Tax Treatment of Prepaid Expenses, In General
Imagine your life had turned out differently, and instead of living in a storage locker and surviving off mustard packets and free samples from Costco, you owned a successful business. November 2015 rolls around, and your business pays its insurance premium covering the company for the one-year period from December 1, 2015 through November 30, 2016.
When it comes time to prepare your 2015 tax return, you wouldn’t be foolish to assume that the insurance payment was just another deductible expense. After all, you paid the premium in full, the insurance is undoubtedly a business expense….why wouldn’t the payment represent a good tax deduction?
The answer is found in a couple of regulations, and if you’re more into conceptual explanations, the “matching principle.”
While you paid the insurance premium in November 2015, the majority of the insurance period covered by the premium fell in 2016 (January 1 – November 30). As a result, your company will benefit from the payment made in 2015 for a good portion of the following year, when it is covered by insurance paid for by the premium until the end of November, 2016. And that’s a problem, because Reg. Section 1.461-1(a)(1) provides the following:
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 tax law has historically done an awful job of defining what constitutes a date “substantially beyond the close of the tax year,” but regulations later promulgated at Reg. Section 1.263(a)-4(d)(3) removed any uncertainty by simply stating: In general, a taxpayer must capitalize prepaid expenses.
Put it all together, and suddenly, the overwhelming majority of your insurance premium paid in 2015 becomes nondeductible. Because the insurance premium covers the period December 1, 2015 through November 30, 2016, the payment creates a prepaid asset under the general rules provided above, and thus may not be immediately deducted by the taxpayer in 2015, regardless of whether the company is on the cash or accrual basis. Instead, the asset must be capitalized for tax purposes.
Then, Regulation Section 1.162-3(d) allows the expense (and resulting tax deduction) to be taken ratably over the period your company enjoys the benefit of the insurance coverage; i.e., 1/12 in 2015 and 11/12 in 2016.
If you care about the debits and credits side, if the premium were $1,200, it would look like this:
Debit: Prepaid Asset: Insurance Premium $1,200
Credit: Cash $1,200
to record the payment on November 30, 2015 of the insurance premium covering the period December 1, 2015 through November 30, 2016.
Debit: Insurance Expense $100
Credit: Prepaid Asset $100
To record, at December 31, 2015, the amount of the prepaid premium attributable to 2015.
Debit: Insurance Expense $1,100
Credit: Prepaid Asset $1,100
To record, throughout 2016, the amount of the prepaid premium attributable to 2016.
As you can see, the effect of the amortization of the prepaid asset is to more accurately “match” the taxpayers tax deduction with the benefit derived from the asset; in this case, the insurance coverage.
Exceptions to the General Rule
As with all things in the tax law, there is an exception to the general rule that a prepaid expense may only be deducted ratably as the taxpayer derives a benefit from the prepayment, and if properly utilized, this exception may yield a boon to a business with taxable income. The exception is found in Regulation Section 1.263(a)-4(f), and it reads as follows:
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:
(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.
This test has become known as the “12-month rule.”
Going back to our insurance example, you prepaid an insurance premium in November 2015 that covered the period December 1, 2015 through November 30, 2016. Under the exception to the general rule requiring capitalization, you may deduct the expense in full in 2015 if the insurance coverage you receive from the premium does not extend beyond the earlier of:
(i) 12 months after the first date on which the taxpayer realizes the insurance coverage beings (it begins December 1, 2015), or December 1, 2016, or
(ii) the end of the tax year following the year the payment is made (2015), or December 31, 2016.
The earlier of these two dates is December 1, 2016, and because the insurance period covered by the prepaid premium ends on November 30, 2016, this particular prepayment satisfies the “12 month rule,” and subject to the discussion below based on methods of accounting, may be deducted immediately.
Let’s look at a few more examples to illustrate the importance of the timing rules:
On December 1, 2015, N corporation pays a $10,000 insurance premium to obtain a property insurance policy (with no cash value) with a 1-year term that begins on February 1, 2016 and ends on January 31, 2017. The amount paid by N is a prepaid expense. Because the right or benefit attributable to the $10,000 payment extends beyond the end of the tax year following the tax year in which the payment is made, the 12-month rule does not apply. N must capitalize the $10,000 payment.
Assume the same facts as in the previous example, except that the policy has a term beginning on December 15, 2015 and ending December 14, 2016. The 12-month rule applies to the $10,000 payment because the right or benefit attributable to the payment does not extend beyond the earlier of December 15, 2016 (one year after the first date the benefit is realized by the taxpayer) nor beyond the end of the tax year following the tax year in which the payment is made (December 31, 2016). Accordingly, N is not required to capitalize the $10,000 payment.
As you can see, the 12-month rule is not particularly complicated. But as you should certainly know by now, the tax law is never that easy. Now, we have to take into consideration the method of accounting used by your businesses and the impact of that overall method on the treatment of prepaid expenses.
Cash Basis Taxpayers
Under Section 461, the timing rules for deductions incurred by a cash basis taxpayer are straightforward: pay the expense, and it’s generally deductible. Unless of course –barring the exception provided by the 12-month rule — the payment creates a prepaid asset.
Courtesy of the 12-month rule, however, most prepayments by a cash basis taxpayer that satisfy the rule can be deducted immediately.
Example: U corporation leases office space from W corporation at a monthly rental rate of $2,000. On August 1, 2015, U prepays its office rent expense for the first six months of 2016 in the amount of $12,000. Assume that U uses the cash method of accounting. The 12-month rule applies to the $12,000 payment because the rights or benefits attributable to U’s prepayment of its rent do not extend beyond the earlier of July 31, 2016 (the period ending one year after the first benefit is derived from the prepayment) or December 31, 2016 (the end of the tax year after the year in which the prepayment is made). Accordingly, U is not required to capitalize its prepaid rent.
It’s important to note, however, that the 12-month rule does not trump any disallowance of a prepaid expense under a different area of the Code. Thus, if a cash basis taxpayer prepays loan interest, the interest is only deductible in the year to which the interest relates under Section 461(g), regardless of whether the prepayment satisfies the 12-month rule.
Accrual Basis Taxpayers
At this point, you’re probably thinking you’ve got this 12-month rule dialed in, and you’re salivating at the idea of being able to accelerate deductions at year end by prepaying the following year’s insurance premiums, debt interest, real estate taxes, etc… But the Code would not be the monstrosity that it is were it not for its exceptions to exceptions, and the rules governing prepaid expenses are no different.
When the taxpayer in question is an accrual basis taxpayer, the regulations at Reg. Section 1.263(a)-4 make clear that the 12-month rule and potential acceleration of tax deductions for prepaid expenses do not trump the “economic performance” rules. And understanding what the hell that means requires a foray into Section 461 and Reg. Section 1.461-4.
While I wrote about it in great detail in this previous Tax Geek Tuesday, one of the three requirements for an accrual basis taxpayer to deduct an accrued but unpaid expense is that “economic performance” must have been met with regard to the liability in the year of accrual.
Economic performance, in basic terms, is the timing of when the liability owed by the taxpayer is truly treated as being incurred, and it varies greatly depending on the nature of the liability. In short, the regulations provide that economic performance occurs for the following liabilities at the following times:
•Rent expense: ratably as the property being rented is used.
•Interest expense: ratably as the taxpayer has use of the money being borrowed.
•Accrued liability to a service provider: as the services are provided to the taxpayer.
•Accrued liability to a provider of goods: as the goods are provided to the taxpayer.
•Accrued insurance, prizes and awards, taxes, warranty expenses, worker’s compensation expenses, rebates and refunds, or liabilities due under a tort or breach of contract: economic performance occurs only when the taxpayer pays the liability to the person owed in cash.
Setting aside the prepaid rules for a moment, let’s take a look at the impact of the economic performance rules on an accrual basis taxpayer’s deduction for an accrued but unpaid liability.
Assume Corporation X enters into a contract with Y to provide advertising services to X. Y provides the services in December 2015 and gives X a bill for $20,000. X does not pay the bill, but accrues a $20,000 liability (with a corresponding $20,000 expense) as of December 31, 2015. X may deduct the liability in 2015 because, among other requirements, economic performance has occurred with respect to the liability because the liability arose out of the provision of services to the taxpayer by another party, and the services were provided by the end of 2015.
If instead, Y did not perform the services until 2016, barring an exception (called the recurring item exception), X would not be able to accrue the $20,000 liability it expects to owe in 2016 at the end of 2015 because economic performance has not yet occurred.
Continuing on, assume Corporation X enters into a lease to rent space from Y on an annual basis. In December 2015, X knows it will owe Y $20,000 for the 2016 rent, so it accrues the liability (and the corresponding rent expense) on its 2015 tax return. While X certainly knows the amount it will owe to Y, it cannot deduct the accrued but unpaid rent expense because economic performance has not occurred with respect to the rent liability, because under Reg. Section 1.461-4, economic performance only occurs for a rent liability as the property is rented. Because the 2016 rent liability relates to the 2016 use of the property, economic performance has not yet occurred at the end of 2015, and thus X cannot accrue in 2015 its liability for the 2016 rent.
Last example: Corporation X knows in 2015 that it will owe Y $20,000 for an insurance premium that will cover X from July 1, 2015 through June 30, 2016. At the end of 2015, X accrues the $20,000 accrued insurance liability (and the corresponding insurance expense). Under the general rule, X cannot deduct the expense in 2015 because a liability for insurance is one of the liabilities specifically listed in the regulations for which only payment constitutes economic performance. Because X will not pay the liability until 2016, it cannot deduct the accrued expense for tax purposes in 2015.
As mentioned in a parenthetical above, however, there is an exception to the general rules of economic performance, and it’s called the recurring item exception. Reg. Section 1.461-5 provides that economic performance will be treated as having occurred with respect to a liability if the liability is recurring in nature, is either a) not material, or b) provides for a better matching of income and expense, and economic performance will actually occur before the earlier of a) 8 1/2 months after year-end, or b) the filing of the tax return.
To illustrate the impact of the recurring item exception, let’s go back to our previous insurance example.
Corporation X knows in 2015 that it will owe Y $20,000 for an insurance premium that will cover X from July 1, 2015 through June 30, 2016. At the end of 2015, X accrues the $20,oo0 accrued insurance liability (and the corresponding insurance expense). and pays the expense in February 2016. X files its 2015 tax return on March 15, 2016. Under the general rule, X cannot deduct the expense in 2015 because a liability for insurance is one of the liabilities specifically listed in the regulations for which only payment constitutes economic performance. Because X will not pay the liability until 2016, barring an exception, it cannot deduct the accrued expense for tax purposes in 2015.
Because insurance liabilities are recurring in nature, the $20,000 expense is not material to X, and X will pay the expense before the earlier of 8 1/2 months after year-end or the date it files its tax return, however, X may use the recurring item exception and deduct the full $20,000 of accrued insurance expense in 2015.
The regulations make clear that the recurring item exception may not be used for interest, rents, worker’s compensation or tort or breach of contract liabilities.
With all of that established, what does any of this have to do with the rules governing prepaid expenses?
Assume again that you are an accrual basis taxpayer. At the end of 2015, you prepay your insurance coverage for the period December 1, 2015 through November 30, 2016 of $20,000. As we’ve established, under the general rule, you must capitalize the $20,000 as a prepaid asset and expense it ratably as the insurance coverage is received. Under the 12-month exception, however, for a moment in time, you could deduct the $20,000 in full in 2015 because the coverage does not extend beyond the end of 2016. However, as mentioned above, we must pause, because the regulations state that the 12-month test does not trump the economic performance rules. So we are required to establish if economic performance has occurred with respect to the insurance liability. After a quick glance, we are reminded that economic performance occurs with respect to an insurance liability only when payment is made. Here, the insurance liability is paid during 2015, so economic performance has occurred. You may deduct the $20,000 prepayment in full.
But what if instead of an insurance liability, you prepaid in November 2015 your debt interest for the period November 1, 2015 through November 30, 2016? Would the facts change?
They sure would, because while the 12-month test would be satisfied, the economic performance rules would trump. And those rules state that for interest, economic performance occurs only while the taxpayer has use of the borrowed money. Applying this to the prepayment, 11/12 of the borrowing for which the interest is being accrued does not occur until 2016, and thus economic performance has not occurred by the end of 2015. Furthermore, you are not permitted to use the recurring item exception for interest expense, so that is of no help. As a result, you must capitalize the $20,000 prepaid asset and deduct 1/12 in 2015, the remainder being deducted in 2016.
Or consider the following, and compare it to the example we provided under the cash basis taxpayer section:
U corporation leases office space from W corporation at a monthly rental rate of $2,000. On August 1, 2015, U prepays its office rent expense for the first six months of 2016 in the amount of $12,000. U’s prepayment of rent is a payment for the use of property by U for which economic performance occurs ratably over the period of time U is entitled to use the property. Accordingly, because economic performance with respect to U’s prepayment of rent does not occur until 2016, U’s prepaid rent is not incurred in 2015 and therefore is not deductible until 2016.
If you’re following along, you’ve come to realize that the 12-month rule is of no help in accelerating deductions for prepaid interest and rent. For other items where cash payment results in economic performance (insurance, taxes, dues) or economic performance may occur by virtue of the recurring item exception (service based liabilities like advertising), a business that prepays these items and satisfies the 12-month test may enjoy the benefit of the full deduction in the year of payment.
How to Claim the Deduction for Prepaid Expenses
One cannot simply begin deducting prepaid expenses, of course. The tax law JUST WON’T HAVE IT. That’s because if you’ve previously capitalized and amortized prepaid assets under the rules initially described above, you’ve established a method of accounting. And once you’ve established a method of accounting, you can’t just switch that method all willy nilly-like.
Instead, you must apply for a change in accounting method on Form 3115 and receive the consent of the IRS; fortunately, the change related to deducting prepaids is an automatic change, meaning you don’t have to file it by year end, but instead can simply attach it to your tax return.
In the year you make the change, you will receive a benefit under Section 481, because you will be required to pretend that you were always employing a method under which you deducted all prepaid expenses that satisfied the 12-month rule. As a result, you will get an immediate one-time deduction for the previously capitalized expenses that would have been deducted under your new method.
In summary, profitable businesses should examine the prepaid asset account to determine if a benefit may be derived by Filing a Form 3115, adopting the 12-month rule, and deducting those prepaid expenses that would have otherwise required capitalization. In doing so, remember to ask the following questions:
1. Does the prepaid expense satisfy the 12-month test?
2. Am I a cash basis or accrual basis taxpayer?
3. If accrual basis, did economic performance already occur with respect to the expense?
4. Have I established a method of accounting with respect to prepaid expenses that I must now change?
From a practical perspective, you will want to identify those prepaid insurance, dues and service contracts. Leave the prepaid rent and interest alone, as there’s generally no benefit.