Every small business will have pre-opening start-up costs. Are they deductible expenses on your business taxes? It makes sense they would be, but at the time you’re incurring many of them you don’t have an up-and-running business yet, so by definition it’s impossible to have business deductions. It’s a horse and cart problem, but take heart – there is a solution, but the rules aren’t the same as for after start-up operating expenses? (The rules have changed in recent years, so you need to be up-to-date.)
Start-up costs are defined by the IRS as “amounts paid or incurred for: (a) creating an active trade or business; or (b) investigating the creation or acquisition of an active trade or business. Start-up costs include amounts paid or incurred in connection with an existing activity engaged in for profit; and for the production of income in anticipation of the activity becoming an active trade or business”. (This is from IRS Publication 535, Business Expenses. You can find information about how to get this publication from the footnote at the bottom of the post.)
That’s pretty straightforward and answers the question – yes, you can definitely deduct start-up costs. But hold on – are there any caveats? When can you deduct? Are there any costs that do not qualify? The answer again is yes – but you’d better read the fine print and study it in detail if you want to get it right. Most importantly, you need to ask yourself – should I deduct my start-up costs?
To answer this question, let’s establish more clearly what the IRS means about “creating an active trade or business” They don’t exactly explain it, but they do mention elsewhere that it’s “before you begin operating the business”, and “the day your active trade or business begins”. But even those two statements are ambiguous. At one time the IRS argued that the business begins when you first accept payment for your products and services, but it’s now been argued successfully to the IRS that it’s the point where you have products and services actually available for sale, even though you might not have sold any yet (as it might take some time to complete the first purchase). So, all expenses before that date are your start-up costs, and those after it are operating costs (the IRS uses the term business expense) – and you need to memorialize that date and provide it to your tax accountant so that expenses before and after are properly accounted for.
Before we go further, here’s a suggestion – from the moment the start-up bug hits you, you should begin documenting all of your expenses. This is important, as these expenses are easy to forget and can add up to sizable amounts, plus you’ll need receipts or acceptable proof if you don’t have receipts.
Start-up costs are capital expenses. Generally, the IRS considers your start-up costs to be capital expenses, since they are incurred for the benefit of your business over many years of operation. By definition, capital expenses are significant purchases that are made as an investment for the business, and are therefore depreciated over a period of time that’s considered the useful life of the asset – and start-up costs fit right in with that definition. Capital expenses also add to your “basis” in the business, which can have beneficial tax effects, offsetting some of the pain if a variety of your start-up costs cannot be immediately deducted. (Capital expenses, assets, and basis are described more thoroughly in my book, Start-Up: An Entrepreneur’s Guide to a Successful Small Business.
For capitalized start-up costs, the IRS uses a 180 month useful life (15 years), depreciated monthly in equal amounts (the 180 month period is a new useful life for business start-up costs incurred after 2008). Once you select the amortization period you cannot change it.
Allowable start-up costs generally include any type of expense that you could deduct if the business was already up and running. These can include:
• Market survey, checking out business facilities, tradeshows, checking labor availability
• Rent or lease payments on your business property (only applies to time before start-up)
• Remodeling and improvements
• Mileage in support of start-up operations – but not simple commute driving
• Logo design; website design
• Utilities
• Supplies and materials for start-up (see below for inventory and raw materials)
• Advertisements for the opening of the business.
• Employee recruiting costs
• Salaries and wages for employees who are being trained and costs of instructors.
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
• Salaries and fees for consultants, or for legal and accounting professional services.
(Be sure to read the section below about pre-opening expenses that are really operating expenses, or expenses that qualify under IRS rules defined in Section 179, and need to be treated as such for tax purposes.)
Start-up versus organization costs. IRS rules distinguish between start-up costs and the costs for creating your business structure (corporation, LLC, partnership). The method and rules for taking the deductions are similar for the two, although each category is reported separately to the IRS. Organization costs have specific rules describing “qualifying” versus “non-qualifying” costs – where a qualifying cost can be amortized (as discussed below) and a non-qualifying cost cannot be amortized and only deducted when you sell or close down the business. The first year, one-time “expensing” allowance of up to $5,000 is applied separately to start-up costs and organization costs (more about this in a bit).
The rules for organization costs are sufficiently complicated that you really should read Chapter 8 of Publication 535 – there’s a section specifically on rules for corporations and another on partnerships. Interestingly, there’s no mention of rules for an LLC, as the IRS doesn’t officially recognize an LLC business structure, and you specifically declare to the IRS whether your LLC is to be taxed as a corporation or a partnership – and you’ll need to follow the corporation/partnership rules accordingly.
Organization costs typically include:
• Legal and accounting fees incurred as part of the business organization process
• Filing fees
Should you capitalize or immediately deduct your start-up costs? This is a very important question, and one that centers on when you want the tax benefit from the expense. As a result of a tax law change in 2011, the IRS assumes that you’ll immediately deduct as much of your start-up expenses as possible (prior to that, you had to specifically file a form to say you were going to). Current tax law allows you to deduct up to $5,000 of your start-up costs at the end of your first tax year (i.e., if you open your business doors at any time in 2016, you’d take the deduction when you pay your 2016 taxes). All start-up expenses above $5,000 are required to be capitalized, and you’d then write them off in future years on an amortization schedule. The same rule applies to your organization costs – you can deduct up to $5,000 at the end of your first tax year.
These initial deductions are great if you expect to have a profit in your first business year (obviously, an expense deduction is only relevant if there’s taxable profit to deduct from). If you don’t deduct any start-up expenses in that first year, all start-up expenses will be treated as capitalized – and then amortized over 15 years.
There’s another zinger on the initial deduction rule. If your total start-up expenses exceed $50,000, the $5,000 allowable deduction amount is reduced, dollar for dollar, for every dollar of start-up cost above $50,000. So, if your total start-up costs are $51,000, you can deduct a maximum $4,000 in the first year; if your total costs are $55,000 or above, you can’t deduct anything in the first year. Same rules for organization costs, although it’s unlikely the cost will exceed this total.
Start-up versus operating costs. It’s important that your recordkeeping for these costs are separated, as they are accounted for differently to the IRS. At the end of this post I’ll have some suggestions for how to keep track of start-up costs, along with a specific list of what you need to do, and when you need to do it.
Operating costs are your normal, day-to-day business expenses, including Cost of Sales for each product/service that you create and sell. It also includes your Sales and Marketing costs, and your General and Administrative costs (G&A). All of these costs are deductible business expenses, deducted from a tax standpoint at the time you pay for them, and they are generally expenses that are recurring in support of your normal business operations. By contrast, start-up costs that are somewhat similar in nature must be capitalized, since they are considered to be costs that benefit your business over the long haul.
For example, you might attend a tradeshow (even as a vendor) as part of your pre-start-up marketing. Since your business hasn’t yet opened its doors, all of your costs for attending are treated for tax purposes as start-up costs (and might have to be amortized). You might attend the same tradeshow, in the same capacity, six months after you open for business, but this time it’s part of Sales and Marketing, and deductible as a normal business expense.
For that reason there might be favorable tax advantages if you can move some start-up expenses to operating expenses. So, if you need to do pre-opening marketing to help initial sales, the costs can be deducted sooner if the marketing is done as part of operating costs rather than start-up costs. But obviously it doesn’t make business sense to delay this critical marketing effort just for tax reasons. But – and this is a large “but” – if you can maneuver your start-up efforts so that your business is in a position to be considered “open for business” or “up and running” – at least in the sense required to satisfy the IRS definition – some of these expenses would become operating costs.
Looking at it another way, consider whether you can have the business up and running in a smaller sense for initial start-up, and then concentrate on getting it all finished in the next phase after start-up. For example, maybe you originally planned to have two products or services available from the start. If you can get one product or service available sooner, you can declare that you have a bona fide business up and running with just the first product or service, and then complete the second product or service next. All of the (otherwise start-up) costs associated with the second product or service now become operating expenses. If your overall start-up costs are less than $5,000, all this rigmarole is not necessary (as we’ll see below). At the other end of the scale, since the one-time start-up deduction rule mentioned above becomes rather punitive above $50,000 of start-up costs, anything you can do along this line to stay below the $50,000 limit will give you even more benefit.
Also, there are significant differences in how start-up expenses are treated if it’s a business that you’re creating from scratch, versus a going-concern that you purchase (i.e., an already existing business). We won’t be covering the latter, as our focus is on new small business creation.
Pre-opening expenses that don’t qualify as start-up costs. Certain expenses that you incur before the day you actually open for business will be treated as operating expenses. Others can be deducted under a special deduction “bucket” known as Section 179. If an expense is to be treated as an operating expense, timing and amount of the deduction will follow the regular rules for operating expenses. The limit on Section 179 deductions is $500,000, and has been made a permanent rule of business deductions as of 12/15/2015. Below are examples of each.
Operating expenses:
• Loan interest, real estate taxes, research and experimental costs
• Business insurance
• Inventory and raw material costs (they are deducted as they are used up or sold)
Section 179 expenses:
• Office furniture
• Office equipment
• Manufacturing equipment
• Vehicles (over 6,000 GVW)
• Computers and “off the shelf” software
The real beauty of the Section 179 deductions is, the type of expenses listed above tend to be big-ticket items, and getting an immediate tax deduction for them through Section 179 – and not as a start-up expense – is huge. Take advantage of it to the maximum.
What if your start-up attempt is unsuccessful? Again, the IRS has figured it all out, and they’ve defined exactly what you can do, and documented it in Publication 535. There are three possible situations: if you’re an individual (i.e., haven’t yet formed a business structure), if you’ve formed a corporation, or if you’ve formed a partnership. As explained earlier, if you’ve formed an LLC, which of the above situations you fall into depends on how you’ve elected to have your LLC taxed – either as a corporation or a partnership.
• If you’re an individual and your business idea fails before it launches, well, you might have a couple of possibilities for recouping something. Essentially, though, the IRS considers your start-up attempt as basically a hobby, and so you are able to deduct your losses up to the amount of your income reported for the year.
• If you’ve proceeded to the point of creating a business structure (an LLC, corporation, or partnership), well, you can deduct capital losses against any capital gains you might have (for example, when you dispose of equipment that you’d purchased). The problem is, you can only deduct expenses when you have a business up and running – which means you need to figure out how to document that your business was really up and running prior to its demise. That’s a pretty aggressive tax strategy, but it could be worth a shot.
How to keep track of start-up and organization costs. An Excel spreadsheet is ideal for this, with a separate worksheet for start-up costs and organization costs. You’ll need a column for what, when, where, purpose, mileage to/from, and amount, and maybe an explanation column. Set up a file for receipts, and you should be good to go. Just make certain that you keep this contemporaneously up-to-date, and have it ready for your bookkeeper or tax accountant when your start-up day arrives.
Summary. The biggest problem for first-time entrepreneurs with managing their start-up costs is, they aren’t in business yet, and aren’t thinking like a business person. The entrepreneur spirit is moving them, they are faced with a huge number of decisions to make, and keeping records isn’t one of today’s hot buttons. But keep in mind – one of the reasons you’re going into business for yourself is to make money, and saving on your business taxes is one of the very good ways to do it. Correctly keeping track of your start-up costs is just part of a good business practice that should be developing as you head toward the big day.
Footnote: You can download a PDF copy of the IRS Publication 535, titled Business Expenses, at https://www.irs.gov/pub/irs-pdf/p535.pdf. Once downloaded, settle yourself in for a lot of study within this 52 page document, as the start-up information is scattered throughout it. Bits and pieces are in Chapter 1 (Deducting Business Expenses), subsection Going Into Business. Also, Chapter 7 (Costs You Can Deduct or Capitalize), subsection Business Start-Up and Organizational Costs. Spend some time in three areas of Chapter 8 (Amortization), subsections Starting a Business, and Costs of Organizing a Corporation and Costs of Organizing a Partnership, and How To Amortize. In fact, though, you might as well plow through all 52 pages of it, as you’ll need to know a lot about deducting business expenses after your business begins operating anyway, and it’s almost certain that little tidbits of start-up information are scattered in lots of other places throughout this document.
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