Rules for Deducting Prepaid Business Expenses

If you're in need of extra business deductions before the end of the year, one method is to prepay some of your business expenses for future years, such as:

• business insurance
• rent on offices and equipment, and
• lease payments on business vehicles.

However, you need to be aware of some tricky rules to deduct such payments this year.

General Rule for Deducting Prepaid Business Expenses

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 to which it applies. For example, if you pay a two-year lease in advance, you could only deduct the portion of the lease payment that applies to the current year.

Important Exception: The 12-Month Rule

But an important exception exists, 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.

You may use the 12-month rule for business insurance premiums, business licenses, rents and leases, and payments to terminate business contracts. However, you may not use it for payments for interest, loans, and other financial interests, or purchases of furniture, equipment, and other long-term capital assets.

Example. You're a calendar-year taxpayer, and you pay $1,000 per month in rent for your business office. On December 31, 2022, you mail a rent check to your landlord for $12,000 to cover all of your 2023 rent. Your landlord doesn't receive the payment in the mail until January 2, 2023. The 12-month rule applies. The benefit you've paid for—a business office—doesn't extend more than 12 months beyond January 1, 2023. So, the full $12,000 is deductible in 2022. Also, your landlord doesn't have to pay tax on the $12,000 until 2023 because he didn't get the rent check until 2023.

Before you prepay expenses in this way, let the payee, whether your landlord or other person or company, know what you're doing. Otherwise, they might not deposit your payment, thinking you sent it by mistake. Most landlords and others are more than happy to accept payments in advance.

Also, make sure you can prove to the IRS when you sent the advance payment. You could pay electronically through your bank or an online service like PayPal. That way, you'll automatically have a record of the electronic payment. If you pay by mailed check, use U.S. Postal Service priority mail with tracking, or certified or registered mail. This way, you have proof of the date you mailed the check and proof of when the payee received it.

Whether You Should Prepay Expenses

Of course, whether prepaying expenses makes sense depends on your tax rate this year and in future years, as well as future changes in tax laws that might raise your taxes. If you expect your income to go up substantially next year, you could be better off not prepaying expenses and instead maximizing your deductions for next year.

Learn More

To learn more about making the most of your business deductions, get Nolo's Deduct It! by Stephen Fishman, J.D.