Question

Explain the 12-month rule for prepaid expenses allowed under the US tax law and explain its importance for taxpayers.

Answer 1

The 12-Month Rule

The 12-month rule says that the individual may deduct the full amount of an advance payment in the year the payment is made if it creates rights or benefits for the taxpayer that do not extend beyond the earlier of:

• 12 months after the right or benefit begins, or
• The end of the tax year after the tax year in which payment is made.

Example 1: The 12-Month Rule.

• Individual a cash basis taxpayer on a calendar year.
• On September 30, 2014 individual pay $2,000 for business insurance covering one year.
• The policy begins October 1, 2014 and ends September 30, 2015.

Result:

• The 12-month rule applies.
• Deduct the full $2,000 in 2014

The benefit does not extend beyond 12 months after the right to receive the benefit begins - October 1, 2014.

Example 2: The 12-Month Rule.

• Individual a cash method taxpayer on a calendar year.
• On September 1, 2014 individual pay $1,000 for business insurance covering the first six months of 2015 (January 1, 2015 through June 30, 2015).

Result:

• The 12-month rule applies.
• Deduct the full $1,000 in 2014 when the payment was made.

Although the benefit begins January 1, 2015, it does not extend beyond the end of 2015 (the year following the year of payment).