Generally cash basis taxpayers must deduct payments of prepaid interest using the accrual method

A cash basis taxpayer is a taxpayer who reports income and deductions in the year that they are actually paid or received. Cash basis taxpayers cannot report receivables as income, nor deduct promissory notes as payments.

• There are two accepted accounting methods that can be used by taxpayers: the accrual method and the cash method.
• A cash basis taxpayer reports income and deductions in the year that they are actually paid or received.
• A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred.
• Taxpayers who use the accrual method must report income in the year it is earned, not received, and expenses must be deducted in the year they are incurred, not paid off or settled.

All individual and business taxpayers are required to pay taxes on their income every year. A consistent accounting method must be used to report income and taxes for any given tax year. The two accounting methods used by taxpayers in reporting income are the accrual method and the cash method.

Taxpayers who use the accrual method must report income in the year it is earned, not received. Likewise, expenses must be deducted in the year they are incurred, not paid off or settled.

A cash basis taxpayer, on the other hand, reports income in the year it is received, regardless of when it was actually earned. Basically, all items of income that are actually or constructively received during the tax year are included in the taxpayer’s gross income.

If the taxpayer receives property and services, they must include the fair market value (FMV) in income. According to the Internal Revenue Service (IRS), income is constructively received when an amount is credited to the taxpayer’s account or made available to them without restriction, regardless of whether they have possession of the funds.

For instance, if an agent is authorized to receive income on behalf of a taxpaying entity, the taxpayer is considered to have received the money when the agent receives it. Also, an employee who received a paycheck at the end of one year must report it as income that year, even if they didn't actually deposit the check until the following year.

A cash basis taxpayer deducts expenses in the year they are paid off, which is not necessarily the year they were incurred. However, expenses paid in advance may not be deducted; instead, the IRS allows the taxpayer to capitalize certain costs. Expenses paid in advance are deductible only in the year to which they apply unless the expenses qualify for the 12-month rule, under which a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer.

Although taxpayers can choose any tax reporting method at their discretion, there are some entities prohibited from using the cash basis method. These taxpayers include:

• A corporation (other than an S corporation) with average annual gross receipts exceeding $25 million for the past three years (increasing to $27 million in 2022)
• A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $25 million (increasing to $27 million in 2022)
• A tax shelter

The following taxpayers are not prohibited from using the cash method of reporting:

• Any corporation or partnership that has an average annual gross receipt of $25 million or less for the three preceding tax years (increasing to $27 million in 2022)
• A qualified personal service corporation (PSC), defined as any corporation (1) that performs services in qualifying fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and (2) whose stock is substantially owned by current or retired service-providing employees or their estates.

The cash accounting method is one of two main accounting methods that determine how expenses and income should be reported. The cash accounting method stipulates that all income and expenses are to be recorded in the year that they received and paid, respectively. This is the opposite of the accrual accounting method when income and expenses are recorded when they are earned or incurred, regardless if any cash is exchanged.

The cash accounting method has a few disadvantages, primarily making a company appear more profitable than it is because expenses that have been incurred have not yet been paid. It also provides a very narrow view of a company's finances because it doesn't take into consideration the larger picture, where expenses will be coming due and revenue may be coming in.

No, not every company can use the cash accounting method. Companies have to pass certain tests to determine if they are eligible to use the cash accounting method. The main test is that a company's average annual gross receipts for the past three years must be less than $25 million (increasing to $27 million in 2022) for it to use the cash accounting method.

Accelerating deductions for prepaid expenses is a good way to save on your taxes for the current year. The general rule for prepaid expenses is that any prepayment for a service or benefit must be capitalized and amortized over the useful life of such payment. However, the IRS allows the accelerated deduction of certain prepaid expenses, with some complex restrictions involved. The following are general rules to qualify for the prepaid expense tax deduction and how they can impact your business.

The 12-Month Rule

The “12-month rule” allows for the deduction of a prepaid expense in the current year if the right or benefit paid for does not extend beyond the earlier of:

• 12 monthsfrom the date the prepayment is made, or
• the end of the taxable year following the taxable year in which the payment is made.

For cash basis taxpayers, prepaid expenses can be deducted as long as the 12-month rule is met.

Example: Calendar-year cash basis taxpayer SmallCorp pays $10,000 on December 31, 2021, for an insurance policy that is effective January–December 2022. Since the benefit of the insurance policy does not extend more than 12 months or beyond the end of the taxable year following the year the payment was made, the 12-month rule applies and the full $10,000 is deductible in 2021.

The All Events Test & Economic Performance Test

For accrual-basis taxpayers, the rules are more complicated. There are two tests that must be met before the taxpayer can apply the 12-month rule. These are commonly known as the “all events test” and “economic performance test.” The general rule is that the taxpayer cannot deduct a prepaid expense until the obligation to pay is fixed (all necessary events have occurred to establish liability), the cost is determinable, and the prepaid services or property are actually provided to the taxpayer (economic performance).

There are a few notable exceptions where a cash payment results in economic performance. Common items include insurance contracts, warranty contracts, taxes, and workers’ compensation liability.

Example 1: Calendar-year accrual basis taxpayer BigCorp pays $10,000 on December 31, 2021, for property taxes covering January–June 2022. Since taxes are listed as one of the items where payment is economic performance, the prepaid property tax expense can be deducted in 2021.

Example 2: Calendar-year accrual basis taxpayer BigCorp pays $10,000 on December 31, 2021, for rent expense covering January 2022. Economic performance occurs when the property is being used during the rental period. Therefore, the prepaid rent expense cannot be deducted in 2021.

Opportunity

If accelerating the deduction of prepaid expenses was not a strategy in the past, there could be opportunities to do so this year. If this is the initial year of a business, the business can simply take the accelerated deductions for prepaid expenses on the tax return. However, if prepaid expenses were capitalized in the past, a method of accounting has already been established. In order to start accelerating prepaid expenses, the IRS requires filing Form 3115 to change the accounting method. This change is automatic and does not require permission from the IRS in advance. An immediate one-time deduction is available for the previously capitalized prepaid expenses that would have been deducted under the new method for the year the change is made.

If you have questions or would like more information, please contact Bella Wang at or 844.4WINDES (844.494.6337).