In tax practice, bright-line rules provide clarity and certainty for clients. One example is the statute of limitation for tax assessment. Under Sec. 6501, the IRS generally has three years (with some notable exceptions) to assess any additional tax owed. While it is easy to see the express exceptions in Sec. 6501—such as when no return was filed or when a fraudulent return was filed—some exceptions are not so readily ascertainable. One such example is found in Bosamia, 661 F.3d 250 (5th Cir. 2011).
In Bosamia, the petitioners owned two S corporations, which were related parties under Sec. 267. Sec. 267(a)(2) provides that payments between related parties cannot be deducted until the payments from the payer corporation are included in the gross income of the payee. In Bosamia, the payer S corporation, an accrual-basis entity, purchased inventory from the other S corporation and then deducted annual increases in its accounts payable from gross income for these amounts. The payee S corporation, a cash-basis entity, did not include in income those owed payments until they were actually received.
The IRS issued notices of deficiency to the petitioners, noting that the payer S corporation was not entitled to the deductions until the payee included the amounts in income. When the IRS issued these deficiency notices, the three-year statute of limitation had expired on some of the years in issue. The IRS, however, argued that the deduction disallowance resulted in a change in accounting method under Sec. 481. Consequently, it made an upward adjustment to the payer S corporation's income in an open year. These S corporation adjustments created a corresponding deficiency at the shareholder level in an open year. The Tax Court upheld the Service's actions (see Bosamia, T.C. Memo. 2010-218).
On appeal, the Fifth Circuit, noting this was a matter of first impression, framed the issue as "whether the Commissioner of Internal Revenue effects a change in a taxpayer's method of accounting for the purposes of § 481 when he requires that taxpayer to postpone a deduction from gross income pursuant to § 267(a)(2)."
The Fifth Circuit explained that "Section 481 requires the Commissioner to adjust a taxpayer's taxable income to ensure accurate computation of income when that taxpayer changes its method of accounting from one year to the next." Quoting its prior opinion in Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 570 (5th Cir. 1965), the Fifth Circuit noted that under Sec. 481, "if income escapes taxation because of a change in accounting method, the Commissioner may make an adjustment by including the omitted income in the year of the change."
Interestingly, the court in Bosamia recognized that:
[a]lthough neither the language of § 267(a)(2) nor § 481 explicitly provides that a disallowance under § 267(a)(2) amounts to a change in a taxpayer's method of accounting, we still conclude that Congress plainly intended that a § 267(a)(2) disallowance effectuates a change in a taxpayer's method of accounting given the specific context in which the language in that subsection is used.
Under Regs. Sec. 1.446-1(e)(2)(ii)(a), a change in accounting method includes "a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan." Because the payer S corporation never changed its overall plan of accounting, only the latter part could be applicable, i.e., treatment of a material item.
The same regulation defines a material item as "any item that involves the proper time for the inclusion of the item in income or the taking of a deduction." The IRS argued that by disallowing the accounts payable deduction, it effectively changed the treatment of a material item. The Fifth Circuit agreed. It explained that:
by "matching" the time at which [the payer entity] could deduct its accounts payable owed to [the payee] with the time at which [the payee] could include those payments as income, the Commissioner's § 267(a)(2) disallowance effectively changed [the payer's] accounting method for its account payable deduction in the 2004 taxable year from an accrual basis to a cash basis.
Consequently, it added, the "Commissioner effected a change in [the payer's] treatment of a material item in 2004 by postponing the proper time for taking its account payable deduction." In effect, then, the payer entity was required to compute its income under a method of accounting different from the one it used to compute the preceding year's taxable income.
The shareholders argued, among other things, that the statute of limitation should bar the adjustment. In effect, the statute of limitation and Sec. 481 conflicted because nothing prevented the IRS from correcting the Sec. 267 issues while the years were still open. The Fifth Circuit disagreed; it noted that "although the Commissioner had the authority to correct [the payer's] improper deductions in an earlier tax year if he had discovered them, we nevertheless find that applying § 481 here does not conflict with the Code's statute of limitations."
The court relied on its decision in Graff Chevrolet Corp., in which it stated, "[w]hen a taxpayer uses an accounting method which reflects an expense before it is proper to do so . . . , he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income" (quoting Note, "Problems Arising From Changes in Tax Accounting Methods," 73 Harv. L. Rev. 1564, 1570 (1960)). Therefore, the court concluded that "applying § 481 to this case 'does not hold the taxpayer to any income which he has any reason to believe he has avoided, and does not frustrate the policy that men should be able, after a certain time, to be confident that past wrongs are set at rest' " (quoting 73 Harv. L. Rev. at 1576).
Bosamia demonstrates another potential end run around the statute of limitation. This case is especially important for advisers of passthrough entities, in which the individual owners report flowthrough income. Practitioners and advisers need to be aware of how direct changes of accounting methods—or more indirect approaches, such as the application of Sec. 267—can practically affect the limitation period. Although Bosamia is not about an express extension of the limitation period, its resolution resulted, effectively, in an extended limitation period by making closed-year issues relevant in an open year.
Valrie Chambers is an associate professor of accounting at Stetson University in Celebration, Fla. Timothy M. Todd is associate dean for academic affairs and associate professor of law at Liberty University School of Law in Lynchburg, Va. Mr. Todd is a member of the AICPA Tax Practice and Procedures Committee. For more information about this column, contact email@example.com.