Taxpayers seeking additional business deductions before the end of the year might consider adopting the 12-month rule by prepaying some business expenditures before year-end. Certain expenses such as insurance, rebates, and licenses can be prepaid before year-end without needing to be capitalized for tax purposes, thus allowing a tax deduction for the current tax year. The 12-month rule must satisfy the requirements of economic performance in order to be utilized. The recurring item exception may provide some relief if the economic performance standard isn’t met.
Basics of the 12-Month Rule
Under normal circumstances, IRS regulations require taxpayers to capitalize (i.e., not deduct) amounts paid for certain prepaid assets. In other words, let’s say you spend $1,000 of your hard-earned money in October on a license that lasts one year. This doesn’t necessarily mean the entire amount is deductible in the tax year the payment is made. Cash-out = tax deduction. Those more familiar with accounting principles will argue that the matching principle needs to be applied, meaning that the deduction should be applied to the period in which it provides a benefit. Meaning, you would deduct 3/12 of the expense in the year the payment is made and 9/12 in the following year. This would be the IRS’ approach (See Reg. Sec. 1.162-3(d)). Taxpayers may be allowed to deduct the full $1,000 amount in the year in which it was paid by applying the 12-month rule. To apply this rule, we must look to Reg. Sec. 1.263(a)-4(f) which states that:
Except as otherwise provided in this paragraph, a taxpayer is not required to capitalize amounts paid to create any right or benefit for the taxpayer that does not extend beyond the earlier of:
- 12 months after the first date on which the taxpayer realizes the right or benefit; or
- The end of the taxable year following the taxable year in which the payment is made.
Let’s apply this to our license example. A license that lasts one year was purchased in October of the current year and it is set to expire in September of the following year. The payment creates a right that does not extend 12 months after it is initially created, thus satisfying the first condition. Also, it does not extend past the following taxable year since it ends in September, which satisfies the second condition. If the right had extended beyond September of the following year, the 12-month rule would no longer be satisfied, and the license would need to be deducted ratably over the life of the license.
Exception to the Exception: Understanding Economic Performance
The 12-month rule cannot be universally applied in all situations. If another regulation or code section specifically states that a certain type of prepaid asset is disallowed, the 12-month rule will not apply. Cash basis taxpayers will have slightly different results from accrual basis taxpayers. The rules for cash-basis taxpayers are relatively straight-forward: make the payment, and as long as the conditions above for the 12-month rule are satisfied, the taxpayer is eligible for the deduction. However, in order for this to always be true, economic performance must be satisfied. This is also true for accrual-basis taxpayers, but unlike cash basis taxpayers, accrual basis taxpayers will accrue certain expenses at year-end that a cash basis taxpayer will not.
In basic terms, economic performance is the timing of when a liability owed by a taxpayer is truly treated as being incurred. All of the necessary events need to have happened to determine that a) a liability is fixed, b) the amount can be determined with reasonable accuracy, and c) a specific action or event has taken place. For example, economic performance occurs for the following liabilities:
- Rent Expense – generally, ratably over the period the taxpayer is entitled to use the property
- Services – occurs as services are provided
- Insurance – occurs when payment is made
This means that for prepaid services and prepaid rent, economic performance isn’t satisfied until the property is used or until the service is provided to the taxpayer, respectively. Merely paying the liability doesn’t mean the payment can be deducted. However, payment for an insurance premium in the event that needs to take place for economic performance. Assuming the 12-month rule is satisfied, prepaid insurance will be deductible upon payment. A more comprehensive list of prepaid assets and their respective economic performance traits can be found at the end of the article.
Exception to the Exception to the Exception: The Recurring Item Exception
What happens if economic performance hasn’t occurred, but you really want that tax deduction? It’s at the top of your wish list and you’ve been good all year. Surely Santa will step in on your behalf. Well, congratulations! The recurring item exception exists! Reg. Sec. 1.461-5 states that economic performance will be treated as having occurred with respect to liability if:
- The liability is recurring in nature and is either not material, or provides for better matching of income and expense,
- And economic performance will occur before the earlier of 8 1/2 months after year-end, or the filing of the tax return.
For example, a taxpayer accrues an expense for an insurance premium year-end. The premium covers October of the current year to September of the following year. The taxpayer makes the payment on January 15th of the following year. Even though this satisfies the 12-month rule, economic performance has not occurred before year-end since payment has not been made. However, under the recurring item exception, the deduction may be taken since insurance premiums are recurring in nature. It is not material, and payment was made within 8 ½ months of year-end.
Note: The recurring item exception cannot be applied to interest, rents, worker’s compensation, tort, breach of contract, and violation of law.
Bringing It All Together
To see how all of these concepts work together, let’s go through two examples:
Example 1: Prepaid Advertising
On December 15th, a taxpayer pays a marketing firm $10,000 for advertising services that the taxpayer believes will be performed over the next 3 months. The marketing firm completes the advertising service by February 28th of the following year.
- 12-Month Rule – The conditions for the 12-month rule are satisfied because the benefit to the taxpayer is realized within 12 months of the payment.
- Economic Performance – For services, economic performance is satisfied as services are provided. The amount of the liability is fixed and determinable at year-end. However, the services were not provided by the end of the year so economic performance is not satisfied. Economic performance rules trump the 12-month rule, so it’s not looking good for the taxpayer thus far.
- Recurring Item Exception – The taxpayer argues that they regularly engage marketing firms and the amount paid is not material to their financial statements. Also, the payment was made before filing the tax return.
- Conclusion – The recurring item exception allows the taxpayer to apply the 12-month rule and the taxpayer is able to take the deduction. Note that for prepaid services, services must be provided within 3 ½ months of the payment being made. Other prepaids, such as prepaid interest, can be paid within 8 ½ months of year-end and still be deductible.
Example 2: Prepaid Interest
On December 15th, a taxpayer pays an interest obligation of $10,000 related to business debt covering the second half of December and the first half of January of the following year.
- 12-month Rule – The conditions for the 12-month rule are satisfied because the benefit to the taxpayer is realized within 12 months of the payment.
- Economic Performance – For interest, economic performance is satisfied as the borrower has use of the money. The amount of the liability is fixed and determinable at year-end. However, the taxpayer cannot “use” the money for January in December, so economic performance is not satisfied. Again, economic performance rules trump the 12-month rule; so, it is still nondeductible.
- Recurring Item Exception – The taxpayer argues that they regularly pay interest and the amount paid is not material to their financial statements. Also, the payment was made before filing the tax return. However, prepaid interest is one of the exclusively carved out items that cannot be applied by the recurring item exception.
- Conclusion – Even though the 12-month rule is satisfied, economic performance and the inability to apply the recurring item exception prevent the taxpayer from deducting the prepaid January interest.
As you can see, these concepts work together to provide some relief to taxpayers while still trying to prevent abuse by others who would seek to make large prepayments before year-end for the sole purpose of lowering their tax liability. When determining the deductibility of prepayments for tax purposes, every situation is unique and requires a fair bit of analysis and understanding to make sure the taxpayer takes a defensible position. One should always consult with their tax advisor on their own circumstances to determine best practices.
Prepaid Expenses and Economic Performance
|Prepaid Expense||Economic Performance|
|Prepaid Warranty and Service Contracts||Payment|
|Prepaid License or Permit Fees||Payment|
|Prepaid Dues and Fees||Payment|
|Prepaid Rent||Ratably over the period of time the taxpayer is entitled to use the property|
|Prepaid Services||As services are performed|
|Prepaid Interest||Ratably as the taxpayer has use of the money being borrowed|
|Prepaid Goods||As the goods are provided to the taxpayer|
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.