As an entrepreneur you know that start-ups incur costs before officially being open for business. The good news is that you may be entitled to deduct certain start-up and organizational costs on your tax return. Let’s take a closer look at how to write off the costs of starting your new business.
Two types of deductions
According to the Internal Revenue Service (IRS), there are two categories of start-up costs eligible for tax deductions, and you can only deduct them if you actually opened the business. The start-up costs must be related to:
- The cost of “investigating the creation or acquisition of an active trade or business.” This includes costs incurred for surveying markets, product analysis, labor supply, visiting potential business locations and similar expenditures.
- The cost of getting a business ready to operate (before you open your doors or start generating income). These include employee training and wages, consultant fees, advertising and travel costs associated with finding suppliers, distributors and customers.
You might notice that equipment purchases are markedly absent in this list. These types of costs are not considered start-up expenses and instead can be written off through depreciation, with different rules for different assets.
If you decide to incorporate or organize as a partnership while you are still setting up your business, you can deduct or amortize some of the costs incurred. These include the cost of state incorporation fees and legal fees, organizational meetings and salaries for temporary directors. Partnership deductibles include legal, accounting and filing fees related to developing the partnership agreement. These costs must have been incurred before the end of your first tax year in business.
How much can you deduct?
The IRS lets you deduct $5,000 in business start-up costs and $5,000 in organizational costs – but these come with a caveat: your overall start-up costs have to be $50,000 or less. If your start-up costs exceed $50,000, the amount of your allowable deduction is reduced by that dollar amount. And if your costs are more than $55,000, the deduction is completely eliminated.
For example, if the costs you incurred before opening your business were $53,000, you would lose $3,000 of your deduction, and would be allowed to deduct $2,000. If the costs were $56,000 or more, you wouldn’t be able to deduct any of the costs.
You should claim the deduction for the tax year the business officially opened. If you miss this window, you can still file an amended return within six months of the due date of the return, excluding extensions.
What is considered the start-up phase?
Basically, you are in start-up mode during the development and planning phase of your business. As soon as you are operational (either open for business or conducting transactions), your costs are considered to be the expenses of an operating business.
Talk to an accountant…
In some cases, taking the deduction in the first year of business doesn’t make financial sense. For example, if you suffer losses for the first few years in business, you might be better off amortizing the deductions over a few years to balance out your eventual profits. Talk to a tax advisor or accountant about the best options for your business.