|All content presented here and elsewhere is solely intended for informational purposes only. The reader is required to seek professional counsel before beginning any legal or financial endeavor.|
Startup costs deduction is defined as subtracting an amount of money that was spent on an item that was required to start your business either from your salary or the business’s profits in order to reduce the amount of tax that needs to be paid.
Business startup costs include costs for startup and for setting up your business legal structure.
These costs are part of your investment in your business, and they must be deducted over several years, using a process called amortization.
You may be able to deduct up to $5,000 of startup costs and $5,000 of organization costs in your first year in business.
How New Companies Can Deduct Their Startup Costs From Taxation
The type of startup costs you incur as well as the total amount will dictate the amount you can deduct. If your startup costs are under $50,000, for example you may be able to deduct $5,000 in startup costs during your first year of a business.
If your startup costs exceed $50,000, your qualifying first year deductions will be lowered by the amount you go over $50,000. Let’s say you incur $52,000 in startup costs.
In this scenario, you’ll only be able to deduct $3,000 in your first year of business ($5,000 minus the amount you exceeded $50,000). After your first year, you can amortize the remaining costs over the next 15 years. We’ll go over how this works further below.
Understanding Business Startup Costs
Startup costs refer to all of the expenses you incur before you begin business. The money you spend to buy or prepare a business also counts as startup expenses. Here are some examples of some of the most common startup costs.
- Travel expenses when scouting possible business locations: If you’re on the lookout for an office space, commercial building, or warehouse, you’ll likely incur travel expenses as you shop around and explore your options.
- Advertising the business launch: Advertising will be essential if you’d like to build brand awareness and inform your target audience of your products and services.
- Customer surveys: Customer surveys can help you hone in on the ideal offerings for your business and/or make improvements to the product or service lineup you already have.
- Market research: Market research is important if you want to ensure you meet the needs, preferences, and expectations of your target audience.
- Legal fees: You might have to pay an attorney to write up various contracts and other legal documents that are vital for your business operations.
- Accounting fees: Accounting fees will apply if you hire an in-house accountant or outsource your accounting functions to a third-party.
- Product research costs: You’ll pay product research costs if you want to perform market research, understand your customer base, and learn about industry trends.
- Building a website: Since most people visit a website before they decide whether they want to invest in a certain product or service, website design and development expenses are likely.
- Costs for training employees: Chances are you’ll have to train the workers you hire, even if they have experience and education in your industry.
- Starting inventory: If you’re launching a product based business, you’ll need to invest in inventory to get up and running.
- Business licensing and permits: Most businesses require licensing and permits that can get expensive.
Understanding Organizational Costs
Organizational costs are any costs that help you form your LLC, corporation, or partnership. Also known as incorporation costs or partnership costs, some of the typical organizational costs include:
- Incorporation fees: These are the costs that you incur to submit formation papers or articles of incorporation to your Secretary of State.
- Legal fees: Legal fees are for certain attorney services that help establish your legal entity.
Accounting fees: Accounting fees are for services related to setting up books and records for your business.
- Organizational meeting costs: These refer to expenses for casual get-togethers or formal meetings that are hosted to discuss the formation of your business.
- Temporary director costs: If you need to hire some workers before your business is officially formed, you may be able to include their wages and benefits in your organizational costs.
What Expenses for Starting a Business Are Tax Deductible?
Capital expenses are the total expenses you incur to launch or purchase as a specific business. According to the Internal Revenue Service (IRS), capital expenses are used for longer than a year.
This means you can’t classify all of them as an expense to your business in the first year. If you have intangible assets, you'll need to amortize them over 15 years, starting with the year your business starts. Some examples of capital expenses that you can deduct include:
What are Special First-Year Deductions?
The IRS will allow you to deduct up to $5,000 of your business startup costs and $5,000 of your organizational costs in the first year you’re in business. Each $5,000 deduction you take will be reduced by the total that your startup or organizational costs exceed $50,000. You can deduct a variety of expenses for things like:
- Product analysis
- Visiting potential business locations
- Employee training and wages
- Business incorporation or organization
From a Tax Standpoint, When Does Your Business Actually Begin?
There is no hard and fast rule that states when your business actually begins. But in general, you can assume it’s in operation on the date of incorporation or the date it's recognized and filed for business registration. Other signs that your business is operational may be that you’ve started to generate income, your website is live, and you’ve attempted to sell your products and services. The IRS will look at the unique circumstances of your business to determine a startup date.
What Expenses Can I Deduct?
Deductible startup costs are expenses that would have been deductible if they were incurred when your business was operational. Some examples of them include:
- Business property: Business property can include property, inventory, land, and repair and maintenance costs that don’t increase the value of your asset, make it more useful, or increase its lifespan.
- Home office deduction: If you use part of your home for business, you can deduct expenses for things like mortgage interest, insurance, utilities, repairs, and depreciation.
- Business use of vehicle expenses: As long as you use your car for your business exclusively, you may be able to deduct expenses such as gas, oil, tires, insurance, and registration fees.
- Cost of goods sold: Your cost of goods sold considers your cost of products or raw materials, storage, direct labor, and factory overhead.
How to Know if Business Startup Costs Are Deductible
To deduct your business startup costs, these costs must have been spent before you were already in business.
They are not deductible after you begin your business. In general, deductible startup costs are expenses you spend to create or acquire a business or engage in a for-profit activity with the hopes that the activity will become an active business.
How to Calculate the Startup Expense Deduction?
If you spent less than $50,000 on startup costs for your business, you may deduct $5,000 of those expenses right away, in the year your business begins operating. The same rule applies to your organizational costs. In the event you spend more than $50,000 on your business startup costs, your first year deduction will go down by $1 for every dollar you spend over $50,000.
How to Claim Business Startup Deductions
To claim your first year deduction, you will need to record your information on your business tax form. The form you use will depend on the status of your business. If you're in a partnership, for example, you will need to use a K-1. If you’re an S-corporation, you will use Form 1120. If you’re a sole proprietorship, you will use Schedule C. You can claim any deductions that you amortize in the succeeding years on Form 4572, Depreciation and Amortization.
How Does Cost Amortization Work?
Amortization lets you claim business deductions over a period of time instead of the year they occurred. Each deduction will be divided into equal annual amounts that you’ll be able to claim on your tax returns for that specific year. The IRS requires that you amortize business startup costs and organization costs over a period of 15 years of 180 months.
What Is Depreciation?
Depreciation is the process in which you reduce the value of assets over time. This may be as a result of age, normal wear and tear, or decay. As a small business owner, you will need to fill out Form 4562 on your tax return to take the depreciation deduction. Let's say you spend $20,000 on a machine. Instead of claiming the $20,000 expense upfront, you will depreciate it over time and eventually claim the entire cost.
What Doesn’t Qualify as Expense Startup Costs?
There are some expenses you might have that are not considered startup costs. This means they don’t qualify for the startup or organizational expense deduction. Some of the most common ineligible startup costs include:
- Experimental expenses
- Depreciation costs
- Fees for selling and issuing stocks
- Fees for transferring assets to your business
- Real estate taxes
What Happens if You Don’t Start a Business?
In a perfect world, everything will go as planned and you will launch your business. But if this doesn’t occur, you may or may not be able to deduct your expenses, depending on your situation.
If you were exploring a specific business to either launch or acquire, you might be able to deduct some of these expenses as a personal capital loss. Also, if you made any large investments for things like property or equipment, you can potentially deduct those losses when you sell them.
On the flipside, if you were simply performing some general research and didn’t have a specific business in mind, your expenses are classified as personal expenses and can’t be deducted.
What Happens if I Purchase an Active Trade or Business?
You may decide to purchase a business that’s fully operational instead of launching a new one from scratch. If so, you can only recover investigative costs. Investigative costs refer to costs that help you decide whether to invest in a business. These might include expenses for market research, searching for an office space, or advertising your launch. Unfortunately, any costs you incur to purchase a specific expense are considered capital expenses and do not qualify for amortization.
What Happens if I Expand an Existing Business?
You may decide to expand an existing trade or business. If so, you may be able to deduct the expenses that allow you to do so. Several of the most common deductible expenses that come with business expansion include:
- Developing a new sales territory
- Performing marketing activities to boost sales
- Purchasing or upgrading equipment
- Adding new locations or branches
When Is The Right Time to Claim the Deduction?
Contrary to popular belief, it doesn’t always make sense to take your deduction in the first year. This is because you may suffer losses for the first few years of business and be better off if you amortize your deductions over a few years. By doing so, you can balance out the profits you earn eventually.
While startup costs can add up quickly, they’re inevitable if you’d like to launch, purchase, or expand a business. If you take the time to familiarize yourself with startup costs deduction, you’ll be able to maximize your tax savings.
Don't hesitate to reach out to a CPA or other tax professional if you’re feeling overwhelmed and would like some professional guidance. You might also like to learn more about the best startup business loan offers we have gathered on our list.