How to Deduct Startup Costs on Business Taxes
Starting a business? The bad news is that it costs a lot to pay for all the costs for a business startup. But the good news is that you can use most of these startup costs to reduce your business taxes.
Lots of misinformation is floating around the internet about business startup costs and what you can deduct. Some startup costs can be deducted in your first year of business, while other costs must be spread out over several years. It's complicated (it's the IRS, you know), but we'll straighten it out.
What Are Business Startup Costs?
New businesses can use startup costs to reduce business taxes, but there are limits and restrictions on these costs.
The IRS says that start-up costs are "amount paid or incurred for
- Creating an active trade or business, or
- Investigating the creation or acquisition of an active trade or business."
Costs of starting a business can be separated into two time periods:
- costs for investigating and
- costs of the start-up.
IRS Publication 535: Business Expenses. "Going into Business." Page 4. Accessed Sept. 17, 2019.
Business Startup Costs as Capital Expenditures
The IRS regulations state that business start-up costs are typically considered capital expenses because they are for the long-term, not just the first year. The classification of startup costs as capital expenses is important because it means you can't take those costs as an expense to your business in the first year.
You must depreciate (spread out) the costs of buying certain business assets, and other costs can be amortized (also spread out). You may not able to recover these costs until you sell the business or go out of business; that's a complicated discussion best left to your tax professional.
But, You Can Deduct Some Costs in the First Year
You can elect to deduct up to $5,000 of business startup costs and $5,000 of organizational costs for costs. Let's look at each of these separately:
Deducting Startup Costs: You may deduct up to $5,000 in start-up costs in your first year in business. This deduction is restricted if you have over $50,000 in start-up costs. If you have additional start-up costs over the $5,000, you can amortize these costs over 15 years. I
If you are not going to be profitable in your first year, you may want to consider another option to minimize your taxes in years where you make more profit.
Instead of deducting $5,000 in your first year, you may amortize all start-up costs over 15 years, taking the same deduction each year. For example, if your start-up costs are $45,000, you could deduct $3,000 a year for 15 years.
You can also wait to recover your start-up costs until you sell your business or close the business, but most business owners don't want to wait that long to get the tax benefit from these start-up costs.
Deducting Organizational Costs. In addition to the $5,000 start-up deduction, you can take up to $5,000 in an additional deduction for small business organizational expenses, up to $50,000. Organizational costs are those costs involved in forming a corporation, partnership, or limited liability company (not a sole proprietorship) and they would include legal fees and other expenses for forming your business structure. These costs must be incurred before the end of the first tax year the company is in business.
Deducting Business Startup Costs: An Example
Let's say you have started an LLC in 2019. You have $8,000 in deductible startup costs and $2,000 in organizational costs to set up the LLC. Here's how the deduction might work:
- You can deduct the $2,000 in LLC setup costs on your 2019 business tax return, as organizational expenses.
- You can also deduct $5,000 of your other startup costs on your 2019 business tax return.
The other $3,000 in startup costs must be amortized over the following few years, as required by the IRS.
What Is Not Included in Startup Costs?
Some expenses you might have during the startup phase of your business are not deductible as startup costs, including
- Costs to qualify to get into that type of business (getting a real estate license, for example).
- Costs of buying business assets (like a building, equipment, or vehicles). These costs are considered separately for tax purposes. They must be depreciated over a specific number of years.
Don't worry too much about whether a startup expense is deductible or must be spread out, or is a startup cost or an organizational expense. Your job is to collect ALL THE COSTS starting your business and let your tax professional tell you if they are legitimate and how they can be used to reduce your business tax bill.
What If I Don't Go Into Business? Are these Costs Still Deductible?
If your search for a business or startup of a business fails, costs to you fall into two categories:
Preliminary costs are considered personal costs to you, and they are not deductible as business expenses. These would be costs before you make the decision to buy or start a business, costs for doing a general search, or preliminary investigation of possibilities.
If you have preliminary costs, and the deal doesn't work, you may be able to deduct these costs as miscellaneous expenses on Schedule A of your Form 1040, if they are more than the standard deduction.
Costs for an unsuccessful attempt at startup for a specific business are considered startup costs, and expenses can be deducted or depreciated in the same way as startup costs.
When Does a Business Start?
Determining the date when your business actually starts depends on several factors, but it's important to determine a startup date for the purpose of deducting startup costs. For example, if you are investigating the purchase of a business, you need to know how far back you can deduct these costs. Typically, you can go back one year from the startup date.
A Startup Costs Worksheet
To help you put all your startup costs in one place, and make sure you don't miss any costs, here's an article showing you how to create a startup costs worksheet.
A Disclaimer: As you can see, attempting to deduct business startup costs is complicated, each business tax situation is unique, and the tax laws change frequently. It's best to let your tax professional sort out the taxes for startup costs so you can be sure they are done right to give you the maximum tax benefit.