The Test
To determine if the prepayments were deductible, the Tax Court applied a three-prong test. The test applies whenever the issue is the deductibility of prepaid items under §§ 162 and 446(b). Each prong is independent and must be satisfied for a prepayment to be deductible:
First, there must be an “actual payment of the item in question.” A mere refundable deposit will not support a deduction.
Second, there must be a “substantial business reason” for making the prepayment early. If prepayment occurred simply to accelerate a tax deduction, no deduction will be allowed in the year of prepayment. Tax reduction is not considered a “valid business purpose,” and thus is not an ordinary and necessary expense under § 162. Grynberg at
Third, prepayment of the item must not cause a “material distortion” in the taxpayer’s taxable income in the year of prepayment. IRC § 446(b). The taxpayer carries a heavy burden to overcome the IRS’s determination that the taxpayer’s method of accounting does not clearly reflect income.
Read more about this topic: Grynberg V. Commissioner
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