Most individuals and many small businesses use the cash basis method of accounting. With this method you record income when money is received and you record expenses when money is paid out. Tax deductions are taken in the year they're paid for. The general rule is that you can’t prepay business expenses for a future year and deduct them from the current year’s taxes. An expense you pay in advance can be deducted only in the year or years to which it applies. Such an expense must be prorated over time, rather than deducted in full in the tax year in which it is paid. This makes these expenses more like capital expenditures than current expenses.
However, there’s an important exception called the 12-month rule. It lets you deduct a prepaid future expense in the current year if the expense is for a right or benefit that extends no longer than the earlier of:
- 12 months, or
- until the end of the tax year after the tax year in which you made the payment.
Common prepaid expenses include rent, insurance, interest, and the cost of obtaining a lease or loan.
Unless the 12-month rule applies, rent payments for the use of property after the taxable year are only partially deductible in the year you make the payment.
Example: In January 2016, Company A enters into a three-year lease at a rent of $10,000 a year. The company pays the entire $30,000 rent for the full three-year period in January 2016. The 12-month rule does not apply because the expense is for a benefit (a lease) that extends for more than 12 months and also beyond the end of the following tax year. Only $10,000 is deductible in 2016. The remaining $20,000 must be deducted in 2017 and 2018 ($10,000 each year).
Example: In July 2016, Company B pays $10,000 to lease an office through December 2017. The entire $10,000 may be deducted in 2016. The 12-month rule applies because the rental period only extends to the end of the tax year after the year the payment was made.
Prepaid insurance premiums are deductible when paid as long as they don't apply to a period extending more than 12 months after the end of the taxable year when the payments were made. If the insurance contract runs for a longer period, you need to take the deduction over time.
Example 1: You’re a calendar-year taxpayer and you pay $10,000 on December 31, 2016 for a business insurance policy that is effective for one year beginning January 1, 2017 and ending on December 31, 2017. The 12-month rule applies. The benefit you’ve paid for—a business insurance policy--does not extend more than 12 months beyond January 1, 2016 (the first date you realized the benefit from the policy). Nor does it extend beyond the tax year following the year the payment was made (which would be tax year 2017 or later). Therefore, the full $10,000 is deductible in 2016.
Example 2: On the other hand, if your policy had a one-year term beginning on February 1, 2017, the 12-month rule would not apply. In this event, the benefit obtained from the December 31, 2016 payment would extend until February 1, 2018. This is beyond the end of the tax year following the year you made the payment.
Other Prepaid Expenses
These same rules apply to other prepaid multi-year expenses deductible as miscellaneous business or investment expenses—for example, business subscriptions, union and professional dues, as well as safe deposit box rentals.
Example: In December 2016, John pays $300 in advance for a three-year subscription to a business magazine. The subscription begins in January 2017. The 12-month rule does not apply because the benefit from the prepayment—the subscription—lasts more than 12 months and longer than the end of the following tax year. John gets no deduction in 2016. He may deduct $100 in 2017, 2018, and 2019.
Expenses of obtaining a loan include commissions, escrow expenses, legal fees, and commitment fees. These expenses are deductible if the loan is related to the production of business or investment income. However, prepaid loan expenses for a personal loan generally aren't deductible at all. If deductible, loan expenses must be deducted over the life of the loan. The 12-month rule can't be used to deduct such expenses in a single year.
Prepaid interest is interest that you pay in advance for a period that goes beyond the end of the tax year. You can’t fully deduct such prepayments in a single year. Rather, you must deduct them over the life of the loan. This is, prepaid interest must be deducted in the year it is due, not the year it is paid.
Example: Joe must pay $1,000 interest each year for his student loans. In December 2016 he submits to his lender $2,000 to prepay the interest payments due for 2017 and 2018. He can’t deduct the $2,000 payment in 2016. Instead, he may deduct $1,000 in 2017 and $1,000 in 2018.
Points paid to obtain a loan are generally treated as additional interest charges, so they're treated as paid over the term of the loan. However, special rules apply to points paid to obtain a home mortgage. Homeowner-taxpayers can deduct the points in full in the tax year they're actually paid if:
- the loan is secured by the taxpayer's principal residence
- paying points is an established business practice in the area where the loan was made, and
- the points paid were not more than the points generally charged in that area.
Qualifying to Use the 12-Month Rule
To use the 12-month rule, you must apply it when you first start your business or first file taxes as an individual. You must get IRS approval if you haven’t been using the rule and want to start doing so. IRS approval is granted automatically. You must file IRS Form 3115, Application for Change in Accounting Method, with your tax return for the year you want to make the change. When you do this, you apply the 12-month rule to your prior years’ taxes, which may result in additional deductions and tax refunds for prior years. Filing Form 3115 is a complex process best done by a tax professional.
Questions for Your Attorney
If you're thinking about prepaying some of your expenses, make sure you know the tax consequences. Don't assume you'll be able to get the full tax benefits of the payment in the year it's made. If you have any questions, talk to a professional tax preparer or a tax lawyer before you file.
- Is it a good idea to prepay expenses?
- Can a prepaid salary be deducted in the year it was paid?
- Are there any prepaid multi-year expenses that are fully deductible in the year of payment?
- Do I need to file Form 3115 to use the 12-month rule?