Can You Prepay Expenses or Defer Income to Cut This Year’s Tax? The 12-Month Rule

Every December an owner asks the same two questions: can I pay next year's bills now and deduct them, and can I push this month's income into January? The answer depends on the accounting method the business uses, and the rules are narrower than the folklore. This post sets out what a cash-method business may do, what an accrual-method business may do, the 12 month rule for prepaid expenses that governs most of it, and the one bonus deadline that trips up employers. The December checklist that puts these moves in order is in year-end tax planning.

Who may use the cash method

Section 448 bars three kinds of taxpayer from the cash method: a C corporation, a partnership with a C corporation as a partner, and a tax shelter (IRC 448(a)). The first two get it back if they meet the gross receipts test, which for a tax year beginning in 2026 means average annual gross receipts of $32,000,000 or less for the three prior tax years (IRC 448(c); Rev. Proc. 2025-32, section 3.30). Sole proprietors, S corporations and partnerships without a corporate partner may use it at any size. Changing method after the first return generally requires IRS approval (Publication 538).

Cash-method income: received or constructively received

Under the cash method, “gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received” (Treas. Reg. 1.451-1(a)). The second word is the limit on deferral. Income is constructively received “in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time,” unless the taxpayer's control of it “is subject to substantial limitations or restrictions” (Treas. Reg. 1.451-2(a)). A customer who pays by check in January produces January income. A customer who tried to pay in December and was told to wait produces December income. Billing on your normal schedule is not constructive receipt; refusing money that is on the table is.

Cash-method expenses: paid, with one large exception

Deductions under the cash method “shall, as a general rule, be taken into account for the taxable year in which paid” (Treas. Reg. 1.461-1(a)(1)). The same sentence carries the exception: if an expenditure creates an asset with a useful life that extends substantially beyond the close of the year, it may be deductible only in part, or not at all, in the year paid. A prepaid expense is exactly that kind of asset, which is why the question of prepaying is settled by the 12-month rule rather than by the date on the check.

The 12-month rule for prepaid expenses

A taxpayer is not required to capitalize amounts paid to create a right or benefit that does not extend beyond the earlier of “12 months after the first date on which the taxpayer realizes the right or benefit” or “the end of the taxable year following the taxable year in which the payment is made” (Treas. Reg. 1.263(a)-4(f)(1)). Both tests apply, and the second one is the trap: a 12-month policy that starts in February of next year runs into the year after next and fails. The regulation's own examples draw the line at a $10,000 premium paid December 1 for a policy beginning February 1 (capitalize) against the same policy beginning December 15 (deduct). Renewal periods count toward the length of the benefit if the facts show a reasonable expectancy of renewal (1.263(a)-4(f)(5)). The rule does not apply to amounts paid to create financial interests, to self-created section 197 intangibles, or to rights of indefinite duration (1.263(a)-4(f)(3), (4)). A business that has been deducting prepayments only in the year they apply to must get IRS approval before switching to the 12-month rule, since that is a change in accounting method (Publication 538).

Prepaid rent, insurance and subscriptions

For a cash-method business the three common prepayments fit the rule the same way: up to 12 months of coverage or service, starting no later than the first days of next year, paid this year. The regulation's Example 10 applies it to a cash-method tenant prepaying six months of next year's rent; insurance follows Example 2; non-renewable 12-month service contracts are named as the kind of payment the rule reaches (1.263(a)-4(f)(7)). A taxpayer may also elect out and capitalize, for all similar transactions in the year.

Accrual method: the all-events test and economic performance

An accrual-method business takes a liability into account “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred” (Treas. Reg. 1.461-1(a)(2)(i)). Economic performance for services and property provided to the taxpayer occurs as they are provided, and for the use of property as the taxpayer uses it (IRC 461(h)(2)). That is why the 12-month rule does less for accrual taxpayers: it does not change whether a liability has been incurred (1.263(a)-4(f)(6)), so an accrual tenant's December prepayment of next year's rent is not deductible in December. The recurring item exception in section 461(h)(3) can pull an item into the earlier year when economic performance follows within 8½ months and the item is recurring and consistently treated. On the income side, an accrual business reports income when the right to it is fixed and the amount determinable, and no later than when an applicable financial statement recognizes it (IRC 451(b)).

Deferring income on the accrual method: advance payments under section 451(c)

Customers who pay in advance create the accrual method's one real deferral. An accrual taxpayer that receives an advance payment includes it in income for that year, or elects to include only the portion required by the AFS rule and to include “the remaining portion of such advance payment in gross income in the taxable year following the taxable year in which such payment is received” (IRC 451(c)(1)(B)). A business without an applicable financial statement uses the non-AFS deferral method: it includes the payment to the extent earned in the year of receipt and the rest the next year (Treas. Reg. 1.451-8(d)). The deferral is one year, not the life of the contract, and it does not cover rent, insurance premiums governed by subchapter L, financial instruments or several other categories (IRC 451(c)(4)(B)). A software company that bills annual subscriptions in December therefore reports the unearned part in the following year, not over the months the subscription runs.

Bonuses: paid by the 15th day of the third month

A year-end bonus is deductible by an accrual employer in the year it is accrued only if the liability is fixed and determinable at year end and the bonus is paid soon enough. Compensation received by the employee after “the 15th day of the 3rd calendar month after the end of the employer's taxable year” in which the services were rendered is presumed to be deferred compensation (Treas. Reg. 1.404(b)-1T), and deferred compensation is deductible only when paid; for that purpose “no amount shall be treated as received by the employee, or paid, until it is actually received by the employee” (IRC 404(a)(11)). For a calendar year that is March 15. A cash-method employer deducts the bonus when it is paid whatever the accrual. Bonuses to owners have a further rule: when the payee is a related person on the cash method, the deduction waits until the payee reports the income (IRC 267(a)(2)), and for an S corporation every shareholder is related (267(e)), as is a more than 50% shareholder of a C corporation (267(b)(2)). For owner bonuses the payroll date is the deduction date; S corp reasonable salary covers the amount.

A labeled illustration: a cash-method S corporation in December 2026

Timing moves taxable income between two adjacent years; it does not remove any. A prepayment deducted in 2026 is a deduction 2027 no longer has, which pays when 2026 income is the higher of the two and not otherwise. Small equipment bought in December is a separate question, answered by the de minimis safe harbor. Licensed tax professionals at BEG's tax partner run both years side by side as part of Forward Tax Planning with your CPA.

Sources: 26 U.S.C. 448, limitation on use of cash method of accounting; 26 U.S.C. 451(b) and (c), general rule for taxable year of inclusion; advance payments; 26 U.S.C. 461(h), certain liabilities not incurred before economic performance; 26 U.S.C. 404(a)(11), determinations relating to deferred compensation; 26 U.S.C. 267(a)(2) and (e), matching of deduction and payee income for related persons; 26 CFR 1.451-1(a), general rule for taxable year of inclusion; 26 CFR 1.451-2, constructive receipt of income; 26 CFR 1.451-8, advance payments for goods, services, and other items; 26 CFR 1.461-1(a), general rule for taxable year of deduction; 26 CFR 1.263(a)-4(f), the 12-month rule; 26 CFR 1.404(b)-1T, deferred compensation paid after the 15th day of the 3rd month; IRS, Rev. Proc. 2025-32, section 3.30 (2026 gross receipts test); IRS, Publication 538 (Rev. January 2022), Accounting Periods and Methods. Figures and rules checked against these sources on September 26, 2026. This is general information, not tax advice for your situation. Tax services are provided by licensed tax professionals under a separate engagement agreement. BEG does not provide tax advice.