Timing of Tax Deductions

§461 What year to deduct an expense?:

see:
The 2½ month rule: Regs §1.404(b)-1T A-2(b)(1) regarding accrual of deferred compensation
The 3½ month rule: Regs §1.461-4(d)(6)(ii) regarding prepaid services
The 8½ month rule: Regs §1.461-5(b)(1)(i) regarding accrual of reoccurring items
The 12 month rule: Regs §1.263(a)-(4)(f) regarding prepaid intangibles

The 3½ month rule:
Regs §1.461-4(d)(6)(ii) A taxpayer is permitted to treat services or property as provided to the taxpayer as the taxpayer makes payment to the person providing the services or property (as defined in paragraph (g)(1)(ii) of this section), if the taxpayer can reasonably expect the person to provide the services or property within 3-1/2 months after the date of payment.

The 8½ month “recurring item” rule:
Under the recurring item exception, a liability is treated as incurred for a taxable year if —

1.461-5(b)(1)(i) As of the end of that taxable year, all events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy;

(ii) Economic performance with respect to the liability occurs on or before the earlier of

(ii)(A) The date the taxpayer files a timely (including extensions) return for that taxable year; or

(ii)(B) The 15th day of the 9th calendar month after the close of that taxable year;

(iii) The liability is recurring in nature; and

(iv) Either

(iv)(A) The amount of the liability is not material; or

(iv)(B) The accrual of the liability for that taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs.

From IRS Publication 538

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.

The all-events test has been met. The test is met when:
- All events have occurred that fix the fact of liability, and
- The liability can be determined with reasonable accuracy.
Economic performance has occurred.

You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Example. You are a calendar year taxpayer. You buy office supplies in December 2003. You receive the supplies and the bill in December, but you pay the bill in January 2004. You can deduct the expense in 2003 because all events have occurred to fix the fact of liability, the liability can be determined, and economic performance occurred in 2003.

Your office supplies may qualify as a recurring item, discussed later. If so, you can deduct them in 2003, even if the supplies are not delivered until 2004 (when economic performance occurs).

Workers’ compensation and tort liability. If you are required to make payments under workers’ compensation laws or in satisfaction of any tort liability, economic performance occurs as you make the payments. If you are required to make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments.

Taxes. Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. are paid. However, you can elect to treat taxes as a recurring item, discussed later. You can also elect to ratably accrue real estate taxes. See chapter 6 of Publication 535 for information about real estate taxes.

Other liabilities. Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts.

Interest. Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender’s money) rather than as payments are made.

Compensation for services. Generally, economic performance occurs as an employee renders service to the employer. However, deductions for compensation or other benefits paid to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. For information on employee benefit programs, see Publication 15-B, Employer’s Tax Guide to Fringe Benefits.

Vacation pay. You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the amount is vested, within 2 months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid. An amount is vested if your right to it cannot be nullified or cancelled.

Exception for recurring items. An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. The exception applies if all the following requirements are met.

The all-events test, discussed earlier, is met.
Economic performance occurs by the earlier of the following dates.
- 8½ months after the close of the year.
- The date you file a timely return (including extensions) for the year.
The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met.
Either:
- The item is not material, or
- Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance.

This exception does not apply to workers’ compensation or tort liabilities.

Amended return. You may be able to file an amended return and treat a liability as incurred under the recurring item exception. You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 8 1/2 months after the close of the tax year.

Recurrence and consistency. To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future.

Materiality. Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements.

An item considered material for financial statement purposes is also considered material for tax purposes. However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance.

Matching expenses with income. Costs directly associated with the revenue of a period are properly allocable to that period. To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles are an important factor. For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. However, the matching requirement is considered met for certain types of expenses. These expenses include taxes, payments under insurance, warranty, and service contracts, rebates and refunds, and awards, prizes, and jackpots.

An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the “12-month rule.” Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following.

12 months after the right or benefit begins, or
The end of the tax year after the tax year in which payment is made.

If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. See Change in Accounting Method, later, for information on how to get IRS approval. See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules.

Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person’s gross income. Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons. For purposes of this rule, the following persons are related.

Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal descendants.
Two corporations that are members of the same controlled group as defined in section 26 USC 267(f).
The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
A tax-exempt educational or charitable organization and a person (if an individual, including the members of the individual’s family) who directly or indirectly controls such an organization.
An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
A PSC and any employee-owner, regardless of the amount of stock owned by the employee-owner.

Ownership of stock. To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

Stock owned directly or indirectly by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries.
An individual is treated as owning the stock owned directly or indirectly by or for the individual’s family (as defined in item (1) under Related persons ).
Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly or indirectly by that individual’s partner.
To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock.

Reallocation of income and deductions. Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests.

If you use an accrual method of accounting and contest an asserted liability, you can deduct the liability either in the year you pay it (or transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions.

Conditions to be met. You must satisfy each of the following conditions to take the deduction in the year of payment or transfer.

Liability must be contested. You do not have to start a suit in a court of law to contest an asserted liability. However, you must deny its validity or accuracy by a positive act. A written protest included with payment of an asserted liability is enough to start a contest. Lodging a protest in accordance with local law is also enough to contest an asserted liability for taxes. You do not have to deny the validity or accuracy of an asserted liability in writing if you can show by all the facts and circumstances that you have asserted and contested the liability.

Contest must exist. The contest for the asserted liability must exist after the time of the transfer. If you make payment after the contest is settled, you must accrue the liability in the year in which the contest is settled.

Example. You are a calendar year taxpayer using an accrual method of accounting. You had a $500 liability asserted against you in 2000 for repair work completed that year. You contested the asserted liability and settled in 2002 for the full $500. You pay the $500 in January 2003. Since you did not make the payment until after the contest was settled, the liability accrues in 2002 and you can deduct it only in 2002.

Transfer to creditor. You must transfer to the creditor or other person money or other property to provide for the payment of the asserted liability. The money or other property transferred must be beyond your control. If you transfer it to an escrow agent, you have met this requirement if you give up all authority over the money or other property. However, buying a bond to guarantee payment of the asserted liability, making an entry on your books of account, transferring funds to an account within your control, transferring your indebtedness or your promise to provide services or property in the future, or transferring (except to the creditor) your stock or the stock or indebtedness of a related person will not meet this requirement.

Liability deductible. The liability must have been deductible in the year of payment, or in an earlier year when it would have accrued, if there had been no contest.

Economic performance rule satisfied. You generally cannot deduct contested liabilities until economic performance occurs. For workers’ compensation or a tort liability, or a liability for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, warranty and service contracts, and taxes, economic performance occurs as payments are made to the person. The payment or transfer of money or other property into escrow to contest an asserted liability is generally not a payment to the claimant that discharges the liability. This payment does not satisfy the economic performance test, discussed earlier, except as provided in section 26 USC 468B or the regulations thereunder.

Recovered amounts. An adjustment is usually necessary when you recover any part of a contested liability. This occurs when you deduct the liability in the year of payment and recover any part of it in a later tax year when the contest is settled. Include in gross income in the year of final settlement the part of the recovered amount that, when deducted, decreased your tax for any tax year.

In general, an expense cannot be deducted if paid in advance. This is true for both the cash basis method of accounting (the choice for most individuals) and the accrual method of accounting (used by some businesses, including businesses run by individuals). The prepaid amount is treated as an asset with a useful life extending beyond the current tax year, and carried over to the tax year where the expense applies.

The general rules for prepaid expenses (and income) and for accrued expenses (and income) are listed below for Cash Basis taxpayers and then for Accrual Basis taxpayers. Don’t take these two terms too literally. Some Cash Basis taxpayers are allowed to accrue some items. And some Accrual Basis taxpayers must report on the Cash Receipts and Cash Disbursements method for some items.

There are many special rules and exemptions dealing with all sorts of unique circumstances, so you should check with your income tax advisor before applying any of these general rules to your own situation.

Cash Receipts and Cash Disbursements method of accounting

Cash basis taxpayers record income when it is received, and claim deductions when expenses are paid. (Treas. Reg. § 1.446-1(c)(i)) A cash basis taxpayer can look to the “doctrine of constructive receipt” and the “doctrine of cash equivalence” to help determine when income is received. Most individuals start as cash basis taxpayers. There are three types of taxpayers that cannot use the cash basis: (1) C corporations; (2) partnerships with at least one C corporation partner; and (3) tax shelters. (IRC § 448(a))

See (IRC § 448(c)) for the less than $25,000,000 Gross Receipts exception

Accrual method of accounting

Accrual basis taxpayers record items when they are earned and claim deductions when expenses are owed. (Treas. Reg. § 1.446-1(c)(ii)) An accrual basis taxpayer looks to the “all-events test” and “earlier-of test” to determine when income is earned. (Treas. Reg. § 1.446-1(c)(1)(ii)(A); Revenue Ruling 74-607) Under the “all-events test,” an accrual basis taxpayer generally must include income “for the taxable year when all the events have occurred that fix the right to receive income and the amount of the income can be determined with reasonable accuracy. Under the “earlier-of test,” an accrual basis taxpayer receives income when (1) the required performance occurs, (2) payment therefore is due, or (3) payment therefore is made, whichever happens earliest. (Revenue Ruling 74-607) Under the “earlier of test” outlined in Revenue Ruling 74-607, an accrual basis taxpayer may be treated, as a cash basis taxpayer, when payment is received before the required performance and before the payment is actually due. An accrual basis taxpayer generally can claim a deduction “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.” (Treas. Reg. § 1.461-1(a)(2)(i))

Per reg 1.263(a)-4(f)(7), you can elect not to have the 12-month rule apply. But once you elect for a particular item, are you bound as an accounting method for that item? I do not think so but thought I would confirm.

An example is prepaid insurance. Assume for 12/31/07 there is prepaid insurance which expires 6/30/08 for $10,000, and taxpayer capitalizes it for books, and elects not to deduct the $10,000 for tax purposes either. At 12/31/08, there is prepaid insurance of $12,000 which expires 6/30/09. I think I can still deduct the $12,000 on the 2008 calendar year tax return even though it is capitalized for books.

Twelve month rule exception:
•the rule does not apply if the prepaid amount does not extend beyond 12 months after the benefit begins.
•paying a 12 month insurance policy or 12 month licensing fee, for example, is generally deductible when the payment is made.
•cash basis taxpayers have been allowed to deduct insurance prepayments in excess of 12 months in the 8th circuit court (Waldheim Realty & Investment Co. v. Comr., 245 F.2d 823 (8th Cir. 1957), rev’g 25 T.C. 1216 (1957). The decision appears to turn on the taxpayer’s uniformity in deducting prepaid premiums.)
•prepayments which are purely tax-motivated may not be allowed as a current deduction even if they meet the 12-month test. (e.g., McMullan v. US., 686 F.2d 915 (Ct. Cl. 1982); Burck v. Comr., 63 T.C. 556 (1975), aff’d, 533 F.2d 768 (2d Cir. 1976).)
•Zaninovich v. Commissioner, KTC 1980-4 (9th Cir. 1980)

Since the proposed transfer will be in lieu of paying the 2003 rent and will not create a benefit in excess of 12 months after the current year, the exception to the general rule will not apply. Therefore, if you are a cash method taxpayer, you would be entitled to a rent deduction equal to the entire value of the realty in the year the property is transferred to Mr. Smith.
If you have adopted the accrual method of accounting for federal income tax purposes, the proper year for claiming a rental deduction is the year in which you occupy the property to which the rent payment relates. Since your proposed transfer of the 10 acres will be in lieu of payment of rent for 2003, you would be entitled to a rental deduction equal to the value of the 10 acres only on your 2003 federal income tax return if you are an accrual method taxpayer.

PPC 15L 15-16

Cash-basis taxpayers are not required to capitalize expenses that create any right or benefit that expires on or before the earlier of (1) 12 months after the first date on which the taxpayer realizes the right or benefit or (2) the end of the tax year following the year the payment was made. Taxpayers can elect, however, not to apply this 12 month rule. In that case, prepaid expenses are capitalized and amortized.

How to elect: the election is made by treating the amounts as capital expenditures on a timely filed original tax return for the year the amounts are paid.

Exception to the twelve month rule exception:
•the exception does not apply to interest expense.
•interest paid in one year that relates to a charge for the use of funds for any portion of a subsequent year may be deducted only in the subsequent year.

Exception to the exception to the twelve month rule exception:
•A narrow exception to the rule relating to prepaid interest applies to the payment of “points” when buying a house.
•A current deduction for points is allowed if: ◦the indebtedness upon which the points are paid is incurred to purchase or improve the payor’s principal residence; ◾a refinancing of the amount of existing debt does not pass this test.
◾new debt acquired after the purchase or improvement does not pass this test.

◦the indebtedness is secured by the taxpayer’s principal residence;
◦charging points is an established business practice of lenders in the locality in which the debt is incurred; and
◦the amount of the points does not exceed the amount generally charged by lenders in the locality.
◦All four conditions must be met in order for the taxpayer to be entitled to a current deduction for the points. If all four conditions are not met, the amount of the points must be amortized and deducted ratably over the term of the loan.

Exception to the exception to the exception to the twelve month rule exception:
•up to $100,000 is allowed as an exception.

to work on later..

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.

http://www.allbusiness.com/personal-finance/individual-taxes-tax-deductions/1090535-1.html

Since USFreightways could not prove that sections 162 and 263 sanction deductibility of the expenses, the court did not even address the issue of whether the company’s accounting method clearly reflected its income. Its conclusion was broad enough to apply to all accrual-method taxpayers and all expenditures whose benefits extend beyond the end of the current tax year. Accrual-method taxpayers must capitalize all expenditures that provide a substantial benefit beyond yearend. The fact that the expenses are recurring is immaterial. Likewise, there is no 12-month rule for accrual-method taxpayers.

Three-Pronged Test for Certain Prepaid Expenditures

All Events Test

Economic Performance

Recurring Item Exception

3½ month rule

2½ month rule accrued wages and payroll taxes

30 days rule for prepaid expenses (Tax Savvy page 71)

http://www.irs.gov/pub/irs-utl/am2007009.pdf

The first exception is the so-called “3 ½ month rule” in § 1.461-4(d)(6)(ii). That rule provides that a taxpayer is permitted to treat services or property as provided to the taxpayer (i.e., as economic performance) as the taxpayer makes payment to the person providing the services or property if the taxpayer can reasonably expect the person to provide the services or property within 3 ½ months after the date of payment

Unlike the deferred compensation rule, the 3 ½ month rule is an “all or nothing” rule with respect to a particular liability. Therefore, the 3 ½ month rule does not apply to allow a deduction in year 1 for a prepayment made at the end of year 1 for services to be performed in the first 3 ½ months of year 2 under a contract that extends beyond that 3 ½ month period

9 month rule

Property taxes generally accrue at some specific point in time when the tax becomes a lien on the property, personal liability for the tax arises, or some other definite event occurs. Economic performance, moreover, does not occur until the tax is paid. However, if a special election is made by an accrual method taxpayer, the taxpayer may deduct real property taxes ratably over the period to which the tax relates.

§461(c). See Regs. §1.461-1(c)(3)(ii) (Requiring that a taxpayer submit a written request for permission to make the election within 90 days after the beginning of the taxable year to which the election first applies); Rev. Proc. 2005-63, 2005-36 I.R.B. 491 (Providing a waiver of the 90-day requirement and procedures for eligible taxpayers to follow); Rev. Proc. 2007-56, 2007-34 I.R.B. 388 (Due date for election may be further extended for taxpayers affected by a Presidentially declared disaster or terroristic or military action (§7508A) and is extended for taxpayers serving in, or in support of, the Armed Forces in an area designated by the President as a combat zone or serving with respect to a contingency operation §7508)). See ¶2340 for further discussion of the election.

Tr month rule exception:
•etc.

http://www.farmdoc.uiuc.edu/legal/articles/ALTBs/archive/ALTB_01-12.html

Prepaid Expenses

Abstract:

While the rules for deducting prepaid farm expenses have not changed, the IRS is taking a closer look at the deduction in recent audits. This material discusses the general rules that make the expenses eligible for a current deduction.

FARM ISSUE, FOUND ON THE INTERNET (TO BE DELETED AFTER REVIEWING)

ISSUE 5: PREPAID EXPENSES: CHANGE OF PLANS

GENERAL RULES FOR PREPAID EXPENSES

Farm producers who use the cash method of accounting are allowed to deduct the cost of supplies purchased during the year even if the supplies will not be used until the following year if they meet the requirements of two sets of rules.

One set of rules comes from case law and IRS rulings. The general rule is stated in Grynberg v. Commissioner, 83 T.C. 255 (1984), and is applied to feed expenses in Rev. Rul. 79-229 1979-2 C.B. 210. This rule requires the producer to meet the following three conditions to claim a deduction in the year of the expenditure:

1. The expenditure must be a payment for the supply rather than a deposit.

2. The prepayment must be made for a business purpose and not merely for tax avoidance.

3. The deduction must not result in a material distortion of income.

The other set of rules is set out in I.R.C. §464(f). Those rules limit a taxpayer’s deduction for prepaid expenses to 50% of deductible expenses other than the prepaid expenses unless the taxpayer is a “qualified farm related taxpayer.” A “farm related taxpayer” is any taxpayer:

1. Whose principal residence is on a farm

2. Whose principal occupation is farming, or

3. Who is a member of the family of a taxpayer who meets the requirements of 1 or 2 above

To be “qualified,” the farm related taxpayer must meet one of the following two requirements:

1. Aggregate prepaid farm supplies for the prior three years must be less than 50% of the aggregate deductible farming expenses other than prepaid expenses, or

2. Extraordinary circumstances (such as a flood or a drought) caused prepaid expenses to exceed 50% of farming expenses other than prepaid expenses in the current year.

Example 1. Patty Producer uses the cash method of accounting. In December 2000, she paid $20,000 to Supply Cooperative for fertilizer to be applied in the spring of 2001 on her corn crop. Patty’s deductible expenses for 2000 other than this purchase of fertilizer was $100,000. She purchased the fertilizer in December for two reasons. First, she was offered a discount for purchasing in December rather than the following spring. Second, she was concerned that fertilizer may be difficult to buy at any price the following spring. Patty is allowed to deduct the $20,000 she paid for the fertilizer on her 2000 income tax return. She meets the three requirements of the general rule. I.R.C. §464(f) does not limit her deduction for two reasons. First, she is a qualified farm related taxpayer, so the 50% limit does not apply to her. Second, she has not exceeded the 50% limit.

EFFECT OF CHANGE IN PLANS

After purchasing supplies for the following year, a producer’s plans may change. He or she may decide not to produce the crop or raise the livestock for which the supply was purchased. Such producers must address the tax consequences of that change in plans.

Example 2. Assume the same facts as in Example 1, except that the price of corn dropped dramatically before Patty planted her crop and the cost of fertilizer increased significantly. Consequently, Patty decided to sell the fertilizer she had purchased and plant an alternative crop that does not require fertilizer. She found a buyer that paid her $25,000 for the fertilizer.

What are the income tax consequences of Patty’s change in plans?

Law and Analysis

Deduction on 2000 Tax Return. A potential consequence of Patty’s change in plans is a denial of the $20,000 deduction on her 2000 income tax return.

In Rev. Rul. 82-208, 1982-2 C.B. 58, the prepayment rules were applied to a payment of estimated state income taxes on December 31, 1981. The IRS noted that estimated state income taxes are deductible in the year they are paid if the amount of the payment is reasonably determined in good faith at the time of the payment. In that ruling, the IRS held that the taxpayer had no reasonable basis to believe that he owed any additional state income taxes and did not allow the estimated payment to be deducted on the 1981 income tax return.

Applying the principle of Rev. Rul. 82-208 to the facts in Example 2, the IRS is not likely to challenge Patty’s deduction of the $20,000 on her 2000 income tax return. At the time she made the payment, she in good faith thought that she would use the fertilizer on her 2001 corn crop.

Income on 2001 Tax Return. The sale of the fertilizer in 2001 results in taxable income for 2001. Since Patty deducted the cost on the fertilizer on her 2000 income tax return, she has a zero basis in the fertilizer. Therefore, Patty must report the full $25,000 that she received for the fertilizer on her 2001 income tax return. The other income line of Schedule F (line 10 on the 2001 Schedule F) is the logical place to report this income since it was neither purchased for resale (Schedule F, line 1) nor raised (Schedule F, line 4).

Other Supplies

The same tax consequences are likely to follow from the purchase and sale of other farm supplies so long as there is a good faith expectation the supply will be used in the farm business when it is purchased and there is a genuine change in plans that results in a sale of the supply. The following supplies are likely to qualify for the above tax consequences for the reasons listed with each supply.

Supply Reason for Sale

Feed Drought forced sale of livestock

Seed Weather conditions or market caused producer to not plant the crop

Pesticides Weather conditions or market caused producer to not plant the crop

Fuel Weather conditions or market caused producer to not plant the crop

Return of Supplies to Seller for a Credit

If the supplies are returned to the seller for a credit, the taxpayer must be careful to not trigger the deposit rule. If the supply is returned to the seller for a credit equal to the original amount paid, the original transaction could appear to be a deposit rather than a purchase. The taxpayer should document the negotiations that result in a credit for the taxpayer.

Example 3. Assume the same facts as in Example 2, and in addition assume that Patty sells the fertilizer back to Supply Cooperative and receives cash for the sale. These facts do not jeopardize Patty’s argument that the original purchase was a purchase and not a deposit.

If Patty received a credit from Supply Cooperative that could only be used to purchase other supplies from the cooperative, the IRS could argue that her original payment was a deposit and not a purchase. However, since Patty negotiated a different price for the fertilizer, she can show that she faced the risk of a price change. Therefore, she is likely to prevail on her argument that the original payment was a purchase.

If Patty received a credit from Supply Cooperative that is exactly equal to her original purchase price, it is more difficult for her to show that her original payment was not a deposit. She should document her negotiations with Supply Cooperative so that she can prove that she faced the risk of a price change and that the credit was the same as the original purchase price only because the value of the fertilizer when she returned it was the same as the cost of the fertilizer when she purchased it.

Sec. 461. General Rule For Taxable Year Of Deduction

461(a) General Rule
The amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.

461(b) Special Rule In Case Of Death
In the case of the death of a taxpayer whose taxable income is computed under an accrual method of accounting, any amount accrued as a deduction or credit only by reason of the death of the taxpayer shall not be allowed in computing taxable income for the period in which falls the date of the taxpayer’s death.

461(c) Accrual Of Real Property Taxes
461(c)(1) In General
If the taxable income is computed under an accrual method of accounting, then, at the election of the taxpayer, any real property tax which is related to a definite period of time shall be accrued ratably over that period.
461(c)(2) When Election May Be Made
461(c)(2)(A) Without Consent
A taxpayer may, without the consent of the Secretary, make an election under this subsection for his first taxable year in which he incurs real property taxes. Such an election shall be made not later than the time prescribed by law for filing the return for such year (including extensions thereof).
461(c)(2)(B) With Consent
A taxpayer may, with the consent of the Secretary, make an election under this subsection at any time.
461(d) Limitation On Acceleration Of Accrual Of Taxes

461(d)(1) General Rule
In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.
461(d)(2) Limitation
Under regulations prescribed by the Secretary, paragraph (1) shall be inapplicable to any item of tax to the extent that its application would (but for this paragraph) prevent all persons (including successors in interest) from ever taking such item into account.

461(e) Dividends Or Interest Paid On Certain Deposits Or Withdrawable Accounts
Except as provided in regulations prescribed by the Secretary, amounts paid to, or credited to the accounts of, depositors or holders of accounts as dividends or interest on their deposits or withdrawable accounts (if such amounts paid or credited are withdrawable on demand subject only to customary notice to withdraw) by a mutual savings bank not having capital stock represented by shares, a domestic building and loan association, or a cooperative bank shall not be allowed as a deduction for the taxable year to the extent such amounts are paid or credited for periods representing more than 12 months. Any such amount not allowed as a deduction as the result of the application of the preceding sentence shall be allowed as a deduction for such other taxable year as the Secretary determines to be consistent with the preceding sentence.
461(f) Contested Liabilities
If–
461(f)(1) the taxpayer contests an asserted liability,
461(f)(2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability,
461(f)(3) the contest with respect to the asserted liability exists after the time of the transfer, and
461(f)(4) but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer (or for an earlier taxable year) determined after application of subsection (h), then the deduction shall be allowed for the taxable year of the transfer. This subsection shall not apply in respect of the deduction for income, war profits, and excess profits taxes imposed by the authority of any foreign country or possession of the United States.

461(g) Prepaid Interest
461(g)(1) In General
If the taxable income of the taxpayer is computed under the cash receipts and disbursements method of accounting, interest paid by the taxpayer which, under regulations prescribed by the Secretary, is properly allocable to any period–
461(g)(1)(A) with respect to which the interest represents a charge for the use or forbearance of money, and
461(g)(1)(B) which is after the close of the taxable year in which paid, shall be charged to capital account and shall be treated as paid in the period to which so allocable.
461(g)(2) Exception
This subsection shall not apply to points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer to the extent that, under regulations prescribed by the Secretary, such payment of points is an established business practice in the area in which such indebtedness is incurred, and the amount of such payment does not exceed the amount generally charged in such area.

461(h) Certain Liabilities Not Incurred Before Economic Performance
461(h)(1) In General
For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

461(h)(2) Time When Economic Performance Occurs
Except as provided in regulations prescribed by the Secretary, the time when economic performance occurs shall be determined under the following principles:
461(h)(2)(A) Services And Property Provided To The Taxpayer
If the liability of the taxpayer arises out of–
461(h)(2)(A)(i) the providing of services to the taxpayer by another person, economic performance occurs as such person provides such services,
461(h)(2)(A)(ii) the providing of property to the taxpayer by another person, economic performance occurs as the person provides such property, or
461(h)(2)(A)(iii) the use of property by the taxpayer, economic performance occurs as the taxpayer uses such property.
461(h)(2)(B) Services And Property Provided By The Taxpayer
If the liability of the taxpayer requires the taxpayer to provide property or services, economic performance occurs as the taxpayer provides such property or services.
461(h)(2)(C) Workers Compensation And Tort Liabilities Of The Taxpayer
If the liability of the taxpayer requires a payment to another person and–
461(h)(2)(C)(i) arises under any workers compensation act, or
461(h)(2)(C)(ii) arises out of any tort, economic performance occurs as the payments to such person are made. Subparagraphs (A) and (B) shall not apply to any liability described in the preceding sentence.
461(h)(2)(D) Other Items
In the case of any other liability of the taxpayer, economic performance occurs at the time determined under regulations prescribed by the Secretary.

461(h)(3) Exception For Certain Recurring Items
461(h)(3)(A) In General
Notwithstanding paragraph (1) an item shall be treated as incurred during any taxable year if–
461(h)(3)(A)(i) the all events test with respect to such item is met during such taxable year (determined without regard to paragraph (1)),
461(h)(3)(A)(ii) economic performance with respect to such item occurs within the shorter of–
461(h)(3)(A)(ii)(I) a reasonable period after the close of such taxable year, or
461(h)(3)(A)(ii)(II) 8-1/2 months after the close of such taxable year,
461(h)(3)(A)(iii) such item is recurring in nature and the taxpayer consistently treats items of such kind as incurred in the taxable year in which the requirements of clause (i) are met, and
461(h)(3)(A)(iv) either–
461(h)(3)(A)(iv)(I) such item is not a material item, or
461(h)(3)(A)(iv)(II) the accrual of such item in the taxable year in which the requirements of clause (i) are met results in a more proper match against income than accruing such item in the taxable year in which economic performance occurs.
461(h)(3)(B) Financial Statements Considered Under Subparagraph (A)(iv)
In making a determination under subparagraph (A)(iv), the treatment of such item on financial statements shall be taken into account.
461(h)(3)(C) Paragraph Not To Apply To Workers Compensation And Tort Liabilities
This paragraph shall not apply to any item described in subparagraph (C) of paragraph (2).

461(h)(4) All Events Test
For purposes of this subsection, the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.

461(h)(5) Subsection Not To Apply To Certain Items
This subsection shall not apply to any item for which a deduction is allowable under a provision of this title which specifically provides for a deduction for a reserve for estimated expenses.

461(i) Special Rules For Tax Shelters
461(i)(1) Recurring Item Exception Not To Apply
In the case of a tax shelter, economic performance shall be determined without regard to paragraph (3) of subsection (h).
461(i)(2) Special Rule For Spudding Of Oil Or Gas Wells
461(i)(2)(A) In General
In the case of a tax shelter, economic performance with respect to amounts paid during the taxable year for drilling an oil or gas well shall be treated as having occurred within a taxable year if drilling of the well commences before the close of the 90th day after the close of the taxable year.
461(i)(2)(B) Deduction Limited To Cash Basis
461(i)(2)(B)(i) Tax Shelter Partnerships
In the case of a tax shelter which is a partnership, in applying section 704(d) to a deduction or loss for any taxable year attributable to an item which is deductible by reason of subparagraph (A), the term “cash basis” shall be substituted for the term “adjusted basis”.
461(i)(2)(B)(ii) Other Tax Shelters
Under regulations prescribed by the Secretary, in the case of a tax shelter other than a partnership, the aggregate amount of the deductions allowable by reason of subparagraph (A) for any taxable year shall be limited in a manner similar to the limitation under clause (i).
461(i)(2)(C) Cash Basis Defined
For purposes of subparagraph (B), a partner’s cash basis in a partnership shall be equal to the adjusted basis of such partner’s interest in the partnership, determined without regard to–
461(i)(2)(C)(i) any liability of the partnership, and
461(i)(2)(C)(ii) any amount borrowed by the partner with respect to such partnership which–
461(i)(2)(C)(ii)(I) was arranged by the partnership or by any person who participated in the organization, sale, or management of the partnership (or any person related to such person within the meaning of section 465(b)(3)(C)), or
461(i)(2)(C)(ii)(II) was secured by any asset of the partnership.
461(i)(3) Tax Shelter Defined
For purposes of this subsection, the term “tax shelter” means–
461(i)(3)(A) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale,
461(i)(3)(B) any syndicate (within the meaning of section 1256(e)(3)(B)), and
461(i)(3)(C) any tax shelter (as defined in section 6662(d)(2)(C)(ii)).
461(i)(4) Special Rules For Farming
In the case of the trade or business of farming (as defined in section 464(e)), in determining whether an entity is a tax shelter, the definition of farming syndicate in section 464(c) shall be substituted for subparagraphs (A) and (B) of paragraph (3).
461(i)(5) Economic Performance
For purposes of this subsection, the term “economic performance” has the meaning given such term by subsection (h).

461(j) Limitation On Excess Farm Losses Of Certain Taxpayers
[Editor’s Note: Section 15351(a) of Pub. L. 110-246 added subsec. (j) effective for taxable years beginning after December 31, 2009.]
461(j)(1) Limitation
If a taxpayer other than a C corporation receives any applicable subsidy for any taxable year, any excess farm loss of the taxpayer for the taxable year shall not be allowed.
461(j)(2) Disallowed Loss Carried To Next Taxable Year
Any loss which is disallowed under paragraph (1) shall be treated as a deduction of the taxpayer attributable to farming businesses in the next taxable year.
461(j)(3) Applicable Subsidy
For purposes of this subsection, the term “applicable subsidy” means–
461(j)(3)(A) any direct or counter-cyclical payment under title I of the Food, Conservation, and Energy Act of 2008, or any payment elected to be received in lieu of any such payment, or
461(j)(3)(B) any Commodity Credit Corporation loan.
461(j)(4) Excess Farm Loss
For purposes of this subsection–
461(j)(4)(A) In General
The term “excess farm loss” means the excess of–
461(j)(4)(A)(i) the aggregate deductions of the taxpayer for the taxable year which are attributable to farming businesses of such taxpayer (determined without regard to whether or not such deductions are disallowed for such taxable year under paragraph (1)), over
461(j)(4)(A)(ii) the sum of–
461(j)(4)(A)(ii)(I) the aggregate gross income or gain of such taxpayer for the taxable year which is attributable to such farming businesses, plus
461(j)(4)(A)(ii)(II) the threshold amount for the taxable year.
461(j)(4)(B) Threshold Amount
461(j)(4)(B)(i) In General
The term “threshold amount” means, with respect to any taxable year, the greater of
461(j)(4)(B)(i)(I) $300,000 ($150,000 in the case of married individuals filing separately), or
461(j)(4)(B)(i)(II) the excess (if any) of the aggregate amounts described in subparagraph (A)(ii)(I) for the 5-consecutive taxable year period preceding the taxable year over the aggregate amounts described in subparagraph (A)(i) for such period.
461(j)(4)(B)(ii) Special Rules For Determining Aggregate Amounts
For purposes of clause (i)(II)–
461(j)(4)(B)(ii)(I) notwithstanding the disregard in subparagraph (A)(i) of any disallowance under paragraph (1), in the case of any loss which is carried forward under paragraph (2) from any taxable year, such loss (or any portion thereof) shall be taken into account for the first taxable year in which a deduction for such loss (or portion) is not disallowed by reason of this subsection, and
461(j)(4)(B)(ii)(II) the Secretary shall prescribe rules for the computation of the aggregate amounts described in such clause in cases where the filing status of the taxpayer is not the same for the taxable year and each of the taxable years in the period described in such clause.
461(j)(4)(C) Farming Business
461(j)(4)(C)(i) In General
The term “farming business” has the meaning given such term in section 263A(e)(4).
461(j)(4)(C)(ii) Certain Trades And Businesses Included
If, without regard to this clause, a taxpayer is engaged in a farming business with respect to any agricultural or horticultural commodity–
461(j)(4)(C)(ii)(I) the term “farming business” shall include any trade or business of the taxpayer of the processing of such commodity (without regard to whether the processing is incidental to the growing, raising, or harvesting of such commodity), and
461(j)(4)(C)(ii)(II) if the taxpayer is a member of a cooperative to which subchapter T applies, any trade or business of the cooperative described in subclause (I) shall be treated as the trade or business of the taxpayer.
461(j)(4)(D) Certain Losses Disregarded
For purposes of subparagraph (A)(i), there shall not be taken into account any deduction for any loss arising by reason of fire, storm, or other casualty, or by reason of disease or drought, involving any farming business.
461(j)(5) Application Of Subsection In Case Of Partnerships And S Corporations
In the case of a partnership or S corporation–
461(j)(5)(A) this subsection shall be applied at the partner or shareholder level, and
461(j)(5)(B) each partner’s or shareholder’s proportionate share of the items of income, gain, or deduction of the partnership or S corporation for any taxable year from farming businesses attributable to the partnership or S corporation, and of any applicable subsidies received by the partnership or S corporation during the taxable year, shall be taken into account by the partner or shareholder in applying this subsection to the taxable year of such partner or shareholder with or within which the taxable year of the partnership or S corporation ends.
The Secretary may provide rules for the application of this paragraph to any other pass-thru entity to the extent necessary to carry out the provisions of this subsection.
461(j)(6) Additional Reporting
The Secretary may prescribe such additional reporting requirements as the Secretary determines appropriate to carry out the purposes of this subsection.
461(j)(7) Coordination With Section 469
This subsection shall be applied before the application of section 469.
(Aug. 16, 1954, ch. 736, 68A Stat. 157; Sept. 14, 1960, Pub. L. 86-781, Sec. 6(a), 74 Stat. 1020; Oct. 24, 1962, Pub. L. 87-876, Sec. 3(a), 76 Stat. 1199; Feb. 26, 1964, Pub. L. 88-272, title II, Sec. 223(a)(1), 78 Stat. 76; Oct. 4, 1976, Pub. L. 94-455, title II, Sec. 208(a), title XIX, Sec. 1901(a)(69), 1906(b)(13)(A), 90 Stat. 1541, 1775, 1834; July 18, 1984, Pub. L. 98-369, div. A, title I, Sec. 91(a), (e), 98 Stat. 598, 607; Oct. 22, 1986, Pub. L. 99-514, title VIII, Sec. 801(b), 805(c)(5), 823(b)(1), title XVIII, Sec. 1807(a)(1), (2), 100 Stat. 2347, 2362, 2374, 2811; Dec. 22, 1987, Pub. L. 100-203, title X, Sec. 10201(b)(5), 101 Stat. 1330-387; Nov. 10, 1988, Pub. L. 100-647, title I, Sec. 1008(a)(3), 1018(u)(5), 102 Stat. 3436, 3590; Dec. 19, 1989, Pub. L. 101-239, title VII, Sec. 7721(c)(10), 103 Stat. 2400; Nov. 5, 1990, Pub. L. 101-508, title XI, Sec. 11704(a)(5), 104 Stat. 1388-518; Aug. 20, 1996, Pub. L. 104-188, Sec. 1704, 110 Stat. 1755; Dec. 21, 2005, Pub. L. 109-135, title IV, Sec. 412(aa), 119 Stat. 2577; Pub. L. 110-246, title XV, Sec. 15351(a), June 18, 2008, 122 Stat. 1651.)

All-events test’s recurring-item exception under IRC §461(h)(3)

Rev. Rul. 2012-1

IRS Clarifies Recurring-Item Exception

IRS Sheds Light On The Use Of The Recurring Item Exception

Chief Counsel Advice CCA 201442048

Regs. §1.451-5(b) §1.451-5(d)

Accelerating Your Deduction for Prepaid Expenses

26 CFR § 1.461-1 – GENERAL RULE FOR TAXABLE YEAR OF DEDUCTION

§ 1.461-1 General rule for taxable year of deduction.

(1)Taxpayer using cash receipts and disbursements method. Under the cash receipts and disbursements method of accounting, amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid. Further, a taxpayer using this method may also be entitled to certain deductions in the computation oftaxable income which do not involve cash disbursements during the taxable year, such as the deductions for depreciation,depletion, and losses under sections 167, 611, and 165, respectively. If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made. An example is an expenditure for the construction of improvements by the lessee on leased property where the estimated life of the improvements is in excess of the remaining period of the lease. In such a case, in lieu of the allowance for depreciation provided by section 167, thebasis shall be amortized ratably over the remaining period of the lease. See section 178 and the regulations thereunder for rules governing the effect to be given renewal options in determining whether the useful life of the improvementsexceeds the remaining term of the lease where a lessee begins improvements on leased property after July 28, 1958, other than improvements which on such date and at all times thereafter, the lessee was under a binding legal obligationto make. See section 263 and the regulations thereunder for rules relating to capital expenditures. See section 467 and the regulations thereunder for rules under which a liability arising out of the use of property pursuant to a section 467 rental agreement is taken into account.

Retirement Plan Deduction: see IRC Sec §404(h)(1)(B) The contributions shall be deducted for a taxable year if such contributions are made on account of such taxable year and are made not later than the time prescribed by law for filing the return for such taxable year (including extensions thereof).
Cash-basis taxpayer paying for deductible items with a credit card:
IRS Revenue Ruling 71-216 previously held that once the credit card was paid off, than at that time the taxpayer may take the expense deduction. But later it was decided, with IRS Revenue Ruling 78-38 (and re-confirmed in T.C. Memo 2015-83) that when a credit card is used to pay for a deductible item a 3^rd party loan / debt is incurred and when that debt happens to be repaid does not have any bearing on when the deduction is allowable. Therefore, the item is deductible when the credit card is used to make a purchase and not when cash is disbursed to pay down the balance owed.

But that when the loan / debt is coming from the store or the provider of the item being deducted this is not the same situation. Examples are an in-house store open charge account or charge card, or a bank mortgage paying some of your interest by internally lending you the money (increasing the debt balance) to make the payment. One notable exception to this rule is for points charged with the original purchase money mortgage loan for the acquisition of a taxpayer’s primary residence.