Academic journal article Journal of Accountancy

Disallowed Deduction Equals Change in Accounting Method

Academic journal article Journal of Accountancy

Disallowed Deduction Equals Change in Accounting Method

Article excerpt

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. …

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