Starting a new business venture can be exciting. Whether you are forming your first company or expanding into a new area, it is important to properly account for start-up and organizational costs. The rules concerning these costs are different for income tax purposes and for financial reporting under US GAAP.
For those companies reporting under US GAAP, Financial Accounting Standards Codification 720 states that start up/organization costs should be expensed as incurred. However, it is important to identify the costs as incurred because some particular costs may fall under other code sections and require specialized treatment.
The income tax treatment is different. Consult with your tax advisor to determine if you can take an immediate deduction or if the cost must be capitalized and amortized (spread out) over a period of years. Typically, it depends on the type of cost and the amount invested, but there are other IRS regulations that may apply.
The IRS defines start-up costs as amounts paid or incurred for creating an active trade or business, or to investigate the creation or acquisition of an active trade or business. Start-up 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. Start-up costs include:
- An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
- Advertisements for the opening of the business.
- Salaries and wages for employees who are being trained and their instructors.
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
- Salaries and fees for executives and consultants, or for similar professional services.
Start-up costs do not include deductible interest, taxes, or research and experimental costs. These costs are considered separately for tax purposes, as well as:
- Costs related to obtaining licenses and other qualifications to get into the business.
- Costs of buying business assets such as a building, equipment, or vehicles.
Organizational Costs for Partnerships or Corporations
Organizational costs are expenses related to forming a corporation, partnership, or limited liability company (not a sole proprietorship). These may include legal, management, consulting, accounting and filing fees.
The costs for issuing and marketing interests in a partnership or corporation such as brokerage, registration, and legal fees and printing costs do not qualify as organizational costs. The IRS considers these “syndication fees” which are capital expenses that cannot be depreciated or amortized. You also cannot claim a loss on syndication fees.
Deducting or Amortizing Start-up and Organization Costs
Start-up costs can be capitalized and amortized if they meet both of the following tests:
- You could deduct the costs if you paid or incurred them to operate an existing active trade or business (in the same field), and;
- You pay or incur the costs before the day your active trade or business begins.
In the first year you are in business, you can deduct Up to $5,000 in start-up costs provided you’ve spent $50,000 or less. This deduction must be made in the first year you are actively in business. The balance over $5,000 must be capitalized and amortized over the applicable number of years.
If you incurred more than $50,000 in start-up costs but less than $55,000,there is a phase out of the $5,000 deduction. For example, if you spent $52,000, your deduction would be $3,000 and $49,000 would have to be capitalized and amortized.
Should your startup costs be greater than $55,000, you do not qualify for an immediate $5,000 deduction, but you would capitalize those costs and take the amortization expense as a deduction each year.
Since the IRS separates startup costs and organizational costs, you can also take a deduction up to $5,000 for organizational expenses (up to $50,000). These costs must be incurred before the end of the first tax year your company is in business. The same IRS rules apply to organizational expenses between $50,000 and $55,000, as well as over $55,000.
If you do not expect to make a profit in the first year you are in business, you should consider amortizing the full amount of start-up and organizational costs over 15 years. This will allow you to minimize taxes in years where you make more money. For example, if your start-up costs are $30,000, you could deduct $2,000 per year for 15 years instead of taking the $5,000 deduction in year one.
There are many other IRS rules that need to be taken into consideration on the tax treatment of start-up and organizational costs. The professionals at LaPorte work on a substantial number of initial year returns annually where we analyze how start-up and organizational costs need to be treated for income tax purposes. For additional information, contact a member of the LaPorte Tax Services Group.