One of the most common questions I get from people opening a business for the first time is, 'How do I deduct all of the many expenses incurred before the business actually opens its doors?' Most of these can be handled as either start-up expenses or organizational expenses. You can think of organization expenses as creating the paperwork part of a business and start-up expenses as setting up the physical structure of a business.
Business start-up expenses are those incurred for investigating or creating an active trade or business and the cost must meet these two requirements:
- It is a cost that would be deductible if it was paid or incurred to operate an existing business (in the same field as the one entered into), and
- It is a cost paid or incurred before the business began.
Typical start-up expenses usually include:
- An analysis or survey of potential markets, products, labor supply, etc.
- Advertisements for the opening of the business
- Salaries and wages for employees who are being trained to work in the business
- Travel and other costs for securing prospective distributers, suppliers, or customers
- Salaries and fees for consultants or professional services
Although many ordinary and necessary expenses are incurred before a business opens its doors, all expenditures made before a business opens are not start-up costs. The cost to retro-fit the restaurant and the furniture, equipment, and supplies your clients purchased before the opening are not start-up costs. Leasehold improvements, depreciable property, and supplies should be handled according to the normal rules of depreciation.
It is import to separate the types of expenses because you can deduct more of the startup and organizations expenses upfront the first year. For example:
A business may deduct up to $5,000 of start-up costs in the year the business opens. The remaining start-up costs may be amortized over 180 months (15 years) starting with the month the business begins. For example, suppose you had $25,000 of start-up costs. In 2022, they could deduct $5,444, figured as follows:
$5,000 immediately deductible +
$444 [($20,000 remaining costs / 180 months) × 4 operating months in 2022] =
Total: $5,444 deduction the first year
It should be noted that the $5,000 deductible cap is reduced dollar-for-dollar if start-up expenses exceed $50,000. Thus, if expenses are $51,000, the cap is reduced to $4,000 and if expenses are $55,000 or over the immediate deduction is not available.
Organization expenses can also be deducted much the same as startup expenses. They include:
- Incidental to the creation of an entity, such as costs of creating a partnership or corporation
- Items chargeable to the capital account
- Items amortizable over the life of the entity if the entity had a fixed life
For example, organization costs for a partnership include legal fees for the preparation of the partnership agreement and filing fees. If the partnership paid or incurred such costs they can choose to deduct up to $5,000 of organization expenses. Similar to start-up costs, the balance of organization costs must be capitalized and amortized over a 180-month (15 year) period, starting with the month in which the partnership begins business.