By Andrea Flores, owner of Simmer Tax and Accounting
Every December, business owners ask the same question. If I pay next year’s bills now, can I deduct them this year? Sometimes the answer is yes. Sometimes it is no. And sometimes it is yes, but you still should not do it. Here is how it works.
The basic rule
If your business uses the cash method (you count money when it actually comes in or goes out), which most small businesses do, you usually deduct an expense when you pay it. But there is a catch for prepaid expenses. In general, an expense you pay in advance is deductible in the year it applies to, not the year you paid it. So paying next year’s rent in December does not automatically make it a deduction this year.
The 12 month rule
The IRS has an exception called the 12 month rule. You can deduct a prepaid expense in the year you pay it if the benefit does not last longer than the earlier of these two things: 12 months after the benefit starts, or the end of the next tax year.
Here is a simple example. You pay $6,000 in December for a one year business insurance policy that starts January 1. The benefit lasts 12 months, so it fits the rule, and you can generally deduct the full $6,000 this year. Now say you pay for a three year policy instead. That does not fit, so you can only deduct the part that belongs to this year.
Things this often applies to
Common examples are business insurance, a year of software subscriptions, and rent for the next 12 months. The IRS also says that if you have not been handling prepaid expenses this way before, you may need IRS approval to change how you handle them. That is a conversation for your tax preparer, not something to figure out on December 30.
When prepaying is a bad idea
A deduction is not free money. If you spend $6,000 to save maybe $1,500 in taxes, you are still out $4,500 in cash. Prepaying only makes sense if you were going to spend the money anyway and you have the cash to spare. Draining your bank account in December to lower a tax bill can leave you short in January and February, which are slow months for a lot of businesses.
This is where a Q4 tax projection helps. It shows whether a prepayment would actually make a real difference this year, or whether you are better off keeping the cash.
Record it the right way
Prepaid expenses need to be recorded correctly in your bookkeeping. If a prepayment is recorded wrong, your monthly reports next year will look off, because the whole cost shows up in one month instead of being spread out. A real person on our team reviews prepayments so your reports stay accurate all year.
This is general information, not tax advice for your specific situation.
If you want help planning year end moves with bookkeeping you can trust, take our short quiz. It is three questions, and it tells you if we would be a good fit to work together.
https://simmertaxquiz.netlify.app/
Andrea
Common questions
Q: Can I deduct prepaid business expenses this year?
A: Sometimes. Under the IRS 12 month rule, a cash method business can generally deduct a prepaid expense in the year it is paid if the benefit does not extend beyond the earlier of 12 months after it starts or the end of the next tax year.
Q: What is the IRS 12 month rule?
A: The 12 month rule lets cash method businesses deduct certain prepaid expenses in the year they pay them, as long as the benefit does not last longer than 12 months after it begins or past the end of the following tax year.
Q: Is prepaying expenses in December always a good idea?
A: No. A deduction only saves part of what you spend. Prepaying only makes sense if you were going to spend the money anyway and can afford to have less cash on hand.
Q: Do I need IRS approval to use the 12 month rule?
A: If you have not been applying these rules to prepaid expenses before, the IRS says you may need approval to change your method. Ask your tax preparer first.
Sources: IRS Publication 538, Accounting Periods and Methods
