Pushing Accounting Methods Too Far

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:

             (a) In general

(1) Deduction for losses disallowed

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.

Senator Baucus Revs Up Tax Reform Discussion

Today (November 21, 2013) Senator Baucus released the third in a series of staff discussions on tax reform. This discussion focuses on depreciation (also called “cost recovery”) and tax accounting methods.

Not the most exciting topics, and I will not miss Thursday Night Football reading up on them. Let’s review them quickly.

The Senator leads off with:

America today is using a bloated tax code that was built for businesses close to 30 years ago. The code is completely outdated and acting as a brake on economic growth.  More must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

I cannot disagree with him, but I am not optimistic about politicians – today, tomorrow – keeping their hands off any tax reform. Remember that Chief Justice Roberts deemed ObamaCare to be a “tax” – even though the White House itself did not present brief or argue it to be a tax. With that level of verbal schizophrenia, I would wager that any “reform” would last about as long as when the first politician needs to get reelected.

Baucus is proposing the following depreciation changes:

(1) Reduce the number of depreciation classes to four: three for short- to mid-term property and one for longer-lived assets. There would be only one permitted depreciation method.

a.     By longer-lived, think real estate, which Baucus proposes to depreciate over 43 years.

COMMENT: There goes the never-worked-in-the-real-world-crowd again. I have thirty years in this business, and I have never seen a proposed real estate investment analyzed over a 43-year recovery. Doesn’t happen, folks.

(2) Slow depreciation from double-declining balance to declining balance. Real estate would remain straight-line.

(3)  Allow expanded general asset accounting. This means that asset categories are pooled, and depreciation is calculated by…

a.     Starting with last year’s asset pool balance

b.     Increased by additions and improvements

c.      Decreased by proceeds from asset sales and dispositions

d.     And multiplying the result by a depreciation factor

(4)  Repeal like-kind exchanges.

COMMENT: Yipes.

(5) Repeal depreciation recapture for pooled assets.

COMMENT: Yay!

Treat all gain from disposition of pooled assets as ordinary income.

          COMMENT: Nay!

(6)  The maximum cost of mixed- use vehicles is capped at $45,000.

a.     That means that – if a car is used for both business and personal use – the maximum cost that can be depreciated is $45,000. That amount in turn is depreciated over 5 years.

b.     I am not overly surprised. There is still a lot of abuse – truly – in this area.

Then there are some tax accounting changes:

(7) Repeal expensing for research and development expenses. The default treatment will be to capitalize and depreciate over 5 years.

COMMENT: This cannot make business sense. You want to explain this proposal change to Apple, Samsung, Pfizer, or any number of research-intensive companies?

(8) Disallow the deduction for advertising. In its place, you would deduct one-half immediately and then amortize the balance over 5 years.

COMMENT:  This makes no sense to an accountant. I associate depreciation and amortization with assets that have use or value over more than one year. Advertising doesn’t make that cut. Does anyone talk about the commercials from last year’s Super Bowl, for example?

(9) Treat “qualified extraction expenditures” the same way as research and development.

COMMENT: Think fracking. The United States is increasingly moving to energy independence (Bakken Shale, for example), even under a hostile Administration. Do you think this change is going to help or hurt that effort?

(10)  Repeal percentage depletion.

COMMENT: Same comment as (9).

(11)  Make permanent Section 179 expensing.

a.     The maximum expensing would be set at $1,000,000, with the phase-out beginning at $2,000,000.

COMMENT: Frankly, it’s about time.

(12)  The Section 197 amortization period is increased from 15 to 20 years.

(13)  All business with less than $10 million in annual gross receipts can use the cash basis of accounting and not account for inventory.

          COMMENT: Wait for it...

(14)  If you are not described in (13) then you are on the accrual basis of accounting.

COMMENT: When the government talks about accrual basis, they means that they want you to pay taxes on your receivables before you actually collect them.

(15)  Businesses described in (13) do not have to suffer through the Section 263A uniform capitalization calculations.

        COMMENT: Good. 

(16)  LIFO is repealed.  

COMMENT: I do not particularly care for LIFO, but I acknowledge that major industries use it extensively, and it is considered GAAP when auditors render their auditors’ report. The government is not chasing this down because they had brilliant debates while in accounting theory class. They want the jack.

(17) The completed contract method of accounting (think contractors) is repealed, except for small construction contracts.

Overall, Baucus is trying to reduce corporate tax rates. At 35%, the United States has the dubious distinction of having the highest corporate tax rate in the world. There are consequences to having the highest rate, such as having less business.  To reduce rates, he has to raise money somewhere, and we see some of those sources above.

And remember folks: these are only proposals.