Starting a brand new business usually requires the expenditure of money on things. Luckily, you can take a startup cost deduction to limit your tax bill.
Let's dive into how to write off the costs of starting your new business.
Startup costs deduction: What you can write off
Once your business begins, you can deduct the cost of all such items as business expenses. Yet, it's a bit tougher for expenses that happened before the business started.
These business startup costs are capital expenses. These are the costs that you incur to get an asset (a business) that will benefit you for more than one year.
Typically, you can't deduct these types of expenses until you sell or otherwise dispose of the business. Yet, a special tax rule allows you to deduct up to $5,000 in start-up expenses the first year you are in business. Then, you can deduct the rest, if any, in equal amounts over the next 15 years. (I.R.C. § 195.)
Example
EDiana Drudge is sick of her office job. She decides to start a fashion design business. Before her business begins, she spends $20,000 of her life savings on advertising. Her business finally starts on July 1, 2014.
Because this advertising is a startup expense, she can't deduct the full cost in her first year of business. Instead, she can deduct $5,000 of the expenses the first year she's in business. She can deduct the remaining $15,000 in equal installments over 15 years.
This means she may deduct $1,000 of the remaining $15,000 for each full year she's in business, starting with the first year. Yet, Diana's business is open for only six months in her first year. She may deduct only $500 of the $15,000 that year, plus the initial $5,000 she's entitled to. Her first-year total business deductions would be $5,500.
If you can, try to spend no more than the first-year ceiling on start-up expenses. That way, you won't have to wait 15 years to get your money back.
Some startup costs you can write off
Some business deductions for your next company include the costs of:
- Legal and accounting fees
- Licenses, permit, and other fees
- The cost of investigating what it would take to create a successful
- business, including research on potential markets or products
- Advertising costs, including advertising for your business opening and creating a business website
- Office rent and utilities paid before the business begins operating
- Rental of business equipment such as computers and office supplies
- Costs for employee training before the business opens, and
- Expenses related to obtaining financing, suppliers, customers, or
- distributors
Can a small business deduct the cost of a computer?
If you buy a computer for your business and use it exclusively for your business, you can normally deduct the entire cost. If you use it more than 50 percent of the time for business, you can still deduct the costs.
Are there exceptions to start up cost deduction?
Some costs related to opening a business that are not considered start-up expenses. Many of these costs are still deductible, but different rules and restrictions apply.
Inventory
The largest expense many home business people incur before they start their businesses is for inventory. That is, buying the goods (or the materials to make them) that they will sell to customers. For example, if you decide to start an eBay business selling items you buy at flea markets, you would treat the items you purchase for resale as inventory. You deduct the cost of inventory as it is sold or if it becomes unsaleable.
Long-term assets
Long-term assets are things you buy for your business that will last for more than one year. This includes computers, office equipment, cars, and machinery. Long-term assets you buy before your business begins are not considered part of your startup costs.
Instead, you must treat these purchases like any other long-term asset you buy after your business begins. You must either depreciate the item over several years or deduct the cost in one year under Section 179. Yet, you can't take depreciation or Section 179 deductions until after your business begins.
Research and development costs
The tax law includes a special category for research and development expenses. These are costs a business incurs to discover something new in the laboratory or experimental sense. This could be a new invention, formula, prototype, or process.
These costs include laboratory and computer supplies, salaries, rent, utilities, other overhead expenses, and equipment rental. But it doesn't the cost of purchasing long-term assets. R&D costs are currently deductible under Section 174 of the Internal Revenue Code. This applies even if you incur the costs before the business begins operations.
Organizational costs
Costs you incur to form a partnership, limited liability company, or corporation is technically not part of your startup costs. Yet, the rule for deducting these costs is the same as for start-up expenses. (I.R.C. § 248.) But, if you form a one-member LLC, you get no business deductions at all if your start-up expenses exceed $5,000
When can you deduct business startup costs?
Expenses that were startup expenses before your business began become currently deductible business operating expenses. For example, supplies you purchase after your business starts are currently deductible operating expenses. But, supplies you buy before your business begins are startup expenses.
For tax purposes, when does my new business begin?
So, just when does a new business begin? The courts have held that a new business begins for tax purposes when it starts to function as a going concern. It also must start performing the activities for which it was organized. (Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965).
The IRS says that a venture becomes a going concern when it acquires all the assets necessary to perform its intended functions. It must also put those assets to work. Your business begins when you start doing business, whether you are actually earning money.
For example, if your business involves providing a service to customers or clients. This includes accounting, consulting, financial planning, or law services. Your business begins when you first offer your services to the public. No one has to hire you; you just have to be available for hire. For example, a consultant's business begins when he or she is available for hire by clients.
If you're a knowledge worker your business begins when you start using your business assets to make sellable products. These types of workers could include writers, artists, computer programmers and more.
The products don't have to be completed, nor do sales have to be solicited or made. For example, an inventor's business begins when he or she starts working on an invention in earnest. It doesn't matter when the invention is completed, patented, or sold. Likewise, a writer's business begins when he or she starts working on a writing project.
As a seasoned expert in taxation and business strategies, I bring a wealth of knowledge to guide you through the intricacies of startup costs deduction. My expertise is rooted in years of hands-on experience and a comprehensive understanding of tax laws and business financial practices. Let's delve into the concepts presented in the article about starting a new business and leveraging startup cost deductions.
1. Startup Costs and Capital Expenses:
- Startup costs are the expenditures incurred before a business begins its operations, often considered capital expenses.
- Capital expenses are costs associated with acquiring assets that provide benefits for more than one year.
2. Tax Rule for Deduction:
- A special tax rule allows a deduction of up to $5,000 in startup expenses in the first year of business.
- Any remaining startup expenses can be deducted in equal installments over the next 15 years (I.R.C. § 195).
3. Example Scenario:
- The article provides an example of Diana Drudge, who spent $20,000 on advertising before her fashion design business started.
- Diana can deduct $5,000 in the first year and the remaining $15,000 in equal installments over 15 years.
4. Eligible Startup Costs for Deduction:
- Legal and accounting fees, licenses, permits, and other fees.
- Costs related to researching potential markets or products.
- Advertising costs, including business opening promotions and website creation.
- Pre-operational office rent, utilities, and equipment rental.
- Employee training expenses before the business begins.
- Costs related to obtaining financing, suppliers, customers, or distributors.
5. Deducting Business Equipment Costs:
- If a computer is purchased exclusively for business use, the entire cost can be deducted.
- Even if the computer is used more than 50% of the time for business, deductions are still allowed.
6. Exceptions to Startup Cost Deduction:
- Inventory costs are not considered startup expenses but are still deductible as the items are sold.
- Long-term assets (e.g., computers, office equipment) bought before the business begins are not part of startup costs.
- Research and development costs are deductible under Section 174 even before business operations start.
7. Organizational Costs:
- Costs incurred to form a partnership, LLC, or corporation are not technically startup costs but share similar deduction rules (I.R.C. § 248).
- In the case of a one-member LLC, no business deductions are allowed if startup expenses exceed $5,000.
8. Determining Business Start:
- A new business, for tax purposes, begins when it functions as a going concern and starts performing its intended activities.
- The IRS considers a venture a going concern when it acquires all necessary assets and puts them to work.
- Business commencement is not solely dependent on earning money; offering services or making products available for hire constitutes the start.
9. Knowledge Worker's Business Start:
- For knowledge workers (e.g., writers, artists, computer programmers), the business begins when assets are used to create sellable products.
- Completion, patenting, or selling of products is not necessary for business commencement.
By understanding these concepts, you can navigate the complexities of startup costs and deductions, ensuring optimal financial management for your new business venture.
