The general rule for prepaid expenses is that any prepayment for a service or benefit must be capitalized and amortized over the useful life of such payment. The following are general rules to qualify for the prepaid expense tax deduction and how they can impact your business.
The 12-Month Rule
The “12-month rule” allows for the deduction of a prepaid expense in the current year if the right or benefit paid for does not extend beyond the earlier of:
- 12 months, or
- the end of the taxable year following the taxable year in which the payment is made.
For cash basis taxpayers, prepaid expenses can be deducted as long as the 12-month rule is met.
Example: Calendar-year cash basis taxpayer SmallCorp pays $10,000 on December 31, 2020, for an insurance policy that is effective January–December 2021. Since the benefit of the insurance policy does not extend more than 12 months or beyond the end of taxable year following the year the payment was made, the 12-month rule applies and the full $10,000 is deductible in 2020.
Prepaid expenses
