Prepayment: to Deduct in Year 1 or Year 2?

Say you hire someone to provide a service to you in year one, the service is to be provided to you over a twelve month period, and you prepay the person for this yet to be provided service. When can you claim a deduction for this prepayment? The IRS Office of Chief Counsel recently said that accrual method taxpayers cannot deduct any portion in year one.

Accrual method taxpayers are generally entitled to a deduction when “all events” with respect to the liability have occurred and the amount of the liability is relatively certain. “All events” occur with regard to service contracts when the services are performed. There are two exceptions to this general rule, namely the taxpayer can deduct the expense if the services will likely be rendered in three and one half months or, if the payment is a recurring payment, if the services will be provided by September 15th.

The question then is can you deduct a portion of the expense for the three or nine month periods in the first year if the services will be rendered over a period that is beyond these time periods? In other words, must all services be rendered before these periods in order for taxpayers to deduct the prepayment expense?

According to the IRS, yes, all services must be rendered before these periods or else taxpayers cannot deduct the expense. The IRS attorneys held that the time periods are strict.

So if taxpayers want to claim a deduction in year one for a prepayment on a service agreement, taxpayers must structure the governing legal contract to fit within these time periods. Of course, the same rules apply (in reverse) for taxpayers who receive prepayments pursuant to a service agreement and who want to delay recognizing the income and paying tax on the income….

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