                  T.C. Memo. 2010-218


                UNITED STATES TAX COURT



     RAMESH J. AND PRAGATI BOSAMIA, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 27960-08.             Filed October 7, 2010.



     Ps’ S corporation (S1) purchased inventory from Ps’
other S corporation (S2) on credit. S1, using the accrual
method of tax accounting, reduced its sales by cost of
purchased goods in the year of purchase, whereas S2, using
the cash method of accounting, would not report income from
the sales to S1 until the year that S2 was paid. For 2004 R
determined that S1 is not entitled to reduce its sales by
the cost of purchases from S2 until S2 reports the
corresponding income. R also made a sec. 481, I.R.C.,
adjustment to Ps’ income to account for the deductions taken
in years prior to 2004 even though the period for assessment
had expired in some of the years. For all of the years
under consideration, S1 did not pay S2 and no sales income
was reported by S2 although S1 reduced its income in each
year by the amount of the purchases from S2.

     Held: Sec. 481, I.R.C., applies and adjustments can be
made for closed prior years as part of R’s 2004
determination.
                                  -2-


       L. Don Knight, for petitioners.

       Sara W. Dalton, for respondent.



                          MEMORANDUM OPINION


       NIMS, Judge:   Respondent determined a $295,818 deficiency in

petitioners’ 2004 Federal income tax and a $59,163.60 accuracy-

related penalty under section 6662(a).     In this fully stipulated

case, the issue framed by the parties is whether respondent may

use section 481 to make an adjustment to petitioners’ income for

2004 that arises from closed years.

       Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                              Background

       This case was submitted fully stipulated pursuant to Rule

122.    The stipulations of the parties, with accompanying

exhibits, are incorporated herein by this reference.    Petitioners

resided in Texas when they filed their petition.

       Petitioners were the sole shareholders of India Music, Inc.

(India Music), and Houston-Rakhee Imports (HRI).    India Music and

HRI were both S corporations.
                                -3-

     India Music purchased most of its inventory from HRI on

credit, creating an account payable to HRI.   India Music used the

accrual method of accounting and therefore annually subtracted

from its gross receipts the yearly increase in the account

payable to HRI even though no payments were made in 7 years.

India Music accordingly claimed cost of goods sold of $353,339,

$11,062, $147,138, $79,336, $69,478, $217,226, and $23,351 for

the years 1998, 1999, 2000, 2001, 2002, 2003, and 2004,

respectively.   HRI, using the cash method of accounting, reported

no income from its sales to India Music for the years 1998

through 2004.

     On August 14, 2008, respondent issued petitioners, for their

tax year 2004, a notice of deficiency in which it was determined

that India Music was not entitled to claim cost of goods sold for

1998 through 2004 until such time as the sales were included in

HRI’s income.   When the 2004 notice of deficiency was issued,

respondent was barred from assessing income tax deficiencies for

petitioners’ 1998 through 2002 tax years (closed years) because

of the expiration of the 3-year period for assessment under

section 6501(a).   Respondent, however, made a section 481

adjustment of $877,581 to petitioners’ 2004 income, reflecting

the total of India Music’s claimed cost of goods sold for 1998
                                  -4-

through 2003.1    Respondent thus determined for petitioners’ 2004

tax year a $295,818 deficiency and a $59,163.60 accuracy-related

penalty under section 6662(a).

                              Discussion

     The parties submitted the case fully stipulated and have

framed the issue very narrowly.    They agree that India Music may

not reduce income in the amounts of the purchases from HRI until

the sales representing those purchases have been included in

HRI’s income.    They disagree only as to whether respondent may

make a section 481 adjustment which takes into account the

inventory or cost of goods sold adjustments from petitioners’

closed years.    We confine our opinion to that issue.

     If we hold that respondent may make an adjustment for

petitioners’ 2004 tax year based on cost of goods sold

adjustments for closed years, then petitioners concede that they

are liable for the full amount of the deficiency and penalty.

     Section 481(a) permits adjustments to prevent omissions or

duplications when a taxpayer changes a method of accounting.    The

adjustment may include amounts attributable to taxable years for

which assessment is barred by the expiration of the period for

assessment.     Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572

(5th Cir. 1965); Hamilton Indus., Inc. v. Commissioner, 97 T.C.



     1
      India Music’s purchases from HRI for 1998 through 2003
actually total $877,579. The record does not explain the $2
discrepancy.
                                 -5-

120, 125 (1991).   Respondent contends that a change in accounting

method occurred when India Music was required to postpone the

realization of its cost of goods sold.

     We agree.   “A change in method of accounting to which

section 481 applies includes a change in the overall method of

accounting for gross income or deductions, or a change in the

treatment of a material item.”   Sec. 1.481-1(a)(1), Income Tax

Regs.   “A material item is any item that involves the proper time

for the inclusion of the item in income or the taking of a

deduction.”   Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.     We have

previously indicated that a change made to comply with section

267(a)(2) is a change in the treatment of a material item.     See

Summit Sheet Metal Co. v. Commissioner, T.C. Memo. 1996-563.      In

Summit Sheet Metal, the taxpayer sought to change the year it

deducted bonuses to its officers from the year the bonuses were

authorized to the year of payment.     The taxpayer argued that this

change was merely a correction required to comply with section

267(a)(2) rather than a change of accounting method.    We held

that the change affected the timing of a deduction and that it

was a change in the treatment of a material item.

     Petitioners contend that an accounting change made in order

to comply with section 267(a)(2) is not a change in the treatment
                                -6-

of a material item because section 267 may in some cases affect

more than just the timing of a deduction.   Petitioners express

their contention as follows:

          More specifically, although Section 267 typically
     results in a timing difference, it can also permanently
     disallow a deduction between “related parties” as that term
     is used in Section 267(b). For example, if India Music were
     to go out of business and fail to pay HRI for the accrued
     expenses owing to HRI, India Music would never be permitted
     to deduct the corresponding expense item. This disallowance
     would arise solely by virtue of Section 267. In the absence
     of Section 267, however, India Music would be allowed the
     deduction in the current year irrespective of events
     occurring in later years.

     Petitioners’ contention, however, is incorrect.   In

analyzing the hypothetical situation petitioners propose, it

becomes apparent that their analysis is faulty because the

section 267 adjustment simply causes a delay or timing

difference.   The parties agree that section 267 requires the

postponement of India Music’s deductions.   India Music’s failure

to pay HRI is the proximate cause of the “disallowance” or

inability to claim the “deductions”.   Uniquely, petitioners

control both the purchaser and the seller and have exercised

their discretion to delay payment, causing the deferral of India

Music’s “deductions”.   Petitioners’ hypothetical is incomplete

and does not support their position.

     Petitioners also argue that section 267 preempts section 481

and prevents a section 481 adjustment arising from closed years.

In support, petitioners cite Tate & Lyle, Inc. & Subs. v.
                                 -7-

Commissioner, 87 F.3d 99 (3d Cir. 1996), revg. and remanding 103

T.C. 656 (1994).   Petitioners’ reliance on that case is

misplaced.    In Tate & Lyle, the Court of Appeals for the Third

Circuit considered the issues of whether section 1.267(a)-3,

Income Tax Regs., was valid and whether retroactive application

of that regulation violates the Due Process Clause of the Fifth

Amendment.    The opinion of the Court of Appeals does not refer to

or consider section 481.   The holding in Tate & Lyle does not

provide a basis for petitioners’ argument that a section 481

adjustment based upon adjustments from a closed year is

prohibited.

     Accordingly, we hold that section 481 applies and that

petitioners are therefore liable for the deficiency and section

6662(a) accuracy-related penalty.

     To reflect the foregoing,


                                            Decision will be entered

                                       for respondent.
