One-Year Rule for Prepaid Expenses
The final regulations under Sec. 263(a) issued
in January 2004 included a 12-month rule (Regs. Sec. 1.263(a)-4(f)), whereby
taxpayers are not required to capitalize an expense if it is paid or incurred
(see Regs. Sec. 1.263(a)-4(j)) to create a right or benefit that does not extend
beyond the earlier of (1) 12 months after the first date of the right or benefit
or (2) the end of the tax year following the tax year in which the expense was
paid or incurred.
Regs. Sec. 1.263(a)-4(f)(6) makes it clear
that, for an accrual-method taxpayer, the 12-month rule does not eliminate the
other requirements for deduction – 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.
Example: Corporation X, an accrual-method
taxpayer with a calendar tax year, made two prepayments in June 2005. One
payment was for a fire and casualty insurance policy; the other was for
equipment rental. Both payments covered the period July 1, 2005 to June 30,
2006. X is not required to capitalize the portion of the insurance payment
attributable to 2006 because of the 12-month rule, and the portion can be
deducted in 2005 because the all-events test is met, the amount is determinable
with reasonable accuracy, and economic performance was satisfied on payment.
The portion of the rental payment attributable to 2006 does not have to be
capitalized because of the 12-month rule and, with the all-events and
determinable-with-reasonable-accuracy requirements met, it can be deducted in
2005 if the payment satisfies the requirements for the economic performance
recurring-item exception under Regs. Sec. 1.461-5.
The Sec. 263(a) regulations provided that for the first tax
year ending on or after December 31, 2003, taxpayers wishing to change their
accounting method to a method consistent with the regulations can make the
change using the automatic consent procedure described in Rev. Proc. 2002-9.
Accordingly, for example, a calendar-year taxpayer could make a change to apply
the 12-month rule beginning with its tax year ended December 31, 2003, by filing
Form 3115, Application for Change in Accounting Method, by the due date
(including extensions) of its 2003 return.
Rev. Proc. 2004-23 was issued later. It provided
additional guidance for completing Form 3115 under the automatic consent
procedure to change to an accounting method to conform to the Sec. 263(a)
regulations for the first tax year ending on or after December 31, 2003.
Taxpayers could also use the procedure to correspondingly change their
accounting methods to use the economic performance 3½-month rule or
recurring-item exception in conjunction with the items changed under the
12-month rule, by including this information on the same Form 3115. The
availability of the automatic consent procedure to change to the 12-month rule
and to use the 3½-month rule or recurring-item exception was later extended by
Rev. Proc. 2005-9 for taxpayers’ second tax year ending on or after December 31,
2003.
Rev. Proc. 2006-12 was issued on December 21, 2005. It
allows taxpayers to change, under the automatic consent procedure, to an
accounting method provided under the Sec. 263(a) regulations beginning with tax
years ending on or after December 31, 2005. However, a major departure form
Rev. Proc. 2004-23 and 2005-9 was made. Rev. Proc. 2006-12 only applies to
taxpayers changing to an accounting method provided under the Sec. 263(a)
regulations; it does not apply to taxpayers changing their method using the
economic performance 3½-month rule or recurring-item exception. Rev. Proc.
2006-12 states:
Thus, for a change in method of accounting
utilizing the 3½-month rule or the recurring-item exception in conjunction with
a change to a method provided by the final regulations, a taxpayer must file two
separate applications for a change in method of accounting – an application for
a change in method of accounting under this revenue procedure to change to the
method of accounting provided in the final regulations, and a separate
application for a change in method of accounting under Rev. Proc. 97-27 for a
change in method of accounting utilizing the 3½-month rule or the recurring-item
exception.
Accordingly, in the example above, to change to an
accounting method under which X could deduct in 2005 the insurance premium and
equipment rental payments attributable to 2006, X would have to file two Forms
3115 – one under the automatic consent procedure by the due date of the 2005
return to change to the 12-month rule for both payments, and the other under the
advance consent procedure, which would have to be filed by December 31, 2005 to
permit X to use the recurring-item exception to deduct its equipment rental
payment.
It appears the IRS made this significant change due to its
findings that change to the use of the 3½-month rule or recurring-item exception
when it is necessary to comply with the economic performance requirement in
conjunction with a change to the 12-month rule was often not being made, and
when made the exception may not have been applied correctly. It also appears
that the IRS is proposing to modify Rev. Proc. 2006-12 to allow taxpayers in
this situation to file one Form 3115 for both changes (instead of two) under the
advance consent procedure. Rev. Proc. 2006-12 was modified by Rev. Proc.
2006-37 to allow taxpayers to file one Form 3115 for both changes.
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