Way back
when, when I was attending a one-room tax schoolhouse, some of the earliest tax
principles we learned was that of accounting methods and accounting periods. An
accounting method is the repetitious recording of the same underlying
transaction – recording straight-line depreciation on equipment purchases, for
example. An accounting period is a repetitious year-end. For example, almost
all individual taxpayers in the U.S. use a December 31 year-end, so we say they
use a calendar accounting period.
Introduce
related companies, mix and match accounting methods and periods and magical things
can happen. Accountants have played this
game since the establishment of the tax Code, and the IRS has been pretty good
at catching most of the shenanigans.
Let’s talk
about one.
Two brothers
own two companies, India Music (IM) and Houston-Rakhee Imports (HRI). Mind you,
one company does not own the other. Rather the same two people own two separate
companies. We call this type of relationship as a brother-sister (as opposed to
a parent-subsidiary, where one company owns another). IM sold sheet music. It
used the accrual method of accounting, which meant it recorded revenues when a
sale occurred, even if there was a delay in receiving payment. It bought its
sheet music from its brother-sister HRI. Under accrual accounting, it recorded
a cost of sale for the sheet music to HRI, whether it had paid HRI or not.
Let’s flip
the coin and look at HRI. It used the cash basis of accounting, which meant it
recorded sales only when it received cash, and it recorded cost of sales only
when it paid cash. It is the opposite accounting from IM.
Both
companies are S corporations, which means that their taxable income lands on
the personal tax return of their (two) owners. The owners then commingle the
business income with their other personal income and pay income taxes on the sum.
From 1998 to
2003 IM accrued a payable to HRI of over $870,000. This meant that its owners
got to reduce their passthrough business income by the same $870,000.
But….
Remember
that the other side to this is HRI, which would in turn have received $870,000 in income. That of course would completely offset the deduction to IM.
There would be no tax “bang” there.
What to do,
what to do?
Eureka! The
two brothers decided NOT to pay HRI. That way HRI did not receive cash, which
meant it did not have income. Brilliant!
The IRS
thought of this accounting trick back when the tax Code was in preschool. Here
is code Section 267:
No deduction shall be allowed in respect of any loss from
the sale or exchange of property, directly or indirectly, between persons
specified in any of the paragraphs of subsection (b). The preceding sentence
shall not apply to any loss of the distributing corporation (or the distributee)
in the case of a distribution in complete liquidation.
(2) Matching of deduction and payee income item in the
case of expenses and interest
If—
(A) by reason of the method of accounting of the person to
whom the payment is to be made, the amount thereof is not (unless paid)
includible in the gross income of such person, and
(B) at the close of the taxable year of the taxpayer for
which (but for this paragraph) the amount would be deductible under this
chapter, both the taxpayer and the person to whom the payment is to be made are
persons specified in any of the paragraphs of subsection (b), then any deduction allowable under this
chapter in respect of such amount shall be allowable as of the day as of which
such amount is includible in the gross income of the person to whom the payment
is made (or, if later, as of the day on which it would be so allowable but for
this paragraph). For purposes of this paragraph, in the case of a personal
service corporation (within the meaning of section 441 (i)(2)),
such corporation and any employee-owner (within the meaning of section 269A (b)(2),
as modified by section 441 (i)(2))
shall be treated as persons specified in subsection (b).
What the
Code does is delay the deduction until the related party recognizes the income.
It is an elegant solution from a simpler time.
Our two
brothers were audited for 2004, and the IRS immediately brought Section 267 to
their attention. The IRS disallowed that $870,000 deduction to IM, and it
now wanted $295 thousand in taxes and $59 thousand in penalties.
The brothers
said “No way.” Some of those tax years were closed under the statute of
limitations. “You cannot come back against us after three years,” they said.
What do you
think? Do the brothers have a winning argument?
Let me add
one more thing. To a tax practitioner, there are a couple of ways to
increase income in a tax audit:
(1) An adjustment
This is a one-off. You deducted your vacation and should not
have. The IRS adds it back to income. There is no concurrent issue of
repetition: that is, no issue of an accounting method.
(2) An accounting method change
There is something repetitious going on, and the IRS wants to
change your accounting method for all of it.
The deadly
thing about an accounting method change is that the IRS can force all of it on
you in that audit year. In our case, the IRS forced IM to give back all of its
$870,000 for 2004. It did not matter that the $870,000 had accreted
pell mell since 1998.
With that
sidebar, do you now think the brothers have a winning argument?
You can
pretty much guess that the brothers were arguing that the IRS adjustment was a
category (1): a one-off. The IRS of course argued that it was category (2): an
accounting method change.
The case
went to the Tax Court and then to the Fifth Circuit. The brothers were
determined. They were also wrong. The brothers advanced some unconvincing
technical arguments that the Court had little difficulty dismissing . The Court
decided this was in fact an accounting method change. The IRS could make the
catch-up adjustment. The brother owed big dollars in tax, as well as penalties.
The case was
Bosamia v Commissioner, by the way.
My thoughts?
The brothers
never had a chance . Almost any tax
practitioner could have predicted this outcome, especially since Section 267
has a long history and is relatively well known. This is not an obscure Code
section.
The question
I have is how the brothers found a tax practitioner who would sign off on the tax
returns. The IRS can bring a CPA up on charges (within the IRS, mind you, not
in court) for unprofessional conduct. The IRS could then suspend – or bar –
that CPA from practice before the IRS. To a tax CPA – such as me – that is
tantamount to a career death sentence. I would never have signed those tax
returns. It would have been out of the question.
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