Just a few months ago, the 2017 Federal Budget was released. While the overall budget was nonthreatening, there were some hard hits for professionals, such as accountants, doctors, and lawyers, regarding income recognition of work in progress (WIP) in taxable income.
Currently, under Section 34 of the Income Tax Act, professionals including accountants, dentists, lawyers, medical doctors, veterinarians or chiropractors, have the option to exclude the value of WIP from their taxable income. This means that the recognition of income, for tax purposes, will occur in the year in which the services are billed.
Under the 2017 budget, the ability to deduct WIP will no longer be possible, meaning that professionals will now have to include WIP in the calculation of taxable income, even if the services have not been billed. The amount included in income will be the lesser of cost and fair market value (FMV).
This legislative change will result in accelerated tax revenues for the government. The justification behind the change is that expenses for the WIP are claimed in the current year, however, as all business owners know, most of these expenses are paid in the same year they are incurred. WIP is not.
This has two major disadvantages.
First, companies who have up to this point decided not to record their WIP because it would be offset using the section 34 deductions, must change their reporting systems.
Second, it will create substantial cash flow problems.
To demonstrate, suppose that as a professional you have done $7,000 of WIP for a client, come year end. In the first few months of the new year, you do an additional $2,500 worth of work and then bill the client in February 2018. Now assume that the client does not pay for two months, until May 2018.
Under current legislation, you would include the $9,500 ($7,000 + $2,500) income in your 2018 tax return. Meaning that you will have been paid prior to owing taxes on this income.
Under the new rules, you will have to include the $7,000 WIP on your 2017 income tax return and pay the appropriate taxes. However, you will receive no income from your client until May 2018, thus creating a cash flow problem. A problem that is amplified for professionals who complete work over several months or even years. The remaining $2,500 would be claimed on your 2018 return.
The budget does propose some relief during the implementation, requiring professionals to include only 50% of WIP in income during the first year. After this, 100% WIP will have to be included in income.
No specific changes were proposed regarding small business owners, however, the above tax changes have emphasized some unfair tax advantages that the government will be looking into. This raises concerns for small businesses as potential changes could affect their current tax planning strategies, as well.
If you would like more information on this important tax change, the elimination of the Section 34 WIP deduction, or would like to work out an effective tax planning strategy for you and your estate, please contact us today!