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Year-End Tax Planning Strategies: Prepaid Expenses

Part 2 of 2 Part Tax Strategy Series

As we approach the end of another year, we thought it would be a good time to talk about some year-end tax planning strategies. Of course, having up-to-date records is essential for the tax planning process. If you discover that you might end up with a large tax liability, there are a few things you can do before the year is over.

In this series of two blog posts, we will examine two different strategies of accelerating expenses. This post will cover prepaid expenses. The other post will cover depreciation strategies.


Prepaid Expenses

Prepaying expenses is one of the most common tax management practices that we see­–it is also an area that is scrutinized by the IRS during audits. Thus, what follows is a review of the rules regarding prepaid expenses.
There are three conditions that must be met in order for a cash basis taxpayer to claim a deduction in the year the prepayment is made.
  1. The expenditure must be a payment for a supply and not merely a deposit. This means you need to have an invoice clearly stating the quantity purchased and the price. Delivery before the end of the year is not required.
  2. The prepayment must be made for a valid business purpose and not merely to accelerate a tax deduction. Some examples of valid business purposes include the availability of the supply item or locking in a guaranteed price.
  3. The deduction must not result in a material distortion of income.
In addition, you need to be aware that there is a 50% rule that limits the deduction for prepaid expenses to 50% of deductible farm expenses unless you are a “qualified farm-related taxpayer”.

Prepaid expenses are a very good way to accelerate expenses, however, for a very profitable business, you can get stuck in a cycle of always having to prepay once you start, regardless of your cash flow situation.

Please contact your Farm Credit Tax Specialist to review your overall tax strategy, keeping in mind a long-term view.

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