Publication 535, Business Expenses; Chapter 1 - Deducting Business Expenses, When Can an Expense Be Deducted?

V. Preparing Your Tax Return(s) and Information Returns

XI. Alerts and Tutorials

Update

When Can an Expense Be Deducted?
When an expense can be deducted depends on your accounting method.An accounting method is a set of rules used to determine when and howincome and expenses are reported. The two basic methods are the cashmethod and an accrual method.
For more information on accounting methods, see Publication 538.
Cash method.Under the cash method of accounting, you deduct business expensesin the tax year you actually paid them, even if you incur them in anearlier year.
Accrual method.Under an accrual method of accounting, you generally deductbusiness expenses when you become liable for them, whether or not youpay them in the same year. All events that set the amount of theliability must have happened, and you must be able to figure theamount of the expense with reasonable accuracy.
Economic performance rule.Under an accrual method, you generally cannot deduct or capitalizebusiness expenses until economic performance occurs. If your expenseis for property or services provided to you, or for your use ofproperty, economic performance occurs as the property or services areprovided, or as the property is used. If your expense is for propertyor services you provide to others, economic performance occurs as youprovide the property or services.
Example.Your tax year is the calendar year. In December 1999, the FieldPlumbing Company did some repair work at your place of business andsent you a bill for $150. You paid it by check in January 2000. If youuse an accrual method of accounting, deduct the $150 on your taxreturn for 1999 because all events that set the amount of liabilityand economic performance occurred in that year. If you use the cashmethod of accounting, you can deduct the expenses on your 2000 return.
Prepayment.You cannot deduct expenses in advance, even if you pay them inadvance. This rule applies to both the cash and accrual methods. Itapplies to prepaid interest, prepaid insurance premiums, and any otherexpense paid far enough in advance to, in effect, create an asset witha useful life extending substantially beyond the end of the currenttax year.
Example.In 1999, you sign a 10-year lease and immediately pay your rent forthe first 3 years. Even though you paid the rent for 1999, 2000, and2001, you can deduct only the rent for 1999 on your current taxreturn. You can deduct on your 2000 and 2001 tax returns the rent forthose years.
Contested liabilities.Under the cash method, you can deduct a contested liability only inthe year you pay the liability. Under an accrual method, you candeduct contested liabilities, such as taxes (except foreign or U.S.possession income, war profits, and excess profits taxes), in the taxyear you pay the liability (or transfer money or other property tosatisfy the obligation) or in the tax year you settle the contest.However, to take the deduction in the year of payment or transfer, youmust meet certain conditions. See Contested Liability inPublication 538for more information.
Related persons.Under an accrual method of accounting, you generally deductexpenses when you incur them, even if you have not paid them. However,if you and the person you owe are related persons and the person youowe uses the cash method of accounting, you must pay the expensebefore you can deduct it. The deduction by an accrual method payer isallowed when the corresponding amount is includible in income by therelated cash method payee. See Related Persons inPublication 538.