partner as they are simply entitled to the net residual profits. Additionally what overhead expenses relate to providing these services? How much of the time incurred is actually billable or receivable?
This is a difficult analysis prior to the completion of a task or project. There are many items of subjectivity that add a significant layer of complexity to professionals that didn’t exist before.
There is some relief provided. Not much, but some.
The application of the transitional provisions to phase in these rules over two years can be outlined as follows:
Active Law Corporation has a December 31 taxation year and it earns $1,000,000 of net income during each of its 2017, 2018 and 2019 tax years. Historically, Active has included in its income the WIP at the end of the year, valued at FMV. The amount of WIP at the end of each of the 2016, 2017, 2018 and 2019 taxation years was $200,000, $230,000, $250,000 and $170,000 respectively.
As a result of the proposed new rules, the computation of taxable income will be as follows:
|Dec. 31, 2017||Dec. 31, 2018||Dec. 31, 2019|
|Accounting Income||$ 1,000,000||$ 1,000,000||$ 1,000,000|
|Prior year s.34(a) deduction||200,000||230,000||N/A|
|Current year s.34(a) deduction||(230,000)||N/A||N/A|
|Taxable income||$ 970,000||$ 1,105,000||$ 1,125,000|
Overall the changes to the taxation of professionals on first glance may seem to be straightforward, but the complexity and cost to professionals can be substantial.
Further, to ensure compliance with the new tax legislation, professional businesses will need to determine their specific reporting requirements and address their own internal reporting and accounting functions to determine the best way to not only comply with these new rules, but also efficiently gather the information necessary to do so.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.