Deducting
Start-Up Expenses:
An Open or Shut Case
Starting
a business typically takes more than a little know-how. More often than not, it
requires cold, hard cash. However, there is some good news — you may qualify
for a little help from Uncle Sam in the form of a tax deduction for some of your
start-up costs.
The costs, which include amounts you pay to investigate the possibility
of creating or purchasing a business and also expenditures you incur to get the
business started, are called "capital expenses." Although you
generally cannot directly deduct capital expenses, you may elect to recover your
investment in a business by depreciating or amortizing your costs over a number
of years. The rules for deducting start-up expenses hinge on whether or not you
actually open for business.
When You Open the Doors for
Business
What are some legitimate start-up expenses? The Internal Revenue Service cites surveys of potential markets; analyses of available facilities, labor, and supplies; travel and other necessary costs for securing distributors, supplies or customers; advertisements for the opening of the business; salaries and wages for employees who are being trained; and fees for consultants and professional services.
Under tax law, you may elect to amortize these start-up costs ratably
over a period of 60 months, commencing with the month in which the business
begins, if they meet the following tests: (1) they are costs that would be
deductible if they were paid or incurred in connection with the expenses of an
existing business in the same field; and (2) they are paid or incurred before
you actually begin business operations.
Consider the
following example. Anna decides to open a catering business. Her start-up
expenses for establishing the business include travel, advertising, repairs,
office supplies, and professional services — a total of $12,000. Anna gets her
first catering job in July. All of her pre-July expenses are capital
expenditures and, if an election is made, are deductible over 60 months at the
rate of $200 per month ($12,000 divided by 60 months). That means, during the
first year of business, Anna may deduct $1,200 for the first six months the
business is opened (July through December). In the following year, Anna’s
first full year of operation, she may deduct $2,400.
Under tax rules governing start-up expenses, you must make an election to amortize expenses by the due date of the return (including extensions) for the year in which active business begins. To qualify, you must include a description of the expenses, the amounts, the dates they were incurred, the month in which the business began, and the number of months in the amortization period. Sole proprietors, partners, and LLC members claim these deductions on IRS Form 4562, Depreciation and Amortization.
If you sell or otherwise dispose of your business before the end of the
amortization period you have selected, any start-up costs for the business that
you have not yet deducted may be deducted to the extent that they qualify as a
business loss.
When Your Business Idea
Doesn't Work Out
What happens if, after incurring start-up expenses, you decide not to open a business? If your attempt to go into business is not successful, you must divide your start-up costs into two categories. If you are not operating in corporate form, costs incurred for a general search or preliminary investigation prior to making a decision to acquire or to begin a specific business become personal expenses and are not deductible. An example of a preliminary investigation expense might be an analysis of potential markets and the area's labor supply.
Start-up expenses you incur after you've made a decision to acquire or to
establish a specific business — and prior to its actual operation — may be
deducted as a business loss in the year in which your attempt to go into
business fails.