Answer:
Carl's Insurance Expense Deduction for Year 2
Since he took advantage of the 12-month prepayments rule, his Year 2 Insurance deduction was deducted in Year 1.
While his deduction should have been equal to
= Annual Insurance Expense/12 x 9 = $3,300/12 x 9 = $2,475
In Year 2, it is equal to $0 since he did not make any payment for Insurance.
Explanation:
Under the cash method of accounting, two rules govern how someone can deduct prepaid expenses:
1. The General Rule
2. The 12-Month Rule
1. The General Rule
Under the general rule, you cannot deduct the full amount of an advance payment covering more than 12 months. You must deduct a portion of the payment in the year to which it applies.
Example: The General Rule.
Carl is a cash method taxpayer on a calendar year.
On October 1, 2018 Carl pays $3,600 in advance for business insurance covering three years.
Coverage begins October 1, 2018.
Coverage ends September 30, 2021.
Result:
The general rule applies.
The advance payment covers more than 12 months (36 months).
A portion of the $3,600 must be deducted ratably over the three-year period.
To find the portion of the $3,600 Carl deduct each tax year:
First, divide the $3,600 by 36 (months) to find the monthly premium amount.
Then, multiply the number of months remaining in each tax year by the monthly premium
Monthly premium: $3,600 / 36 = $100 per month.
Oct. 1, 2018 - Dec. 31, 2018: 3 x $100 = $300 deduction for 2018
Jan. 1, 2019 - Dec. 31, 2019: 12 x $100 = $1,200 deduction for 2019
Jan .1, 2020 - Dec. 31, 2020: 12 x $100 = $1,200 deduction for 2020
Jan. 1, 2021 - Sep. 30, 2021: 9 x $100 = $900 deduction for 2021
The 12-Month Rule
The 12-month rule says that Carl may deduct the full amount of an advance payment in the year the payment is made if it creates rights or benefits for the taxpayer that do not extend beyond the earlier of:
12 months after the right or benefit begins, or
The end of the tax year after the tax year in which payment is made.
Example 1: The 12-Month Rule.
Carl is a cash basis taxpayer on a calendar year.
On October 1, 2018 he pays $2,000 for business insurance covering one year.
The policy begins October 1, 2018 and ends September 30, 2019.
Result:
The 12-month rule applies.
Deduct the full $2,000 in 2018
The benefit does not extend beyond 12 months after the right to receive the benefit begins - October 1, 2018.
