Business Startup and Organizational Expenses
Before a business starts to receive revenue, it incurs expenses that the Tax Code classifies as startup or organizational expenses. The startup phase begins when the entrepreneur starts spending money on the business and ends when revenue is 1streceived. There are special rules for deducting these expenses. However, any expenses incurred to actually buy a business or any expenses related to the purchase must be capitalized, meaning that they must be added to the buyer's basis in the business, which is considered a capital asset. Costs that must be capitalized can only be recovered when the business is disposed of or if it is terminated.
Startup expenses — both ordinary and necessary — are considered capital expenses, which must be amortized over at least a 15-year period, but longer periods can be elected. However, tax and interest expenses are deducted under the normal rules — these deductions are no different in the startup phase. However, capital equipment will be capitalized as a fixed asset, which is depreciated over its class life. If the business owner chooses not to amortize other startup or organizational expenses, then those expenses are added to the basis of the business, which can then only be recovered when the business is disposed of.
If the total startup expenses are less than $50,000 for tax years before 2021 or less than $60,000 thereafter, then up to $5000 of those expenses incurred before 2021 or up to $10,000 for tax year 2021 and after can be deducted in the 1st year. However, this phases out dollar for dollar as the total of startup expenses exceed $50,000 for tax years before 2021 and $60,000 thereafter. For organizational costs, the maximum 1st year deduction is $5000 and the phaseout begins at $50,000 regardless of tax year.
The election to expense the 1st-year deduction is deemed to be made if the startup expenses do not exceed the maximum deduction; otherwise, the taxpayer must attach a statement to the tax return noting the election. The note for a sole proprietorship must state that the election is being made under Section 195(b)(1) of the Internal Revenue Code (IRC) and that any remaining expenses will be amortized over 180 months, or 15 years. The business name and description must also be noted and the month that the business began. The election for partnerships is made under IRC Regulation 1.709-1(b) and (c); for corporations, IRC Regulation 1.248-1(c). If a business owner failed to make the election, then an amended return can be filed within 6 months of the due date of the return, including extensions, noting the election and with the phrase "Filed pursuant to Section 301.9100-2."
There could be hundreds of startup expenses. Each of the expenses must be listed separately, but they are grouped under Startup Expenses. If the business ends before the amortization period, then any unamortized amount can be deducted in the final year but only to the extent they qualify as a business loss.
|Startup Expenses Incurred||Type of Cost||First-Year |
|Dollar for Dollar |
|Before 2021||business start-up costs||$5,000||$50,000|
|2021 and after||business start-up costs||$10,000||$60,000|
Business startup costs do not include expenses incurred to investigate whether to start or buy a particular business. These expenses include travel and other expenses incurred to investigate businesses. However, once a decision is made to buy a particular business, then the costs associated with buying or setting up of the business are deductible, including surveys of perspective suppliers or customers, surveys of potential markets, facilities, labor, and supplies, professional service fees, advertisements to alert potential customers that the business is opening, salaries and wages for employees being trained and for their instructors. Other expenses that would normally be deductible by an operating business would also be amortizable if incurred or paid before the start of business operations.
The purchase price of a business + any expenses incurred in purchasing the business are not amortizable, but must be capitalized, so these expenses cannot be recovered until the business is disposed of.
Organizational expenses, which are expenses incurred for creating a separate business entity, such as a limited liability company, partnership, or a corporation, are accounted separately, but only if total startup expenses exceed $5000. Although a sole proprietorship may have legal and accounting expenses and expenses for setting up a business, these expenses must be deducted as startup expenses, not as organizational expenses.
Expenses that are deducted as organizational expenses must be incurred before the end of the 1st tax year for a corporation or before the due date, including extensions, of the return for a partnership or limited liability company taxed as a partnership. Although treated somewhat differently, organizational expenses are deducted and amortized similarly to startup expenses. If organizational expenses are less than $5000, the entrepreneur may still elect to deduct the expenses as organizational expenses, especially if the amount of the expenses is close to $5000. If it later turns out that there was an error in the total amount of organizational expenses, then the return can be amended to write off the 1st $5000 and to amortize the remainder. If the election was not made, then the IRS may not allow amortization of the amount exceeding $5000.
For an C or S corporation, examples of organizational costs include:
- incorporation fees,
- legal services,
- temporary directors, and
- organizational meetings.
However, the cost for issuing and selling stocks or other securities, such as printing costs, commissions, and professional fees, and the costs incurred by the transfer of assets to the corporation must be capitalized.
The costs of organizing a partnership include the creation of the partnership, but not for starting or operating expenses. The cost must be chargeable to a capital account and if the partnership has a fixed life, then the amortization period will be over the life of the partnership. However, any organizational costs must have been incurred by the due date of the partnership return, not including extensions for the 1st year in which the partnership is in business. The organizational expense must be for an item that is expected to benefit the partnership as an entity, including :
- legal fees for the organization of the partnership;
- drafting the partnership agreement;
- accounting fees that pertain to the organization of the partnership; and
- filing fees.
Costs that cannot be amortized include:
- acquiring assets or transferring assets to the partnership;
- adding or removing partners, except when 1st organized;
- the drafting of legal contracts that pertain to the operation of the partnership.
Syndication fees, such as brokerage, registration, and legal fees that are used market partnership interests to others must be capitalized. If the partnership is terminated before the amortization period, then any unamortized amount can be deducted as a business loss or against business profits in the final year.
Startup costs and organizational costs can be amortized over different periods, but they cannot be less than 180 months, or 15 years. Once the amortization period is selected, it cannot be revoked.
The deductible amount equals the startup + organizational costs divided by the number of months in the amortization period. A partnership or corporation using the cash method of accounting can only deduct a startup or organizational expense if it has been paid by the end of the tax year.
The election to amortize is made on Form 4562, Depreciation and Amortization, which must be attached to the return for the 1sttax year of the business. If the business has both startup and organizational costs, then a separate statement should be attached for each. For the cash method of accounting, the expenses must have been paid by the end of the tax year, not including any extensions.
Rather than amortize, a business can choose to capitalize startup and organizational expenses if the 1st tax return for the business treats the costs as such and is filed by the due date, including extensions. The election to amortize or capitalize is irrevocable. For a business entity organized as a corporation or partnership, only the corporation or partnership can make the election, not shareholders or partners. However, a partner can make the election for any costs incurred in investigating the partnership interest.
The amortization election can be done by filing a statement early in any tax year before the business actually begins. However, the election becomes effective only when the business starts. The business can also revise the statement to include any startup costs that were not included. However, any costs characterized as something other than a startup cost cannot be recharacterized as a startup cost. Organizational costs can also be added later by amending the return.
The election statement should provide the following information:
- business description;
- description of the startup cost, including the date and the amount;
- the month when the business actually began operating; and
- the number of months in the amortization period.
For partnerships, organizational costs of less than $10 do not have to be listed individually but the total sum can be listed along with the date of the 1stoccurrence and the last occurrence of these costs.