When are prepaid expenses deductible?

In Brief

Deducing Deductibility As long as the clear-reflection-ofincome standard is satisfied, taxpayers in the Seventh Circuit, regardless of their accounting method, now have authority for deducting fixed, one-year recurring items whose benefit extends into the next taxable year. The Seventh Circuit joins the Ninth Circuit in adopting this position. importantly, the IRS appears to have conceded the issue by announcing that it expects to issue proposed regulations allowing for the immediate deduction of prepaid expenses that satisfy a one-year rule. When issued, these proposed regulations will eliminate much of the uncertainty Surrounding this issue.

In U.S. Freightways Corp. [88 AFTR 2d 2001-6703 (6th Cir. 2001), rev'd and rem'd 113 TC 329 (1999)], the Seventh Circuit reversed the Tax Court's decision and allowed an accrual-bases taxpayer to currently deduct licenses, fees, and insurance premiums benefiting a 12-month period that extended into the next tax year. The Seventh Circuit adopted a one-year rule that allows both cash-and accrual-bases taxpayers to immediately deduct fixed, one-year recurring expenses that benefit the next taxable year. The IRS argued against a one-year rule, but later announced plans to issue proposed regulations that would allow taxpayers to immediately deduct prepaid items that satisfy a 12-month rule (Ann. 2002-9, 2002-7 IRB 536). The proposed regulation will allow taxpayers to immediately deduct prepaid expenses whose benefit does not extend beyond the earlier of 12 months after the taxpayer starts realizing the benefit from teh expenditure or the end of the taxable year following the year of payment.