New Business Costs:
One common misconception that we often hear is that new business can expense all startup costs in their first year of doing business. That unfortunately, is not true. In this post, we hope to clarify the guidelines on this topic. Starting a new business involves various expenses, and understanding how to categorize and deduct those costs can significantly impact tax savings.
To read more about starting a new business, click here.
Startup Costs Vs Organizational Costs:
According to the IRS, there are two types of costs when starting a business, startup costs and organizational costs. Startup costs are amounts a business pays or incurs when creating or acquiring a trade or business. They can also be costs to investigate the creation or acquisition of a trade or business. The business, however, must be made for the purpose of generating a profit. Organizational costs are expenses incurred to form the business entity. Both of these costs are different from operational costs which are costs incurred after the business operations begin.
Startup Costs – Qualifying & Non-Qualifying Costs:
Qualifying costs include:
- Market surveys
- Advertisements
- Wages for employees in training
- Travel to solidify distributor, supplier, or customer contract
- Fees for professional consultants
These costs must be paid prior to the business becoming active and must be related to the normal operations of the business.
Non-qualifying costs include:
- Interest
- Taxes
- Research
- Experimental Costs
Operational Costs:
As mentioned previously, operational costs are expenses that are specific to form the business entity prior to beginning operations. The following is a list of general fees associated with setting up a business entity.
- Legal fees
- Accounting fees
- State & local filing fees
- Franchise fees
- Incorporation fees
While this is not an exhaustive list, it provides a general idea of how operational costs differ from startup costs.
How To Account for Startup Costs:
Generally, businesses would capitalize all costs prior to becoming operational and then depreciate the expenses over a period of time. However, starting after October 22, 2004, the IRS began allowing businesses to expense up to $5,000 of startup costs and $5,000 of organizational costs on their first-year tax return. The remaining amount would then be depreciated over 15 years (180 months). The caveat to the $5,000 rule is that it is reduces by any amount above $50,000.
For example, if a company incurred $52,000 in startup costs, they would only be able to expense $3,000 in the first year, not the full $5,000. Therefore, if a business incurs $55,000 or more of startup expenses, the full amount must be capitalized and depreciated over 15 years.
Overview:
When starting a new business, there are a lot of expenses, and navigating the complexities of the accounting and tax world is no small task. A simple way to look at this topic is to consider whether an expense related to the period before or after the business began operations. If the expense was made before the company began operations, it is likely a startup or organizational expense. If it is spent after the company began operations, it is likely an operational expense. Startup and organizational expenses are capitalized and depreciated over 15 years, and the business can expense up to $5,000 in the first year as long as it does not go above the $55,000 threshold.
Helpful Links:
At Accounting Execs, we always recommend going to the source of information. To further your understanding of this topic, please select one of the following IRS links.
Publication 535 – A comprehensive document on business expenses provided by the IRS
Publication 583 – IRS publication related to starting a business and keeping records
Guide to Business Expense Resources – Helpful links provided by the IRS related to business expenses
