Based on U.S. Census Bureau data for business applications, new business formation is on the uptick. The pandemic forced many business closures, but this data show the entrepreneurial spirit will not be stifled. If you’re thinking of starting a business now, recognize that it may be costly to get started and some time before you begin to bring in revenue. From a tax perspective, how do you handle start-up and organizational costs…what can you deduct and when?
Allowance for start-up and organizational costs
Start-up costs include any amounts paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational costs include the costs of creating a corporation or partnership. These are explained in greater detail later.
These costs usually must be capitalized. This means the costs are added to the balance sheet as an investment in the business. But you may elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs simply by claiming the deduction on your return for the first year you’re in business (what this means is discussed below); no separate election statement or attachment is required. For example, a sole proprietor claims the deduction in Part V of Schedule C (Form 1040 or 1040-SR).
The $5,000 cap is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized and deducted ratably (evenly) over 15 years. For example, if your start-up costs are $53,000, your initial deduction is limited to $2,000 ($5,000 – $3,000 excess over $50,000). Once expenses are $55,000 or more, that $5,000 allowance is reduced to zero. If you have to amortize costs (e.g., total expenses are more than $55,000), do this on Form 4562, Depreciation and Amortization.
When to claim the deduction
The election to deduct start-up costs is made in the year you commence business. It’s not always easy to know when this occurs. It’s commonly thought to be when a business is positioned to begin generating income. You may think of this in terms of when you “open your doors to the public.”
Some steps that indicate you’re in business:
- You attempt to sell your products or services
- Your website launches
One district court case several years ago said a retailer was “in business” for purposes of depreciation once it had done all its shelving, obtained its inventory, and received a certificate of occupancy. This was so even though it hadn’t yet opened its doors to customers or made any sales. Does this reasoning apply to start-up costs? Who knows?
What costs are deductible
Various costs may be treated as start-up or organization costs. But not every cost is deductible.
Deductible start-up costs. These are expenses that would have been deductible had they been incurred when the business was operational. They include:
- An analysis or survey of potential markets, products, labor supply, transportation facilities, etc. (“investigatory costs”).
- Ads/promotions for the opening of the business.
- Salaries and wages for employees while they’re being trained.
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
- Professional and consulting fees.
You can’t treat as deductible start-up costs any expenses to attempt to buy a business. Only costs to investigate one (i.e., costs to help you deduct whether to buy a business and which one to buy) are deductible. Also, the cost of interest, taxes, and research and experimental costs before commencing business are not deductible start-up costs.
Deductible organizational costs. Costs for organizing a partnership or corporation include expenses for this purpose, such as costs for:
- Legal services
- State fees for incorporation or filing fees for partnerships
- Temporary directors and organizational meetings for corporations
Corporations may not treat as organizational costs any expenses for issuing and selling stock or those associated with the transfer of assets to the corporation. Partnerships may not treat as organization expenses any costs for acquiring and transferring assets to the partnership, admitting new partners, or for contracts between the partnership and its partners.
If you’re just getting started, it’s advisable to work with a CPA or other knowledgeable tax adviser to optimize your deductions for start-up costs and organizational expenses.
The recommendation to work with an experienced tax person is a good one. They can usually help you save more on your taxes than their fee, so they’re a great investment.