In most cases, there's nothing "small" about the expenses you incur when you start a new small business. Dozens of expenses pop up long before you actually open your doors for business. You need a place to work, supplies, furniture, and possibly employees. You may also incur substantial expenses investigating whether to start a new business and legal expenses to set it up.
Once your business is up and running, many of these expenses are currently deductible in a single year as business operating expenses. Others you can depreciate over several years. However, until your business actually begins, you don’t have any deductible or depreciable business expenses. Luckily, special start-up expense rules permit you to currently deduct some of the expenses you incur before your business begins.
What Are Business Start-Up Costs?
Business start-up costs are expenses for creating an active trade or business or investigating whether you should create or buy one. They include any expenses that would be currently deductible as business operating expenses after your business begins, such as:
- advertising the opening of the business
- wages for workers who are being trained, along with instruction costs
- travel and related expenses in finding customers, distributors, or suppliers
- researching the viability of the business, such as possible markets for your goods or services, the local labor pool, and the availability of transportation
- licenses, permits, and other fees, and
- operating expenses incurred before the business begins, such as rent, telephone, utilities, office supplies, and repairs.
Costs that don't qualify include inventory you purchase before your business begins and tax-deductible interest and real estate and other taxes. Start-up expenses also don’t include long-term assets you purchase for your business such as computers, office equipment and furniture, cars, buildings, and machinery. You must wait until your business begins to deduct these long-term assets. The cost of some long-term assets must be deducted over several years through depreciation; others can be fully deducted in one year under Section 179, or the de minimis safe harbor or materials and supplies deductions for less expensive items.
How to Deduct Business Start-Up Costs
You can currently deduct in a single year up to $5,000 of your business start-up costs. However, the $5,000 limit is reduced by the amount your start-up expense exceed $50,000. For example, if you have $53,000 in start-up expenses, your first-year deduction is reduced to $2,000 instead of $5,000. If you have $55,000 or more in start-up expenses, you get no current deduction for start-up expenses.
Any start-up expenses you can’t currently deduct are amortized (deducted in equal amounts) over 180 months (15 years), starting with the first month you begin business. Divide the start-up costs by 180 months to determine how much you can deduct for each month. Multiply that amount by the number of months you were in business for the year, and that's the amount you amortize on that year's tax return. The IRS has detailed instructions to help you.
Example: You incur $47,000 in expenses to start your new restaurant business. You may deduct $6,340 in start-up expenses in the year when you open your business. This consists of your $5,000 current start-up expense deduction and an amortizable amount of $1,167 ($42,000/180 x 6 months = $1,340. You get a $2,800 deduction every year you’re in business ($233.33 per month) after your first year until the whole $42,000 is written off.
You elect (claim) this deduction on IRS Form 4562, Depreciation and Amortization, you then list your start-up costs as “Other expenses” on your Schedule C (or other appropriate return). This election is irrevocable and is voluntary—you need not deduct or amortize your start-up expenses if you don’t want to. You can choose to forgo the election to amortize by affirmatively electing to capitalize your start-up costs on your income tax return filed for the year your business begins. However, most business owners want to deduct everything they can as fast as they can.
Business Organizational Costs
The costs of forming a corporation, partnership, or limited liability company to operate your business are not considered business start-up costs. However, they are currently deductible in the same manner as start-up costs.
Corporate Organizational Costs
These are the direct costs of creating a corporation. Examples of such costs include:
- expenses for temporary directors
- costs of organizational meetings
- legal and accounting expenses to form the corporation, and
- state incorporation fees.
Corporation-related expenses that can't be deducted include the costs of issuing and selling stock or securities, such as commissions, professional fees, and printing costs.
Partnership and LLC Organizational Costs
These are the direct costs of creating a partnership or limited liability company (LLC). Examples of deductible costs include:
- legal fees for negotiating and preparing a partnership agreement or LLC member agreement
- accounting fees related to organizing the partnership or LLC, and
- state filing fees.
Some items that can't be deducted include the costs of:
- acquiring assets for the partnership or LLC or transferring assets to it
- admitting or removing partners or LLC members after the partnership or LLC has been organized, or
- making a contract between a partner or member and the partnership or LLC.
Deducting Organizational Costs
Organizational expenses are deducted in the same way as start-up costs. You may deduct the first $5,000 in the first year you are in business, and any excess over the first 180 months. However, your first-year deduction is reduced by the amount by which your organizational expenditures exceed $50,000. You must file IRS Form 4562, Depreciation and Amortization, with your tax return.
Questions for Your Attorney
- I didn't know that I could amortize my start-up costs when I filed my tax return last year. Can I file an amended return? Can I start amortizing those costs now, on this year’s return?
- I bought a business last year, and the prior owner didn't amortize any of her start-up costs. Can I include those costs as part of my start-up costs?
- Can I deduct and amortize a start-up cost if I perform the service myself? I started a business this year, and before I opened, I researched things like the local labor pool and availability of transportation. Can I deduct that expense even though I didn't pay anyone to do it?