Some NH businesses could feel the financial pinch of proposed changes to federal tax law, as well as a recently enacted Massachusetts tax change. The federal proposal could change the accounting practices used by some companies, while the change in Massachusetts law could mean more NH businesses having to pay taxes in that state.
Restricting Accounting Methods
David Camp (R-MI), the House Committee on Ways and Means chairman, earlier this year released a draft of his proposed Tax Reform Act of 2014. Included is a provision restricting certain businesses from using the cash method of accounting. Should this proposal be enacted into law in its present form, affected businesses’ tax and accounting compliance costs could increase, and they may have to pay tax on income that has not yet been received and may never be received.
The cash method of accounting generally provides that a business recognizes income when cash is received and expenses when actually paid. Businesses unable to use the cash method must use the accrual method, which generally provides for income recognition when the income is earned (and not necessarily when the cash is received) and expense recognition generally when the expenses are incurred (and not necessarily when they are paid). It is quite possible under the accrual method to recognize income in a different year than when cash receipts are received.
Who Could be Affected?
Under Camp’s proposal, businesses (other than farms and sole proprietorships) with average annual gross receipts of more than $10 million would be prohibited from using the cash method and would be required to use the accrual method. This change could particularly affect pass-through entities.
Many closely-held businesses are formed as pass-through entities: S corporations, limited liability companies and partnerships. A pass-through entity generally does not itself pay any income taxes. Rather its owners are allocated the business income, and the owners pay taxes on the
net income.
The proposed accounting change could have a profound effect on the income an owner of a pass-through entity must recognize and his or her ability to pay taxes. Under complicated accounting rules, the change could require a pass-through entity to immediately accelerate recognition of income, causing the business owner to recognize more taxable income on his or her individual tax returns without a corresponding increase in cash flow to pay the taxes.
There is some relief built into the proposed change. The Camp proposal would allow affected companies to spread out this one-time acceleration of income gradually over four years. However, those businesses would also have to carefully monitor cash flow and income accrual each year to assure they have sufficient cash to pay any tax liabilities since income may not correspond with cash receipts.
Professional services providers, such as accountants, law firms and consultants may be hit hardest by the proposed changes as they generally perform work in advance of receiving any payment. Under an accrual method of accounting, the income would have to be recognized once the work is completed and the business has the right to receive the income, even if it takes a couple of months for a client to pay the bill, or the payment is received in a subsequent tax year. Businesses that use the cash method of accounting should keep an eye on this proposal and confer with their tax and accounting professionals to determine how to proceed should this or a similar proposal ever be enacted into law.
Mass. Tax Comes to NH
Closer to home, Massachusetts recently enacted a change in the method by which it sources business income that is subject to Massachusetts income tax. New Hampshire businesses are generally only subject to Massachusetts income tax if they receive income sourced from the Bay State.
Prior to Jan. 1, 2014, Massachusetts determined the source of income for professional services based on where the income-producing activity occurred. If the services occurred in Massachusetts, or a greater portion of the services occurred in Massachusetts than in any other state, the Bay State generally treated the income as coming from Massachusetts. For instance, if a NH consulting company had a Massachusetts client, but the majority of the work was performed in NH, then under the prior rules, the income was not sourced to Massachusetts and not subject to that state’s business income tax, even if some of the work was performed in Massachusetts.
Effective Jan. 1, 2014 though, Mass-achusetts switched to a market-based approach to sourcing sales other than sales of tangible personal property. Under this method, income for professional services will generally be considered sourced to Massachusetts if the services are delivered to a location in Massachusetts. The Bay State will no longer look to where services are actually performed. So if a NH consultant provides services to a Massachusetts company, even if most of the work is done in NH, they will be subject to Massachusetts business income tax.
The working draft of the regulations, available at press time, states when services are provided to individuals, the sale is generally assigned to the individual’s primary residence. When services are provided to a business, the sale is generally assigned first to where the contract of sale is principally managed by the customer, then to where the customer placed the order, and finally, if the location cannot be determined by the prior two standards, based on the customer’s billing address.
Companies providing professional services to clients in Massachusetts may end up paying more income taxes to Massachusetts as a result of this change.
Russell J. Stein is an attorney with the law firm of Sheehan Phinney Bass + Green PA, which has offices in Manchester. He can be reached at 617-897-5638 or rstein@sheehan.com. For more information, visit www.sheehan.com.