What Are Start-Up Costs?
Start-up costs are amounts that are paid or incurred in connection with:
- Investigating the creation or acquisition of an active trade or business;
- Creating an active trade or business, or
- Any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.
Common examples of start-up costs include:
- Cost to develop a website
- Cost paid to survey market demand
- Training of employees who will work for the business
- Travel expenses to meet and negotiate with suppliers
- Cost incurred in the search for a business to acquire
Note the following two requirements:
- Such costs are treated as start-up costs ONLY IF they would be deductible if incurred in connection with the operation of an existing and active trade or business. In other words, they are also subject to the general ordinary and necessary rule of business expense deductibility.
- The law emphasizes on the investigatory nature of the costs. Therefore, for example, if taxpayer already entered a transaction to purchase an existing business, the costs incurred in transferring ownership will not be considered as start-up costs.
What Are Organizational Costs?
Organizational costs are amounts incurred to create a corporation or partnership. Examples include:
- Legal costs for drafting of the corporate bylaws, minutes, or stock subscription agreements
- Fees paid to the state of incorporation
Note that the law specifically excludes expenditures connected with issuing or selling shares of stock from the meaning of organizational costs.
When Are Start-Up and Organizational Costs Deductible?
A very important rule about start-up and organizational costs is that such costs are only deductible when the taxpayer starts to actively engage in the business activities. A corporation starts existing on the date it files the Articles of Incorporation, but it is not necessarily considered to have begun operating actively at the same time.
To decide whether an active trade or business has begun, we should examine factors such as whether the taxpayer has started to advertise its business activities to the general public, whether the business has started to generate sales and accept clients, and so on. The business must have begun to function as a going concern and performed those activities for which it was organized.
How Are Start-Up and Organizational Costs Treated on Tax Return?
A taxpayer may deduct up to $5,000 in start-up expenses and up to $5,000 in organizational expenses in the year the business begins. Any amount of such expenses that cannot be deducted must be capitalized and amortized over 180 months beginning with the month in which the active trade or business begins. If such expenses exceeds $50,000, the amount the taxpayer may deduct in the first year is reduced on a dollar-for-dollar basis by the total amount of such expense over $50,000.
For example, if the total amount of a taxpayer’s start-up cost equals $40,000, the taxpayer may deduct $5,000 in the first year and amortize the remaining $35,000 over 180 months after which the business activities begins. If, on the other hand, the start-up costs equals $55,000, the whole $55,000 should be amortized over 180 months because the first $5,000 deductions generally allowed is reduced dollar-for-dollar by $5,000 ($55,000 – $50,000) and becomes zero.
Taxpayers should deduct such costs, up to $5,000 by claiming it on a timely-filed tax return and amortize the remaining amount on Form 4562.
What If the Business is Disposed of before the Amortization Period?
If the business is completely disposed of before the amortization period ends, the remaining deferred costs may be deducted to the extent that they qualify as losses under Section 165.
