Tax Court addresses prepaid service contract issues

February 2012

Overview

A taxpayer that accelerates into the current year a payment under a service contract may be able to deduct the payment in that year in reliance on the "3 1/2-month rule." That rule allows a taxpayer to treat the economic performance requirement as having been met at the time of the prepayment if the taxpayer reasonably expected the services to be provided within 3 1/2 months after the date of payment.

A recent Tax Court decision provides insight on how the IRS and courts may analyze issues under the rule. Taxpayers may need to consider the structure of the service contract and how the 3 1/2-month rule applies in determining the proper tax treatment of payments under the contract.

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