Year End Tax Planning: Pre-Paid Insurance Expense For Accrual Accounting TaxpayersPosted November 9th, 2010
Why is this Topic Important to Wealth Managers? Discusses the key differences and similarities to the treatment for the deduction of an insurance contract premium payment with regards to accrual basis taxpayers with that of the cash receipts and disbursement method.
Today’s blogticle continues our week long series on year-end tax planning for businesses and individuals. Specifically we pick up right where we left off yesterday, except today’s focus is on accrual basis taxpayers with regards to prepaid expenses.
Accrual taxpayers are treated slightly different than cash taxpayers when it comes to prepaid expenses, and in fact the process can sometimes add complications. The idea behind accrual accounting is to match revenues with expense in the period in which they occur. For a detailed discussion on the difference between cash and accrual taxpayers see our August 23 blogtice: Advisor FYI: Accounting for Corporations and Limited Liability Companies and How it Relates to Insurance
As was discussed yesterday, an ordinary and necessary expense is deductible when it is paid or incurred in the taxable year for the purpose of carrying on a trade or business. 
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.” 
Generally, an accrual basis taxpayer, unlike cash method taxpayers, may deduct a business expense in the first year in which the taxpayer “incurs,” or becomes liable for, that expense, regardless of when the taxpayer actually pays for the expense.  Whether a taxpayer has incurred an expense is governed by the “all events” test. Under this test, all the events must have occurred that establish the liability, and the amount must be capable of being ascertained with reasonable accuracy. 
Furthermore, in “determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.” 
Economic performance with regard to insurance, warranty or service contracts, occurs when “payment is made to the person to which the liability is owed.”  “The term payment has the same meaning as is used when determining whether a taxpayer using the cash receipts and disbursements method of accounting has made a payment.” 
On its face, one may consider how the tax law treats insurance contract premium payments for cash receipts and disbursements method of accounting with that of an accrual election, and note that the deduction for both cash and accrual taxpayers occurs when the payment of cash or cash equivalents is made. The short answer is, the law has conflated the two and there is no significant difference in the timing of this accrual deduction as compared to cash basis taxpayers, discussed yesterday.
This also means that an accrual based taxpayer may take a deduction in the year the premium is paid, and if the contract is for less than 12 months, the taxpayer need not capitalize and amortize the premium over the life of the contract. 
Tomorrow’s blogticle will continue the year-end tax planning series.
We invite your questions and comments by posting them below, or by calling the Panel of Experts.
 26 U.S.C. § 162 (a); Neonatology Associates, P.A. v. C.I.R. 115 T.C. 43, 88 (U.S.Tax Ct.,2000) Citing, Commissioner v. Lincoln Savs. & Loan Association, 403 U.S. 345, 352, 91 (1971); Welch v. Helvering, 280 U.S. 111, 115, (1933).
 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).
 Treas.Reg. § 1.461-1(a)(2); United States v. Anderson, 269 U.S. 422, 424, 46 S.Ct. 131, 70 L.Ed. 347 (1926).
 26 C.F.R. § 1.461-1(a)(2); Valero Energy Corp. v. C.I.R. 78 F.3d 909, 915 (C.A.5,1996). See also, U.S. v. General Dynamics Corp. 481 U.S. 239, 243 U.S.,1987).
 26 U.S.C. § 461(h)(1).
 26 C.F.R. § 1.461-4 (g)(5).
 26 C.F.R. § 1.461-4 (g)(1)(ii).
 26 C.F.R. § 1.263(a)-4 (f)(1).