Prepaid services must be fully completed to use 3 1/2-month rule.

Tax Adviser, The, August, 2007 by Fiore, Nicholas J.

At the end of year 1, T enters into a 12-month service contract with X. Under the contract, X will provide services to T until the end of year 2. At the end of year 1, when the contract is executed, T makes a prepayment to X for a portion of the services to be provided in year 2. On its Federal income tax return for year 1, T deducted the prepayment as an expense, citing either the 3 1/2-month rule or the recurring-item exception as authority.

Analysis

Sec. 461 provides general rules that govern the year of deduction. Regs. Sec. 1.461-1 (a)(2) states that, under an accrual method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the tax year in which (1) all the events have occurred that establish the...

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