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 or rent. However, there are some tricky rules you need to be aware of to deduct such payments this year.
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.
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:
Example 1: You’re a calendar-year taxpayer and you pay $10,000 on December 31, 2016, for a business insurance policy that’s 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, 2017 (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 2018 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.
To use the 12-month rule, you must apply it when you first start your business. You must get IRS approval if you haven’t been using the rule and want to start doing so. Such 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.
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.
To learn more about making the most of your business deductions, see Nolo's Deduct It! by Stephen Fishman, J.D.