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.