Prepaid Expenses and Taxes

A common question we get from business owners is “what else can I deduct?” Most of our clients are on the cash basis, meaning the net of income received and expenses paid in any given year is the amount that is reported on the tax return. Since cash drives taxable income there is often a rush at year end to spend as much as possible. This is especially true in a great financial year for the business. However, in certain instances just because expenses are paid before year end does not mean that they are deductible.

Items like insurance, dues, and service contracts may be paid in the last month of the year but provide benefit that extends into the following year. If these items do not meet what is called the “12 month rule” they are required to be capitalized as a prepaid expense and deducted over the expense’s “useful life”. The general rules to be deductible are the following:

You can deduct an expense if the “useful life” (time of benefit) does not exceed the earlier of:

(i)                  12 months after the first date the benefit starts

(ii)                The end of the taxable year following the taxable year when the payment was made


(a)    Yearly business dues are paid in June 2015 for the period July 1, 2015 to June 30, 2016. Those would be deductible in full in 2015 since the benefits ends within 12 months of when it was paid.

(b)   IT service contract for two years is paid January 2015 for the term January 1, 2015 to December 31, 2016. Only one year’s worth of service would be deductible in 2015 and the rest would be capitalized and expensed in 2016.

Keep these rules in mind when rushing for purchases closer to year end. While they can be useful tax strategies, if the above rules are not followed then a large cash outlay could occur without tax benefit until future years. As always, consult your tax professional when making large purchases that could affect cash flow to make sure you are maximizing the tax benefit.