Accelerating Your Deduction for Prepaid Expenses

Adam Aucoin, Tax Manager
November 2015

Navigating various tax laws often seems like playing a game with a child. Children tend to make up an elaborate, confusing set of rules as the game progresses, making it nearly impossible to understand the instructions or the outcome.  The tax code often provides a general rule, but then presents exceptions, and then exceptions to the exceptions.  (Another thing they have in common is that children and the IRS tend to create rules that favor the party making them up!)

Determining the appropriate tax year in which to deduct prepaid expenses is a good example of an elaborate set of rules and exceptions.  In some cases, though, a taxpayer who is paying attention will find that the exceptions can work in his or her favor.

General Treatment of Prepaid Expenses

One might assume that an expense is deductible when paid. Say you prepay your 2016 business liability insurance in full in December 2015. You may think in that scenario that it would be deductible in 2015. It isn’t quite that simple however, due to Reg. Section 1.263(a)-4 which states that “in general, a taxpayer must capitalize prepaid expenses.”

Reg. Section 1.461-1(a) also vaguely states: “If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.”

The 12-Month Rule
So the general rule is that all prepaid expenses must be capitalized. There is an exception to that, however, in certain circumstances. Under Reg. Section 1-263(a)-4(f), taxpayers are not required to capitalize prepaid expenditures for “any right or benefit for the taxpayer that does not extend beyond the earlier of

  1. 12 months after the first date on which the taxpayer realizes the right or benefit; or
  2. The end of the taxable year following the taxable year in which the payment is made.”

Example: Grayson Corporation purchased an insurance policy on October 31, 2015 covering November 1, 2015 to October 31, 2016. The general rule says that must be capitalized and expensed as it is utilized. However, the 12 month rule can apply here because the policy does not cover a period beyond 12 months after the date on which the taxpayer realized the benefit (November 1, 2015). Therefore the entire amount of the policy could be expensed in 2015.

Unfortunately, the 12-month rule is not the end of the analysis. Taxpayers also need to consider their accounting method and the rules of Section 461 for the taxpayer’s method of accounting. 

Cash Basis Taxpayers
In general, the rules for cash basis taxpayers are fairly straightforward. When revenue is received it is income. When expenses are paid they are deducted. However, because of the general rule regarding prepaid expenses, simply prepaying an expense does not make it immediately deductible (barring an exception due to the 12-month rule).
Say for example that on November 1, 2015, Drake Corp purchased a computer maintenance service program that covered from November 1, 2015 to October 31, 2017. This prepayment must be capitalized because it does not meet the 12-month rule and therefore it is expensed as the benefit is received, even for cash basis taxpayers.

Accrual Basis Taxpayers
Things get a little trickier for accrual basis taxpayers because of Section 461, which requires the taxpayer to consider the all-events test and the economic performance test.

Before any expense can be taken, the all-events test must be met. For an expenditure to be deducted, all events need to have occurred so that the amount of the liability can be determined with reasonable accuracy and its existence cannot be in question.

The fact of the liability needs to be fixed and the amount needs to be determinable.

The next test the expenditure needs to pass is the economic performance test so that economic performance has occurred.

Determining when economic performance has occurred depends on the nature of the expense. Please refer to the following chart for more details in this area:

Type of Expense When Economic Performance Occurs Example
Services provided TO the taxpayer When the other person provides their services Computer Maintenance Contract
Services provided BY the taxpayer When the taxpayer performs services Professional Fees
Property provided TO the taxpayer As the other person provides such property or as property is used by the taxpayer Rent Expense
Property provided BY the taxpayer When the taxpayer provides the property Rent Expense
Worker’s Compensation and Tort Liabilities When payments are made Worker’s Compensation
All Other Items Determined on a case by basis under regulations prescribed by the secretary Depends on nature of the expenditure. For example with insurance, economic performance would likely occur when paid.

Of course, there is more to the concept of economic performance, because as one might have guessed, there is an exception! The exception (that will allow deduction prior to economic performance) is for recurring items.

For an item to meet this exception it must:

  1. Pass the all-events test, and
  2. Economic performance must occur within the shorter of:
    1. A reasonable period after the close of such taxable year, or
    2. 8 ½ months after the close of such taxable year, and
  3. The item must be recurring in nature and treated consistently in terms of when the taxpayer considers the event as occurring, and
  4. The item must not be material or the accrual of the item is a more proper match against income compared to the year in which economic performance occurs.

Let’s apply these economic performance rules in a couple of examples:

Example 1: Gordon Enterprises prepays its rent expense on June 30, 2015 to cover the period from July 1, 2015 to June 30, 2016.

Solution: According to the economic performance rules economic performance occurs as the property is being used. Therefore only the portion of the rent related to use of the property from July 1, 2015 to December 31, 2015 can be deducted in 2015. The rest can be deducted in 2016.

As you may notice, because rent is deducted when the property is used, it means that it is very unlikely that prepayments for rents will lead to accelerated deductions.

Example 2: Nigma Solutions, Inc. annually pays for liability insurance premiums. On July 2, 2016 the company paid $2,000 for liability insurance to cover August 1, 2015 to July 31, 2016. Assume the $2,000 is not a material number to the company, the company is a calendar-year taxpayer, and the company files its extended Form 1120 on August 15, 2015.

Solution: Normally, because payment was not made until 2016, economic performance did not occur until 2016 and the deduction should be taken in 2016. However, because the payment passes the all-events test, is made before the earlier of the date when the tax return is filed or 8 ½ months after the close of the tax year, is not material, and is recurring in nature, the expense may be accrued and deducted in 2015.

It should be noted that the recurring item exception may not be used for interest, claims involving worker’s compensation, or tort/breach of contract liabilities.

Form 3115
If historically you have not been deducting prepaid expenses but instead have been capitalizing them, to start accelerating the deduction of prepaid expenses under one of the exceptions you must file a Form 3115 to change your accounting method. This change generally is automatic, meaning you do not need to obtain permission from the IRS in advance.

In the year of change, you likely will enjoy a “catch-up” deduction equal to the amounts that should have been deducted under the new methodology as of the beginning of the year.

Conclusion
The guidance concerning timing of the deductions for prepaid expenses for tax purposes are full of rules and exceptions to the rules.  It is necessary to verify whether the outlay meets the definition of a prepaid expense, and address whether the 12-month rule applies.  Then, accrual basis taxpayers must verify the economic performance and all-events tests are met, and determine whether the recurring-item exception applies.  Finally, any prior deductions of prepaid expenses will have established an accounting method, and optimizing or correcting it may require the filing of IRS Form 3115 to effect the change. If you have not been accelerating the deduction of prepaid expenses in the past, now may be the time to reevaluate.

If you would like to discuss these matters further, please contact your BNN professional at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.