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Theresa Greenway
September 27, 2014 Article 3 min read

Recently the IRS issued Chief Counsel Advice 201311021 addressing the prepaid FDIC assessments mandated by the FDIC in late 2009 and advised on the extent to which taxpayers are required to capitalize amounts paid to acquire, create, or enhance intangible assets.  The FDIC assessments in late 2009 required insured depository institutions to prepay their 2010, 2011 and 2012 quarterly assessments in December 2009.  The IRS concluded this prepayment was not deductible for income tax purposes because it failed the 12-month rule.  Although the IRS concluded that the prepaid FDIC assessments were not deductible when paid, there are certain prepaid expenses that may be deductible to most financial institutions.

A prepaid expense generally must meet four requirements in order to be deducted when paid under the accrual method of accounting:

  1. All events have occurred to establish the fact of the item.
  2. The amount can be determined with reasonable accuracy.
  3. Economic performance occurs with respect to the item.
  4. The 12-month rule is satisfied.

Fact of the item

Generally, all events have occurred to establish the fact of a prepaid item when the payment is due.  In Revenue Ruling 2007-3, the IRS ruled that the mere execution of a contract does not fix the liability under a contract. This is not often a problematic requirement for most prepaid items as the payment has already been made before year end. However, if a prepayment is made voluntarily before year-end, the item may not be fixed. 

Determined with reasonable accuracy

This requirement is not often difficult for most taxpayers to meet because the fact that it is a prepaid suggests that an amount has already been agreed upon.  However, prepayments based upon mere estimates or that are subject to future revisions may have difficulty meeting this requirement.

Economic performance 

Economic performance for services or property provided to a taxpayer occurs only as the services or property is provided.  This test is generally not met for most prepaid items in this category because no service or property has been provided by year-end if it is still recorded as a prepaid.  However, there is an exception to the general economic performance rules for payments to a person providing services if the taxpayer can reasonably expect the person to provide the services within 3 ½ months after the date of payment.  If this exception is satisfied, the taxpayer can deem that the economic performance requirements were satisfied by year-end.  Still, there are certain items for which payment satisfies the economic performance rules.  These items most commonly include taxes, licensing fees, insurance contracts and warranty contracts.

12-month rule 

Under the 12-month rule, if a contract right or benefit of an expenditure does not extend beyond the earlier of 12 months after the first date on which the tax payer begins receiving benefit or the end of the taxable year following the year in which the payment is made, then the taxpayer is not required to capitalize the expenditure.  If all of the other requirements are met, this means that the taxpayer can generally deduct the prepaid item.  The taxpayer may still elect to capitalize the expenditure for tax purposes even if it would otherwise qualify to apply the 12-month rule.

Opportunity 

When all of the above tests are viewed together, only a limited amount of prepaid items tend to meet each of the requirements.  However, many financial institutions incur many of the items that generally do meet each of the tests including (1) insurance that was required to be prepaid by year end, (2) warranty or service contracts that a taxpayer enters into in connection with property bought or leased by the taxpayer, pursuant to which the other party to the contract promises to replace or repair the property under specified circumstances and (3) amounts paid for a licensing or permit fee required by a governmental authority.

The prepaid insurance and regulatory assessments (other than the prepaid FDIC assessment) are still valid deductions under these rules. 

In order to take advantage of the opportunity to deduct certain prepaid expenses, a taxpayer is required to file a Form 3115 in order to change the method of accounting with respect to that prepaid item.  In many cases, this is an automatic change and a taxpayer can file the Form 3115 with the Federal Income Tax return for the year of the change.