What Is the 12-Month Rule for Prepaid Expenses?

Companies often pay for goods and services before receiving them. These payments are known as prepaid expenses and represent a future benefit, such as a year of insurance coverage or a six-month software subscription. Standard accounting practice requires recording these prepayments as an asset on the balance sheet. As the benefit is used, the cost is gradually moved to the income statement as an expense through a process called amortization.

Defining the 12 Month Rule

The 12-month rule is an exception to the standard practice of amortizing prepaid expenses. This tax regulation allows a business to deduct the full amount of a qualifying prepaid expense in the year it is paid, rather than spreading the cost over the period it covers. This accelerates tax deductions and reduces a company’s taxable income for the current year.

To qualify, the benefit from a prepaid expense must not extend beyond the earlier of two dates: 12 months after the benefit begins, or the end of the taxable year following the year the payment is made. For instance, a calendar-year taxpayer who prepays for a 12-month service on March 1, 2025, receives a benefit that ends on February 28, 2026. Since this is within the 2026 tax year and the benefit is not over 12 months, the prepayment qualifies. However, if a payment is made on December 1, 2025, for a 12-month service starting February 1, 2026, the benefit ends on January 31, 2027, which extends beyond the end of 2026 and would not be eligible for the immediate deduction.

Qualifying Expenses and Taxpayers

The 12-month rule primarily benefits cash-basis taxpayers, who record expenses when they are paid. For these taxpayers, the application is straightforward if the expense qualifies under the rule’s time-based conditions. While also available to accrual-basis taxpayers, their requirements are more complex, involving an “all events test” and “economic performance test” to determine when a liability is fixed. Because of these additional hurdles, cash-basis businesses are the most common users of this provision.

Common business expenditures qualify for this treatment, such as insurance premiums for a 12-month policy. Prepaying rent for business premises for up to 12 months can also be deducted in the year of payment. Other qualifying payments include annual business licenses, permits, professional dues, or software subscriptions that cover a 12-month period.

Certain payments are excluded from the 12-month rule. Prepaid interest must be deducted over the life of the loan. Payments for assets with a useful life that extends substantially beyond 12 months, such as machinery or furniture, do not qualify. These must be capitalized and depreciated over their useful lives.

Applying the Rule on Your Tax Return

To apply the 12-month rule, the full amount of the prepaid item is deducted on the appropriate line of the business’s tax return for the year the payment was made. For example, a sole proprietor filing a Schedule C (Form 1040) would include a prepaid insurance premium on the “Insurance” line. The same principle applies to partnership and corporate tax returns.

Consistency is required when using the 12-month rule. Once a taxpayer chooses to deduct a specific type of prepaid expense in the year of payment, this accounting method must be used in subsequent years. If a business previously capitalized these expenses and now wants to apply the rule, it may need to file Form 3115, Application for Change in Accounting Method.

Clear record-keeping is necessary when applying this rule. Businesses must retain documentation for each prepaid expense, including the invoice detailing the service and its coverage period. Proof of payment, such as a canceled check or bank statement, is also required. These records are necessary to substantiate the deduction in the event of an IRS audit.