Under an accrual method of accounting, generally you report income in the year it's earned - when you know someone owes you. You deduct expenses in the year they're incurred - when you know you have a bill to pay.
Generally, under an accrual method of accounting, you deduct a business expense when both the following apply:
- The all-events test has been met
- Economic performance has occurred
All-Events Test
The all-events test is met when both of the following happen:
- All events have occurred fixing your liability to pay the expense
- The amount of the expense can be figured out with reasonable accuracy
Economic Performance Rule
Generally, you can't deduct a business expense until there's economic performance. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
For example, say you buy office supplies, receive them and get billed for them all in December 2010. You pay the bill in January 2011. You can deduct the expense in 2010 because your liability was fixed, you knew how much you owed and economic performance happened in 2010.
Certain Payments
If you're required to make payments under workers compensation laws or to pay off any tort liability, economic performance occurs as you make the payments. If you must make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments.
Vacation
You can take a current deduction for vacation pay earned by your employees if you pay it during the year, or if the amount is vested, within two and one-half months after the end of the year. If you pay it later than this, you must deduct it in the year actually paid. An amount is vested if the right to receive the funds can't be cancelled.
Taxes
Economic performance generally takes place as estimated income tax, property taxes, employment taxes and so forth are paid.
Exception for Recurring Items
An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance hasn't occurred. The exception applies if:
- The all-events test is met
- Economic performance occurs by the earlier of eight and one-half months after the close of the year or the date you file a timely return (including extensions) for the year
- The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met, and
- Either the item isn't material or accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance
For example, if the office supplies you bought in December 2010 were not delivered until 2011 (when economic performance occurs), you could deduct them in 2010 if they qualify as a recurring item.
The recurring item exception to the economic performance rule doesn't apply to ongoing workers compensation or tort liability payments.
Questions for Your Attorney
- Is the accrual accounting method right for me? What other method could I use?
- What is the economic performance rule?
- If I could taken a deduction last year but forgot to, can I take that deduction this year, or do I need to file an amended return for last year?