IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 10-60921

RAMESH J. BOSAMIA; PRAGATI BOSAMIA

Petitioners-Appellants

v.

COMMISSIONER OF INTERNAL REVENUE

Respondent-Appellee

Appeal from the Decision

of the United States Tax Court

Before REAVLEY, GARZA, and GRAVES, Circuit Judges.

EMILIO M. GARZA, Circuit Judge:

This case presents a question of first impression under the Internal

Revenue Code, 26 U.S.C. § 1 et seq. (“the Code”): whether the Commissioner of 1

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). Because we conclude that a § 267(a)(2)

disallowance constitutes a change in a taxpayer’s method of accounting under

§ 481, we AFFIRM the judgment of the Tax Court.

United States Court of Appeals

Fifth Circuit

F I L E D

October 24, 2011

Lyle W. Cayce

Clerk

 All statutory references herein are to the Code unless otherwise indicated.

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I

Petitioners-Appellants, Ramesh and Pragati Bosamia, are the sole

shareholders of two Subchapter S corporations, India Music and HRI, engaged

in the business of importing and selling music, making those entities related

parties under § 267. Because the two entities are related parties under the

Code, subsection 267(a)(2) bars the entities from deducting payments owed to

the other party from income until the related party includes the payments in its

income. Summit Sheet Metal Co. v. Comm’r, T.C. Memo 1996-563, 72 T.C.M.

(CCH) 1606, 1996 WL 740748, at *11 (1996). Nonetheless, from 1998 to 2004,

India Music purchased most of its inventory from HRI on account, yet India

Music and HRI accounted for those payments using different methods of

accounting. India Music was an accrual-basis taxpayer, deducting the yearly

increase in the accounts payable from its gross income as costs of goods sold

when its liability became fixed. Burks v. United States, 633 F.3d 347, 358 (5th

Cir. 2011) (“Under the Code, gross income of a trade or business is usually

calculated by subtracting the cost of goods sold from the gross receipts of the

sale.”) (citing 26 U.S.C. § 61(a)). Meanwhile, HRI was a cash-based taxpayer,

opting not to include the payments owed to it by India Music in income until it

actually received those payments.

From 1998 to 2003, India Music claimed accounts payable deductions for

payments owed to HRI totaling $877,579, even though it never made a payment

to HRI and HRI did not include the payments in its income. Because India

Music is a Subchapter S corporation, all of its income passes through to its

shareholders for tax purposes. Nail v. Martinez, 391 F.3d 678, 683 (5th Cir.

2004). Accordingly, the Commissioner issued the Bosamias a notice of deficiency

in August 2008, informing them that India Music was not entitled to claim

deductions for the payments to HRI from 1998-2004 until HRI included those

payments in income. The Commissioner then disallowed India Music’s claimed

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account payable deduction of $23,351 for payments to HRI it accrued in tax year

2004. 

When the Commissioner issued his notice, the Code’s three year statute

of limitations for assessing income tax deficiencies barred him from assessing

deficiencies against the Bosamias for the 1998 through 2002 tax years. 26

U.S.C. § 6501(a). However, because the Commissioner determined that his

disallowance of India Music’s year 2004 account payable deduction amounted to

a change in India Music’s method of accounting under § 481, he upwardly

adjusted India Music’s 2004 income to prevent the omission of income from tax

by result of the change in accounting method. Specifically, the Commissioner

made an upward adjustment of $877,581 to India Music’s 2004 income to ensure

that India Music’s claimed accounts payable deductions from 1998 to 2003 did

not escape taxation. These adjustments to India Music’s year 2004 income

created a corresponding deficiency in the Bosamias’ 2004 income tax. Hence, the

Commissioner determined that the Bosamias were liable for a tax deficiency of

$295,818 and an accuracy-related penalty of $59,163.60.

The Taxpayers petitioned the Tax Court for a redetermination of the

deficiency in tax and penalty determined in the notice of deficiency. They argued

that the Commissioner’s § 267(a)(2) disallowance did not constitute a § 481

change in method of accounting, thereby prohibiting the Commissioner from

adjusting their 2004 income to account for the improper deductions claimed in

the closed years from 1998-2002. The Tax Court upheld the Commissioner’s

notice of deficiency and penalty, holding that the § 267(a)(2) disallowance

effected a change in India Music’s method of accounting under § 481 because the

disallowance amounted to a change in its treatment of a material item by

postponing the timing of its cost of goods sold deduction. This appeal followed.

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II

A

On appeal, the Taxpayers contend that the Tax Court erred as a matter

of law by deciding that the Commissioner’s § 267(a)(2) disallowance constituted

a § 481 change in India Music’s method of accounting. Instead, the Taxpayers

assert that the Commissioner’s § 267(a)(2) disallowance was only an “audit

adjustment” to correct India Music’s “erroneous deductions” for the 2004 tax

year. In essence, they submit that the disallowance did not amount to a § 481

change in India Music’s method of accounting because it neither (a) changed that

entity’s overall method of accounting nor (b) effected a change in that entity’s

treatment of a material item. The Commissioner, however, counters that the §

267(a)(2) disallowance effected a change in India Music’s treatment of a material

item because it postponed the proper time for the taking of the entity’s account

payable deduction for the 2004 tax year. In short, the Commissioner contends

that by disallowing India Music’s 2004 account payable deduction until HRI

includes the underlying payments in income, it changed India Music’s year 2004

method of accounting for accounts payable owed to HRI from the accrual method

of accounting to the cash method of accounting. Because the Tax Court’s

decision rests on a pure question of law, we review its decision de novo. Arevalo

v. Comm’r, 469 F.3d 436, 438 (5th Cir. 2006). 

The parties stipulated in the tax court that if the Commissioner’s §

267(a)(2) disallowance amounted to a change in India Music’s method of

accounting for tax year 2004, the Commissioner properly adjusted that entity’s

2004 income to include the improper deductions from 1998-2003. The parties

also stipulated that India Music and HRI were related parties under the Code

and that India Music improperly deducted payments to HRI from its income for

the tax years 1998-2004 because HRI did not include those payments in its

income. Lastly, the parties stipulated that the Commissioner properly

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disallowed India Music’s claimed account payable deduction for tax year 2004

for payments owed to HRI.

Thus, the only question before us is whether the Commissioner’s §

267(a)(2) disallowance of India Music’s account payable deduction for tax year

2004 effected a change in India Music’s method of accounting for the purposes

of § 481. If it did, § 481 required the Commissioner to adjust India Music’s 2004

income upward to prevent the amounts erroneously deducted from 1998-2003

from escaping taxation. If it did not, the Code’s statute of limitations barred the

Commissioner from assessing any deficiency based on erroneous deductions

claimed by India Music in closed years. 

B

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. It provides, in relevant part:

In computing the taxpayer’s taxable income for any taxable

year (referred to . . . as the “year of the change”)—

(1) if such computation is under a method of

accounting different from the method under

which the taxpayer’s taxable income for the

preceding taxable year was computed, then 

(2) there shall be taken into account those

adjustments which are determined to be

necessary solely by reason of the change in order

to prevent amounts from being duplicated or

omitted . . . .

26 U.S.C. § 481(a)(1)-(2). 

Under § 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.” Graff Chevrolet Co. v. Campbell, 343 F.2d

568, 570 (5th Cir. 1965). The section “authorizes ‘necessary’ adjustments ‘to

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prevent amounts from being duplicated or omitted,’ in the ‘year of change’

whether ‘initiated’ by the taxpayer or the Commissioner.” Id. at 572. Morever,

there is “no necessary conflict between section 481 and the [Code’s] statute of

limitations.” Id. Instead, the very purpose of § 481 is to allow the Commissioner

to adjust a taxpayer’s income for open years to reflect amounts attributable to

closed years that would otherwise escape taxation due to a change in method of

accounting. Id. (“Section 481 is designed to prevent a distortion of taxable

income and a windfall to the taxpayer stemming from a change in accounting at

a time when the statute of limitations bars reopening the taxpayer’s returns for

earlier years.”). 

Meanwhile, § 267(a)(2), as amended in 1984, “provides for a matching of

[expenses] deductions and income where, in the case of related persons, the

payor is an accrual-basis taxpayer and the payee is on a cash method of

accounting.” Ronald Moran Cadillac, Inc. v. United States, 385 F.3d 1230, 1233

(9th Cir. 2004). The provision “prevent[s] the use of differing methods of

reporting income [by related parties] for Federal income tax purposes in order

to obtain artificial deductions for interest and business expenses.” Id. (quoting

Metzger v. Comm’r, 76 T.C. 42, 75 (1981) (describing purpose of the predecessor

of § 267(a)(2)). Specifically, § 267(a)(2) “bars a taxpayer from deducting a

payment to a related taxpayer before the related taxpayer includes the payment

in income.” Summit Sheet Metal Co., T.C. Memo 1996-563, 72 T.C.M. (CCH)

1606, 1996 WL 740748, at *11.

C

The first step in statutory interpretation “is to determine whether the

language at issue has a plain and unambiguous meaning with regard to the

particular dispute in the case.” Robinson v. Shell Oil Co., 519 U.S. 337, 340

(1997). “The plainness or ambiguity of statutory language is determined by

reference to the language itself, the specific context in which that language is

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used, and the broader context of the statute as a whole.” Id. at 341 (citations

omitted). Although 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. 

The applicable Treasury Regulations define a “change in the method of

accounting” as including either “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.” Treas. Reg. § 1.446–1(e)(2)(ii)(a); see Huffman v.

Comm’r, 518 F.3d 357, 364 (6th Cir. 2008) (finding that § 1.446–1(e)(2)(ii)(a)

defines changes in methods of accounting for the purposes of § 481). The 2

Commissioner agrees that India Music never changed its overall plan of

accounting; therefore, in order for the § 267 disallowance to constitute a change

in method of accounting, it must have effected a change in the treatment of a

material item. 

The applicable regulations define 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.” Treas. Reg. § 1.446–1(e)(2)(ii)(a); Huffman, 518 F.3d at 364-65. 

The Commissioner contends that by disallowing India Music’s 2004 account

payable deduction until HRI included the underlying payment in income, it

effectively changed India Music’s treatment of a material item. We agree. 

The Taxpayers are not asserting that the definition in Treas. Reg. §

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1.446–1(e)(2)(ii)(a) fails to comport with § 481; instead, their appeal appears to be limited to

whether a § 267(a)(2) disallowance constitutes a change in method of accounting under the

definition in Treas. Reg. § 1.446–1(e)(2)(ii)(a).

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From 1998 to 2004, India Music accounted for the accounts payable owed

to HRI on an accrual basis, deducting the payments from income each year as

they became fixed. But since HRI was a cash-basis taxpayer, it could not include

the payments from India Music in its income until it received those payments. 

See Arnwine v. Comm’r, 696 F.2d 1102, 1111 (5th Cir. 1983) (“Cash basis

taxpayers are required to include items of income in the taxable year in which

such item is actually or constructively received.”) (citations omitted). Thus, by

“matching” the time at which India Music could deduct its accounts payable

owed to HRI with the time at which HRI could include those payments as

income, the Commissioner’s § 267(a)(2) disallowance effectively changed India

Music’s accounting method for its account payable deduction in the 2004 taxable

year from an accrual basis to a cash basis. That is, the Commissioner effected

a change in India Music’s treatment of a material item in 2004 by postponing the

proper time for taking its account payable deduction. See Summit Sheet Metal

Co., T.C. Memo 1996-563, 72 T.C.M. (CCH) 1606, 1996 WL 740748, at *11

(holding that an “item is material . . . if the time for including it in income or

deducting it is at issue”). Accordingly, the disallowance constituted a change in

accounting method for the purposes of § 481 because it forced India Music to

“comput[e]” its taxable income for the tax year 2004 “under a method of

accounting different from the method under which [India Music’s] taxable

income for the preceding taxable year was computed.” 26 U.S.C. § 481; see Graff

Chevrolet, 343 F.2d at 572 (holding that § 481 authorizes necessary adjustments

to income in the year of change whether the change in method of accounting was

initiated by the taxpayer or the Commissioner). 

Therefore, we find that the language of §§ 267(a)(2) and 481 plainly

provides that a § 267(a)(2) disallowance constitutes a change in a taxpayer’s

method of accounting for the purposes of § 481, given the definition in the

applicable Treasury Regulations. In essence, when Congress enacted the

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current language in § 267(a)(2), empowering the Commissioner to postpone a

related party payor’s deduction until its related party payee included the

underlying payment in its gross income, see Deficit Reduction Act of 1984, Pub.

L. 98-369, § 174(a), 98 Stat 494 (1984), the applicable Treasury Regulations

explicitly provided that a change in method of accounting included a change in

the treatment of any material item—i.e., “any item which involves the proper

time for the inclusion of the item in income or the taking of a deduction.” Treas.

Reg. § 1.446-1(e)(2)(ii)(a). Accordingly, by requiring the Commissioner to

postpone the proper time at which taxpayers could take certain deductions

arising from related party transactions pursuant to § 267(a)(2), Congress evinced

a clear intent that applications of § 267(a)(2) necessarily change a taxpayer’s

method of accounting.

Further, the Tax Court’s holding in Summit Steel Co., supra at 2, supports

our holding that a § 267(a)(2) disallowance constitutes a change in a taxpayer’s

method of accounting under § 481. In that case, the taxpayer argued that it had

not changed its accounting method when it sought to change the year it deducted

its officers’ bonuses from the year it authorized them to the year in which the

officers received and reported them. Summit Steel Co., 1996-563, 72 T.C.M.

(CCH) 1606, 1996 WL 740748, at *11. The taxpayer argued that the change did

not effect a change in its method of accounting because it was only a “correction

required to comply with section 267(a).” Id. The Tax Court rejected that

contention, finding that even if § 267(a)(2) required the taxpayer to change the

year it deducted its bonus payments, the postponement of the bonus deductions

constituted a change in the taxpayer’s method of accounting under § 446(e). Id.

The Taxpayers contend that Summit Steel Co. does not support the

Commissioner’s position in this case because that case concerned a change in

method of accounting under § 446(e), which requires a taxpayer to “secure the

consent of the Secretary” before it changes its method of accounting. But we find

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this distinction immaterial for deciding the case before us because the Taxpayers

have failed to offer a persuasive rationale for why a § 267(a)(2) disallowance

causes a change in a taxpayer’s method of accounting for the purposes of § 446,

but not § 481. 

D

The Taxpayers make three main arguments challenging our holding,

which we find all lack merit. First, they submit that although the § 267(a)(2)

disallowance had the potential to delay India Music’s deductions, it could also

“preclude ultimate deductibility” if India Music were to go out of business before

paying its accrued expenses to HRI. But that contingency is precisely the reason

why the disallowance amounts to a change in India Music’s method of

accounting from an accrual basis to a cash basis. When parties account for

expenses on a cash basis, as opposed to an accrual basis, they necessarily bear

the risk that they will be unable to deduct those expenses if they never actually

pay them. Arnwine, 696 F.2d at 1111. Thus, by postponing the time at which

India Music could deduct its account payable and then upwardly adjusting its

income to capture the improper deductions, the Commissioner only placed India

Music in the same position it would have been had it properly accounted for its

accounts payable on a cash basis from 1998-2004 as required by § 267(a)(2). 

Second, the Taxpayers assert that the Commissioner has failed to provide

any examples where he previously found that a § 267(a)(2) disallowance involves

timing issues invoking a § 481 adjustment. This lack of authority, they contend,

supports their argument that the two provisions “are not to be read together.” 

They submit that the requirements of § 481 are mandatory, providing that the

Commissioner “shall” make “necessary” adjustments to a taxpayer’s income to

avoid the “omission” of income from tax. Thus, the Taxpayers maintain that we

would expect to find precedent for the proposition that a § 267(a)(2) disallowance

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constitutes a change in a taxpayer’s accounting method necessitating a § 481

adjustment if that has been the Commissioner’s consistent position. 

In essence, the Taxpayers’ argument amounts to a claim that the

Commissioner has changed his interpretation of the Code and relevant Treasury

Regulations with retroactive effect. See Microcomputer Tech. Inst. v. Riley, 139

F.3d 1044, 1050 (5th Cir. 1998) (holding that when an agency changes its policy

with retroactive effect, a reviewing court must determine the reasonableness of

the new interpretation and whether application of the new policy to a party who

relied on the old is so unfair as to be arbitrary and capricious). But our review

does not reveal any case where the Commissioner previously adopted an explicit

position on this question. Moreover, even if that doctrine applied to this case,

we would find that the Commissioner was justified in changing its policy with

retroactive effect because (1) his interpretation is plainly reasonable and (2) “the

detrimental effect of prospectivity—partial frustration of what we have now

determined is the proper statutory interpretation”))outweighs “the

disadvantages of retroactivity))frustration of parties’ expectations.” Id. at 1051. 

That is, the Taxpayers cannot establish that they justifiably relied on the

Commissioner’s alleged implicit prior position when they violated § 267(a)(2),

because it would amount to asserting that they violated the Code believing that

they would be protected by the Code’s statute of limitations if the Commissioner

failed to disallow their improper deductions before the relevant tax years became

closed. 

Lastly, the Taxpayers maintain that the statute of limitations should bar

the Commissioner from adjusting India Music’s 2004 income to reflect improper

deductions claimed in closed years; holding otherwise, they contend, would not

serve our rationale for concluding that the application of § 481 did not conflict

with the Code’s statute of limitations in Graff Chevrolet, supra at 5. In that

case, we found:

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There is no necessary conflict between section 481 and the

statute of limitations. Until the year of the accounting change, the

Commissioner has no claim against the taxpayer for amounts which

the taxpayer should have reported in prior years. The statute of

limitations is directed toward stale claims. Section 481 deals with

claims which do not even arise until the year of the accounting

change. 

343 F.2d at 572. In this case, however, the Taxpayers submit that the purpose

of the statute of limitations and the application of § 481 do conflict because

nothing prevented the Commissioner from immediately correcting the § 267(a)(2)

violations while the closed years were still open. 

But, although the Commissioner had the authority to correct India Music’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 for the very reasons stated in Graff Chevrolet: “‘[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 . . . .’” Graff Chevrolet, 343

F.2d at 572 (quoting Note, Problems Arising from Changes in Tax-Accounting

Methods, 733 HARV.L. REV. 1564, 1576 (1960). Therefore, as in Graff Chevrolet,

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.’” Id. (quoting Note, 733 HARV. L. REV. at 1576.

III

For the foregoing reasons, we affirm the judgment of the Tax Court,

finding that the Taxpayers are liable for the deficiency and § 6662(a) accuracyrelated penalty.

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