In the process of running a business, you learn so many things. Today, I want to shed light on a tax topic that business owners need to know from the beginning, yet many do not have a full understanding of: Start-Up Costs!
Surprisingly, Start-Up Costs are not always immediately deductible, and how those expenses are treated can make a big difference in the taxes you pay. Before we dive into the detail of the tax law, let’s start with a few definitions. Start-Up Costs include expenses paid to create a business, including acquisition costs, costs for investigating the creation of a business, and any other business expenses incurred before the first day of operations. These type activities often include the analysis of possible products, markets, and activities, wages paid to employees for training before the business has begun, required travel expenses, professional services, and research fees. Organizational Costs are expenses directly related to the creation of a corporation or partnership entity. Common examples include amounts paid for organizational meetings, state incorporation fees, filing fees, accounting fees related to the organization of the entity, and legal fees for bylaws, partnership agreements, and other organizational documents.
By default, both costs are capital expenses. They are treated as an asset of your business, NOT as an expense. Capital costs increase your investment (or “basis”) in your business, and they can be recovered over time through amortization expense. Further, any basis remaining in your business at the time you sell it, can be recovered at that point. So, have no fear, the costs that go into your basis are not lost forever.
The IRS allows you to deduct up to $5,000 in Start-Up Costs and $5,000 in Organizational Costs. Further, you can amortize any amount in excess of these limits over the next 180 months (15 years). Amortization is the gradual recovery of a capitalized asset over a determinable time span as a deductible expense for the business! This means all the costs you incur leading up to your business start date will (eventually) be allowed as deductible expenses, but they will be spread out over the course of 180 months. There is one caveat to keep in mind: the $5,000 Start-Up Cost deduction allowed in year one is phased out dollar-for-dollar when the total Start-Up Costs exceed $50,000 (same phase-out applies for Organizational Costs), but we will leave that for discussion on another day.
The business start date plays a big role in determining the 'deductibility' of business expenses .Once the business has begun, operating expenses are fully deductible. However, during the time frame leading up to the business start date, when work is being done to prepare the business to begin, the Start-Up Costs must be treated as capital assets, with the option to make elections to deduct some of the amounts in year one and the remainder over the next 15 years. It can be confusing when you have the same expense being treated differently because the business has not yet opened the doors. Well, that’s tax law for you! You can be paying the same person the same wage on the same schedule before and after the business start date, but those expenses are treated different. The treatment all comes down to the first day the business began.
In closing, I want to note two additional items. First, I would not suggest making business decisions based solely on the tax consequences, although they should be considered. When looking holistically at your business strategy and situation, you must choose what is best overall for your company. Second, as a CPA, it is my duty to remind you how important it is to maintain thorough record-keeping. In the event of an audit, the IRS would require you to substantiate and provide documentation of all income and expenses items reported on your tax return, including the costs you capitalize!
I hope this brings some clarity and provides a better understanding of how to approach these costs in your business (or future businesses).
At Brewer, Eyeington, Patout & Co., we can discuss your individual tax situation and provide recommendations for you. Call us today at 979-268-1350.