I have reviewed the rules for deducting prepaid expenses with three different clients in the past week, so I thought this would make a good topic for my blog.
Many of my clients are looking for my input on tax saving strategies as the year draws to a close. For taxpayers wishing to shift taxable income from 2016 into 2017, saving dollars on their 2016 tax obligations, the idea of pre-paying deductible business expenses often comes up.
This strategy usually works to provide a deferral of the taxes from one year to the next. What is saved in 2016 will have to be paid for 2017. But this is a particularly beneficial strategy if there was a bump-up in income in 2016 that is unlikely to repeat in 2017. If a taxpayer is in a lower tax rate bracket in 2017 than in 2016, this results in a tax savings as well as a tax deferral.
Prepaying deductible business expenses is a good strategy for cash basis taxpayers to move deductions from next year into this year. The result is a shifting of net taxable income from the current year to next year. There is no overall dollar limit on a taxpayer’s ability to prepay business expenses but it is important not to waste money prepaying for things that might not be needed.
Most taxpayers file their returns using the cash method, where income is taxed when received in cash and deductions are permitted when paid in cash. Almost all individual taxpayers and almost all small and medium size businesses are cash basis taxpayers. Larger businesses are accrual basis taxpayers. They report their taxable income when it is earned and deduct their expenses when they are incurred. The distinction between cash and accrual basis is important and accountants study the rules for accrual basis accounting in their college accounting courses.
All of my current clients are cash basis taxpayers and the ability to deduct a prepayment is only permitted for cash basis taxpayers. If you are an accrual basis taxpayer this idea will not work for you.
For cash basis taxpayers, IRS regulations prohibit deductions for prepaid interest which is not deductible until incurred. Payments that create an asset (tangible or intangible) are not deductible either.
Since prepaid expenses are all considered to be assets, an exception to the rule, known as the 12-month rule is helpful. Here is an exception that is almost as big as the rule. Under the 12-month rule, prepayments for expense items that create benefits for a relatively brief period of time, such as insurance, security, rent, and warranty service contracts may be immediately deducted when paid if the contract period to which the prepayment applies is not more than a year and the contract period does not extend beyond the end of the taxable year following the tax year in which the payment is made. Other expenses that fit into this 12-month rule would be advertising, marketing, postage (stocking up on postage stamps), business travel expenses (buy those airline tickets before the end of the year), conference registrations and business education. Professional fees for legal and accounting advice will often fit within this rule, but not always.
A cash basis taxpayer receiving prepayments must include the prepayments in taxable income in the year received, so your plan to prepay your expenses may be foiled by your customers who prepay you.
– Mark S Gleason CPA