May 7, 2012

To capitalize or not to capitalize?

Many businesses ask that question. And the answer depends on the circumstances.

Taxpayers aren’t required to capitalize an expense if it is paid or incurred to create a right or benefit that does not extend beyond the earlier of:

  • 12 months after the first date of the right or benefit or
  • The end of the tax year following the tax year in which the expense was paid or incurred.

The 12-month rule, established in Internal Revenue Code Section 263(a), doesn’t eliminate the other requirements for deduction:

  • All the events have occurred that establish the fact of the liability.
  • The amount of the liability can be determined with reasonable accuracy.
  • Economic performance has occurred with respect to the liability.

Example: ABC Corp., an accrual-method taxpayer with a calendar tax year, prepaid its general liability insurance policy on Nov. 30, 2011. The policy covered Dec. 1, 2011, to Nov. 30, 2012.

Because the insurance policy wasn’t longer than 12 months and didn’t extend beyond the tax year following the tax year in which the payment was made, the payment was deductible in the 2011 tax year. But the taxpayer had to elect to use the 12-month rule when deducting prepaid insurance.

To elect to use the 12-month rule, the taxpayer filed a Form 3115 with the 2011 tax return to change the accounting method for prepaid insurance. (See Regs. Sec. 1.263(a)-4(j).)

Daniel J. Larson, CPA
Offices in Oregon and California

This article was originally posted on May 7, 2012 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at