Startup costs can put a huge dent in your budget. When launching a new business, there are many things that need to get done before the doors open and you're ready to take on customers. These may include doing market research, training employees, or refurbishing a building. Since these are all expenses associated with starting up your business, you may consider them deductible startup costs.
You can deduct $5,000 in startup costs and organizational costs on business taxes in the first year, provided you’ve spent less than $50,000.
In this article, we’ll look at organizational and startup costs in detail, explaining how to deduct them so that you can maximize your tax deductions and get your business off the ground.
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Understanding Business Startup Costs
Startup costs are all of the expenses you incur before beginning business operations. The money you spend buying or preparing to buy an existing business also counts as a startup expense.
That said, some of the most common business start-up expenses include:
Travel expenses spent scouting for possible business locations
What if you want to start your business in a new city, state, or even country? You can deduct the costs of traveling for this purpose. However, you may not deduct any part of the cost which is simply to visit your family.
Advertising your business launch
Are you planning a big promotion for your new business? You can include the costs paid in your deduction. Just be sure to keep good records of all promotional expenses, including copies of any print ads or flyers you purchase, and invoices from independent contractors who help design logos or promotional items for your company.
If you want to find out what your potential customers think about your business, then you can deduct the cost of conducting a survey.
Market research is a standard startup cost. If you use your own money to do market research, then the first dollars out of your wallet are eligible for a tax deduction.
If you hire an attorney to help give your business the proper legal business structure like LLC costs, then those expenses can be included in your deduction. However, you cannot include the costs of normal everyday legal services for your business, such as negotiation of contracts, filing for patents or trademarks, etc. Only legal fees related to starting your business.
If you hire an accountant for tax advice to help get your books in order before opening day, then that cost can be deducted too. Most small business owners benefit greatly from the advice from a tax advisor. Professional services for tax who is familiar with their specific needs and local laws.
Product research costs
If you need to do some research on the products you will sell as part of your business, then that cost is deductible too. For example, if you need to try out a new coffee maker before selling it in your store, then the expense of purchasing and trying it out is tax-deductible.
Building a website
Some small business owners choose to build their own websites, while others hire consultants or web design companies to handle this for them. The cost of building your site can be included as part of your deduction if it’s necessary in order to run your business.
Costs for training employees
Yes, you can deduct the cost of training your employees. For example, if you pay someone else to train your future office manager on how to use accounting software, then that expense qualifies as a business start-up cost.
You may also include the cost of any inventory (such as goods for resale) that you purchase specifically to run your business. If you are preparing to open a furniture store selling used items, then the cost of any inventory purchased for resale will be deductible starting on your first day.
Business licensing and permits
Even though it may seem like government red tape and an unnecessary expense, you can claim the costs of obtaining certain licenses and permits as part of your business start-up expenses. Just be sure you get all your paperwork in order before you open your doors for business.
Understanding Organizational Costs
Formation expenses, also known as organizational costs, include any fees associated with establishing a corporation, partnership, or moving from sole proprietor to LLC. These may also be referred to as "incorporation" or "partnership" expenditures.
Typical qualifying organizational expenses include:
Incorporation filing fees
To form a corporation, you must submit formation papers (articles of incorporation) to your Secretary of State and pay a filing fee. Generally, this amount is deductible as an organizational expense.
Cost of hiring temporary directors
If you need to hire a few people before your business is formally organized, then their wages and benefits can be included in the organizational expenses related to your new business.
Expenses incurred when organizing meetings
Even if you don’t hold a formal meeting, simply getting together to talk about the formation of your business can count as an organizational meeting. The expenses you incur when organizing these meetings are deductible and fall under organizational expenses.
Lawyer and accounting fees to help establish the legal entity
Professional fees and consultant fees to help you start your business can be written off. You can deduct the cost of hiring a lawyer to help you form your corporation or Limited Liability Company. You can also include the costs involved of any accounting incurred in setting up books and records for your business.
How to claim business startup deductions
As we've mentioned earlier, the Internal Revenue Service allows you to deduct up to $5,000 in business startup expenses and $5,000 in organizational costs in the current year. The catch, however, is that you need to have spent less than $50,000 in business startup costs and organizational costs.
For instance, if you incur $45,000 in expenses when starting your own business, you can deduct up to $5,000 when you file your returns.
That said, how much will you deduct if you spend more than $50,000 on startup costs? According to the IRS, for every dollar you spend over $50,000, your first-year deduction reduces by $1.
Let's say you spent $53,000 to launch your business. Your deduction will reduce by $3,000 – so you'll only write off $2,000 in the first year.
The same also applies to organizational costs. If you incur $54,000 in organizational costs, you'll be able to deduct only $1,000 in the current year. For the remaining amount, you'll have to amortize it.
What if you spend more than $55,000 in either startup costs or organizational costs? Well, you can't deduct any of the expenses in the current year. Instead, you'll have to amortize all of them.
How does amortization work?
With amortization, you can claim deductions over a period of time rather than in the year that they occurred. Each deduction is divided into equal annual portions that are then claimed on your tax returns for that particular year.
The Internal Revenue Service requires you to amortize business startup costs and organizational costs over a period of 15 years or 180 months.
Here’s an example: Say you spent $53,000 to launch your business as an LLC. Your first-year deduction will be limited to $2,000 (the amount that you’re allowed to deduct immediately in the year your business starts).
You can then claim the remaining $51,000 over the next 15 years. So each year you can claim 1/15 of this amount ($3,400) as a deduction
Naturally, the amortization period can seem like a very long time to many business owners. But if you ever close down your business, the remaining amount will be carried forward and you'll get to deduct it the day you close shop.
What Doesn't Qualify As Expense Startup Costs?
All expenditures you make after you begin the operation of your business aren't eligible for the startup or organizational expense deduction. The following costs incurred, while they appear to be startup costs or organizational expenses, are not eligible for either the first-year write-off or amortization:
Fees for selling and issuing stocks
Fees for transferring assets to your company
Real estate taxes
What happens if you don't start the business?
Personal costs are those incurred in order to explore the prospects of starting a company or purchasing a non-specific existing company and are therefore not deductible.
However, the total expenses you incurred in your effort to start or buy a specific company are considered a capital expenditure, and you can claim it as a capital loss, subject to all of the restrictions that apply to non-business capital losses.
You can deduct the cost of any business assets you acquired throughout the process (for example, some printing equipment) if and when you sell or dispose of them at the end of the tax year.
According to the IRS, there is a clear distinction between costs and expenses. The money you spend preparing to start your firm is considered startup costs at the beginning and is addressed in accordance with the guidelines we've outlined above. Once your company is operational, however, the money you spend becomes a business expense rather than a startup expense.
For instance, suppose you've spent on a website, designed, built, and launched it in April. In May you realize that your company will never see the light of day. Your business is no longer operational—as far as the Internal Revenue Service is concerned—and therefore any further expenditures made to maintain the website will be considered personal costs and they won't be deductible (of course, you can always sell the website and use the resulting capital loss).
Once your company is operational, any costs incurred, apart from those we've outlined above, are deductible as tax write-offs. This means that if you spend money on advertising expenses to promote your business or on research and development expenditures, they'll be considered legitimate deductions since they're directly connected to your company's business.
That said, there's no IRS rule that's carved in stone stating when your company is considered open for business. Determining when a business commences isn't always easy. Generally, though, you can assume you’ve begun trading when your business starts generating income.
Other steps that show you're open for business include:
Your business website goes live
You make efforts to sell your goods or services
You start handing out business cards
How to claim the deduction on your tax return
The first-year deduction should be recorded on your business' tax form, which would be a sole proprietorship's Schedule C, a partnership's K-1, or an S corporation's Form 1120.
Fill out Form 4562 in Part VI, Depreciation and Amortization, to claim a year's worth of amortizing startup costs. Then, submit the form with your tax return.
If you are a sole proprietor, the deduction is carried over to your Schedule C under Other Expenses. If you're a corporation or partnership, the tax credit may be claimed on your income tax form. You can continue to record it under Other Expenses during the amortization period.
Frequently Asked Questions (FAQs)
Here are some of the most frequently asked questions on business startup deductions:
What are "startup costs?"
Startup costs are any expenses you incur before your business is operational. They include: market research, conducting feasibility studies, creating a business plan, and web design.
What are "business expenses?"
Business expenses for self-employed are any money you spend operating your company. These include advertising costs, research and development expenditures, legal fees, and paying an accountant.
What's the difference between business expenses and startup costs?
Before your company becomes operational, any money you spend will be considered a startup cost. However, once it's open for business, the expenses you incur become business expenses and can be deducted from your income tax return.
When is my business considered operational?
Your business generally becomes operational when it starts generating income. If you're in doubt, however, always consider the idea that if your company can't turn a profit, then it's probably not viable.
What is the average cost of starting a business?
Startup costs vary greatly depending on the nature of your firm. For most small businesses, however, these expenses will range between $10,000 and $70,000.
What is the difference between amortization and depreciation?
Amortization is the process of spreading startup costs over a predetermined tax period. Depreciation, on the other hand, is an all-encompassing term that refers to the loss of value of any of your assets.
What are some of the business expenses that I can write off when my business is operational?
Most business owners can deduct common expenses such as marketing costs, attorney fees, rent, utilities, and administrative expenses.
What does it mean to be a sole proprietor?
A sole proprietorship is a business owned by one individual who has complete control over the way in which the specific business is run.
Depending on the nature of your business, total startup costs can vary greatly. Fortunately, you can typically deduct these expenses from your tax return during the first year that you do business. Remember, however, that you can only claim expenses incurred before your company becomes operational as startup costs. Once your company begins active trade or business, you'll be deducting the costs you incur when running your business.
If you're looking for more information about how to deduct startup costs on your taxes or what constitutes deductible business write-offs, consult with an accountant or tax attorney. They can help you understand when your active business begins, organization costs, and all the costs you can deduct for your particular business.
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