If you’re considering starting a business now, be aware that it might be expensive to get it off the ground, and it could take some time before you start earning revenue. From a tax perspective, how should you handle start-up and organizational costs, and what can you deduct and when?
Data from the U.S. Census Bureau shows that new business formation is on the rise. Although many businesses closed during the pandemic, this data indicates that the entrepreneurial spirit remains strong.
### Allowance for Start-up and Organizational Costs
Start-up costs cover any expenses paid or incurred in connection with creating an active business or investigating the creation or acquisition of one. Organizational costs include expenses related to forming a corporation or partnership.
Typically, these costs need to be capitalized, meaning they’re added to the balance sheet as an investment in the business. However, you can elect to deduct up to $5,000 of start-up and organizational costs by claiming the deduction on your tax return for the first year you’re in business. No separate election statement or attachment is required. For example, a sole proprietor claims the deduction in Part V of Schedule C (Form 1040 or 1040-SR).
The $5,000 cap is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized and deducted evenly over 15 years. For instance, if your start-up costs are $53,000, your initial deduction is limited to $2,000 ($5,000 minus $3,000 exceeding $50,000). If your expenses are $55,000 or more, the $5,000 allowance is reduced to zero. If you need to amortize costs (for example, if total expenses exceed $55,000), this is done on Form 4562, Depreciation, and Amortization.
### When to Claim the Deduction
The election to deduct start-up costs is made in the year you start your business. Identifying when this occurs can be challenging. It’s generally considered to be when a business is ready to begin generating income, often thought of as when you “open your doors to the public.”
Some indications that you’re in business include:
– Attempting to sell your products or services
– Launching your website
In one district court case, a retailer was deemed to be “in business” for depreciation purposes once it had completed its shelving, obtained its inventory, and received a certificate of occupancy, even though it hadn’t yet opened to customers or made any sales. Whether this applies to start-up costs remains unclear.
### What Costs Are Deductible
Various costs can be treated as start-up or organizational costs, but not all are deductible.
**Deductible Start-up Costs:** These are expenses that would be deductible if incurred while the business was operational. They include:
– Analyzing or surveying potential markets, products, labor supply, transportation facilities, etc.
– Advertising and promotions for the business opening
– Rent
– Insurance
– Salaries and wages for employees undergoing training
– Travel and costs for securing prospective distributors, suppliers, or customers
– Professional and consulting fees
Expenses attempting to buy a business are not deductible start-up costs, only those investigating whether to buy a business and which one to buy. Additionally, costs of interest, taxes, and research or experimental costs before commencing business are not deductible start-up costs.
**Deductible Organizational Costs:** These include expenses for:
– Legal services
– State fees for incorporation or partnership filing fees
– Temporary directors and organizational meetings for corporations
Corporations cannot treat costs for issuing and selling stock or transferring assets to the corporation as organizational costs. Partnerships cannot treat costs for acquiring and transferring assets, admitting new partners, or contracts between the partnership and its partners as organization expenses.
### Conclusion
If you’re just getting started, it’s wise to work with a CPA or knowledgeable tax adviser to optimize your deductions for start-up and organizational costs.
