The Fifth Circuit Court of Appeals upheld a Tax Court decision that a change in accounting method occurred when the IRS disallowed an accrual-basis taxpayer’s deduction for inventory purchased on account from a related-party cash-basis taxpayer. Therefore, the taxpayer was required to include amounts erroneously deducted in closed tax years as income from a Sec. 481 adjustment in the year of the disallowance because the treatment of a material item had changed.
In the year there is a change in a taxpayer’s method of accounting, Sec. 481(a) requires an adjustment of the taxpayer’s taxable income to prevent the duplication or omission of income. According to Regs. Sec. 1.481-1(a)(1), such a change can be a change in the taxpayer’s overall method of accounting or a change in the treatment of a material item, defined by Regs. Sec. 1.446-1(e)(2)(ii)(a) as any item that involves the proper timing of income or a deduction. Accrual-basis taxpayers cannot deduct normally accruable amounts resulting from transactions with cash-basis related parties until the year the related party includes the amount as income (Sec. 267(a)(2)).
Ramesh and Pragati Bosamia were the sole shareholders of two S corporations, India Music Inc., an accrual-basis taxpayer, and Houston-Rakhee Imports (HRI), a cash-basis taxpayer. During 1998–2004, India Music deducted its cost of goods sold of approximately $900,000 related to inventory purchased on account from HRI; however, since HRI had received no payments, HRI reported no income. The IRS disallowed the 2004 deduction under Sec. 267(a)(2), claimed the taxpayer’s method of accounting had changed and then included the 1998–2003 deductions in 2004 income as a Sec. 481(a) adjustment. The taxpayers petitioned the Tax Court for relief, arguing the disallowance was not a change in accounting method and that the statute of limitation barred any assessment for amounts deducted from 1998–2002. However, the court disagreed, holding that there had been a change in the treatment of a material item and that the Sec. 481(a) adjustment was proper. The taxpayers appealed the decision to the Fifth Circuit.
The appeals court held that the disallowance of the deduction of the inventory purchased was a change in India Music’s accounting method, since the timing of the deduction was altered, causing a change in the treatment of a material item in 2004. The taxpayers argued that the court’s disallowance was improper, since India Music might never be able to take the deduction if it went out of business before it paid for the inventory. The court stated any cash-basis taxpayer assumes that risk, and that is exactly why the disallowance of the deduction is a change from the accrual basis to the cash basis of accounting.
The taxpayers also argued that, since the IRS had issued no prior rulings linking Sec. 267(a)(2) and Sec. 481, the Service’s position in this case was a retroactive change from its prior position. The court rejected this argument, stating that, if the taxpayers had relied on this implied prior position, they knowingly violated Sec. 267(a)(2) but assumed they would be protected by the statute of limitation if they were able to avoid IRS scrutiny before the statute of limitation expired. The court also rejected the Bosamias’ argument that the Sec. 481(a) adjustment conflicts with the statute of limitation since the IRS could have disallowed the deductions during the open tax years. According to the court, a taxpayer using an accounting method to improperly deduct an item cannot assume that income has permanently escaped taxation.
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.
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