May 7, 2021 Taxes en_US If you started a business last year and incurred some expenses before you officially opened your doors, you may be entitled to deduct certain startup costs. https://quickbooks.intuit.com/cas/dam/IMAGE/A2JHWTfU0/8270a940416449e86f5eed3c5e2ae650.jpg https://quickbooks.intuit.com/r/taxes/3-tax-deductions-available-only-to-startup-businesses/ Startup costs: Understanding the totals, taxes, and timing
Taxes

Startup costs: Understanding the totals, taxes, and timing

By Taran Soodan May 7, 2021

The best things in life aren’t always free. A beach vacation? A box of fresh doughnuts? Starting your own small business? There are going to be some costs involved.

Think of it as an investment. Those doughnuts are going to, one, improve your mental health, and two, improve your hunger. When you’re starting your own small business, your startup costs are an investment in your mission.

Now, no two startups or doughnuts are the same, but each one requires at least some financial investment. Let’s take a closer look at common expenses for startups. (Unfortunately, we’ll be leaving the doughnuts behind for now.)

A beginner’s guide to startup costs

Few things are as exciting as launching a new business. But—and we’re not trying to rain on your parade—it’s essential to determine which startup expenses are required to get your business off the ground. For most business owners, it’s recommended that you work with a certified public accountant (CPA). A CPA can help you plan out expected costs to give you an idea of how much money you’ll spend on starting your business.

Before you get started, there are a few types of expenses business owners should be aware of. These expenses typically fall into one of two categories: fixed costs or variable costs.

Fixed costs

Fixed costs are ongoing business expenses that need to be paid on a regular basis, like monthly rent. These costs generally don’t fluctuate too much. Common fixed costs include:

Rent

Depending on your type of business, you may need office space. If you can run your business from your house in the first year or two, that’s excellent. Even still, if you think you may grow and need office space down the road, start planning and setting money aside as soon as possible. (Office space isn’t cheap.)

Need real estate? Typically, business spaces and storefronts carry a higher price tag and heftier taxes than residential areas. So do your homework as soon as possible and determine if and where you can afford real estate.

If you’re planning to have an office or retail space for your setup, you need to include rent as a fixed expense. This requires you to estimate how much space you can manage and the type of space your business will need. You can then calculate your rent expenses. If you choose to purchase instead of lease the business space, your mortgage will be your fixed expense.

Co-working spaces like WeWork have become more common over the past few years. If you can’t afford high rent for office space, a co-working space can give you the space you need at a fraction of the cost. Providers like WeWork have national locations, but local co-working spaces are available too.

Some of the best sites to find co-working spaces include Coworker, WeWork, and LiquidSpace.

Payroll

An essential expense that any business model has to include is salaries for everyone involved in the business. This means establishing payroll for you and any cofounders, partners, and employees. The first year of payroll is always challenging because you have to decide when to hire workers and when to contract a freelancer or provider. No matter which you decide, establishing payroll is essential.

To make payroll easier, payroll software like QuickBooks goes a long way in helping you plan out your costs.

Taxes

The taxes that apply to your business depend on revenue, deductible expenses, and your business’s location. If you’re using designated office space for your business, you might need to pay real estate taxes for the property as well.

It’s convenient to start your fiscal year as soon as you start your business. Overlapping the two will make it easy for you to calculate the amount of taxes you need to pay. It is wise to hire the services of a CPA to properly evaluate your business’s taxes, your income taxes, and returns for the fiscal year.

Legal and professional services

Certain businesses may require accountants, experts, or market research to ensure your plan is secure and legal. This is especially true if you’re selling a service. If you’re opening a simple little shop, you will still likely need a business plan, at least. This can set you back several hundred to several thousand dollars, depending on the extent of planning required.

A lawyer may also be a worthwhile investment. Their services include things like drafting various agreements, helping you choose a business structure, forming a separate business entity, or working through the incorporation process. Hiring an attorney to perform these types of services for you can save you a lot of time and money in the long run.

Not sure where to find an attorney? Here are some sites you can use to find legal representation:

Software

Most businesses use software to help run their day-to-day operations or provide services. For example, QuickBooks is a popular accounting tool used by business owners to track expenses, cash flow, and profitability. Other common software includes customer relationship management (CRM) systems, Google Drive, Microsoft Office, website hosting, and hiring software.

Loan payments

If you’ve taken a small business loan to start your business, you’ll need to set aside a portion of your profits to make loan payments. Some businesses are eligible to get loans from the Small Business Administration (SBA), which can offer competitive rates to make it easier to start a business.

The amount you need to reserve for repayment depends on the type of loan payback plan you have negotiated with your loan provider. In addition to the original sum payment, you will likely have to pay interest and should plan for its cost.

Insurance payments

Just like a car, businesses need to be insured. Business insurance protects you and your business from various lawsuits, damages, and more. In short, business insurance—much like car or health insurance—can save you from hefty legal fees and settlements in the event of an accident or lawsuit. Fun? No. Necessary? Absolutely.

Insurance costs vary depending on the plan you choose. They can include coverage like general liability insurance, workers’ compensation insurance, errors and omissions insurance, and commercial property insurance. The type of insurance you opt for depends on the nature of your business, the industry, the number of employees, and other risk factors.

Utilities

Utilities are one of the essential expenses that you will have to take care of when you establish your business. You’ll need to turn the lights on, right? These costs include gas, electricity, water, phone, and internet bills for your business space. Depending on where you live, you might need to pay for additional utility expenses like HVAC units.

Marketing costs

Marketing costs for your business can be in the form of physical marketing materials, such as signs and banners. They can also cover digital marketing, such as ads on social media platforms like Facebook or LinkedIn.

Marketing costs can vary every month depending on the type of business you’re running. For example, if your business is remote, you likely won’t need to print flyers every month. Some marketing costs can be a one-time cost like designing your website or having business cards created.

Office supplies

Even the tiniest businesses will need some office supplies. A package of pens may only cost a few dollars, but over a year, reams of paper, staplers, pens, and office equipment can add up.

Variable costs (or one-time costs)

These expenses can even outweigh the profit for the first few months after starting the business. But don’t stress! Knowing what these costs are will help you plan for them. Common one-time costs include:

Permits and lisences

If you’re not incorporating, you still need to pay for licenses and permits at the state and federal levels. The types of permits and licenses you need depend on your location, your industry, and the nature of your company. For example, retail companies usually need to pay for sales tax licenses and permits, and trade-specific permits are required for service-oriented sectors.

Incorporation fees

If you incorporate your business or form a limited liability company, you will have to pay the expenses and costs of forming that business. The filing fees for articles of incorporation and organization vary by state.

Logo design

Logo designs are an essential part of your company’s branding and make your brand more memorable. The fees for logo designs are paid to various designers. It’s crucial to invest in a good logo design, as it helps create an excellent first impression for your company and strengthens your brand identity.

Website design

Most successful businesses are now opting to have an online presence to widen their reach. Websites are generally a great way to establish your brand on the internet. A good business website should be easy to navigate and include easy access to information about your products, services, and contacting your team. It should also look professional, so you may want to consider investing in your business’s online presence by hiring professional design services.

Brochures and business cards

You may think you can skirt by without them, but there will come a point where you wish you had a business card or brochure to give someone. In the startup phase, networking and word of mouth are especially important.

Taking care of this part means paying for the services of graphic designers, consultants, and printing companies. The material costs for brochures and business cards depend on the type and quality of paper and ink used. You will also need to hire the services of a good content writer for the brochures if you want them to be professional and adequately detailed.

Down payment on rental property

If you’re going to lease office space, you’ll likely have to put a down payment on the property.

Improvements to the chosen location

Depending on what type of new business you start and where you set up shop, you might initially need to invest in furniture and other supplies. Some of these expenses will be one-time expenses, while others, such as stationery and other office supplies, will be ongoing.

Improvements also depend on the nature of your business. For example, suppose you’re starting a new restaurant. In that case, you might have to invest in making appropriate improvements to the site, including installing industrial-grade ovens, countertops, and other relevant upgrades.

Startup costs for a restaurant

Wait, why do restaurants get their own section? Well, because we’re still thinking about those doughnuts. But also, they’re popular small business models, expensive, and have a high failure rate. The average restaurant closes within its first year. Truth be told, they’re costly and complicated.

Understanding restaurant startup costs can help new restaurant owners be better prepared and reduce the chance of failure. If you’re a restaurant startup, here are the typical costs of entering the restaurant business:

Proper square footage

You’re going to need the right amount of space to run a restaurant. How much space will depend on the type of restaurant you want to open. If you’re planning to open a small restaurant, like a coffee shop, a small space is perfect. If you’re aiming for a fine dining mecca with a few Michelin stars, you might want to check out larger spaces.

Kitchen equipment

One of the highest costs of any restaurant is the kitchen equipment. Even small cafés need espresso machines, blenders, mugs, pitchers, utensils, and so on. You can save a bit by purchasing an existing restaurant, but you’ll likely need new equipment before you launch or shortly after.

Point-of-sale system

A point-of-sale system, or POS, is a necessary expense for any restaurant. While you can cut back and use a dated system that doesn’t allow credit cards, you will lose sales. This makes a cutting-edge POS system a worthwhile expense in many cases, but that doesn’t take away the price’s sting.

Full-service bar

Not every restaurant needs a full-service bar, but they can do wonders for sales. If you want to run a full-service bar, you’ll need to look into getting a (typically costly) liquor license. You’ll also need to buy the right bar equipment and hire several employees to staff it throughout the week.

Restaurant costs add up very quickly, but they can be rewarding and profitable if the profit margins are tight. Don’t let the numerous costs scare you off if you genuinely want to pursue the industry. If you deem a restaurant too costly but have still been bitten by the foodie bug, consider whether a food truck might be a good fit.

Understanding startup deductions

Good news! If you incurred expenses before opening a business last year, you may be entitled to deduct certain startup and organizational costs on your tax return this year. However, the IRS has strict guidelines you must follow to claim them. Here’s a look at the rules.

The allowable deductions

According to the IRS, there are three categories of startup costs eligible for tax deductions. Chapters 7 and 8 of IRS Publication 535 outline these deductions in full detail. The key takeaway is that startup costs must be related to one of three things:

Creating a trade or business (or investigating the creation or acquisition of an active trade or business)

Some of these costs might include surveying markets, analyzing products and labor supply, or visiting potential business locations.

Preparing the business to open

Any costs you incur before opening your doors are included in this category, except equipment, which will have to be depreciated. This means you can write off a portion of the cost over a period of time. Eligible expenses in this category could include employee training, travel expenses to locate suppliers and distributors, advertising expenses, and consultant fees (such as attorney or accountant fees).

Organizational costs

If you legally set up your business as a partnership or corporation before the end of your first year in business, you can deduct these costs too. The expenses typically associated with incorporating are legal fees, state organization fees, salaries for temporary directors, and organizational meetings. Expenses related to setting up a partnership agreement include legal expenses as well as filing and accounting fees.

How to take IRS deductions

The IRS allows you to deduct $5,000 in business startup costs and $5,000 in organizational costs, but only if your total startup costs are $50,000 or less. If your startup costs in either area exceed $50,000, the amount of your allowable deduction will be reduced by the overage. And if your startup costs are more than $55,000, the deduction is eliminated.

For instance, if your startup costs were $53,000, you’d have to subtract $3,000 from the $5,000 deduction and would only be allowed to deduct the remaining $2,000. And if your startup costs were $56,000, you wouldn’t qualify for the deduction at all. The costs remaining after your deduction should be amortized (paid off over a period of time) annually in equal portions over the next 15 years.

It would be best to claim the startup deduction for the tax year that the business officially opened. If you fail to claim the deduction, you can still file an amended return within six months of the return’s due date (not counting extensions). If you do that, the IRS instructs that you write “Filed pursuant to Section 301.9100-2” on your amended return. Be sure to send it to the address to which you sent your original return.

Timing is everything

Sometimes taking the deduction in the first year doesn’t always make financial sense. For instance, if it’s likely that you will suffer losses for the first few years in business, you might be better off amortizing the deductions over a few years. This way, you balance out your eventual profits.

To do so, you need to file IRS Form 4562 with your first year’s tax return. You can amortize qualified startup and organizational costs, and they don’t have to be in the same amortization period. But keep in mind that you will not be allowed to change them once you choose the periods for each deduction. Be sure to talk to a tax adviser about this critical decision.

FAQs about startup costs

Before going ahead with your startup, it’s wise to estimate your expected costs through research and consulting with a CPA. Here are a few questions that most people who plan to start a business have in mind:

Can you expense startup costs?

Startup expenses are expenses that you have before your business starts to accept customers. Following the rules in your state, you can select a certain amount of the startup costs as startup expenses and receive tax deductions on those.

How much does the average startup cost?

The cost for your startup depends on the size and nature of your business as well as the industry your business operates in. Online businesses typically cost less to initialize, whereas physical companies are likely to have more initial expenses.

Are startup costs capitalized or expensed?

While setting up your business and researching the potential expenses, you’ll find that certain startup costs are capitalized and others are expensed. Startup expenses are divided into one-time and ongoing expenses. You can generally get some tax deductions for your startup expenses, depending on the tax laws in your state.

What startup costs are deductible?

The rules of the IRS regarding tax deductions for startups are fairly technical. To be deductible, the concerned startup expenses must qualify as ordinary and necessary. Generally, the costs you pay to cover up the depreciation of the essential tools and items for your business are deductible. These deductions depend on the type of business you start, your taxable income, the amount of W-2 wages your business pays, and the property held under your business.

Startup costs: Worth every penny

Looking over the ins and outs of startup costs, you might be feeling a little intimidated. Yes, there’s a lot that goes into a startup, but think of it as an investment. Startups bring with them an unprecedented amount of freedom.

Start tracking what you need for your startup, keep documents and receipts from all purchases, and stay organized. Make sure you’re aware of all appropriate forms—contact your tax specialist or accountant when in doubt—and you’ll have a startup to call your own in no time. Have a doughnut to celebrate.


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Taran Soodan

Taran Soodan

Taran Soodan is the founder of Very Good Marketing Agency, helping businesses with organic growth via SEO, content marketing, partnerships, and more. Read more