Thinking of starting a business? Congratulations! This is one big step in tax savings. Being a business owner provides you a lot of opportunities for tax deductions that are not available to a typical W2 employee.
We talk about those tax savings options in most of our articles but today we are going to talk specifically about the costs associated with starting up your business and how those are handled.
We got this question a lot in our Free Facebook Group so I figured it was time to tackle it to clear things up for everyone!
What Are Start Up Costs?
Instead of waiting until you officially open for business, you can start the timer now on your deductible expenses.
- Per the IRS website, start-up costs are amounts paid or incurred for:
- Creating an active trade or business
- Investigating the creation or acquisition of an active trade or business.
- To qualify as a start-up expense it must meet both of the following tests:
- It is a cost you could deduct if you paid or incurred it to operate an existing active trade or business (in the same field as the one you entered into).
- It is a cost you pay or incur before the day your active trade or business begins.
- Here are some common start-up expenses we see:
- Travel Costs
- Meal Expenses
- Training Costs
- Market Analysis
- Book or magazine purchases related to the business.
- Office supplies to use in the business.
- Advertising fees for the opening of your business.
- Wages or contractor labor for consultants and employees.
- Costs That DO NOT Qualify As Start-Up Expenses
- Research and Development Costs
- However these can generally be deducted under other tax law provision.
What Are Organizational Costs?
Wait, organization costs? That’s not considered start-up?
- The IRS has two separate categories for what you might think of as start-up costs. We discussed actual start-up costs above.
- Organizational costs are those expenses for the actual formation of the company. This would be if you are setting up an actual entity and not just a sole prop.
- Examples of organizational costs are:
- State incorporation or registration fees
- Legal and Accounting Fees
- The cost of temporary directors
- The cost of organizational meetings
- To summarize, you may have both start-up costs AND organizational costs.
How Does The Tax Deduction For Start-Up and Organizational Costs Work?
Alright, so now that we understand what are start-up and organizational costs, how does the deduction work?
- Important Number: $50,000 (For Each Start-Up and Organizational Costs)
- Total Less Than $50k
- Deduct $5,000 in the first year the business starts
- Amortize Remaining
- Total More Than $50k
- First year deduction decreases by $1 for every dollar over $50k
- Amortize Remaining
- How Amortization Works
- Deduct Remaining Equally Over 180 Months (15 Years)
- Complete and attach Form 4562 to your return for the first year in business.
Examples Of Start-Up Costs Deduction
Lets put this into practice and use some actual numbers..
- Start-Up Costs: $3,500
- Deduct all in first year of business
- Start-Up Costs: $45,000
- Deduct $5,000 in first year of business
- Amortize remaining $40,000 equally over 180 months ($222 per Month)
- Start-Up Costs: $52,000
- Deduction $3,000 in first year of business ($5,000 less $2,000 over $50k)
- Amortize remaining $49,000 equally over 180 months ($272 per Month)
- Start-Up Costs: $65,000
- Amortize all $65,000 equally over 180 months ($361 per Month)
- Organizational costs would work the exact same way, if you qualify.
Start-Up Costs Frequently Asked Questions
I still have questions..
- When are you considered “in business” and no longer start-up costs?
- When a “sale” occurs. Lets use an example of starting a lawn service. You may have made flyers and bought some weed killer and a few garden tools these would all be start-up costs until you have your first sale. Once you first sale occurs expenses are just normal operating costs.
- How does equipment factor into this?
- Equipment would not be included in start-up costs but rather depreciated. Lets assume you are starting that lawn care business. Your new lawn mower for the business would be an asset that you depreciate and not included in start-up costs.
- When can I start recording these start-up costs?
- You have to wait until the new business actually begins to start realizing the tax benefits of your start-up expenses but you can start accruing and recording them as soon as you start thinking about creating your business.
- What happens if my start-up never becomes an active business?
- You need to start and make the business an active business for the start-up costs to be deductible. If you fail after starting, then you can realize the unamortized deductions. If you never start, the costs you had in your attempt to acquire or begin a specific business are capital expenses and you can deduct them as a capital loss. Costs you had before making a decision to acquire or begin a specific business would be personal and non deductible.
- Keep in mind the specific piece. Example, if you are just doing general research/analysis and do not have any specific business in mind and you end up not moving forward with anything, those are considered personal expenses and not deductible.
- What else should I keep in mind?
- Always keep detailed and accurate records to substantiate your costs in case the IRS challenges you.
- Once your business starts, expenses after that start date move to normal operating expenses and stops the addition to start-up costs.
- If you close your business before costs are fully amortized (180 months) you will take the remaining when closing.
This can often times be a confusing area but hopefully we were able to break it down in an easier to understand format for you.
For more details on this along with additional training and tax strategies to ensure you are paying the least amount in taxes as legally possible, check out our Tax Minimization Program!
If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.