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The 12-month Rule for Prepaid Expenses Explained

September 5, 2022

Businesses that use the cash basis of accounting record prepaid expenses at the time of payment. Under the accrual-based accounting method, the prepaid expense is recorded as an asset at the time of payment. The balance in the prepaid account is gradually transferred to the specific expense account over time.

ThIRS requires all businesses irrespective of the accounting method to deduct prepaid when they become due. An exception is the special 12-month rule that we will discuss in this blog post.

An Overview of the 12-Month Rule

Prepaid expenses refer to the expenses that are paid in advance. The prepaid expense generally relates to rent, utility, estimated taxes, and equipment.

The IRS requires that all businesses capitalize prepaid expenses. In other words, the expenses must be recorded as an asset for tax purposes.

However, the 12-month rule is an exception under which businesses can record prepaid expenses as an expense. Under this rule, businesses are allowed to deduct prepaid expenses in case the benefit of that expense does not exceed the earlier of the following.

  • 12 months from the date when a business paid the prepaid expense
  • End of the accounting year on which the prepaid expense is paid

As an example, suppose that you made advance payments for utility on July 01, 2022. The accounting benefit will extend up to June 25, 2023. In this situation, you can deduct the prepaid expenses in the income statement due to which the taxable amount will be lower.

Let’s consider another example.

Suppose that your company paid 8 months’ rent in advance on November 2022. You must capitalize the expense as the benefits extend beyond the end of the accounting year.

Conditions Under Which 12-month Rule Does Not Apply

Remember that under certain situations the 12-month rule does not apply for capitalizing prepaid expenses. You can write out the expense if the following conditions are met.

  • Salaries or wages
  • Insignificant amount (Less than $1,000)
  • Personal prepaid expenses
  • Amounts connected with payment of policies and plan

Businesses who have been capitalizing prepaid expenses instead of deducting them must submit Form 3115. The form is submitted to change the accounting method. This change ensures that you will not incur a penalty for not complying with taxation rules.

Availing of the 12-month rule allows corporations to deduct prepaid expenses during the same fiscal year. The result is a reduced tax amount for the business.

With the help of an outsource bookkeeping service provider, you can dedicate more time to your business.

Conclusion

Recording prepaid expense as an expense rather than an asset will result in a lower tax bill. But certain conditions must be met that were explained in this blog post.

Remember that you must change your accounting method by informing the IRS about it. This will ensure that you take benefit from the 12-months rule for making tax savings.

You should let Maxim Liberty take care of all your bookkeeping tasks. We have a team of highly experienced CPAs who can prepare accounting statements as per applicable state and federal rules.  Contact us today by dialing (703) 957-6938.

Maxim Liberty is a leading bookkeeping company with over 10 years of experience helping small businesses manage their finances. Passionate about making bookkeeping simple and stress-free, we share practical tips and insights.