Deduct Business Start Up Costs

It takes money to start most businesses. The Internal Revenue Service (IRS) allows business owners to deduct all or a portion of their startup costs for the first year they operate their businesses, and to deduct a portion of their startup costs over the first 15 years of operation. Take advantage of this tax break by familiarizing yourself with the limits of what you can deduct and how to do so when the time comes.

Steps

Determining What You Can Deduct

1. Know the money limits on what you can deduct on your business's taxes. The IRS allows you to deduct up to $5,000 or your actual startup costs (whichever is less), and $5,000 in organizational costs in the first year, whichever amount is less. However, if your costs exceed $50,000, your deduction will be reduced by the amount you go over. If your start-up expenses exceed $55,000, you won’t be able to claim the $5,000 deduction for the first year.
   • For example, if start-up or organizational costs are $51,000, your deduction is reduced to $4,000. If start-up or organizational costs are $55,000 or more, the $5,000 deduction is completely phased out for the first year. If your startup or organizational costs are $3,000, that is the amount you can deduct since it is less than $5,000.
   • Whatever portion of your startup costs that you can't deduct during the first year can be deducted over the next 180 months of operation, starting with the month after you started your business. Organizational costs appear on the income statement as an expense if deducted, or on the balance sheet as an asset that will be amortized (expensed or deducted from income)over a period of years.
2. Know what expenses qualify as deductible startup costs. Startup costs that can be deducted fall into one of two categories: money spent investigating opening a business and money spent to get the business started before it actually opens. Here are some typical costs involved in starting a new business:
   • Deductible startup costs associated with investigating a business opportunity include market surveys, visiting prospective business facilities, product analysis and labor surveys, whether you perform them yourself or pay a consultant to do so for you.
   • Deductible startup costs associated with getting the business ready to open include advertising, wages paid to employees in training and their instructors, and travel costs incurred to find suppliers and distributors of raw materials and customers to buy your finished products. Small equipment purchases (less than $1,000) also fall under the heading of deductible startup costs.
   • Large equipment purchases (over $1,000) are not deductible as startup costs as they need to be depreciated over time once put to use in the running of your business. However, large equipment purchases qualify under other tax provisions — Section 179 — that allows deduction up to $25,000.
   • Costs such as taxes, loan interest and expenses for research and experimentation are not deductible as startup costs, although they may be deductible as ordinary business costs.
3. Determine deductible organizational expenses. If you set up your business as either a partnership or a corporation, you can deduct or amortize (deduct the expense over a number of years) certain costs incurred while setting up the business. These costs must be incurred before the end of the first tax year, and chargeable to a capital account. They can be amortized over the amount of time the partnership or corporation exists, if it is dissolved after a fixed amount of time.
   • Deductible organizational costs for a corporation include incorporation fees and related legal expenses, the cost of meetings to organize the corporation and salaries paid to temporary directors. They exclude costs for issuing stock or other securities and any costs related to transferring assets to the corporation.
   • Deductible organizational costs for a partnership include legal fees for preparing the partnership agreement and fees for accounting services related to establishing the partnership. They exclude costs for bringing in or removing partners after the partnership is formed, setting down the contractual obligations of each partner in the partnership or brokerage and registration fees.

Deducting Startup Costs

1. Decide whether to deduct appropriate startup costs in the first year. Under previous tax laws, the IRS required all taxpayers with business startup costs to decide whether to deduct the appropriate amount in the first year or amortize over a period of years. Following the passage of the American Jobs Creation Act of 2004, the IRS makes the assumption that taxpayers will want to take the deduction in the first year if they can. Once you make the decision, you can't revoke it.
   • You will have to file IRS Form 4562 only if you decide to amortize the costs over a longer period of time rather than deducting them in the first year.
2. Analyze your expected revenue stream. Before deciding whether or not to deduct business startup costs in the first year, you need to determine approximately how much revenue you expect to earn in that time period. If you don't have a large initial income, you may want to stretch out deductions over several years to avoid a large tax bite as soon as you start making money. Consult your tax adviser before making a decision.
   • If your business is organized as a corporation or partnership, only the corporation or partnership can make the decision, not an individual shareholder or partner.
3. File the appropriate forms. If you choose to amortize your costs over time instead of deducting them in the first year, you need to file a statement with your tax return that describes the business, when it began, the nature of each startup cost, and the amortization period you'll use. You must also file Form 4562.
   • If you are deducting startup costs, you can report them on Schedule C, E, or F of Form 1040, depending on the nature of the startup costs. For specific instructions, see IRS Publication 535, Business Expenses.

Planning Ahead and Keeping Records

1. Determine if you have enough cash for startup expenses. Calculate expected startup costs and compare them to your assets. Assets include cash and loans you have in order to start the business. Using a spreadsheet, create a list of the start-up expenses by month as well as long term capital expenditures that you expect to incur. Then compare your expected assets to expenses to determine if you have enough cash reserves based on your estimated monthly spending and money in the bank.
   • If the costs are looking too high, look for ways to cut your expenses.
2. Keep good records from the moment you decide to start a business. You must be able to backup your expense deduction claims with hard copy receipts, vendor invoices and partnership and corporation agreements. Keep a startup business expense file separate from your regular business files.
3. Take advantage of free resources for advice. Your local Small Business Development Center, Women’s Business Center, Veteran’s Business Center or the mentoring experts at SCORE can all help you in getting your new business started. They can advise on determining what are startup expenses and what should be spread out over a period of years.

Tips

• Take the time to figure out what equipment is most important to running your business. You'll want to write off purchases for those items you have to have first and put off purchasing less important, more expensive items that have to be depreciated for later.

Things You'll Need

• IRS Form 1040, with Schedules C, E or F (depending on nature of the startup costs)
• IRS Publication 535, Business Expenses
• IRS Form 4562, Depreciation and Amortization (if amortizing startup costs)

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Sources and Citations

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