Business Startup Expenses – Tax Deduction Guide
You’ve likely often heard it said that you have to spend money to make money, and there is truth in these words. Even if you watch your pennies closely and try to shell out as little as possible, there are certain unavoidable expenses you will incur when starting a new business. Fortunately, the IRS allows business owners to deduct quite a few of these costs to help ease the financial burden.
What Are Business Startup Costs?
Startup costs are those incurred as a direct result of starting or attempting to start a business. Startup expenses include the costs of market research, advertising, wages, employee training, consultation fees and more. Start up costs also include any money you invested in finding and acquiring a space for your business.
If applicable, you can also count the money you spent purchasing and preparing to purchase an existing business. You don’t need to start from scratch in order to take advantage of the business start up expenses tax deduction. Acquiring an existing business that’s new to you absolutely qualifies for the deduction.
Other costs you may be able to deduct include:
- Utility deposits
- Logo and website design
- Brochure and business card printing
- Permit acquisition
- Hiring employees
- Travel expenses
- Accounting fees
- Legal fees
- Renovation or building expenses
Organizational costs, while still deductible, aren’t the same in the eyes of the IRS. Whereas startup expenses include the things you need to get the business going, organizational costs are those required to establish the business as an entity. These costs include incorporation fees and partnership filing fees in addition to the cost of having an attorney incorporate the business or draft partnership agreements.
Both legal and accounting fees are organizational fees if they pertain directly to creating the business. They move out of the organizational category and into the startup category if they involve anything else. Fees from your lawyer, for example, may count as organizational fees when he drafts a partnership agreement but become startup expenses if he creates an employment agreement you plan to use when hiring staff.
Under this organizational category, you can also deduct the costs of meetings you host while working out the details of creating a business entity. You can even deduct the cost of a temporary board of directors if you need them as placeholders for positions you wish to fill later. This may become necessary if you need corporate officers now for your incorporation paperwork but want to hire different board members later.
How Does Amortizing Start-Up and Organizational Expenses Work?
Hopefully, your new business venture will be wildly successful for many years to come. Given this expected longevity, the IRS counts the money you spend on your startup as a capital expense. This means that you can’t deduct it all at once since you will benefit from the expense for more than one year. There are certain startup fees you can claim in your first year of business. (We’ll talk more about that in a minute.) Once you’ve deducted those, you need to amortize the rest of your costs.
Amortization is the process of spreading out your expense deductions over time. Under section 195 of the tax code, you can take up to 15 years to amortize the costs of starting your business. This 15-year span is the amortization period.
To amortize your expenses, take any deductions you can now. Divide your remaining expenses by 180 months (15 years). You’ll then add this amount to your business expenses each month. This may sound daunting but it’s not. It’s essentially the same process you use to depreciate your business equipment if using straight-line depreciation over the useful life of the asset. (The IRS calls the process depreciation when expensing a tangible asset and amortization when dealing with intangible items. It’s the same concept with different names.)
First-Year Business Deductions
Deducting startup costs is not a free pass for reducing your tax liability. These costs can run quite high, and the IRS doesn’t allow businesses to deduct all of their expenses during their first tax year. Generally speaking, in the first year of your business, you can deduct $5,000 worth of organizational costs and $5,000 for start-up costs. There’s a catch, however.
If you spend more than $50,000 starting your business, your first-year deduction is reduced by $1 for every dollar over $50,000 you spent. This dollar applies to each deduction — to both your organizational cost deduction and your startup expense deduction.
Let’s say you spent $52,000 getting your business started. In that case, you’ll have to reduce your $5,000 deduction by $2,000. This reduction represents that you went $2.000 over the IRS threshold. Your first-year deduction is now only $3,000 rather than $5,000.
Keep in mind that because of this rule, you will be ineligible for a deduction in your first year of business if your startup spending is $55,000 or more. But all is not lost. Don’t forget your amortization. You may not be able to deduct any expenses in your first year, but you can still amortize them as we discussed earlier.
What Can’t Be Deducted?
There are a few expenses related to starting your business that you aren’t allowed to deduct. You can’t, for example, deduct any fees you paid to qualify to perform your business. If you need to acquire a real estate license or sit for the bar exam, you can’t deduct the associated fees. You would need a real estate or law license to practice even if you worked for someone else, so you can’t claim them as part of the expense of starting your own business.
You may not deduct any money you pay for interest, taxes and experimental research either. Keep in mind that these expenses aren’t deductible under the law’s startup provisions, but that doesn’t mean you can’t deduct them at all. You may be able to deduct these items as business expenses rather than startup expenditures. It’s wise to talk to a CPA so you don’t miss out on these deductions altogether.
Failed attempts at buying an existing business aren’t deductible, either. if you tried to buy a specific business and failed to put a deal together, expenses you acquired during the attempt aren’t deductible.
When calculating your deduction, keep in mind that an item is only deductible as a startup deduction if it would count as a business expense. If you can’t deduct an item while running your business, you can’t deduct it before you start. This example is admittedly kind of silly, but it gets the point across:
If you’ve been in business for a year and you want to know how things will go next quarter, you could hire a psychic to come in and tell you. The IRS wouldn’t let you count the psychic’s fee as a legitimate business expense, however. As such, you also can’t deduct it as a start up cost if you hire a psychic to predict how well your business will do before you start it.
How To Claim Startup Costs on Your Tax Return
To claim your filing deduction, you need to do two things. The first is to claim your first-year deductions if you’re taking them. Both your organizational and startup deductions get listed under “other expenses” on Part V on your Schedule C. You’ll need to report the amount on your Form 1120 instead if you’re preparing a corporate tax return and on your Schedule K-1 if your startup is a partnership.
To amortize the rest of your costs, you’ll need to fill out Form 4562. Fair warning: this is a pretty complicated tax form. You may certainly complete it yourself if you wish, but this one is a good candidate for getting a little help from a CPA like Picnic Tax. There’s no shame in needing a little help with this head-scratcher.
Can I Deduct Expenses from Failed Business?
The answer to this one is a definite maybe. Perhaps you’ve been pondering the idea of starting a business but you’re not sure what you want to do. You may have done some general market research and looked around at what’s out there, contemplating whether or not you can find a money maker. In this case, any fees you incurred considering a business are not deductible.
If you narrowed things down, however, and were actively pursuing the start of a specific business, your expenses may be deductible. In this case, you can deduct the expenses even if you failed to open the business. These deductions would be considered a personal capital loss, however, and not a business loss since there is no business.
When Am I “In Business?”
It is very important to be aware that the IRS distinguishes between costs and expenses. Any money that you spend preparing to open your doors is considered a cost of starting the business and gets treated according to the rules outlined here. Once your business is open and functioning, however, the money you spend becomes a business expense, not a startup expense.
This is true even if there is some overlap. Let’s say, for example, that you rented office space for your business in June. You paid June’s rent, but your office wasn’t open yet. You spent all of June renovating and revamping the space. You moved your business in and started working out of the office in July. In this case, June’s rent is a start up cost but July’s rent is a business expense.
There really is no hard and fast rule about when your business is considered open, however. It may vary from one business to another. If you’re opening a retail store or restaurant, the first day you unlock the door for customers is when you are open and in business. In other businesses, you may be considered “in business” as soon as your website goes live or you hand out your first business card.
Do I Need Professional Help?
Opening a business is a massive process and there is much to consider, even if you plan to start small. You don’t want one of your first official acts as a business to be running afoul of the IRS, but you don’t want it to be losing out on a valid tax deduction either. The friendly and knowledgeable CPAs that work with Picnic Tax can help you make sure you’re getting your new business off on the right foot. We’re happy to take you through the entire startup process or just jump in when you need a little extra help. Reach out to us today and we’ll help you get started on your new adventure.