Business Startup Expenses

Investigating the potential for a new business and getting it started can be an expensive proposition. However, under the general rules for business deductions you couldn't deduct these expenses, because only expenses for an existing trade or business can be deducted. By definition, you incur your startup expenses prior to the time that your business is born.

Fortunately, there is a way around this dilemma. If your startup expenditures actually result in an up-and-running business, you can elect to amortize the costs (that is, deduct them in equal installments) over a period of at least 60 months, beginning with the month in which your business opens.

Save Money Effective for amounts paid or incurred after October 22, 2004, there is an alternative to the standard 60-month amortization of startup expenses. The American Jobs Creation Act of 2004 allows taxpayers an election to deduct up to $5,000 of start-up expenditures in the tax year in which their trade or business begins. The $5,000 amount must be reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000. The remainder of any start-up expenditures, those that are not deductible in the year in which the trade or business begins, must be ratably amortized over the 180-month period (15 years) beginning with the month in which the active trade or business begins. Similarly, partnerships and corporations may now elect to deduct up to $5,000 of their organizational expenditures for the tax year in which the partnership or corporation begins business. This provision will benefit smaller businesses that have around $5,000 of start-up or organizational expenditures. For larger start-ups, however, amortizing most or all of these expenses over 15 years rather than the five-year period currently provided is not an attractive option.

Amortizing startup expenses enables you to eventually deduct both the cost of investigating the creation of the business and the costs of actually creating it. However, only those costs that would be deductible if they were incurred by an existing trade or business are eligible for the election.

What costs qualify? Investigation expenses that can be deducted over the 60-month period include those relating both to business conditions generally, and those relating to a specific business, such as market or product research to determine the feasibility of starting a certain type of business. The costs of checking out the various factors involved in site selection would also be an amortizable investigation expense.

Amortizable costs of creating a business include advertising, wages and salaries, professional and consultant fees, and costs of travel before the business actually begins.

What costs don't qualify? Although they are frequently incurred before a new business goes into operation, the following costs don't qualify for 60-month amortization:

• incorporation costs
• partnership organization costs
• startup expenditures for interest, real estate taxes, and research and experimental costs that are otherwise allowed as deductions when incurred
• the costs attributable to the acquisition of a specific property that is subject to depreciation or cost recovery do not qualify for amortization — instead, the property should be depreciated under the appropriate rules

Save Money It's usually best to claim the 60-month amortization deduction as early as possible if there is any doubt about when your business began. If the IRS determines that your business began in a year before the election to amortize startup costs was made, the right to deduct these costs in the earlier year will be lost.

What if you change your mind? If you ultimately decide not to go into business, what happens to your costs? The portion of costs you paid to generally investigate the possibilities of going into business at all, or to purchase a non-specific existing business, are considered personal costs and are not deductible.

However, the total costs that you paid in your attempt to start or purchase a specific business would be considered a capital expense and you can claim it as a capital loss.

If you purchased any business assets along the way (for instance, some bagel-making machinery), you can claim a loss only if and when you sell or dispose of the property.

Claiming amortization expenses. Assuming your business was successfully launched and you want to amortize your startup costs, total up all the costs paid or incurred before your business opened and divide them by 60 months (or longer, if you desire). The result is the monthly deduction amount. Your amortization period will begin with the month in which your business opened.

Example If you opened on October 31, 2005, you could deduct costs for October, November and December of 2005 which would be equal to 3/60thsof your total startup costs.

For the first year, your amortization deduction would be shown on Part VI of Form 4562, Depreciation and Amortization, and then carried over to the appropriate tax form for your business. For sole proprietors, it would be carried over to your Schedule C as an "other" expense.

You'll need to attach a statement to your tax return itemizing the amortization costs, giving the date each cost was incurred, stating the month your business began operations, and specifying the number of months in your amortization period (not less than 60). The fact that you need to attach this statement precludes you from electronically filing your tax return this year.

In later years, if you are filing Form 4562 for some other reason (generally you must file this form in the first year you put a capital asset into service), you would continue to show your amortization costs on Part VI; if you don't need to file the 4562 in a particular year, simply list your amortization amount as an "other" expense on your Schedule C (or your partnership or corporate income tax form).