Why is this Topic Important to Wealth Managers? Generally, wealth managers can help identify situations where clients may benefit from one or more concepts, and present ideas to clients as part of a comprehensive planning partnership.  This blogticle discusses on way in which wealth managers can contribute to client tax planning discussion. 

As December 31 approaches we would like to take this opportunity to discuss some of the common tax planning concepts that are used by professionals in an effort for legal tax mitigation.  Therefore, this week’s blogticles discuss year-end tax planning for businesses and individuals.  Today’s blogticle kicks off our discussion with pre-paid expenses for cash disbursements and receipts method taxpayers. 

As with all transactions, it should be kept in mind that the transaction, to comply with Federal tax law, needs to change the taxpayers “economic position” in a meaningful way not including any tax benefits, and the taxpayer has a” substantial purpose” for entering the transaction not including any tax considerations. [1] Satisfying the above conditions is commonly referred to as a transaction that contains economic substance. 

For more information on the economic substance doctrine, please see our October 29^th AdvisorFYI blogticle entitled: One More to Note: The Economic Substance Doctrine, as well as: AdvisorFX: The Economic Substance Doctrine Can Unwind Even the Best Laid Plans . 

Traditionally, taxable income of a business is computed by its gross income less its deductions and exclusions. [2]  Generally, gross income means all income from whatever source derived unless otherwise excluded by law. [3]  Congress allows for a “deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” [4]

The taxpayer has the burden to show that the item claimed as a deductible business expense: 1) was paid or incurred during the taxable year; 2) was for carrying on its trade or business; 3) was an expense; 4) was a necessary expense; and 5) was an ordinary expense. [5] 

One such class of deductions that is generally allowable is, “insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business, and rental for the use of business property.” [6]

There is a general rule that cash receipts and disbursements method taxpayers may deduct expenses when actually paid in cash. [7]

Can the taxpayer deduct the entire amount paid, if reasonable, for a benefit that expires within a 12 month period, or must the expense be capitalized and depreciated over its useful life? 

The Treasury Regulations state, “a taxpayer is not required to capitalize…amounts paid to create [a] benefit for the taxpayer that does not extend beyond…12 months after the first date on which the taxpayer realizes the right or benefit”. [8]

Compare the 12 month standard to “[a] prepayment for multiyear insurance coverage creates an asset having a useful life longer than a taxable year, which must be capitalized.” [9]  The former is generally fully deductible in the year paid, the latter is not. 

Tomorrow’s blogticle will discuss pre-paid expense for accrual method taxpayers. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 26 U.S.C. § 7701(o). 

[2] 26 U.S.C. § 63 (a). 

[3] 26 U.S.C. § 61(a). 

[4] 26 U.S.C. § 162 (a)   

[5] Neonatology Associates, P.A. v. C.I.R.  115 T.C. 43, 88 (U.S.Tax Ct.,2000) Citing, See Commissioner v. Lincoln Savs. & Loan Association, 403 U.S. 345, 352, 91 S.Ct. 1893, 29 L.Ed.2d 519 (1971); Welch v. Helvering, 280 U.S. 111, 115, 50 S.Ct. 49, 74 L.Ed. 217 (1933).

[6] 26 C.F.R. § 1.162-1; U.S. v. Weber Paper Co., 320 F.2d 199, 63-2 U.S. Tax Cas. (CCH) P 9630, 12 A.F.T.R.2d 5256 (8th Cir. 1963).

[7] 26 C.F.R. § 1.461-1(a)(1); Eckert v. Burnet  283 U.S. 140, 141, 51 S.Ct. 373, 374 (U.S., 1931); Chapman v. U.S., 527 F. Supp. 1053, 1054 82-1 U.S. Tax Cas. (CCH) ¶9119, 49 A.F.T.R.2d 82-443 (D. Minn. 1981).  

[8] 26 C.F.R. § 1.263(a)-4 (f)(1). 

[9] Toyota Town, Inc. v. C.I.R.  L 140819, 9 -10  (U.S.Tax Ct.,2000), citing Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566, 577 (1927);  26 C.F.R. §  1.461-4(g)(8), Example (6).; see also USFreightways Corp. v. Commissioner, 113 T.C. —-, (1999); Johnson v. Commissioner, supra at 488; Hinshaw’s, Inc. v. Commissioner, T.C. Memo.1994-327.

Tags: accounting, Expense, Individual Retirement Account, insurance, Tax, Tax deduction, Treasury Regulations

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