Under the accrual method, expenses are deductible only in the tax year to which they apply. But expenses can still qualify for the 12-month rule, just as prepaid expenses under the cash method. If the rights or benefits generated by the payment do not extend beyond 12 months, or beyond the end of the following tax year, the expenses can be deducted in the period they are paid.
Related Persons
If you owe business expenses or interest to persons who are related to you, or who are defined as related for income tax purposes, and the related person is on the cash basis, you can deduct the expenses only when they are actually paid and includible in the related person’s gross income, even if you are reporting on the accrual basis.
Related persons for this purpose include the following, among others:
Members of a family (whole or half brothers and sisters, spouses, ancestors, and lineal descendants)
A professional service corporation and any employee-owner, regardless of the amount of stock owned,
An individual and a corporation when the individual directly or indirectly owns more than 50% of the stock,
Any two S corporations if the same person owns more than 50% of the stock of each,
A corporation and a partnership if the same person owns more than 50% of each.
Contested Liability
If you use the accrual method and you contest a liability that has been asserted, you can deduct the expense either in the year you pay it, or in the year you settle the contest. But in order to be able to deduct the expense when you pay it, you must meet the following conditions:
You must have contested the liability. This does not have to be a suit you file in a court of law, but you must deny the validity or accuracy of the claim by making a positive act. A written protest included with your payment will start a contest. Also, lodging a protest in accordance with local law will be enough to contest an asserted liability for taxes.
The contested liability must exist after the time of transferring payment. If you make payment after the contest is settled, you accrue the expense in the period the contest was settled. For example, if you settle a contested liability in one tax year and pay it in the following tax year, you must report it in the year you settled the contest, which was before you paid it.
You must transfer money or other property to provide for the payment of the liability, to the creditor or another person. And the money or property you transferred must be outside your control. You can do this by transferring it to an escrow agent.
The liability must have been deductible even if you had not contested it.
Economic performance must have occurred. For example, in the case of incidental and consequential damages related to a worker’s compensation claim or liability for breach of contract, economic performance occurs when payment is initially made to the person.