Accrual basis taxpayers can generally deduct liabilities incurred when (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. For taxpayers that prepay a liability for services before services are actually provided, the requirement of economic performance can be a bar to deductibility until those services are actually performed.
This rule is softened by the 3 ½ month rule and 8 ½ month rule. The 3 ½ month rule provides that a taxpayer is allowed to treat services or property as provided to it as the taxpayer makes payment to the person providing the services or property, if the taxpayer can reasonably expect the person to provide the services or property within 3 ½ months after the date of payment (per Treas. Reg. §1.461-4(d)(6)(ii) ). Under the 8 ½ month rule, if the liability is recurring in nature, economic performance occurs on or before the earlier of (i) the date that the taxpayer files a return (including extensions) for the tax year, or (ii) the 15th day of the ninth calendar month after the close of the tax year (i.e., 8 ½ months), and certain other requirements are met, the liability can be deducted before economic performance occurs (Code Sec. 461(h)(3) ; Treas.Reg. § 1.461-5(b)(1))
Some taxpayers have deducted expenses relating to prepaid services that are only partially performed within the requisite 3 ½ month or 8 ½ month period. The IRS Chief Counsel has now indicated that this is inappropriate, and that the two special rules are all or nothing rules. If the services are fully performed within the requisite time period, the deduction is allowed. If they are only partially performed, then no deduction (and not a partial deduction) will be allowed.