Prepaid Expenses

With some exceptions, taxpayers using the cash method of accounting must recognize income when funds are received and may take deductions only when expenses are actually paid. Accrual method taxpayers generally must recognize income when all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy; expenses may be deducted when all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

At year end, and assuming a taxpayer will be in the same or lower tax bracket in the following year, deferring income until the next year and accelerating expenses to the current year will defer taxes and save money. However, this can only be done within the restrictions discussed above. With respect to accelerating expenses, a further complication is that any expense attributable to an asset with a life that extends beyond the current tax year generally must be capitalized, as opposed to being fully deducted in the current tax year.

One opportunity for accelerating expenses is discussed in Treas. Reg. 1.263(a)-4(f): "[A] taxpayer is not required to capitalize under this section amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of (i) 12 months after the first date on which the taxpayer realizes the right or benefit; or (ii) the end of the taxable year following the taxable year in which the payment is made." The regulation gives examples that specifically allow the following for an accrual method taxpayer:

On December 1, a corporation pays $10,000 for rent or insurance on a one-year lease or policy that begins December 15 of that same year. Because benefit attributable to the payment neither extends more than a year beyond the first date the benefit is realized nor beyond the end of the taxable year following the taxable year in which the payment is made, the payment need not be capitalized and may be deducted in full in the current year. In this way, taxpayers with certain prepaid expenses can defer taxes and save money.

Posted in: Income Tax