The Unique Tax Rules to be Followed by Startup Entities

Taxation for startups and their related startup costs is different from expenses incurred by companies that are up and running and generating revenue.  Certain tax limitations and rules apply for startups that are unique to that sector and are significantly different than the rules followed by regular operating businesses.

A startup business can deduct up to $5,000 of business startup costs. The $5,000 deduction is reduced dollar for dollar (but not below zero) by the cumulative amount of startup costs exceeding $50,000. The remaining startup costs can be deducted ratably over a 15-year period beginning with the month in which the active trade or business begins. Active conduct of a trade or business generally occurs when the corporation has begun the conduct of operations for which it was organized (i.e., is in a position to begin generating revenue).

Startup costs are costs paid or incurred in connection with investigating the creation or acquisition of an active trade or business or creating an active trade or business. Startup costs include amounts paid or incurred in connection with an existing activity engaged in for profit, and for the production of income in anticipation of the activity becoming an active trade or business. To be a startup cost, the expenditure must have otherwise been deductible as an ordinary and necessary business expense. Expenditures that would have otherwise been capitalized, such as the costs associated with the construction of a capital asset, are not startup costs.

Expenses of investigating the creation or acquisition of a trade or business are known as investigatory expenses. They are the costs incurred in searching for and analyzing prospective businesses prior to making a final decision whether to acquire an existing business, create a new business, or forgo a business transaction altogether. These costs may relate to a category of businesses or to a particular business. They may be treated as deductible/amortizable startup costs only if they would be currently deductible by an existing trade or business in the same field. Deductible investigatory expenses include costs incurred for the analysis or survey of potential markets, products, labor supply, and transportation facilities.

Expenses of creating an active business are costs incurred after the investigatory process has determined that a particular business should be acquired or established but before the business actually begins operations. Examples include:

  • Advertising costs;
  • Salaries and wages paid to trainee employees and their instructors;
  • Travel and other expenses incurred in lining up prospective distributors, suppliers, or customers; and
  • Salaries or fees paid or incurred for executives, consultants, and professional services.

Other startup expenses might include:

  • Business investigation expenses such as surveys, market studies, and consultants’ fees;
  • Preopening advertising and promotional efforts;
  • Travel and entertainment (for efforts to find a location, to secure suppliers or customers, etc.);
  • Salaries, employee benefits, insurance, and overhead;
  • Preopening repair and maintenance of capital assets to be used in the business;
  • Mortgage standby commitment fees to ensure financing for the new venture;
  • Accounting and legal fees that are not organizational costs;
  • Employee training;
  • Rent and utilities for space maintained in the preopening phase; and
  • Costs of expanding an existing business or beginning a new business if a new entity is used.

Excluding Items Not Considered Startup Costs

Interest, taxes, and research and experimental expenditures specifically are excluded from the definition of startup costs.

The IRS allows research and experimental expenditures to be amortized only if incurred in connection with a trade or business. Many entrepreneurs incur such expenses before they actually form a business and can never amortize the expenses. Incorporating and starting the business before making the expenditures supports a trade or business connection and shows that business activities have commenced.

Deemed Election

A taxpayer is not required to make a separate election statement to deduct startup costs. Such an election is deemed to be automatically made for the tax year in which the taxpayer begins an active trade or business. The taxpayer can forgo the deemed election by clearly electing to capitalize its startup expenditures on a timely filed return for the year the taxpayer begins business in accordance with instructions provided with the tax return.

Failure of Business

Investigatory and other preopening expenses will be fully deductible by a corporation as a business loss (rather than subject to these amortization provisions) if the business venture or for-profit transaction proves to be unsuccessful and the corporation abandons the search or investigation. Unamortized startup costs are deductible as a business loss in the year the related trade or business is terminated.

The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.