You’re leaving money on the table! How to deduct business start-up expenses

Start-up expenses are incurred before the business actively commences operations.

Start-up expenses can include costs incurred: 

1. To investigate the creation or acquisition of a business, 
2. To create a new business, or
3. To engage in any for-profit activity before the active conduct of business begins, in anticipation of such an activity becoming an active business. 

Common examples of start-up expenses include employee training, rent, utilities and marketing expenses incurred prior to opening a business. 

In the tax year when active conduct of business commences, the rules allow taxpayers to elect to amortize start-up expenses. The election potentially allows an immediate deduction for up to $5,000 of start-up expenses. However, the $5,000 deduction allowance is reduced dollar-for-dollar by the amount of cumulative start-up expenses in excess of $50,000.

Any start-up expenses that can’t be deducted in the tax year the election is made are amortized over 180 months on a straight-line basis. Amortization starts in the month in which the active conduct of business begins. 

A taxpayer is deemed to have made this election in the tax year when active conduct of business commences unless, on a timely filed tax return for the year, the taxpayer elects instead to capitalize start-up expenses. 

Start-up expenses don’t include interest expense, taxes or research and development costs. Those expenses are subject to specific rules that determine the timing of the deductions. Start-up expenses also don’t include corporate organizational costs or partnership or LLC organizational costs — although the tax treatment of those expenses is similar to the treatment of start-up expenses. 

Factors to Consider 

The IRS has historically focused on these three factors to determine if a taxpayer has commenced the active conduct of a business:

1. Did the taxpayer undertake the activity intending to earn a profit? 
2. Was the taxpayer regularly and actively involved in the activity? 
3. Has the activity actually commenced?

The Tax Court recently concluded that the taxpayer wasn’t engaged in a business during 2009 and 2010, because they didn’t have any income or clients and didn’t bid on any jobs during those years. Though the taxpayer did engage in promotional activities, they didn’t intend to earn a profit in those years, because they didn’t pursue contracts or bid on jobs. 

Therefore, the court ruled that the IRS was correct in denying the deductions reported on the taxpayer’s 2009 and 2010 returns, because they were amortizable  start-up expenses rather than currently deductible business expenses. However, if the taxpayer could properly substantiate the expenses, the opinion notes that the taxpayer could begin amortizing them in the year when his business activity started. 

Finally, the court ruled that the IRS was correct in imposing the 20% substantial understatement penalty, because the taxpayer had failed to establish that there was any reasonable cause for the tax underpayment or that the taxpayer had acted in good faith. 

Important Reminders about Start-Up Costs

When you incur business start-up expenses, it’s important to remember two key points. First, start-up expenses can’t always be deducted in the year when they are paid or incurred. Second, no deductions or amortization write-offs are allowed until the year when active conduct of your new business commences. That usually means the year when the business has all the pieces in place to begin earning revenue. 

Time may be of the essence if you have start-up expenses that could be deducted in the current year. 

Remaining start-up expenses after business is closed

If any unamortized start-up costs or organization costs remain on your books when your business is closed, deduct the balance remaining on your final return.

For example, if you elected to amortize organization costs over five years, and you still have two years of unamortized organized costs remaining when your business is closed, deduct the remaining two-year balance on your final return.

Contact John L Mottram CPA LLC Certified Public Accountants for more ways to apply understand how start-up expenses may reduce your tax liabilities. Reach out to John L Mottram directly at 214-543-1855 or jlm@mottramcpas.com.