If you are starting a new business, you are probably facing a lot of business start-up costs. This can be very confusing when it comes to taxes. What can you deduct in year one, and how do you make deductions in the following years? It’s an overwhelming situation.
Luckily, the government allows you to deduct a portion of your business startup costs on your tax return to reduce your tax bill. Now, it’s just a matter of understanding how to do this properly.
In this article, we will cover what business startup costs are, examples of typical business startup costs, how startup costs may be classified and treated on your tax return, and how much of your costs you can deduct each year. We’ll also look at a few examples of how to do this right on your tax return.
What are business startup costs for tax purposes?
According to the IRS, startup costs include:
“amounts paid or incurred for (a) creating an active trade or business, or (b) investigating the creation or acquisition of an active trade or business. Startup costs include amounts paid or incurred in connection with an existing activity engaged in for profit, and for the production of income in anticipation of the activity becoming an active trade or business.”
The IRS further explains that startup costs must be:
“ones that could be deducted as business expenses if incurred by an existing, active business and must be incurred before the active business begins.”
If that sounds confusing, don’t worry; we’ll go over some examples and explanations on what exactly business startup costs are for tax purposes.
What are the different kinds of business startup costs?
There are three types of business startup costs:
(1) Creating or investigating a trade or business,
(2) Preparing the business to open, and
(3) Organizational costs.
For the full details related to these three types of business startup costs, see IRS Publication 535: Business Expenses.
To further explain this, we’ll look at some examples of business startup costs – what they are and what they are not.
What are some examples of business startup costs?
According to The Journal of Accountancy, startup costs include:
“consulting fees and amounts to analyze the potential for a new business, expenditures to advertise the new business, and payments to employees before the business opens.”
Startup costs DO NOT include interest, taxes, and/or research and experimentation.
Typical business startup costs include business insurance, real estate, office space, business assets (equipment and machinery), office supplies, and professional fees.
Other expenses you may incur when starting a business include licenses, permits, employee training, employee hiring, technological expenses, advertising, promotional fees, travel costs, rent, legal expenses, internet connection costs, and utility bills.
To qualify as a deduction, costs must be ordinary and necessary to the business industry. This means business expenses must be related to the industry that you are trying to be a part of. Expenditures must also be normal for the course of business for that industry.
So, if you are opening a law firm, you cannot deduct the cost of paint of works of art you are planning to display at the office if you paint on the side. Painting is not a normal expense for a law firm, and it does not occur in the normal course of business. Therefore, it does not qualify as a business expense.
When can I deduct startup costs?
The Journal of Accountancy explains:
“A taxpayer may elect to deduct a portion of startup costs in the tax year in which the active conduct of the business to which the costs relate begins and to amortize the portion of the startup costs not deducted over a 180-month period under Sec. 195(b)(1)(A)” of the IRS tax code.
In other words, you may elect to deduct a portion ($5,000) of startup costs in the first year, and you can amortize (deduct the remainder to an extent over a 15 year period) the rest of the startup costs.
Note: You may also deduct a portion ($5,000) of your organizational costs in the first year. Examples of organizational costs include legal fees, registration fees, and legal agreements/contracts.
When do business costs cease to be startup costs?
Once you acquire the business, the costs to acquire it are no longer considered to be business startup costs; instead, you must capitalize the acquisition costs.
How much startup costs can you deduct?
You may deduct up to $5,000 of startup costs in the first year of business. You must amortize any business startup costs over the deduction limit for 15 years.
In detail, The Journal of Accountancy explains:
“In addition, if the startup costs related to the business exceed $50,000, the taxpayer must reduce the $5,000 limit on the deduction (but not below zero) by the startup costs over $50,000 (Sec. 195(b)(1)(A)). If the startup costs are $55,000 or more, the taxpayer cannot deduct any of the startup costs except as an amortization deduction.”
This may sound rather confusing, but this article will go over a couple examples to explain this in everyday language.
What are organizational costs, and how can I deduct them?
Organizational costs are costs involved in forming a partnership, corporation, or LLC (not a sole proprietorship). These costs include expenses like registration fees and legal fees.
You are permitted to deduct up to $5,000 in organizational costs on your tax return (up to $50,000 total for amortization purposes). See the examples below for further clarification.
What are business assets, and how can I deduct them?
Business assets are usually equipment, machinery, and/or vehicles. The cost of business assets must be depreciated (spread over the life of the business asset) on your tax return.
What can I deduct if I don’t go into business?
Preliminary costs are not deductible in this case. These costs would be costs you incurred before making the decision to start a business, preliminary investigation of possibilities for a new business, or costs for doing a search.
Costs for an unsuccessful attempt at a startup business (for specific businesses) are considered to be startup costs. In this case, expenses may be deducted or depreciated in the same way as startup costs.
How to Deduct Startup Costs on Annual Tax Return – Example
Jones Corporation has $51,000 in startup costs. Jones may deduct $4,000 ($5,000 – [$51,000 – $50,000]) of these startup costs currently. Additionally, Jones can amortize the remaining $47,000 ($51,000 – $4,000) of business startup costs over 15 years (beginning in the month it begins to actively conduct business). (To calculate the exact amount per month, just take 15 years X 12 months = 180 months).
Jones has the option in year one to amortize all of the startup costs if it wants to. This would mean the $51,000 would be deducted at $3,400/year for 15 years.
International Coffee Corporation (ICC) has startup costs of $45,000 and organizational costs of $2,000 in the first year. ICC can deduct $5,000 in startup costs in year one. They can also deduct the full $2,000 of organizational costs.
Alternatively, they can take the full organizational costs and amortize the startup costs. This means that they would be taking $3,000/year ($45,000/15 years) as a deduction on their tax return for 15 years. Sometimes, this can be more advantageous. Consult with a tax professional for more assistance on which method is right for you and your business.
Alexander Electronics (AE) LLC began in 2020. They incurred $9,000 in startup costs and $3,000 in organizational costs. AE LLC can deduct $5,000 of the startup costs in 2020, $3,000 in organizational costs in 2020, and the remaining startup costs of $4,000 ($9,000 – $5,000) must be amortized over 15 years.
FAQ – Can I deduct Fixing and Flipping Classes?
To be eligible to deduct investigative classes like that, many things must be taken into consideration. When you begin your real estate business, if the classes were taken in the year before the business began, the fixing and flipping classes are considered to be startup costs. The cost of the classes (an organizational cost) would be amortized over 15 years or 180 months.
Starting a business can be a trying experience. The tax implications alone can be quite confusing. This article has gone over the different types of startup costs you may experience when starting a new business and how to classify the various business startup expenses you may have incurred on your tax return.
If this still seems like a foreign language, don’t worry; you aren’t alone in this feeling. Many new businesses have trouble with their taxes. That’s why it’s crucial you find a tax accountant that can serve your needs best.
When it comes to your business needs or accounting issues, such as taxes, please hire a qualified professional to go over how you should be doing things. Borshoff Consulting can help you with all of it. You can trust Indiana’s tax expert, so please contact our office today for a free consultation.