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WHEN DO I HAVE TO PAY AN EXPENSE TO DEDUCT IT?

December 26, 2007

The headline of this post is one of the more common search phrases used to reach the Tax Update from search engines. The answer? As with so many things in the tax law, it depends.

In general, if you are a cash-basis taxpayer, you have to pay your business expenses by the last day of the year to deduct them. If you are an accrual-basis taxpayer, you have to clear the "all-events test" -- that is, all events to determine the liability must have taken place by year-end, and the liability must be determinable with reasonable accuracy.

But that it would be so simple. For example, even cash-basis taxpayers may deduct deduct contributions made after year-end to qualified retirement plans that are set up by year-end, as long as the contributions are made by the due date of the tax return.

Most of the time, though, the tax law looks to limit your ability to deduct expenses paid after year-end. For example, even accrual-basis taxpayers can't deduct expenses accrued to "related" cash-basis taxpayers (read the extended entry by clicking "read more" to see who these relatives might be). Such expenses are deductible to the accrual basis taxpayer only when the related cash-basis taxpayer has to record the income. Even when unrelated parties are involved, the expense is deductible only if "economic performance" has occured. That exception to the "all-events" test itself has an exception, the "recurring item exception."

Compensation is normally deductible for accrual-method payors if the expense is actually paid within 2 1/2 months of year-end. When the recipient is a related party, though, the expense is deductible only in the year paid.

Finally, even expenses paid before year-end normally are non-deductible if they purchase a benefit that goes out beyond one year. If, for example, you prepay your tax fees for five years (an idea that I would always encourage for my own selfish reasons), you would only get to deduct the amount for the next 12 months. The remaining prepayment would be capitalized and deducted in the year to which it applies.

So for your year-end planning, this means:

- You have to pay related cash-basis taxpayers by year-end to get the deduction this year.
- You have to have your qualified plan set up by year-end to deduct contributions for this year, but you have until the return due-date to make the contributions.
- Don't overdo prepayments (except perhaps to your friendly tax preparer). If you prepay beyond one year, such prepayments aren't currently deductible.

Commonly-encountered Related Parties

Internal Revenue Code Section 267 affects the timing of deductions among related parties.

For purposes of deducting accrued expenses of C corporations, the following family members are considered related (Secs. 267(a)(2) and 267(b)):

Family Members: You are related to spouses, ancestors, lineal descendants, and siblings (Sec. 267(b)(1) and 267(c)(4)).

C corporations are related to other C corporations that are members of the same "controlled group" (Sec. 267(b)(3) and 267(f)) - Usually this means 50% common ownership. They are also related to those owning over 50% of the corporation, including family member (Sec. 267(b)(2).

S corporations and partneships are considered related to any owner, to any member of the owner's family, and to anybody related to a member of the owner's family. This rule drags in nieces and nephews, for example.

These rules are complex, often using "attribution" to make people "related." For example, if you own a C corporation with your girlfriend, neither of you own more than 50% of the corporation, and neither of you are considered related. But if you marry her, you both are considered to own 100% of the corporation by attribution, and the corporation can only deduct amounts owed to you when they are paid to you. So be careful, and call your tax advisor whenever the numbers are big enough to matter.

Tags: year-end tax planning.

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