Small business tax deductions are great, but you can only deduct them for an existing business. What about all of the expenses you make before you open for business?
The IRS calls these “business start-up” and “organizational costs,” and you can usually claim all or a portion of them on your income tax return in the year you started up your business, depending on how much you spent. You can also “amortize” (i.e. spread out) the remaining costs over a certain number of years. Here’s how.
Which business start-up costs are deductible?
The IRS sorts these into two categories:
Business start-up costs
Before you start or buy a business, you’ll likely go through a long process of analysis and research. The money you spend doing market research, figuring out your product, looking for an office space, advertising your business launch, and doing anything else to investigate, launch or buy a business are generally deductible. (You might hear your accountant or tax lawyer refer to these simply as “investigation” costs.)
Other eligible business start-up costs include:
- Customer surveys
- Market research expenses (publications, focus groups, consulting, etc.)
- Product research
- Site selection costs (i.e. money you spend searching for and securing an office or workspace)
- Wages and salaries for training
- Professional and consultant fees
- Costs associated with acquiring an existing business
- Costs of leasing a business property
- Equipment costs
These are any costs involved in the actual formation of a corporation, partnership or LLC. (Your accountant or tax lawyer might also refer to these as “incorporation” or “partnership” costs.) Typical qualifying organizational costs include:
- Incorporation fees
- Partnership filing fees
- Legal fees for services incident to the organization of the corporation or partnership, such as negotiation and preparation of the partnership agreement
- Accounting fees for services incident to the organization of the partnership
- The cost of organizational meetings
- The cost of temporary directors
How much can I deduct?
If you spent less than $50,000 total on your business start-up costs, you can deduct $5,000 of those costs immediately, in the year that your business starts operating. Same thing goes for your total organizational costs.
If you spent more than $50,000 on your business start-up costs, your first year deduction decreases by $1 for every dollar you spent over $50,000.
For example, if you incur $52,000 in start-up costs before launching your business, you’ll only be able to deduct $3,000 in the first year ($5,000 minus $2,000). After your first year, you can amortize the remaining costs.
This also means that if you spend more than $55,000 in start-up costs, you won’t be able to deduct any of those costs in the first year, and instead you’ll need to amortize all of them.
And once again, the same rule applies to organizational costs. If you spend $52,000 on those, your first year deduction will be limited to $3,000, and you’ll have to amortize the rest.
How does amortizing start-up and organizational expenses work?
In addition to deducting all or a portion of your start-up and organizational expenses in the first year that your business starts operating, you can generally write off the rest of those expenses over the next 15 years. Accountants call this “amortization.”
Generally speaking, once you take your first year start-up and operational expense deductions, you can divide the rest of those costs over 180 months (15 years), and take a monthly start-up and organizational expense deduction for those expenses.
Let’s take the start-up costs from the example above. After you claim the $3,000 deduction in your first year of business, you’ll have $49,000 in start-up expenses left. That means you’ll be able to deduct $272 for every month your company stays in business ($49,000 divided by 180).
To amortize your start-up and organizational expenses in this way, you’ll have to fill out and attach Form 4562, Depreciation and Amortization, to your tax return for the first tax year you are in business. Like the $5,000 one-time deductions we discussed above, the amortization expense calculated on Form 4562 also goes in Part V of Schedule C of Form 1040.
Before you go ahead and start amortizing your start-up and organizational costs, make sure to speak with an accountant or tax lawyer. The IRS is pretty specific about which costs it does and doesn’t let you amortize.
Which costs don’t qualify?
Any costs that you incur after you start operating your business aren’t eligible for the startup-up or organizational expense deduction. And although they might seem like start-up or organizational expenses, the following costs don’t qualify for either the first year deduction or amortization:
- Research and experimental costs
- Real estate taxes
- Depreciation costs
- Costs of issuing and selling stocks
- Costs associated with the transfer of assets to the corporation
What if I never go into business?
Let’s say you make a bunch of start-up and organizational expenses, but never end up launching the business. What happens then? Can you still deduct those expenses?
If you were investigating a specific business to create or acquire—i.e. spent money incorporating a specific business, travelled to check out a specific startup you were thinking of acquiring, etc.—you might be able to deduct some of these expenses as a personal capital loss. If you made any big purchases in the lead up to your launch like equipment or property, you’ll be able to deduct those losses too once you sell them.
On the other hand, if you were just doing general research, didn’t have a specific business in mind, and nothing comes of your research, those expenses are considered personal expenses and are not deductible.