Starting a Business
What Expenses Qualify as Start-up and Organizational Costs
Tax Treatment of Start-up and Organizational Costs
Common Start-up and Organizational Costs
Starting a business can seem daunting to the prospective entrepreneur. A step-by-step plan to get started can alleviate some of the angst. The cost of getting started is one of the first considerations. These costs can be identified and addressed in a solid business plan.
Before getting into the details, let’s first define a couple of terms used extensively when discussing start-up and organizational costs:
Amortize: Amortization is a method of deducting certain capital costs over a fixed period. It is like the straight-line method of depreciation.
Capitalize: When capitalizing a cost or expense, the amount is entered on the business’s balance sheet and full recognition of the expense is delayed, until the business is closed or sold, although for tax purposes some assets can be depreciated (i.e., the cost is recovered over a specified period).
What Expenses Qualify as Start-up and Organizational Costs - Per IRS Publication 535, “Startup costs include any amounts paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational costs include the costs of creating a corporation or partnership.”
An expense qualifies as an amortizable start-up cost if:
It would be deductible if the business was already operating in the same field, and
It was paid or incurred before the business began operating.
Costs incurred to investigate the purchase of an active trade or business are treated as amortizable start-up costs. Costs incurred to attempt to acquire an ongoing business are not considered start-up costs, and so must be capitalized.
Referring again to IRS Publication 535, an expense qualifies as an amortizable organizational cost if:
It was incurred for the purpose of creating the business structure,
It is chargeable to a capital account,
It would be amortizable over the life of the business if it had a fixed life,
It was incurred by the end of a corporation’s first year of operations or prior to a partnership’s first tax filing date, excluding extensions, and
As to partnerships, it is the type of expense that would be expected to benefit the partnership over its lifetime.
Tax Treatment of Start-up and Organizational Costs - Start-up and organizational costs generally must be capitalized and will only be recovered when you sell or close your business. Some assets can be depreciated but the rest are capitalized.
You can, however, choose to amortize eligible start-up and organizational costs over 180 months. The 180-month period begins with the month in which you first operate your business. No election is required to amortize start-up costs. You just take the deduction on your tax return. However, you ARE required to attach a statement to your tax return if you choose NOT to amortize these costs.
You can also elect to deduct up to $5,000 in eligible business start-up costs and $5,000 of eligible organizational costs in your first year of operations. These figures are reduced for every dollar by which your start-up or organizational costs exceed $50,000.
Once filed, an election to deduct or capitalize start-up and organizational costs is irrevocable.
Common Start-up and Organizational Costs - You can’t start a business without incurring some expense. Following are some common examples of business start-up and organizational costs. Remember, they are only considered start-up or organizational costs if they are incurred before you start business operations. Any expense you incur on or after the day you start your business is an operating expense, not a start-up or organizational cost.
Organizational Costs including Licenses and Permits – Most new business owners create a business structure before operations begin. A corporate structure can limit your personal liability for the risks inherent in running a business. Partnership agreements define how multiple owners will work together if no corporation is created. Sole proprietorships do not require the formation of a separate entity.
Regardless of business structure, most businesses need to obtain licenses and permits from the jurisdictions in which they will operate. These costs are considered organizational costs if incurred prior to the start of operations.
Analysis and Surveys – The cost of an analysis or survey of potential markets, products, labor supply, transportation facilities, etc., qualifies as a start-up expense.
Professional Advisor Fees – Professional advisor fees are organizational costs if they relate to setting up the business. This might include legal and accounting fees as well as appraisals and relevant business forecasts.
Insurance – Insurance coverage is best established before operations begin so you are covered from Day 1.
Payroll – You may need to hire and train employees before you get started. Eligible training costs can include expenses paid to others who train your new employees. Some employees may help you get your office or store ready for your opening.
Advertising and Marketing – You need to get the word out before you start operations to launch effectively. Logo design, website design, brochure and business card printing, and signage are examples of pre-opening advertising and marketing costs.
Travel - Costs of travel and other related expenses in connection with securing distributors, suppliers, and customers for the new business.
Operating Expenses – You can incur operating expenses (such as utilities and phone service) prior to opening.
Ineligible Expenses – Interest, taxes, and research and experimental costs do not qualify as start-up costs.
Other Expenses – Although not included in the definition of “start-up” or “organizational” costs that qualify for the special $5,000 deduction allowance, a new business will also incur other costs before business operations begin which cannot be deducted until the business is operational. Even then, these expenses may not be deductible all at once and generally will have to be depreciated or amortized over several years. These include:
Improvements – Improvements are often made to an office or other business structure to best serve the needs of the business. These expenses would not be deductible until the business is operational and, depending upon the nature of the business, may be expensed, or depreciated.
Inventory – Businesses that use inventory will need to obtain sufficient stock to get started. Although a considerable expense prior to the business opening its doors, inventory costs cannot be deducted until the inventory items are sold.
Equipment – You’ll need some sort of office equipment such as computers, printers, and/or equipment specifically related to your line of work. These expenses would not be deductible until the business is operational and depending upon the nature of the business may be expensed or depreciated.
Furniture – Desks, chairs, tables…you’ll need furniture to open your business. These must generally be depreciated over several years or may qualify for immediate write-off in the first year of business, depending on several factors.
Vehicles – You may incur the expense of acquiring a vehicle before your business becomes operational. That expense will not be deductible until the business is operational, and you may have the option of expensing, depreciating or even using the optional mileage deduction for the vehicle.
Amortizable Expenses – Some expenses that are incurred before a business becomes operational and start-up and organization expenses more than the $5,000 maximum expense amounts allowed can be amortized over a period of 180 months (15 years) starting from the month your business begins operations.
Summary - It takes an investment to get a business off the ground. A variety of start-up and organizational costs will welcome you before you’re ready to open your doors. From the cost of creating a business entity to the expense of hanging a sign on your storefront, these costs are generally classified as start-up and organizational costs if incurred before the start of business operations. As such, they are generally amortized over 180 months unless the business elects to capitalize all or a part of them or expense up to $5,000 of start-up and $5,000 of organizational expenses in the first year of operations.
If you are planning to open a business, it may be appropriate to call so the tax aspects and benefits of your start-up and organizational costs can be determined in advance.
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