Law firms are quite unique, as compared to most other businesses; they normally choose to operate on a cash basis. Income isn’t earned, from a tax point of view, until that cash actually comes in the door.  In addition, expenses can’t be deducted until they are actually paid. Cash-in, cash-out that’s how law firms work. Even though smart firms might keep unbilled, accounts receivables and accounts payable on their balance sheet (accrual accounting) it really doesn’t factor into revenue or taxable income. One benefit of cash accounting is that income tax is deferred on accounts receivable, which may or may not be collectible. Law firms on a cash basis can do much more yearend maneuvering to manage the tax consequences of either the corporation or partnership.

 In a Slow Year – Ways to Increase Income

  • Of course, the best way to increase income is by billing more hours through November and collecting it all by December 31st. By this time of the year it’s a little late to expect work to be billed and collected.
  • Stop paying expenses probably has single biggest impact on income. Contact your vendors first so that they understand that November and December bills will be paid by mid-January.
  • Contact clients with large receivables, especially those that are old and risky and negotiate discounts for payment in December. Surprisingly, some companies have “use it or lose it” budgets and they just may want to get this liability off their books. Keep in mind that they operate on an accrual basis; it’s good to reduce liabilities for them.
  • Contact clients with large projects and see if you can get more upfront retainers, (not IOLTA payments). This additional cash will probably be calculated into taxable income.

 In a Good Year – Ways to Keep Taxes Down

  • Just the reverse of a slow year, one excellent way to keep taxes down is to pay forward 2012 expenses in December 2011. This doesn’t mean going on a buying spree. Many vendors would gladly bill2012 services and accept payment in early January. (Checks dated December 31st this year will reach them in early January).
  • One hidden expense that is sizeable in some firms is credit cards, go online and pay off all balances.
  • Make purchases in 2011 instead of 2012 for hardware and software that can be put into service pretty quickly. Only buy the items you were going to purchase in the upcoming year.
  • Contact some large clients and tell them you’ll delay November and December billings and instead bill them in early January for immediate payment. This might benefit the client since they are accrual basis, and if they receive a bill in 2011, it impacts their financials.  

 Beware of Pitfalls

  • Beware of the false sense of security that cash accounting provides. Many of the above suggestions have short term benefits with a potential longer term negative impact.
  • Drawing down the line of credit in a slow year-end, for any reason, is risky.

 Best Practice

Manage the firm day to day on an accrual basis. Accrual reporting provides cleaner snapshot of the health of the firm. Sure, you’ll compensate partners and pay taxes on a cash basis, but accrual will allow you to sleep at night knowing what tomorrow will look like.