Under the general rule you may not deduct the full amount of an advance payment covering more than 12 months.
You must deduct a portion of the payment in the year to which it applies.
The General Rule.
12 month rule:
This rule says that you may deduct the full amount of an advance payment in the year the payment is made if it creates rights or benefits for the taxpayer that do not extend beyond the earlier of:
The 12-Month Rule.
The benefit does not extend beyond 12 months after the right to receive the benefit begins-October 1, 2012.
I hope this clarifies matters for you. Thank you again.
Thank you. I understand these examples, and have seen more similar ones on the Internet. My question wasn't about how to use 12-month rule, rather whether I can choose not to. What gets me confused is some the online articles are using word “elect” as in “company can elect to deduct”. Is that a wrong choice of words?
I went to the source and I looked at IRS publication 538. Page 9, section "Cash Method" subsection "Expense paid in advance" says: "Under the 12-month rule, a taxpayer is not required to capitalize amounts paid..." Again it sounds like a taxpayer's choice: "not required". So I am still confused are there actual court cases to clarify this?
Lastly, what is the difference between prepaid expenses and a loan? So in 2012 I gave some money to a vendor for services they have not provided (yet). Can I call it a loan and capitalize it?
Effective 1.1.2004, however, Treasury Regulation 1.263(a)-4 gave taxpayers a nice little planning opportunity by creating the ”12-month rule.”
The “12-month rule,” however, provides that a taxpayer does not have to capitalize prepaid expenses if the right or benefit doesn't’t extend beyond the earlier of:
(1) 12 months after the first date on which the taxpayer realized the right or benefit, or
(2) the end of the tax year following the tax year in which the payment was made.
A taxpayer with significant qualifying prepaid assets can enjoy a one time favorable timing adjustment by changing their method of accounting to deduct these expenses.
Thank you, XXXXX XXXXX I am afraid I am still confused. I had brought examples of blogs where they use language like "taxpayer can elect to deduct". Then I referred to official IRS publication where they say "taxpayer is not required to capitalize..." And now you have yet another twist with the same confusing meaning. If your latest quite the language is "taxpayer does not have to capitalize...".
As far as my understanding of English goes, when you do "not have to do action A" you should not automatically do opposite to action A. "Do not have to do" to me implies that you have a choice. So the question: is to what extent it is a choice of taxpayer in this case?
I guess that as with everything in taxes the true answer is very nuanced. So I want to know all these nuances. I want to hear about court cases if there were any.
Also I did more detailed digging/goggling myself. There is yet another category called: “Advance Payments”. They explain that the difference between Prepaid Expenses and Advance payments is this. Prepaid Expenses are for services which scope, delivery date and price is predetermined and is not about to change, for example magazine subscription. You know exactly when will get next issue and what the price is. Advance Payments are for services when the scope/delivery date/final price is not exactly clear. For example you pay advance to somebody to prepare a marketing research, at a time of this advance payment there is no clear scope of the research, there is no set in stone delivery date, and at the end the price may vary, so upon final delivery of the report there will be a balance to pay. Very well, now as I know the difference in definition how do I account for "advance payments" in my books and in tax returns? Mind please that I am still using cash accounting method...
Here is a summary of the law on prepaids/cash basis:
In 1973, there was a court case Zaninovich vs. Commissioner. Zaninovich was a cash basis taxpayer and paid rent for 1974 in December of 1973 and took a deduction.
The IRS denied his deduction, saying that he should have recorded prepaid rent, because the rent was for 1974. They went to court. The court agreed, and denied the deduction. Zaninovich appealed. The 9th district court reversed the decision, saying cash basis is supposed to be simple - and deductions are allowed when paid.
This is the court case most other cash basis and prepaid questions come back to. Some use the original ruling and try to "elect" to expense their prepaids as incurred instead of paid. Since 1973, there have been a few courts that rely on the original decision, not the 9th circuit reversal, to have a prepaid IF the prepaid rent, or insurance covers more than 12 months. This is where the 12 month rule comes from. Unfortunately, this issue, when it comes down to it, it depends on which judge in which court you get.
In my opinion, I follow the 9th court decision, and the original tax code Sec. 461. Cash basis means deduct when paid, regardless of when incurred. The only exception is if it is a deposit - or Advanced Payment from your research. This is a long term asset on your balance sheet.
I agree with SoftAssist.168 - if you want to deduct the prepaid, you would consider changing your accounting method. However, you can't just change your accounting method to get the tax deduction you want (or in your case, don't want).
As recent as May 2011, another court case Lattice vs. Comissoner was denied. They were accrual and tried to change to cash basis so that they could take a deduction for expenses they paid. The court said they couldn't do that either, they needed a reason besides better tax treatment. Their request was denied.
I hope I have given you some background on the cash basis/prepaid issue here.
If you are an S-Corp and paid expenses that relate to the next 11 months, you can deduct them. If the expenses relate to rent or insurance over 12 months, deduct a part of it under 12 month rule explained above. You must be consistent, do it the same way next year to support your position. If the payment was for something where the date and scope is not clear, record it as an asset.
Thank you ezcpa, this is very detailed answer, but at the end you confused me again, you said "you can deduct them", I sure can, as I am an S-Corp, but do I have to?
I will take the blame and assume that I am not making myself clear with my question. And I will try again. I understand that a corporation that is using accrual accounting cannot use 12 month rule and deduct prepaid expenses in the current year unless they get permission from IRS to do so. But that is not essence of my question.
I am talking about an S-Corp that is already using cash accounting. And my question is: does 12 month rule "permits" or "orders" deducting in the current year? Suppose in September 2012 an S-Corp (that is using cash accounting method already) purchases one year subscription for a magazine for $120 ($10 per monthly issue). 12 month rule would permit them to deduct entire $120 in 2012. Cool and Dandy! But is that OK for them if they choose so to still expense $40 that belong to 2012 in 2012 and put remaining $80 on the balance sheet as an asset. Can they do that without asking for IRS change in accounting method back to accrual? Thank you
Yes. You have to deduct the amount you paid.
The primary source is the IRS code section 461. You are a cash basis. Anything you paid by September 2012 is deductible in 2012.
If you subscription was for 36 months (more than 12 months) THEN you can look to the 12 month rule - see the insurance example above.
Remember the 12 month rule isn't primary law - it is from IRS and 3rd party interpretations of court cases.
It is not ok to expense $40 in 2012. You should expense $120. The IRS is not likely to challenge you and make you take a deduction in 2012 - but they may deny your deduction for the $80 in 2013. You are after all cash basis. If they did, your CPA or tax attorney would say you are consistently deducting and use the 12 month rule as support ...
If you are looking for a tax planning tool - and you want to move deductions to next year it is better just to wait and pay later. Pay for your subscription on October 1 instead of September 30.
If you don't like cash basis - and want to use accrual for everything - then file a change in accounting method. The accrual method matches income and expenses for the correct period. Cash Basis method reports income when received and expenses when paid. Period.