When Are Prepaid Expenses Deductible?

By Timothy R. Koski

In Brief

Deducing Deductibility

As long as the clear-reflection-of-income standard is satisfied, taxpayers in the Seventh Circuit, regardless of their accounting method, now have authority for deducting fixed, one-year recurring items whose benefit extends into the next taxable year. The Seventh Circuit joins the Ninth Circuit in adopting this position. More importantly, the IRS appears to have conceded the issue by announcing that it expects to issue proposed regulations allowing for the immediate deduction of prepaid expenses that satisfy a one-year rule. When issued, these proposed regulations will eliminate much of the uncertainty surrounding this issue.

In U.S. Freightways Corp. [88 AFTR 2d 2001-6703 (7th Cir. 2001), rev’d and rem’d 113 TC 329 (1999)], the Seventh Circuit reversed the Tax Court’s decision and allowed an accrual-basis taxpayer to currently deduct licenses, fees, and insurance premiums benefiting a 12-month period that extended into the next tax year. The Seventh Circuit adopted a one-year rule that allows both cash- and accrual-basis taxpayers to immediately deduct fixed, one-year recurring expenses that benefit the next taxable year. The IRS argued against a one-year rule, but later announced plans to issue proposed regulations that would allow taxpayers to immediately deduct prepaid items that satisfy a 12-month rule (Ann. 2002-9, 2002-7 IRB 536). The proposed regulation will allow taxpayers to immediately deduct prepaid expenses whose benefit does not extend beyond the earlier of 12 months after the taxpayer starts realizing the benefit from the expenditure or the end of the taxable year following the year of payment.

Tax Court Decision

The taxpayer in U.S. Freightways Corp. was a nationwide trucking company that was required to purchase a large number of licenses and permits and maintain insurance to legally operate its fleet of trucks. During the 1993 tax year, Freightways paid $5,399,062 for these fees, licenses, and insurance premiums (FLIP expenses). None of these FLIP expenses was valid for more than 12 months, and none of the benefit received for them extended beyond one year from the time of purchase. Because the company incurred the FLIP expenses during various times of the year, some of the benefit extended into the next tax year. In particular, $2,984,197 of expenses incurred in 1993 actually benefited the company in 1994. As it had in prior years, Freightways, an accrual-basis taxpayer, immediately deducted all FLIP expenses incurred in 1993. The IRS argued that the company should capitalize expenses incurred in 1993 and deduct them ratably over 1993 and 1994.

The Tax Court summarized the issue as a decision between whether the FLIP expenses are currently deductible under IRC section 162 or whether they must be capitalized under IRC section 263. IRC section 263 disallows a current deduction for capital expenditures. Treasury Regulations section 1.263(a)-2 provides examples of capital expenditures, including “the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.” Citing the Supreme Court’s decision in INDOPCO, Inc. [507 U.S. 79 (1992)], which declared that expenses incurred by a target corporation in the course of a friendly acquisition by another company are not currently deductible, the Tax Court stated that the predominant factor in distinguishing between current and capital expenses is “whether the payment creates a future benefit that is more than incidental.” The duration of the benefit beyond the current taxable year is critical. In determining current deductibility, courts consider whether the benefit extends “substantially beyond” the current taxable year or is merely incidental.

The Tax Court believed that Freightways was arguing for application of the so-called one-year rule. Several courts have permitted taxpayers to currently deduct expenditures creating an asset lasting beyond the current taxable year, provided the asset lasts 12 months or less and there is no tax avoidance purpose or distortion of income. (See Mennuto v. Comm’r [56 TC 910, 924 (1971)], where a current deduction was allowed for costs of installing a leeching pit designed to last for one year; Bell v. Comm’r [13 T.C. 344, 348 (1949)], where a current deduction was allowed for insurance expense where a policy covered part of the next taxable year; and Zaninovich v. Comm’r [616 F.2d 429 (9th Cir. 1980)], where a current deduction was allowed for a rental payment extending 11 months into the next tax year.

The Ninth Circuit affirmatively adopted a one-year rule in Zaninovich and allowed a cash-basis taxpayer to deduct rental payments extending 11 months into the next tax year. The advantage of the rule, as noted by the Ninth Circuit, is its ease of application; it “eliminates pointless complexity in the calculation of the timing of deductions.” Other courts, however, have not clearly adopted a one-year rule that allows for the near automatic deduction of expenditures lasting less than one year. The Tax Court correctly noted that several decisions which Freightways had cited in support of a one-year rule held that expenditures creating a benefit with a duration of one year or more must be capitalized, which is different from allowing the immediate deduction of expenditures with a duration of less than one year. (See: Jack’s Cookie Co. v. U.S. [597 F.2d 395 (4th Cir. 1979)]; Bilar Tool & Die Corp. v. Comm. [530 F.2d 708 (6th Cir. 1976), rev’g 62 TC 213 (1974)]; Clark Oil & Refining Corp. v. United States [473 F.2d 1217 (7th Cir. 1973)]; American Dispenser Co. v. Comm. [396 F.2d 137 (2d Cir. 1968); aff’g TC memo 1967-153]; and Fall River Gas Appliance Co. v. Comm. [349 F.2d 515 (1st Cir. 1965); aff’g 42 TC 850 (1964)].) In addition, these prior cases gave no indication of the meaning of the one-year terminology they employed. For these reasons, the Tax Court concluded, “widespread support for a rule which would permit near-automatic deduction for costs related to benefits lasting less than one 12-month period is lacking.”

Freightways’ method of accounting was a more fundamental problem. According to the Tax Court, even if a one-year rule did exist, it would not be available to accrual-basis taxpayers. The Tax Court thought that case law required treating accrual- and cash-basis taxpayers differently in this situation. The court cited Johnson v. Comm’r. [108 TC 448 (1997), aff’d in part and rev’d in part on other grounds 184 F.2d 786 (8th Cir. 1999)] for the proposition that accrual-basis taxpayers must prorate all expenses extending into the next tax year. In Johnson, an accrual-basis taxpayer was required to capitalize insurance policies covering periods of one to seven years; the court made no attempt to allocate the portion of premiums attributable to policies expiring within the next year.

The Tax Court also relied on the Ninth Circuit’s approval of Bloedel’s Jewelry, Inc. v. Comm. [2 BTA 611 (1925)] in Zaninovich. In Bloedel’s Jewelry, an accrual-basis taxpayer was required to capitalize a rent payment made in September of one year for a term running through August of the next year. Zaninovich stated that the decision in Bloedel’s Jewelry was appropriate because “[t]he accrual method of accounting, unlike the cash method of accounting, aims to allocate to the taxable year expenses attributable to income realized in that year.”

Seventh Circuit Decision

The Seventh Circuit first discussed the appropriate standard of review. The IRS has issued regulations stating that expenditures providing only incidental future benefits are eligible for immediate deduction, while expenditures providing benefits extending substantially beyond the current tax year must be capitalized. These regulations, however, do not directly address the current deductibility of FLIP expenses. Subsequent IRS interpretations of these regulations have not been issued as notice and comment regulations, and therefore full deference is not required. (See Chevron v. Natural Resources Defense Council, Inc. [467 U.S. 837 (1984)].) Instead, the appropriate standard of review is whether the IRS’ interpretation of the regulations is reasonable.

The Seventh Circuit rejected the Tax Court’s determination that accrual-basis taxpayers are not entitled to the benefit of a one-year rule. The Ninth Circuit thought that the Tax Court’s reliance on Johnson was misplaced. Although Johnson may have used broad language inconsistent with the existence of a one-year rule, the court did not link its holding to the taxpayer’s method of accounting. The Seventh Circuit discounted the Tax Court’s reliance on the apparent approval of Bloedel’s Jewelry by the Ninth Circuit in Zaninovich as unnecessary to the decision, saying: “[the Ninth Circuit] made no effort to think carefully about what consequences flow from a taxpayer’s choice of accounting methods.” The Ninth Circuit was also influenced by Treasury Regulations sections 1.461-1(a)(1) on cash-method taxpayers and 1.461(a)(2) on accrual-method taxpayers, which use identical, end-of-the-year language when discussing the capitalization requirement.

Because Freightways’ use of the accrual method of accounting did not automatically disqualify it from expensing the items in question, the Seventh Circuit turned to the question of whether the FLIP expenses extend substantially beyond the close of the tax year and therefore must be capitalized. After weighing factors for and against expensing, the Seventh Circuit adopted a rule allowing for the immediate expensing of “fixed, one-year items where the benefit will never extend beyond that term [and which] are ordinary, necessary, and recurring expenses for the business in question.”

Although the substantially-beyond- the-end-of-the-tax-year standard works well in simple cases (items consumed immediately versus long-term items), the court made it clear that FLIP expenses fall in the middle of the spectrum.

What about items whose useful life was estimated at approximately a year, but that actually failed sooner or lasted longer? The license fees, permit fees, and insurance premiums Freightways paid were, in a sense, easier to characterize as deductible expenses than items like pens or lightbulbs, because the issuing entities and insurance companies have strictly defined the useful life of the item to be exactly one year.

While acknowledging that the FLIP expenses could be characterized as extending substantially into the next tax year, the court stated that they were clearly distinguishable from the expenditures listed in Treasury Regulations section 1.263(a)-2 (buildings, machinery and equipment, furniture and fixtures, and similar property) that clearly have multiple-year life spans. The FLIP expenses are not the kind of expenditures that “the IRS itself thinks must be capitalized.” The court stated that the FLIP expenses fall even further from “the heartland of the traditional capital expenditure” than those in the leading case of PNC Bancorp, Inc. v. Comm’r [212 F.3d 822 (3rd Cir. 2000)], where a bank was allowed to immediately deduct loan origination expenses.

The Seventh Circuit was influenced by the regularity of the FLIP expenses. Because the expenses recurred annually, there is less distortion of income. The court also found it significant that Freightways was not manipulating the tax laws and did not control when the FLIP expenses had to be renewed. Finally, the court considered the administrative burden on Freightways if it had to allocate the FLIP expenses to two tax years. The court was not troubled by the fact that Freightways was already capitalizing the FLIP expenses for financial accounting purposes. The Ninth Circuit thought that requiring a change in Freightways’ tax accounting records imposed an administrative burden regardless of how its financial accounting records were kept.

The Tax Court did not consider the IRS’ alternative argument that Freightways’ method of accounting did not clearly reflect income. Therefore, the Seventh Circuit remanded the case to the Tax Court for the limited purpose of considering this argument. If a taxpayer’s method of accounting is found to not clearly reflect income, IRC section 446(b) allows the IRS to recompute income under a method that does. The Ninth Circuit was reluctant to decide this issue as a matter of law.

Announcement 2002-9

In Announcement 2002-9 the IRS stated that it expects to issue proposed regulations clarifying the application of section 263(a) to expenditures incurred in acquiring, creating, or enhancing intangible assets or benefits. These proposed regulations are expected to include a 12-month rule. Under this 12-month rule, taxpayers will not be required to capitalize certain expenditures whose benefit does not extend beyond the earlier of 12 months after the date the taxpayer first realizes the benefit of the expenditure or the end of the taxable year following the year of payment.

The IRS announced its intention to apply this 12-month rule to several categories of expenditures, including amounts “prepaid for goods, services, or other benefits (such as insurance) to be received in the future.” Thus, prepaid expenses, such as those incurred by Freightways, will be currently deductible under the proposed regulations. The IRS used three examples to illustrate the application of the 12-month rule to prepaid items:

Example 1. A taxpayer that prepays its premium for a three-year insurance policy would be required to capitalize the entire amount paid.

Example 2. A calendar-year taxpayer pays its premium for a 12-month insurance policy on December 1, 2002. The 12-month period covered by the policy begins in February of the following year. This taxpayer would be required to capitalize the premium, because the benefit from the expenditure extends beyond the end of the taxable year following the year in which the premium was paid into 2004.

Example 3. A calendar-year taxpayer pays its premium for a 12-month insurance policy on December 1, 2002, and the policy coverage begins on December 15, 2002. The taxpayer will be able to deduct the entire amount of the premium, because the benefit does not extend more than 12 months from the date when the benefit was first realized; nor does it extend beyond the taxable year following the year in which the expenditure was incurred (2003).

Timothy R. Koski, LLM, PhD, CPA, is an associate professor of accounting at Middle Tennessee State University, Murfreesboro, Tenn.

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