Investigating the potential for a new business and getting it started can be an expensive proposition. However, you can't deduct these expenses under the general rules for business deductions because only expenses for an existing trade or business can be deducted. And, by definition, you incur your startup expenses prior to the time that your business is born.
Fortunately, there is a way around this dilemma. If your startup expenditures actually result in an up-and-running business, you can:
- Deduct a portion of the costs in the first year; and
- Amortize the remaining costs (that is, deduct them in equal installments) over a period of 180 months, beginning with the month in which your business opens
How much can you deduct in the first year?
You are able to deduct up to $5,000 of your qualifying start-up costs, although the first-year deduction starts to phase-out when your expenses reach $50,000.
If your start-up efforts end in the creation of an active trade or business, then on your tax return for the year the business commences, the amount of expenses that you can deduct will be the lesser of:
- Your actual expenses with respect to the new business; or
- $5,000, reduced by the amount by which the start-up expenditures with respect to the active trade or business exceed $50,000
The remainder of your start-up expenditures is deducted ratably over the 180-month period beginning with the month in which the active trade or business begins.
What costs qualify for a deduction?
Investigation expenses that qualify include those relating both to business conditions generally, and those relating to a specific business, such as market or product research to determine the feasibility of starting a certain type of business. The costs of checking out the various factors involved in site selection would also be an amortizable investigation expense. In addition, the costs of creating a business include advertising, wages and salaries, professional and consultant fees,
What costs don’t qualify for a deduction?
The following costs don't qualify for the first year deduction and 180-month amortization:
- Incorporation expenses can not be deducted as startup costs. However, they may be deductible as incorporation expenses
- Startup expenditures for interest, real estate taxes, and research and experimental costs that are otherwise allowed as deductions do not qualify for amortization. These costs may be deducted when incurred
- The costs attributable to the acquisition of a specific property that is subject to depreciation or cost recovery do not qualify for amortization. Instead, the property should be depreciated under the appropriate rules
What if you don’t start the business?
If you ultimately decide not to go into business, what happens to your costs? The portion of costs you paid to generally investigate the possibilities of going into business at all, or to purchase a non-specific existing business, are considered personal costs and are not deductible.
However, the total costs that you paid in your attempt to start or purchase a specific business would be considered a capital expense and you can claim it as a capital loss, subject to all the rules that apply to a nonbusiness capital loss.
If you purchased any business assets along the way (for instance, some bagel-making machinery), you can claim a loss only if and when you sell or dispose of the property.
Start up costs incurred by a partnership
If you decide to conduct your business as a partnership, neither the partnership itself nor you as one of the partners would normally be able to deduct the expenses you paid to start the business. However, your partnership can elect to deduct and amortize the business start-up costs under the same rules as a sole proprietor—except, the election is made by the partnership and reported to the partners on their Schedule K-1s.
If you decide that your partnership should not make this election, the organizational costs must be added to the tax basis of your partnership interest. In that case, when your partnership interest is sold or the partnership itself is dissolved, these capitalized expenses will reduce the amount of your capital gain or loss.
Calculating the startup expense deduction
Once you have determined the amount of your qualifying expenses, you need to determine how much of the expenses can be deducted in the current year.
It's usually best to claim the 60-month amortization deduction as early as possible if there is any doubt about when your business begins. If the IRS determines that your business began in a year before the election to amortize start-up costs is made, the right to deduct these costs in the earlier year will be lost.
For the first year, the calculation is as follows:
- Determine the initial year deduction amount. If you have more than $50,000 in expenses, you must reduce the maximum amount ($5,000) by $1 for each $1 over $50,000 in expenses
Therefore, if you have more than $55,000 in expenses, all of your expenses must be amortized over the 180-month period
- Determine the monthly amortization amount. Subtract your initial year deduction amount from the total expenses. This is the amortizable amount. Then divide that amount by 180 to get the monthly deduction
- Determine how many months of amortization can be claimed on your tax return for the first year the business was operating. The amortization period starts with the month that you began operating the business. The amount that you can amortize on the return is the number of months that the business operated times the monthly amortization amount
For the first year, your amortization deduction would be shown on Part VI of Form 4562, Depreciation and Amortization, and then carried over to the appropriate tax form for your business.
For sole proprietors, it would be carried over to your Schedule C as an "other" expense. After the first year, you simply list your amortization amount as an "other" expense on your Schedule C (or your partnership or corporate income tax form.) However, if you are filing Form 4562 for some other reason (generally you must file this form in the first year you put a capital asset into service), you would continue to show your amortization costs on Part VI and on your Schedule C.
Rose successfully opened a bakery business on October 22. Before the business opened she had $4,000 of start up expenses. Rose can deduct the full $4,000 on her first-year Schedule C as "Other Expenses." Because her total expenses were less that the $5,000 allowable deduction for the first year, she does not need to worry about amortizing any of them.
Assume the same facts, but she incurred $23,000 of start-up costs. She can claim $5,000 off the top as a current deduction. The remaining $18,000 must be amortized over the 180-month period, which is a monthly amount of $100. Her amortization deduction for the first year would be $300 ($100 for each of the 3 months she was in business in 2012.) This amount would be reported on Form 4562 for the first year and carried over to her Schedule C. Her total deduction for start-up expenses in the first year would be $5,300.
Assume the same facts, but she incurred $53,000 of start-up costs. Because the expenses exceed $50,000, she must reduce the initial year deduction by $1 for every $1 over $50,000. Thus, the $5,000 amount is reduced to $2,000. She figures the amortization on $51,000 ($53,000 - $2,000.) Her monthly amortization amount is $283 ($51,000/180), so her first year amortization deduction is $850. Her total start-up expense deduction for the first year is only $2,850.
Incorporation costs follow the same rules
If you decide to operate your business as a corporation, the corporation can elect to deduct up to $5,000 of its organizational expenditures and amortize the remainder over a period of 180 months.
The $5,000 deducted for organizational expenses must be reduced by the amount by which the expenses exceed $50,000.
Unless the corporation clearly treats the expenditures as capitalized (and, therefore, not recoverable until the corporation is liquidated, the IRS will assume the election to deduct/amortize the expenses has been made.
Organizational expenditures are those which are:
- Connected directly with the creation of the corporation
- Chargeable to capital account; and
- Of a character that would be amortizable over the life of the corporation if its life were limited by its charter.
Examples include expenses of temporary directors and organizational meetings, state fees for incorporation privileges, accounting service costs incident to organization, and legal service expenditures, such as for drafting of documents, minutes of organizational meetings, and terms of the original stock certificates.
If your corporation is a success and you want to pass it on to future generations, you'll want to make sure to take advantage of this election. If you don't, as a practical matter, your corporation may never get to deduct its corporate organizational costs.
What are the qualifying expenses?
Which types of expenditures should you include? You can include expenses that meet the following three conditions:
- They must be directly related to the creation of the corporation
- They must be of the type that would be chargeable to a capital account
- If the expenses are related to the creation of a corporation having a limited life, they must be of a character that would benefit the corporation over its entire life
Examples of nondeductible expenditures include costs of issuing shares of stock, such as commissions, professional fees, and printing costs.