Are you thinking about starting a new business? If so, congratulations.
We know it can, and probably will, be an exciting ride. But like many other exciting rides starting or buying your own business can be fraught with dangers, not the least of which are potential tax pitfalls.
In one recent case, a decorated ex–Air Force pilot sought to start an aviation business. She hoped to offer aerial land surveys, photography, and flight charters, along with the provision of aviation safety consulting.
She traveled the country looking to buy an airplane, which she eventually did. Unfortunately, she never got past the preparatory stage and, without clients, gross receipts, or service contracts, the court ruled she was not entitled to deduct any of her expenses.
You can avoid this woman’s tragic consequences and write off all of your costs, including those “thinking about it” costs. But since this is tax law, you face some tricky rules that can prove costly, as they did for our pilot.
In this article, we explain the rules for starting a new business so you can understand them and earn all the tax benefits the tax code offers. And the tax benefits are more than you would think. In fact, they begin when you start spending money while you are thinking about this new business.
Bucket of Tax Deductions for Thinking about the New Business and More
In its business expenses publication, the IRS says that start-up costs include those incurred in creating an active trade or business.
Note the word “creating,” and keep that in mind while reading the next few paragraphs.(Remember, this article is about creating a new business versus buying a new business or expanding your current business.)
The tax code states that start-up expenses arise when you spend money to
- investigate the creation or acquisition of an active business,
- create an active business, or
- engage in a for-profit or production of income activity before the day on which the active business begins, in anticipation that such activity will become an active business.
As we discussed in Tax Benefits for Thinking about and/or Starting a New Business, the expenses can include:
- Travel expenses to gain knowledge from others already in the business
- Entertainment expenses to pick the brains of friends and business acquaintances
- A host of training costs
- Certain automobile expenses
- Long-distance, investigatory telephone calls
- And many more
To qualify as a start-up expense, the expense must be both
- a cost that you could deduct as a business expense if the business already existed, and
- a cost incurred before your business begins.
Here are additional expenses that can qualify as start-up expenses:
- Moneys paid for potential market, labor supply, transportation, or product surveys or analyses
- Advertising expenses incurred prior to opening
- Wages paid before opening to your new employees and their trainers
- Costs incurred to secure distributors, suppliers, and customers
- Fees paid to consultants and other professionals
Costs That Don’t Qualify as Start-Up but Provide Tax Benefits
Costs that don’t qualify as start-up include deductible interest, taxes, and research and development costs.
But not to worry: you generally deduct these expenses under other tax law provisions.
Tax Benefits Begin to Accrue Right Away
You have to wait until the new business begins to start realizing the tax benefits of your start-up expenses.
But you can start earning tax benefits as soon as you begin thinking about creating your new business. This is particularly helpful, since taxpayers usually start running up expenses long before opening their doors for business.
The tax law allows, and automatically deems, that you make an election to deduct up to $5,000 of start-up expenditures in the year in which your business becomes active.
The tax code reduces your immediate, up-to-$5,000 write-off dollar for dollar, for start-up expenses exceeding $50,000.
You don’t lose any excess. Any start-up expenses you can’t deduct up front, such as the $5,000, you amortize on a straight-line basis over 180 months beginning with the month the business begins.
Say you, a calendar-year taxpayer, spend $5,000 on start-up expenses related to a business that is up and running on May 1, 2017. You deduct the $5,000 in 2017.
The facts are the same, but instead of spending $5,000 on start-up expenses, your total outlay amounts to $41,000. In 2017, you deduct $5,000 plus the portion of the remaining $36,000 allocable to May–December, or $1,600 ($36,000/180 x 8).
Same facts, but this time your total expenses are $54,500. Because your start-up expenses exceed$50,000, your 2017 deduction equals $500 ($5,000 – $4,500) plus that portion of the remaining $54,000 allocable to May–December, or $2,400 ($54,000/180 x 8).
Wait—If It’s a Corporation, It Gets Even Better
If you decide to form your new business as a corporation, the tax code allows you to elect to amortize even more expenses in the form of “organizational costs.”
The same principles apply as with start-up costs: current deduction of up to $5,000, reduced (but not below zero) by organizational expenditures that exceed $50,000, and
the remainder of such organizational expenditures deducted evenly over the 180-month period beginning with the month in which the corporation begins business.
Qualifying organizational costs are generally those paid to create the corporation. To qualify, the cost must be
- for the creation of the corporation;
- chargeable to a capital account;
- amortized over the fixed life of the corporation, if any; and
- incurred before the end of the first year of business.
Common examples include the following:
- Legal and accounting services
- State incorporation fees
- Temporary director expenses
- Costs of organizational meetings
Finally, you can also amortize organizational costs in the same manner, and to the same degree, if you form your new business as a partnership.
The requirements are similar, with the cost qualifying only if it is
- for the creation of the partnership;
- chargeable to a capital account;
- amortizable over any fixed life of the partnership; and
- incurred by the due date of the partnership’s first tax return.
What Does All This Mean for Me?
If your attempt to go into business is successful and you end up opening your doors, you’re in good shape. You’ll be able to take advantage of the benefits discussed above. As always, it’s a good idea to keep detailed and accurate records to substantiate your start-up and organizational costs in case the IRS decides to challenge you.
Problems can arise with writing off your start-up expenses if your start-up does reach the stage of an active business. You saw what happened to the pilot. And there’s no clear explanation of what constitutes an active business. You win active business status based on facts and circumstance.
You obviously reach active business status when you operate as a going concern, with attributes such as performing your professional activities (e.g., a dentist seeing patients or a salesperson making sales calls), having your office space and equipment in place, and whatever else makes the business go.
If the business fails after you start, you write off any unamortized start-up costs at that time.
With the corporate structure, you likely can qualify for an ordinary loss deduction on your small-business stock.
The moment you start thinking about starting your own business, you begin to accrue tax benefits know as start-up expenses. Make sure you document those start-up expenses, which are, by definition,
- expenses that would be deductible if the business existed, and
- expenses that you paid before the business started.
And then, don’t be like our pilot who failed to start the business. You need to start and make the business an active business for the start-up expenses to produce benefits. Your business can fail after it starts, and then you can realize the unamortized deductions, but you have to start first.