Is Deductible Based on Date of Service or Date of Payment?

When dealing with medical expenses or business costs, determining when a deduction applies can be confusing. A common question is whether the deductible is based on the date of service or the date of payment. The answer depends on accounting methods and payment arrangements. Different rules apply depending on whether you use the cash or accrual method, and specific situations like prepaid services or late invoices can further affect timing.

Cash Method Implications

Under the cash method of accounting, expenses are deductible in the year they are paid, regardless of when the service occurred. If a business or individual pays for a deductible expense in December 2024, even if the service took place earlier, the deduction applies to the 2024 tax return. The IRS follows this principle under Section 446 of the Internal Revenue Code, which governs accounting methods for tax purposes.

This approach simplifies recordkeeping since deductions align with cash flow. For example, if a self-employed consultant pays an office rent bill on January 2, 2025, for December 2024 rent, the deduction falls in 2025. The same applies to medical expenses—if a taxpayer undergoes surgery in November 2024 but pays the bill in February 2025, the deduction is taken in 2025.

Prepaid expenses can complicate this method. While most payments are deductible when made, prepayments for services extending beyond 12 months or into a future tax year may not be immediately deductible. The IRS limits deductions for prepaid expenses under the “12-month rule,” meaning if a business prepays insurance for two years, only the portion covering the first year is deductible in the year of payment.

Accrual Method Implications

Under the accrual method, expenses are recognized when incurred, not when paid. This means a business can deduct an expense in the tax year when the liability is established, even if payment occurs later. The IRS requires businesses using this method to follow the “all-events test,” which states that a deduction is allowed when: (1) all events have occurred to establish the liability, (2) the amount can be determined with reasonable accuracy, and (3) economic performance has occurred.

Economic performance typically happens when the service is performed. For example, if a law firm provides legal services in December 2024 but the client does not pay until February 2025, the expense is still deductible in 2024, assuming the client uses the accrual method.

The timing of deductions can also be affected by contractual obligations. If a company enters into a binding agreement for services to be rendered in the future, the deduction cannot be taken until the service is performed. This prevents businesses from accelerating deductions by prepaying for services that have not yet been provided.

Differing Payment Arrangements

The structure of payments can also affect deduction timing, particularly when third-party financing, installment agreements, or deferred payment plans are involved.

For example, medical bills paid through a healthcare credit card or financing plan may not be immediately deductible. If a patient receives treatment in June 2024 but charges the expense to a medical credit card, the deduction is generally allowed when the charge is made, not when monthly payments are completed. The IRS typically considers the expense paid at the time the obligation is assumed, provided the taxpayer is legally responsible for repayment.

Similarly, businesses that negotiate extended payment terms with vendors must consider how these agreements impact deductions. If a company receives consulting services in October 2024 but arranges to pay over 12 months, the deduction may still be taken in 2024 under the accrual method. However, if the company operates on a cash basis, the deduction is deferred until actual payments are made.

Prepaid Services

Payments made in advance for future goods or services introduce additional considerations. Unlike standard expenses, prepaid costs often follow specialized tax treatment to prevent improper acceleration of deductions. The IRS has established guidelines, such as the “12-month rule” and the “economic performance test,” to regulate how and when these expenses can be deducted.

For businesses, prepayments for rent, insurance, or service contracts must be evaluated based on the period they cover. If a company pays $24,000 in December 2024 for a two-year insurance policy extending through December 2026, only $12,000 may be deductible in 2024, corresponding to the coverage for that tax year. The remainder must be amortized over the applicable period.

Taxpayers using prepaid medical plans or subscription-based professional services must also be cautious. If a self-employed individual prepays for a year of business consulting in November 2024, but services do not begin until January 2025, the deduction may be deferred until the service is rendered.

Late Invoices

Unpaid invoices can create uncertainty when determining the appropriate tax year for deductions. The timing of deductibility depends on whether an expense is recognized when billed or when payment is made, which varies based on accounting methods and contractual terms.

For cash-basis taxpayers, an invoice received in one year but paid in the next does not qualify for a deduction until the payment is completed. This can impact year-end tax planning, as delaying payment until January can shift the deduction to the following tax year. In contrast, accrual-basis businesses can deduct expenses when the liability is established, even if the invoice remains unpaid.

Disputes over invoices can further complicate deductions. If a business contests a charge and withholds payment pending resolution, the deduction may be deferred until the dispute is settled. The IRS generally does not allow deductions for contingent liabilities, meaning an expense must be fixed and determinable before it can be claimed.

Recordkeeping Essentials

Proper documentation is necessary to substantiate deductions and ensure compliance with IRS regulations. Maintaining accurate records helps taxpayers defend their deductions in the event of an audit and prevents errors that could lead to penalties or disallowed expenses. The IRS requires supporting documentation for all deductible expenses, including receipts, invoices, bank statements, and contracts.

For cash-basis taxpayers, payment records such as canceled checks, credit card statements, and electronic payment confirmations serve as proof of when an expense was incurred. These documents should clearly indicate the payee, amount, and date of payment. Accrual-basis businesses must retain invoices, purchase orders, and service agreements to demonstrate when a liability was established. In cases where economic performance is a factor, additional documentation, such as work completion reports or delivery confirmations, may be required.

Digital recordkeeping solutions can streamline expense tracking and ensure compliance with IRS guidelines. Accounting software with automated categorization and cloud storage capabilities can help businesses maintain organized records and generate reports for tax filings. The IRS recommends retaining financial records for at least three years, though longer retention periods may be necessary for certain deductions, such as those related to capital expenditures or long-term contracts.