Can You Prepay Expenses at the End of the Year to Reduce Your Taxable Income?

If you are a sole proprietor or small business owner, you need to keep track of your income tax liability all year and make estimated tax payments as necessary. As the end of the year approaches you generally have a clearer idea of what your income tax situation will be when it comes time to prepare your tax return for the year. This affects the estimated tax payment you may have to make in January and any tax you will owe or refund you will receive when you file your return.

One of the ways to reduce your tax bill is to increase your tax-deductible expenses for the year. For example, you could purchase supplies in December rather than waiting until January. Or you could purchase items that qualify you for the section 179 deduction. This deduction allows you to write off in the current year the total cost of machinery and equipment, certain installations, off-the-shelf computer software, and livestock.

As indicated by Joyce M. Rosenberg writing for the Associated Press, the amount of the section 179 deduction is scheduled to decrease. In 2011 the maximum deduction is $500,000, and drops to $125,000 in 2012 and $25,000 in 2013.

Prepayments of other types of expenses such as interest, rent and insurance may not be completely deductible in the year you make the payment. According to the IRS, you generally cannot deduct expenses paid in advance, under either the cash or accrual method. If the prepayment creates an asset with a useful life that extends beyond the end of the current year, you could only deduct the portion that applies to the current year. For example, if you pay a two-year lease in advance, you could only deduct the portion of the lease payment that applies to the current year.

Interest can be deducted only in the year when it is due. If you make a prepayment this year on a business loan installment that is not due until next year you could not deduct the interest this year.

The general rule is that you cannot claim a deduction in the current year for the portion of prepaid expenses that apply to a future year. But as explained by Peter Shannon & Co., according to a 12-month rule included in the IRS regulations, you can claim a deduction in the current year if the payment creates a right or benefit that does not extend beyond 12 months.

For example, if you prepay an insurance policy or a rental contract during the year and the period covered is not more than 12 months, you could deduct the entire expense in the year you make the payment rather than allocating part of the expense to the next year. According to Perelson Weiner LLP, the 12-month rule applies to both cash and accrual basis taxpayers. Some of the types of prepayments that can be considered include rent, insurance, licenses, service contracts, and covenants not to compete.

Lowering your tax bill this year by prepaying expenses is a tax strategy related to timing. You are in effect postponing tax. The overall advantage of shifting expenses to the current year depends on your comparative effective tax rate this year and in future years and the effects of any changes in tax laws, such as in tax rates and allowable deductions and credits. Also, the tax effects of making prepayments should be taken into consideration as part of your overall business strategy, including cash flow aspects.

Sources:

Deducting Prepaid Expenses under Cash Basis Method, Lawyers.com

Joyce M. Rosenberg, "Generous small business tax deduction is shrinking", Associated Press

One-Year Rule for Prepaid Expenses, Peter Shannon & Co., Certified Public Accountants

Publication 535, Business Expenses, IRS