Allowed Prepaid Expenses for Cash Basis Corporations

The final regulations for IRC Section 263 created what is known as the

12 month rule with certain exceptions. The 12 month rule is the exception to the general rule that says if the benefit extends beyond the current year, you should capitalize.

The 12 month rule says you can deduct prepaid expense if the benefit does not extend beyond 12 months AND the benefit does not extend beyond the next tax year.

Some examples for payments made on Aug. 1 of this year:

$12,000 paid for water and sewer charges for your business that cover the period from 8/1/11 to 6/1/12. You can fully deduct the $12K because the benefit does not extend beyond 12 months nor does it go into 2013.

$12,000 paid for business liability insurance that covers a two year period. You can not deduct the $12K because the benefit extends beyond

12 months. You can deduct 5 months / 24 months x $12K in 2011 or $2500.

$12000 paid for an exterminator contract that runs through the end of

2012. You can not deduct the $12K because it fails the 12 month rule. You can only deduct 5 months / 17 months x $12K.

$12,000 prepaid interest for the remainder of a business loan that covers the period through 6/30/12. Even though this meets the 12 month rule, you can not deduct the $12K because interest expense is an exception to the 12 month rule. You can only deduct 5 months of interest.

You can find more info on this subject by doing an internet search on prepaid expenses 12 month rule. Just make sure the result was written after the final regs were published in January 2004.

Also note, that if you have not been following the 12 month rule and decide to now use it, that is a change in accounting that requires you to file Form 3115 Change In Accounting Method consistent with the applicable revenue procedure. You can elect to use the 12 month rule for certain expenditures and capitalization for other expenses. Lastly, I am certain that those involved in farming and ranching have exceptions that allow a deduction for prepaid expenses that create a benefit that goes beyond 12 months.

How do we reconcile this information with something like IRS 2010 Publication 535, page 21, which specifically forbids prepaying insurance premiums?

Page 21 is citing the general rule (the second sentence of my post). You can elect to use the 12 month rule that effectively meets the definition of not extending substantially beyond the end of the year.

To make sure I understand the last paragraph: if a cash basis tax payer has never capitalized expenses that go into future years, are they deemed to be by default already on the 12 month rule? I gather you only need to file Form 3115 if you have explicitly made use of the general rule on some issue in your past?

Here's my understanding for a specific type of expense:

If you have been following the general rule and only have been deducting the current year expense when you prepay (effectively you have been capitalizing the expense paid that goes beyond the current year) and you later decide to deduct all of the prepaid expense that meets the 12 month rule, that's a change in accounting.

If you have been following the 12 month rule and have been deducting all prepaid expense in the year paid that passes the test and you later decide to capitalize the amount that extends beyond the current year, that's also a change in accounting.

To the extent that the general rule is the default, are you allowed to never use the general rule and always use the 12 month rule, and therefore be under the 12 month rule without ever filing an application?

It's not a matter of which is the default. You select your method of accounting when you start to take deductions. If you start out using the general rule, then that's your method. If you start out using the 12 month rule, then that's your method.