Accelerating deductions for prepaid expenses is a good way to save on your taxes for the current year. The general rule for prepaid expenses is that any prepayment for a service or benefit must be capitalized and amortized over the useful life of such payment. However, the IRS allows the accelerated deduction of certain prepaid expenses, with some complex restrictions involved. The following are general rules to qualify for the prepaid expense tax deduction and how they can impact your business.
The 12-Month Rule
The “12-month rule” allows for the deduction of a prepaid expense in the current year if the right or benefit paid for does not extend beyond the earlier of:
- 12 monthsfrom the date the prepayment is made, or
- the end of the taxable year following the taxable year in which the payment is made.
For cash basis taxpayers, prepaid expenses can be deducted as long as the 12-month rule is met.
Example: Calendar-year cash basis taxpayer SmallCorp pays $10,000 on December 31, 2021, for an insurance policy that is effective January–December 2022. Since the benefit of the insurance policy does not extend more than 12 months or beyond the end of the taxable year following the year the payment was made, the 12-month rule applies and the full $10,000 is deductible in 2021.
The All Events Test & Economic Performance Test
For accrual-basis taxpayers, the rules are more complicated. There are two tests that must be met before the taxpayer can apply the 12-month rule. These are commonly known as the “all events test” and “economic performance test.” The general rule is that the taxpayer cannot deduct a prepaid expense until the obligation to pay is fixed (all necessary events have occurred to establish liability), the cost is determinable, and the prepaid services or property are actually provided to the taxpayer (economic performance).
There are a few notable exceptions where a cash payment results in economic performance. Common items include insurance contracts, warranty contracts, taxes, and workers’ compensation liability.
Example 1: Calendar-year accrual basis taxpayer BigCorp pays $10,000 on December 31, 2021, for property taxes covering January–June 2022. Since taxes are listed as one of the items where payment is economic performance, the prepaid property tax expense can be deducted in 2021.
Example 2: Calendar-year accrual basis taxpayer BigCorp pays $10,000 on December 31, 2021, for rent expense covering January 2022. Economic performance occurs when the property is being used during the rental period. Therefore, the prepaid rent expense cannot be deducted in 2021.
If accelerating the deduction of prepaid expenses was not a strategy in the past, there could be opportunities to do so this year. If this is the initial year of a business, the business can simply take the accelerated deductions for prepaid expenses on the tax return. However, if prepaid expenses were capitalized in the past, a method of accounting has already been established. In order to start accelerating prepaid expenses, the IRS requires filing Form 3115 to change the accounting method. This change is automatic and does not require permission from the IRS in advance. An immediate one-time deduction is available for the previously capitalized prepaid expenses that would have been deducted under the new method for the year the change is made.