Disallowance of related party deductions created accounting method change
TAX ALERT |
To prevent duplications or omissions that may arise from the use of a new method of accounting, a change in method of accounting is generally implemented with a section 481(a) catch-up adjustment, which is computed as of the beginning of the year of change. In Bosamia v. Commissioner, 2011 U.S. App. LEXIS 21486 (5th Cir. 2011), aff'g T.C. Memo 2010-218, the Fifth Circuit affirmed the Tax Court's holding that IRS's disallowance of an accrual method S corporation's related party deductions under section 267(a)(2) constituted a change in method of accounting subject to section 481(a). Further, in calculating the resulting section 481(a) adjustment, the IRS was permitted to make an adjustment in the year of change to include adjustments from closed tax years.
Under the facts of the case, Ramash and Pragati Bosamia (a married couple, collectively the Taxpayers) were the sole shareholders of two S corporations, India Music, Inc. (India Music) and Houston-Rakhee Imports (HRI). India Music purchased its inventory on credit from HRI, thereby creating a related party account payable. India Music, an accrual method taxpayer, deducted the annual increases in accounts payable to HRI even though no cash was actually paid to HRI from 1998 through 2004. HRI, a cash method taxpayer, reported no income from sales to India Music for those same years.
India Music was precluded from taking the deduction for payments made to HRI until HRI actually received the payments under section 267(a)(2), which generally defers an accrual method taxpayer's deductions for expenses and interest owed to a related cash method taxpayer until payment is made and the amount involved is includible in the gross income of the cash method payee. Thus, in 2008, the IRS issued a notice of deficiency for the Taxpayers' 2004 tax year, which calculated interest and penalties on India Music's cost of goods sold deductions for 1998 through 2004. At the time that the 2004 notice of deficiency was issued, the statute of limitations for 1998 through 2002 had expired, and the IRS was barred from assessing income tax on those years under section 6501(a); however, the notice of deficiency included a section 481(a) adjustment, which adjusted the Taxpayers' income for the total of India Music's claimed cost of goods sold for 1998 through 2003.
The Tax Court rejected the Taxpayers' claim that a change to comply with section 267(a)(2) was not a change in method of accounting and that such change should not take into account the inventory or cost of goods sold adjustments from the Taxpayers' closed years. Under Reg. section 1.481-1(a)(1), a change in method of accounting to which section 481(a) applies includes a change in the overall method of accounting for gross income or deductions or a change in the treatment of a material item. Under Reg. section 1.446-1(e)(2)(ii)(a), a material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Further, in Summit Sheet Metal Co. v. Commissioner, T.C. Memo 1996-563, the Tax Court held that a change made to comply with section 267(a)(2) affected the timing of a deduction, and, thus, was a change in the treatment of a material item. By deferring India Music's deductions until HRI actually received payment and recognized such income, the IRS effectively changed India Music's accounting method for its accounts payable from the accrual method to the cash method (i.e., the IRS changed India Music's treatment of a material item in 2004 by postponing the proper time for taking its account payable deduction).
In relying on Reg. sections 1.481-1(a)(1), 1.446-1(e)(2)(ii)(a), and Summit Sheet Metal, the Fifth Circuit reasoned that India Music changed its method of accounting when it was required to postpone the realization of its cost of goods sold. Since such a change was a change in the treatment of a material item, section 481(a) applied to the change made to comply with section 267(a)(2). Further, in upholding the IRS's assertion that section 481(a) did not conflict with the statute of limitations, the Court cited Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1968), in noting that the "statute of limitations is directed towards stale claims," while "section 481 deals with claims which do not even arise until the year of the accounting change."
In reviewing related party transactions, taxpayers should be cognizant of the requirements under section 267(a)(2) that generally require the matching of the deduction claimed by an accrual method taxpayer with the income recognized by a related cash method taxpayer. As exemplified in Bosamia, a change in accounting method to comply with section 267(a)(2) is subject to section 481, and, therefore, such change will encompass all years for which section 267(a)(2) applies, even if the statute of limitations has closed. A change in method of accounting to comply with section 267(a)(2) is generally eligible for automatic consent under App. section 12.01 of Rev. Proc. 2011-14 (automatic change number 26).