In general, both cash and accrual basis taxpayers must capitalize prepaid expenses that benefit the taxpayer beyond the end of the taxable year of payment. This is why you often see prepaid assets related to insurance contracts and similar expenses capitalized on the balance sheet; to be expensed as the benefits are enjoyed by the taxpayer.
Effective 1.1.2004, however, Treasury Regulation 1.263(a)-4 gave taxpayers a nice little planning opportunity by creating the “12-month rule.”
The “12-month rule,” however, provides that a taxpayer does not have to capitalize prepaid expenses if the right or benefit doesn’t extend beyond the earlier of:
(1) 12 months after the first date on which the taxpayer realized the right or benefit, or
(2) the end of the tax year following the tax year in which the payment was made.
Consider the following examples:
On December 1, 2010, XCo pays a $10,000 insurance premium to obtain a property insurance policy with a one-year term that begins on February 1, 2011. Because the right or benefit attributable to the $10,000 payment extends beyond the end of the tax year following the year XCo makes the payment, the 12-month rule does not apply and XCo must capitalize the $10,000 payment.
Variation: Assume the same facts except that the policy has a term beginning on December 15, 2010. The 12-month rule now applies because the right or benefit attributable to the payment neither extends more than 12 months beyond December 15, 2010 (the first date the corporation realizes the benefit) or beyond the tax year following the year the payment is made. XCo need not capitalize the $10,000 payment.
Pretty nice, right? A taxpayer will significant qualifying prepaid assets can enjoy a one time favorable timing adjustment by changing their method of accounting to deduct these expenses.
As one taxpayer learned today, however, one of the key requirements for enjoying the benefits of IRS-granted opportunities like the 12-month rule is that the law actually be effective.
In Lattice v. Commissioner, T.C. Memo 2011-100, the taxpayer, a corporation, could see the writing on the wall in 2002 that the 12-month rule was coming. Recent decisions by the appeals court in Zazinovich and US Freightways Corporation had permitted the taxpayer to deduct certain short-term prepaid assets, and the IRS had issued both a Notice of Proposed Rulemaking and Industry Directive indicating that they too would soon adopt a 12-month rule permitting taxapayers to deduct certain prepaid expenses.
However, in December 2002, the IRS asked taxpayers not to submit a change in accounting method to deduct these prepaid expenses until regulations were finalized.
Undeterred, the corporation filed a 3115 seeking to change its accounting method in 2002, and deducted its prepaid expenses on its 2002 return, generating a large NOL that it carried back to earlier years, generating sizable refunds.
The IRS denied the change in method, and then denied the deduction of the prepaid expenses, citing the lack of final regulations on the issue. The Tax Court agreed, holding that in order for the corporation to benefit from the 12-month rule, it would have to wait until the final regulations were promulgated in 2004.