Some people throw up their hands in frustration when they think about taxes. However, you can overcome this knee-jerk reaction by learning more about deductions and how they are used. Deductions can benefit you greatly, so understanding how you can use them to reduce your tax is highly beneficial.
One of the important rules to follow, taxwise, involves your deductions for prepaid costs. Accountants record each prepaid expense on a balance sheet when a prepayment is made for a service or good that a company uses later. An accountant expenses the value, which eventually appears on the income statement for review.
What is the 12-Month Rule?
The IRS allows you to accelerate pre-tax deductions if you’ve made a prepayment for a benefit or service, and the payment has been capitalized and amortized. In this case, the IRS allows you to expedite a deduction of prepaid expenses by following the 12-month rule.
There’s nothing tricky or difficult about the rule, so you can readily deduct certain prepayments with confidence. This rule allows you to make a deduction, provided you pay ahead and the expense covers the next 12 months of the next tax year and the service/benefit does not go beyond that time. If you’re a cash-basis taxpayer, you can easily make the deduction, provided you follow the 12-month rule.
Following the 12-Month Rule for Cash Basis Accounting
Let’s look at an example:
Your company pays $5,000 at the end of 2022 for business insurance that covers you for the next year. Since this benefit does not go past 12 months, nor extend past the next tax year after you make the payment, you can deduct the entire cost. This is a pretty simple formula, as you can see, if you’re a tax basis cash payer.
Reviewing the 12-Month Rules for Accrual-Based Accounting
If your accounting system is accrual-based, you will find making the deduction a bit more complex. In this case, you need to review two criteria–both which must be met–to apply the 12-month rule. You will need to pass an “all events” assessment and meet the guidelines established for “economic performance.”
The rule of thumb here states that you cannot make a deduction for a prepaid expense until you have shown a solid obligation to pay. This means you have to establish liability. You must determine your cost and show you received the prepaid service or asset (economic performance).
Economic performance for workers compensation insurance, other insurance agreements, and taxes is shown through cash payments.
Let’s view an example.
Let’s say your company pays $5,000 at the end of 2022 for property tax that covers the first part of the year for 2023. In this case, if you go by the accrual basis for accounting, the cash you’ve paid proves economic performance. The payment falls within the 12-month time frame. Therefore, you can deduct the prepayment for 2022.
That is pretty clear-cut.
However, let’s say you prepay your office rent at the end of the 2022 tax year – a cost that covers January 2023. In this case, once you begin using the office in 2023, you’ve passed the test for economic performance. In this case, you cannot deduct this expense on your 2022 tax return because you did not use the office until the following tax year.
Maybe you have never considered accelerating your deduction for prepaid costs on your tax return. Perhaps, you’ve capitalized costs historically and have already instituted an accounting system based on accrual recording. To accelerate prepaids costs, you’ll need to fill out IRS form 3115 to switch your method of accounting.
Accelerate Deductions for Prepaid Expenses to Save Money
If you want to save money on taxes and speed up the process, accelerating prepaid costs is one tax strategy you can afford to ignore.
