When you deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and an accrual method.

For more information on accounting methods, see Publication 538.

Cash method. Under the cash method of accounting, you generally deduct business expenses in the tax year you actually paid them, even if you incurred them in an earlier year.

Accrual method. Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.

1. The all-events test has been met. The test is met when:
1. All events have occurred that fix the fact of liability, and
2. The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. 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.

Example. Your tax year is the calendar year. In December 2001, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $150. You paid it by check in January 2002. If you use an accrual method of accounting, deduct the $150 on your tax return for 2001 because all events occurred to fix the fact of liability and economic performance occurred in that year. If you use the cash method of accounting, you can deduct the expense on your 2002 return.

Prepayment. You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example. In 2001, you sign a 10-year lease and immediately pay your rent for the first 3 years. Even though you paid the rent for 2001, 2002, and 2003, you can deduct only the rent for 2001 on your current tax return. You can deduct on your 2002 and 2003 tax returns the rent for those years.

Contested liability. Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under an accrual method, you can deduct contested liabilities, such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes), in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. See Contested Liability in Publication 538 for more information.

Related person. Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not paid them. However, if you and the person you owe are related and the person uses the cash method of accounting, you must pay the expense before you can deduct it. The deduction by an accrual method payer is allowed when the corresponding amount is includible in income by the related cash method payee. See Related Persons in Publication 538.

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