Hew Tittensor says new taxation regulations can bring many benefits to small partnerships and sole practitioners.
New tax regulations which will affect partnerships and sole practitioners may mean a substantial one-off tax bill.
But these regulations also provide the opportunity to improve financial systems, particularly for smaller practices. As a result, practices can become more profitable and, by strengthening their balance sheet, can create the greater financial flexibility needed for future growth.
Many solicitors have traditionally prepared accounts on a cash basis – what has actually been received and paid during the tax year. They have therefore excluded debts arising from the practice, work in progress and some liabilities.
But under the new “accruals” system, practices must include all income and expenditure for a given period, even though some items may not have been received or paid. By using this profit reporting method, a more accurate picture of underlying profitability is obtained because peaks and troughs in reported profits (often caused by the timing of fee receipts) are smoothed out. This also affords a more equitable position on the admission or retirement of a partner.
The new rules will take effect at the beginning of the next tax year. So if your year end is 30 April, the new regulations will begin to affect your practice on 30 April 1999.
From that date, the difference between the value of the practice's assets and liabilities under the accruals basis and the value of assets and liabilities under the old cash basis will be taxable. The tax payment can, in most circumstances, be spread over the following 10 years. Accounts for future years should then be prepared on the accruals basis.
So how will the new system affect lawyers and what are the possible benefits?
One of the first areas for attention is an analysis of work in progress. This is important because it represents part of the earnings for the given period. However, for tax purposes, work in progress should be valued at cost or net realisable value, whichever is lowest. The charge-out rate should not be used. Work in progress is calculated for employees only, because partner time counts towards business profits (it is not a cost) and so should be excluded here.
But what will happen to the smaller practice without a time-recording system? It is unlikely that the Inland Revenue will accept that work in progress represents, for example, three months' billings. Instead it will probably require detailed analysis.
The issue is not what the Inland Revenue wants, but the benefits a practice management system can bring. Such systems identify and analyse one of the main constituents of what is being sold – time.
While considering staff work in progress, it is also worth looking at partner work in progress because this can also provide a chance to unlock practice capital.
The introduction of a comprehensive time-recording system is a prerequisite for good management. Departmental and individual targets can be set and an analysis made of fee earners' time and efficiency.
Since the new regulations also require outstanding debts to be calculated, a second area for attention is debt control. A good debtors' control system helps to ensure fees are collected promptly – something which improves profitability.
Banks have for years been guarded about lending to the legal profession, not only because lawyers have been through lean years, but also because banks have often been unable to judge a practice's true net worth when looking at its balance sheet. The inclusion of debtors and work in progress on the balance sheet gives a more accurate picture of net worth and should make it easier to raise finance.
Another result of including work in progress and debtors on the balance sheet is that each partner's capital account will increase (probably net of the tax charge).
Many smaller practices have operated with each partner running just one capital account for both capital introduced and undrawn profits. This often leads to a situation where imbalances between partners' capital accounts cloud the overall picture of practice finance. But the new rules should provide the impetus to consider a fairer capital and drawings policy between partners, by forcing them to run separate capital accounts (representing long-term capital) and current accounts (representing undrawn profits).
While it is tempting to focus on how the immediate tax bill can be minimised, opportunities for long-term benefits should not be overlooked. By revising management systems and partnership agreements, it should be possible to boost long-term profitability.
How to use the new tax rules to your advantage
Introduce a comprehensive time recording system for staff and partners; set individual and departmental targets; and analyse efficiency, profitability and capital tied up in work in progress.
Enforce a strict debtors control system to speed up the collection of fees.
Reconsider partnership agreements, especially partners policies on drawings, capital and current accounts.
By following the new “accruals” system, the practice's balance sheet will give a truer picture of the financial situation, making it easier to negotiate better finance deals.