Prepaid Rent Could Not Be Deducted, Absent Substantial Business Reason for Prepayment

H is an attorney and CPA, working as a sole practitioner and using the cash method of accounting. In 1989, he signed a five-year lease for business space, under which he would pay rent monthly. In 1992, H paid the entire rent for 1992, 1993 and 1994. (H and his landlord began to negotiate a new lease in 1994 and signed it in 1995.)

On his 1992 return, H deducted the entire rental amount. The IRS allowed the 1992 rent, but disallowed the prepaid rent for 1993 and 1994. In a memorandum decision, the Tax Court (opinion Colvin, J.) held for the Service.

A cash-method taxpayer generally may not deduct prepaid rent in the year paid because it is not an ordinary and necessary business expense for that year. Instead, the taxpayer must deduct prepaid rent ratably over the years in which he uses the property. However, a cash-basis taxpayer may deduct prepaid items when paid, including rent, if he paid the rent (i.e., did not make a mere deposit), had a substantial business reason for making the prepayment in the year it was made and the prepayment did not cause a material distortion in the taxpayer's taxable income in the prepayment year.

H contends that he prepaid rent in 1992 to induce the landlord to agree to a below-market lease rate and to require no personal guaranty in his next lease. H's testimony was implausible; as such, he had no substantial business purpose for prepaying rent in 1992.

H contends that, under Rev. Rul. 69-511, he may deduct the rent he prepaid in 1992. The IRS ruled in Rev. Rul. 69-511 that a taxpayer may deduct damages that the taxpayer paid to a lessor to cancel a lease for a term of years when paid or accrued, depending on his accounting method. H contends that it "logically follows that a lump-sum payment to procure a lease in a time-sensitive context should be deductible as well." We need not decide this point, because we are not convinced that H prepaid rent in 1992 to obtain a lease in 1994 and 1995.

Howard Howe, TC Memo 2000-291