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My wife is starting an architecture business as a sole proprietor. One significant expense is insurance.

Suppose that she pays $10,000 for insurance now that covers the period Nov. 1, 2012 to Nov. 1, 2013. Suppose also that she makes $5000 between Nov. 1 and the end of the year, and that she anticipates making $50,000 in 2013.

How can she take full advantage of the business expense to decrease her taxes?

For example, should she apportion two months of the insurance fee for her 2012 taxes and the remaining 10 months for her 2013 taxes? Should she pay the insurance in installments so that she is actually paying for most of it in 2013? Could the loss for 2012 be carried over to 2013?

I've heard about cash and accrual based accounting. Is that relevant here?

EDITS:

This is in Massachusetts.

As she is just starting, she hasn't chosen an accounting method, but cash based would be preferable as it seems much easier.

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2 Answers

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Here is a Federal court opinion (see third par.) that seems to provide a relatively clear answer:

Taxpayers using the cash method of accounting may deduct allowable business expenses in the year in which they are paid, unless the expenditure results in the creation of an asset having a useful life which extends substantially beyond the taxable year, in which case amortization is required. Treas.Reg. 1.461-1(a). Under the "one-year rule" which we have adopted to define the latter exception, an expenditure creating an asset with a useful life beyond the taxable year of more than one year generally must be amortized.

This is the tax code it refers to:

Under the cash receipts and disbursements method of accounting, amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid. ... If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.

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This is not about an insurance expense, and it is not a bounding precedence in your state (you're in 1st circuit). – littleadv Nov 2 '12 at 0:33
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Cash base does indeed seem to be easier for a small business.

However, certain expenses cannot be taken when paid even when on cash basis, and insurance is one of them. You should indeed apportion the expense per the coverage period - 2 months here and 10 there.

As to losses, since its a sole proprietorship, they're flowing on to her 1040 (or your joint 1040 if filing jointly). If even after deducting them from her/your other income, there's still a loss - NOL rules may kick in, and you can carry it forward or backward.

Quote from the IRS publication 535:

Expenses such as insurance are generally allocable to a period of time. You can deduct insurance expenses for the year to which they are allocable.

Talk to your accountant. Better still - let her talk to her accountant.

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This page suggests that only multi-year expenses are pro-rated: taxation.lawyers.com/… – Kekito Nov 1 '12 at 23:49
@Kekito its a bit fuzzy. Multi-year expenses must be prorated. Prepaid expanses for less than a year don't have to be. But insurance is explicitly said by the IRS to be prorated per the periods of coverage, although they too use a multi-year example. It is 12 months usually, so its not less than a year, I'd say you prorate it. – littleadv Nov 2 '12 at 0:29
Would be great to see some document that supports this. – Kekito Nov 2 '12 at 0:38
@Kekito pub 535: irs.gov/publications/p535/ch06.html – littleadv Nov 2 '12 at 0:44

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