Prepaid Expenses at Year End: Deduct or Spread (12-Month Rule)

Can I deduct in December what I paid for next year's rent or insurance?

Often, but not always. A cash-method business can deduct a December payment in the year paid when the 12-month rule applies: the benefit must end within 12 months of starting and by the last day of next tax year. Rent for January through December of next year passes. The same 12 months starting April 1 fails, and the payment is spread over the years it covers. An accrual business must also pass the economic performance test, covered below.

Prepaying changes the year of a deduction, not the total. When the rule allows it, the deduction moves into the year paid and next year's is smaller. When it does not, the cash leaves in December and the deduction waits.

The 12-month rule is in Publication 538 and 26 CFR 1.263(a)-4(f). Publication 334, written for Schedule C filers, states only the general rule, and its example splits a 1-year policy that starts July 1 across two years. Publication 538 (Example 2) deducts the same kind of policy in full under the 12-month rule. This page covers the federal rule.

A case is not simple if:

• the payment covers more than a year, or the coverage starts well after the year begins;
• the books and the return use different methods, or the business is on accrual;
• earlier returns treated prepaid costs inconsistently;
• the business is on accrual and the payee is the owner, a relative, or a related company that uses cash;
• a lender, investor or buyer will read the books.

If any of these fit, settle the treatment before the return is filed. The later sections show how to check each one.

Gather before deciding:

• the invoice or contract showing the coverage start and end dates;
• the payment date from the bank or card statement;
• the accounting method on the last return (Schedule C, line F, for a sole proprietor);
• the last two returns, to see how prepaids were treated before.

What is the 12-month rule, and does my payment qualify?

The 12-month rule lets a business deduct a prepayment now, instead of capitalizing it as an asset to spread, when the benefit does not extend beyond the earlier of two limits. Both limits must hold (26 CFR 1.263(a)-4(f)). It applies to prepaid rights and benefits such as rent, insurance or a membership.

For a calendar-year business that pays in December, the second limit is December 31 of next year. A 12-month policy that starts January 1 of next year passes. The same policy starting April 1 fails, because it runs into the year after.

Three conditions can change the answer:

• Renewal. If the facts show a reasonable expectation of renewal, the benefit counts as lasting through the renewal period, so a one-year lease you expect to renew can fail the rule. The regulation weighs renewal history, the economics of the deal and the terms of renewal.
• No fixed period. The rule does not apply to a right of indefinite duration: one with no fixed period, such as a government license revocable only for violating its terms, or one measured in a fixed amount of goods or services rather than in time.
• Election out. A business can choose not to use the rule by treating the payments as capital expenditures on its timely filed original return, extensions included. A partnership or S corporation makes the choice itself, not its owners. The choice covers all similar payments that year, and it can be revoked only with IRS consent.

What if a big payment covers more than 12 months or ends after next year?

When the 12-month rule does not apply, an expense paid in advance is deductible only in the year to which it applies (Publication 538). Each year gets the share of the coverage period that falls in it.

Divide the payment by the months covered, then give each tax year its months. Publication 538 splits a three-year policy this way, by months. The part that belongs to later years stays on the balance sheet as a prepaid asset until its months arrive.

This applies when the coverage runs more than 12 months, such as a two- or three-year policy. It also applies when the coverage runs 12 months or less but ends after the last day of next tax year, such as a 12-month policy that starts February 1 of next year on a calendar-year business.

Large leases follow a different rule. A lease with total rent over $250,000 whose rent is paid more than a calendar year ahead, deferred or changes over the term may be a section 467 rental agreement. It has its own rent and interest rules for tenant and landlord, on cash or accrual books (26 USC 467, 26 CFR 1.467-1). Equal monthly rent, all paid in the calendar year it relates to or the year before or after, is not one. Have a multi-year prepaid lease reviewed before the return is filed: bookkeeping help.

Does it change if my business uses the cash method or the accrual method?

Yes. A cash-method business deducts an expense in the year it pays, subject to the prepaid rules above (Publication 538, 26 CFR 1.461-1). An accrual business deducts it when the amount is fixed and economic performance has occurred. The 12-month rule does not change when an accrual business incurs a liability (26 CFR 1.263(a)-4(f)(6)).

How does accrual accounting handle a prepaid expense?

An accrual business deducts or capitalizes an expense when the liability is fixed, its amount can be determined, and economic performance has occurred. That generally means the service is performed, the property is provided or the property is used. Paying early does not by itself move the deduction (Publication 538). When economic performance occurs depends on what was bought (26 CFR 1.461-4):

• Services. As the provider performs them. If the business can reasonably expect the provider to perform all of the services under the contract within 3 1/2 months after payment, it may treat them as provided when it pays. A single year-long contract for one undifferentiated service paid in December generally does not fit that window. A safe harbor covers contracts of 12 months or less that provide regular services, each with independent value, such as cleaning or grounds care: the part of a prepayment for the first 3 1/2 months then counts in the year paid (Revenue Procedure 2015-39). Switching to it is a method change (Revenue Procedure 2025-23, section 20.12, change no. 220).
• Property. As it is provided. A business may treat property as provided when it is delivered or accepted, or when title passes. That choice is a method of accounting and must be used consistently. The 3 1/2 month payment rule also covers property expected within that period, but inventory, supplies and capitalization rules still decide the deduction.
• Rent and other use of property. Evenly over the period of use. Rent prepaid for next year is generally next year's expense.
• Insurance, and warranty or service contracts on property. When payment is made. Here a service contract means one that promises to repair or replace property you bought or leased. Other services follow the services rule above. The 12-month rule then decides whether the payment is deducted or spread.

Two further rules can move the answer:

• Recurring items. A separate exception can treat an item as incurred in the earlier year when performance follows by the earlier of the date a timely return (with extensions) is filed or the 15th day of the ninth month after year end (about 8 1/2 months). A business adopts it as a method of accounting and applies it consistently. The item must recur and be either immaterial or a better match with income. If performance comes after the return is filed but within the 8 1/2 months, an amended return can claim it (Publication 538, 26 CFR 1.461-5). Whether an item qualifies is fact-dependent.
• Related persons. An expense owed to a related person who uses the cash method is not deductible until it is paid and the related person includes it in income (Publication 538).

What about inventory, supplies and small equipment I pay for in December?

These are goods, not prepaid services, so each follows its own rule and not the 12-month rule.

• Inventory. Its cost generally comes out when the goods are sold, not when they are paid for. A small business that skips a formal inventory may deduct sooner, but only if its books really expense the stock. See expensing inventory and supplies.
• Supplies. Minor incidental supplies are generally deducted in the year paid, and other supplies in the year first used or consumed. The guide above covers which is which (IRS tangible property regulations).
• Small equipment. The de minimis safe harbor election lets a business deduct tangible items up to $2,500 per invoice or item, or $5,000 if it has an applicable financial statement. The business needs an accounting policy in place at the start of the year that expenses items of that size (in writing if it has such a statement). It must follow the policy in its books, apply the election to every qualifying item that year, and attach an election statement to its timely filed original return. The safe harbor excludes inventory and land and covers tangible property only, so it does not reach prepaid insurance or rent (26 CFR 1.263(a)-1(f)).

For larger equipment, see buying equipment before year end.

How do I book a prepaid expense, and must the books match the deduction?

Cash-style books expense the payment when it is paid. Books that spread it record the payment as an asset first, then move it to expense as each month passes. Either way, the return's deduction follows the tax rules above, and the books can differ from it.

To spread a payment in the books:

1. On the payment date, debit a prepaid expense account and credit the bank or card.
2. Keep one schedule line per prepayment: vendor, payment date, coverage start and end, amount and months covered.
3. Each month, debit the expense account and credit prepaid expense for that month's share.
4. At year end, tie the prepaid balance to the schedule: unexpired months times the monthly cost.
5. Compare each line with the tax rule. Where the return deducts more or less than the books, keep the difference on a schedule your preparer can use.

The 12-month rule tests the length of the benefit, not how the books record it. Books can spread a payment that the return deducts in full. A corporation (S corporations included) or partnership generally reports such gaps in the reconciliation of income per books with income per return, Schedule M-1, or Schedule M-3 for larger ones. Some very small filers are excused from Schedule M-1 (Form 1120, Form 1120-S and Form 1065 instructions). A sole proprietor has no such schedule, so the schedule in step 5 is the only record of the gap.

The election out of the 12-month rule is made on the return, by treating the payment as capital. If the books are cash basis, a payment that fails the 12-month rule is expensed in the books, so it needs an adjustment on the return to spread it. See accrual books and a cash-basis tax return.

I have handled prepaids differently each year: can I just switch?

Not freely. An accounting method includes the treatment of any material item, so how you treat prepaids year after year can itself be your method. A business that has not been applying the general rule or the 12-month rule needs IRS approval before it starts (Publication 538). The form for a change in "the accounting treatment of any item" is Form 3115.

What the past years mean is fact-dependent:

• Publication 538 says a method is generally not established for an item unless it is treated consistently. Correcting a math or posting error is not a change in accounting method, but deducting a prepayment in the wrong year is a timing question. Whether earlier returns hold errors or an established method depends on the facts.
• A change to the 12-month rule is an automatic change (no. 78, Revenue Procedure 2025-23, section 11.05) with a section 481(a) adjustment. Revenue Procedure 2006-12, section 5.02, names it as an example. Eligibility conditions apply, and which procedure covers a change to the general rule is for a preparer to confirm on the Form 3115 page.

Switching between cash and accrual, and how a Form 3115 change and its adjustment work in general, are covered in switching from cash to accrual accounting.

Example

These examples are illustrative. All figures are in US dollars. Each business has a calendar tax year.

A consultant prepays a year of office rent

A cash-method consultant pays $12,000 on December 15 for office rent covering January through December of next year. The benefit ends December 31 of next year. That is within 12 months of January 1 and within the end of next tax year, so the 12-month rule applies. The consultant can deduct the full $12,000 in the year paid, unless earlier returns consistently spread prepaid costs, which can need IRS approval to change (see "I have handled prepaids differently each year: can I just switch?").

The books can still carry the rent as a prepaid asset and release $1,000 a month next year. The books and the return then differ at year end, and the difference reverses next year.

An accrual-method business paying the same rent would deduct $1,000 a month as the space is used, so the whole $12,000 would fall next year.

A policy that starts in April

The same consultant pays $12,000 on December 15 for an insurance policy that runs from April 1 of next year to March 31 of the year after. The policy ends after the last day of next tax year, so the 12-month rule does not apply. The general rule spreads the payment by months: 9 of the 12 months fall next year and 3 fall in the year after.

In the books, the December 15 entry debits prepaid insurance and credits the bank for $12,000. From April, each month debits insurance expense and credits prepaid insurance for $1,000.

A three-year policy

A business owner pays $9,000 in December for a three-year business insurance policy that starts January 1 of next year. The coverage runs 36 months, so the 12-month rule does not apply. The result is the same on cash or accrual.

If the owner deducted all $9,000 in the year paid, the return would show $9,000 too much that year and $3,000 too little in each of the next three years. Whether that is fixed by amended returns or a method change depends on the facts. See "I have handled prepaids differently each year: can I just switch?"

Different for you?

• You prepaid a large or multi-year bill, your past returns treated prepaids inconsistently, several years of prepaids are missing from the books, or your books and return disagree: which payments qualify, whether a method change filing is needed, and how the books should show each prepaid so they tie to the return are the points to settle before the return is filed. See catching up on overdue books and get bookkeeping help.
• You are on accrual books and the payee is you, a relative or a company you control: the related-person rule can hold the deduction until the payee reports the income, so check it before the return is filed. Get bookkeeping help.
• You are not sure whether the business should be on cash or accrual: see cash or accrual for a small business.
• You want to change from cash to accrual, or back: see switching from cash to accrual accounting.
• Your books are accrual and your return is cash basis: see accrual books and a cash-basis tax return.
• A customer prepaid you: that is the income side. See customer prepayments and deposits.
• Other year-end items: buying equipment before year end, expensing inventory and supplies, accrued payroll at year end for late December wages paid in January, and the year-end close checklist for the full list.