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 and organizational costs on your tax return this year. But 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, and you can only deduct them if you actually opened the business. The startup costs must be related to:
- 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 or the labor supply, visiting potential business locations, and any other costs associated with creating or investigating a new or existing business.
- Preparing the business to open. Any costs you incurred before opening your doors and begin to generate income are included in this category, with the exception of equipment, which will have to be depreciated. Eligible expenses could include employee training and wages, travel costs to locate suppliers and distributors, advertising, and consultant fees such as attorneys and accountants.
- 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 as well. The expenses typically associated with incorporating are legal fees, state organization fees, salaries for temporary directors, and organizational meetings. Expenses to set up a partnership agreement include legal expenses and filing and accounting fees.
Chapters 7 and 8 of IRS Publication 535 outline these deductions in full detail.
How to Take the 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 for either area exceed $50,000, the amount of your allowable deduction will be reduced by that dollar amount. And if your startup costs are more than $55,000, the deduction is completely eliminated. For instance, if your start up costs were $53,000, you would lose $3,000 of the deduction, and would only be allowed to deduct $2,000. And if your start up costs were $55,000 or more, you don’t qualify for the deduction at all. The costs remaining after your deduction should be amortized annually in equal portions over the next 15 years.
You should claim the 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 due date of the return, excluding extensions. If you do that, the IRS says you should write “Filed pursuant to section 301.9100-2” on your amended return, and send it to the same 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 to balance out your eventual profits. To do so, it’s necessary that you file IRS Form 4562 [PDF] with your first year’s tax return. You can amortize qualified startup and organizational costs, and they don’t have to be on the same amortization period. But keep in mind that once you choose the periods for each deduction, you will not be allowed to change them. Be sure to talk to a tax adviser about this important decision.