The Opportunity
As you consider ways to reduce your federal, state and local tax liability, be sure you don’t overlook prepaid expensing. Prepaid expenses cover any payments your business is making for goods and services to be received in the near future, such as prepaid insurance and prepaid maintenance agreements. Unlike accrued expenses, your business will receive the benefits of your payment in a later period. For accrual basis taxpayers, this means that the tax deduction for prepaid expenses won’t be available until after the cash has been expended.
What to Look For
While prepaid expenses are typically recorded as assets on a balance sheet, their value is expensed
over time as the benefit is received. Take insurance, for example. Insurance is a prepaid expense, because the purpose of it is to buy protection in case something unfortunate happens. If your company has a one-year insurance policy cost of $24,000, as each month passes, $2,000 of prepaid insurance would be expensed to the income statement until the account is depleted. If you prepay your insurance on December 31, then under accrual basis accounting, you won’t recognize the expense until the following year, as the business benefits from the insurance coverage.
The Benefit
The tax laws allow most prepaid expenses that span 12 months or less to be deducted when paid, even if
the business is otherwise on the accrual basis, if certain conditions are met. Although this is considered a
change in accounting method, an automatic method change is allowed to deduct prepaid expenses on a
cash basis for income tax purposes. The benefit is that you can accelerate the deduction for the prepaid
expenses on your balance sheet in the current year. Although this is a timing benefit, if you consistently
carry prepaid expenses, the business will essentially gain a one-time permanent benefit from the prepaid
expenses on the balance sheet.
For more information on the above article or any business tax services, contact Lesley L. Price, CPA at 334-887-7022.
