Year-End Tax Tips for 2002:

Cash-Basis Taxpayer’s Success In Deducting Year-End Payments Dependent On Variety Of Regular And Special Rules

    Now that the end of 2002 is drawing near, cash-basis taxpayers will find themselves engaged in down-to-the-wire transactions. Depending upon the application of certain tax rules and special exception, the cost of late-December transactions may be deductible in 2002, or they may require waiting a full year before taking them as a deduction against 2003 income.

General principles
    A cash-basis taxpayer generally takes deductions for a tax year in which cash or property is actually paid or transferred, regardless of when the expense was incurred.
    There is no doctrine of constructive payment comparable to the doctrine of constructive receipt. Even though a cash-basis payee may be deemed in constructive receipt of an item of income that the payee has avoided, a cash-basis payer is only entitled to a deduction when the expense is actually paid. However, when an expense item payable by a cash-basis taxpayer is offset by amounts owed to the taxpayer, the taxpayer deducts the expense in the year of the offset. Payments in the nature of deposits or made in the form of notes are not deductible.
    Prepaid expenses are deductible, either in part based on the duration of the expense item, or in their entirety if there is no material distortion of income. Expenditures for items that have a useful life longer than one year generally must be recovered over the life of the item.

Specific types of payment
    In addition to the general principles being applied to taking year-end deductions, special rules have developed to govern deductions in certain circumstances:
    Checks: A check constitutes payment on delivery, regardless of when the payee cashes the check if (1) there are no restrictions, such as postdating, on the presentation of the check to the drawee bank; and (2) the check is paid on presentation to the bank.
    A taxpayer is treated as having made payment in the tax year in which he mails or delivers a check, even though the check is not cashed until the following year. However, the check must be honored in due course. If the check bounces, then payment is not deemed to have occurred. For example, a calendar- year taxpayer, who mails a check to his physician on December 31 for medical services rendered, is treated as having made the payment in the year the check was mailed, even though the check is not received and cashed by the physician until the following year.
    Because delivery of a check constitutes payment only if there are no restrictions on presentation, the maker of a check is not allowed a deduction in the year of delivery if:
    • The payee has agreed not to cash the check until the following year;
    • The payee knows there are insufficient funds to cover the check and delays cashing the check        until sufficient funds are deposited in the following year;
    • The payee receives the check with the understanding that the check is not to be cashed, but        to be submitted for other debt instruments at some time in the future; or
    • The payer mails a check on December 31, but postdates the check to January 1.
    If a check given in payment of expenses is not cashed and is returned to the cash-basis maker,
the cash-basis maker cannot deduct the amount until paid, because a check constitutes conditional
payment subject to the condition that the check is paid on presentation. If the payee postpones but
ultimately cashes the check, and the date of delivery is not disputed, the payment dates back to the
time of delivery of the check.
    Credit cards: The availability of a deduction for a cash-basis taxpayer who pays an expense with a credit card depends on the type of credit card arrangement. If it is a bank card, the taxpayer is effectively borrowing from the bank and using the borrowed funds to pay the debt, which permits the taxpayer to obtain an immediate deduction when the expense is charged. However, if a department store issues a credit card for use at its store, a cash-basis taxpayer, who uses the card, merely promises to pay the bill in the future but does not actually pay. In this situation, the taxpayer is eligible for an expense deduction when the taxpayer pays the bill rather than when the amount is first charged.
    Prepayments: A cash-basis taxpayer who prepays expenses cannot generally deduct the full amount in the year of payment, but must prorate the expense over the life of the asset or for the duration of the services purchased. However, a cash-basis taxpayer may be able to deduct the full amount of a prepaid expense under the following conditions:
    • The expenditure is an actual payment instead of a refundable deposit;
    • The prepayment is for a substantial business purpose and not merely for tax avoidance; and
    • The deduction of the prepayment does not result in a material distortion of income.
Prepaid charges for materials and supplies are generally deductible only to the extent that the
materials or supplies are used during the tax year. However, prepayments for incidental materials and supplies, that is, materials and supplies that are used without keeping records or annual inventories, are fully deductible in the year of actual payment if this accounting method clearly
reflects income.
    In determining when an expense is deductible, some courts have adopted a one-year rule. Under the one-year rule, an expenditure is treated as a capital expenditure if it creates an asset or secures an advantage to the taxpayer having a useful life exceeding one year. In determining whether the asset or right created has a life extending beyond one year, the starting date for measurement is the date of payment.
    Payment to agent: When a cash-basis taxpayer pays the agent of the taxpayer’s creditor, the taxpayer is entitled to an expense deduction for the tax year of actual payment. In contrast, a cash-basis taxpayer’s payment to the taxpayer’s own agent does not trigger entitlement by the taxpayer to a deduction in that year.

Specific guidelines
Cash-basis taxpayers have specific guidance in many situations to determine when payments for expenses are deductible:
    Charitable contributions. All individual taxpayers, whether on the cash method or accrual method, and all cash-basis corporations deduct charitable contributions for the tax year in which the contribution is actually paid or delivered. A mere pledge or promise of a charitable contribution does not constitute payment for the purpose of allowing a current deduction.
    Compensation: A cash-basis employer generally deducts compensation, like other deductible expenses, in the year of actual payment. Because there is no constructive payment doctrine, an employer cannot claim a deduction for unpaid compensation even though an employee is in constructive receipt of the compensation.
    Depreciation: Depreciation is an exception to the general rule that a cash-basis taxpayer cannot deduct amounts not actually paid. A cash-basis taxpayer, who acquires an ownership interest in property having a useful life exceeding one year in a bona fide arm’s-length transaction for the fair market value of the property, can deduct depreciation using a basis equal to the full purchase price.
    Interest: A cash-basis taxpayer can deduct interest only if: (1) the taxpayer actually pays the interest during the tax year; and (2) the interest is properly allocable to that year or to a prior tax year.
However, a cash-basis buyer can deduct seller-paid points paid in connection with the acquisition of a principal residence.
    Interest paid in advance for a period that goes beyond the end of the tax year must be capitalized, and treated as paid in the period in which it economically accrued. For example, if a cash-basis tax-payer, makes a mortgage payment due January 1 2003, on December 27, 2002, the interest portion of this mortgage payment is deductible in 2003, not 2002.
    Medical expenses: A cash-basis taxpayer may deduct medical expenses, to the extent that they exceed the AGI floor on the medical expense deduction, in the year actually paid if the expenses were incurred in the current or a previous year. A taxpayer who pays medical expenses in an earlier year cannot deduct those medical expenses until they are incurred in a later year.
    Taxes: A cash-basis mortgagor cannot deduct taxes paid as part of his monthly payment to the mortgagee or to an escrow account, since the mortgagee or escrowee, absent special circumstances, is not the agent of the taxing authority for these purposes. Payment occurs when the mortgagee or escrowee transmits the funds to the taxing authority, not when the mortgagor makes payment to the mortgagee or to an escrow account.
    A cash-basis taxpayer deducts otherwise allowable taxes when the taxpayer actually pays the taxes. A cash-basis taxpayer may deduct prepaid taxes if the advance payment is accepted as payment by the governmental authority, the payment is not a deposit, and the payment is made in good faith.
    Stocks and bonds: The holding period of securities generally begins on the trade date if they are publicly traded or upon receipt of title if not publicly traded (rather than on the settlement date when the taxpayer delivers the security and receives the purchase price). The first securities bought are deemed to be the first sold, unless a taxpayer can prove otherwise. The holding period of fractional shares or stock acquired through reinvestment plans begins on the date of acquisition.

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