Tax Treatment of Prepaid Expenses

Prepaid Expenses, as the name implies, are items and services you’ve paid for but not yet received. One of the most common prepaid expense is insurance, where policies are paid for up front then, generally, run for a year. Tax treatment for prepaid expenses can be tricky, especially since the rules for deducting prepaid expenses varies depending on what method of accounting you’re using.

If you’re using the Cash Method of accounting, the tax treatment of prepaid expenses is generally pretty simple: when you pay cash, you deduct. This isn’t always the case (since the government likes to keep accountants in business). Under Reg. 1.263(a)-4(d)(3) (so you can look it up if you’re having a hard time going to sleep), cash payments come under what’s called the 12- month rule. This means the cash you pay out now can be deducted as long as you’ll use up the item or service over the next year. If, however, the item or service will last you longer than a year, you have to capitalize the cash you paid out and expense it over the life of the item. Generally these will be a fixed asset like computers or tables or Arcade Cabinets, but it could also be a multi-year contract for Alien Invasion insurance.

Prepaid expenses get a little more confusing for accrual method taxpayers. The general rule is that you don’t get to deduct anything until that expense has actually happened. Back to the insurance policy example, you’d get to deduct the policy ratably over the life of the policy. However, you can elect under those same Regs listed above to accelerate your prepaid expenses if they qualify for the 12-month rule. So, again with the insurance, as long as the policy is less than a year long, you can deduct it in the year you paid the expense.

All of these prepaid expenses come with some notable exceptions. The big one is rent – prepaid rent is (generally, of course) not deductible. If you pay $10,000 in May for a year worth of rent, on December 31 you can only deduct eight months of that rent (you’d likely just prorate it, until you have a better way to break it out). This is the case for both cash method and accrual method taxpayers.

Next, for accrual method accountants, services (which include software maintenance and subscriptions) do not qualify for the 12 month rule, and would instead be deductible under the normal Section 461 rules. I won’t get into what those 461 rules are here, because that would take an entire rainforest worth of paper to explain.

It’s also important to note that Accrual Method taxpayers are not under any obligation to accelerate these prepaid expenses. Just remember that if you haven’t been accelerating them, and you choose that you want to, this would be a Method Change and require a Form 3115.

Also note that these need to actually be expenses. Something like a deposit, where you’ll get some or all of the money back at the end of the day, would not qualify as an expense, and certainly not a prepaid one.

These are the general rules for the tax treatment of prepaid expenses. There’s always additional exceptions and deduction for nearly any topic (for this one, Reg 1.461-5 comes to mind). If you want to figure out the specific rules for your (awesome, weird, insane, etc) situation, reach out and pay one of my accounting kin. We do so like to get paid.

 

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