Ramesh J. Bosamia, et ux. v. Commissioner, TC Memo 2010-218
This was originally published on PAOO on November 1st, 2010.
The tax law tolerates some significant asymmetrical results. For example if you make a charitable contribution of appreciated property, you get to deduct the fair market value of the property without recognizing income from the appreciation (If your basis is greater than the fair market value it would be smarter to sell the property and give the cash.) Deductions for depletion computed on the percentage method can exceed the basis of the depletable property. That's why having a gold mine is like having a gold mine.
Nonetheless, there are many situations where you ignore the big balance sheet in the sky at your peril. What Ramesh and Pragati Bosamia did was actually on the egregious side. They owned two S corporations - India Music (IM) and Houston-Rakhee Imports (HRI). IM sold sheet music to the public. It purchased the sheet music from HRI. IM was on the accrual basis of accounting. From 1998 to 2003 it recorded over $800,000 in cost of sales for sheet music that it purchased from HRI.
HRI did not do a very good job of collecting its receivables. During the six year period it collected exactly nothing from IM. It should come as no surprise that HRI was on the cash basis of accounting. The IRS finally caught up with this when they audited 2004. They disallowed any cost of sales for 2004 under Section 267 which limits accruals to related parties who are not themselves on the accrual basis.
The statute of limitations was closed on years prior to 2004. So the service took the position that the accruals had constituted an impermissible accounting method. This required a cumulative adjustment for all the accruals hitting the couple with just shy of $300,000 in tax and $60,000 in penalties for the 2004 year.
The Tax Court upheld the IRS determination.