By Shahul Hameed Irfan ACMA, CPA, CGMA, B.Sc.(Hons)
The purpose of this blog article is to provide a general idea on start-up costs/ organizational costs and how to identify, calculate and recognize them for accounting and reporting purposes.
What are start-up costs?
Start-up costs can be defined as any expense incurred before the active business operations begin. The start of operations may be subjective from business to business. If you are in the business of consulting, it could be the point you distribute your visiting card. If you are into e-commerce, it could be the day your website went live. Etc. Start-up costs are also known as pre-opening expenses or preliminary expenses. Few examples of start-up costs would be the cost of market research before starting a business, Cost incurred to train staff on specific skills required for the business before operations start or the cost of any supplies purchased before the start of the business can also be included in start-up cost.
First Year Deduction
If your start-up efforts end in the creation of an active trade or business, then on your tax return for the year the business commences, the amount of expenses that you can be deducted is the lower of:
- Your actual expenses incurred
- $5,000 reduced by the amount by which the start-up expenses exceed $50,000
Start-up expenses are considered as capital expenses, because it is not related ONLY to the first year of operations but for longer term. This classification is important because we cannot take it as an one-off expense and deduct in the first year.
Amortization for 180 months
As described above you may deduct up to $5,000 in start-up costs in your first year in business. This deduction is restricted if you have over $50,000 in start-up costs. (The incremental value above $50,000 will be reduced from the allowable first year deduction of $5,000) If you have additional start-up costs over the $5,000, you can amortize these costs over 15 years. If you think that you will not be profitable for a while, then there is another option to not utilize the entire $5,000 allowance in first year but make the spread to be equal across all 15 years. There is also another option where you can wait till you sell the business to deduct the start-up costs as capital loss, but most businesses do not opt for this option as they would like to gain the tax reduction benefit as early as possible.
Qualifying expenses which can be capitalized as start-up expenses include market research costs, advertising and promotion of the new start up, wages or training expenses, professional fees such as consultancy or legal expenses. Cost of feasibility studies to acquire a running business can also be included in start-up expense. Generally, you can go back one year from the active operations launch to calculate the start-up costs.
There are 3 types of expenses which are not deductible as start-up expenses:
- Formation / Organizational expenses – All expenses directly linked to the formation of the business. (See below, ‘Organizational expenses’ / Formation expenses)
- Start-up expenditures for interest, real estate taxes, and research and experimental costs that are otherwise allowed as deductions do not qualify for amortization. These costs are deducted when incurred
- Purchase of any fixed assets – Building, Vehicle, and Machinery. These will be depreciated over useful economic life.
Organizational expenses/ Formation expenses
In-addition to start-up costs, business formation costs of up to $5,000 can be deducted in the first year and anything above $5,000 will be amortized similar to start-up costs. Formation costs or Organization costs are the expenses directly linked to forming a company. (S-Corp, C-Corp, LLC). Sole proprietorship and Partnerships are not included in this. Examples of Organizational / Formation expenses include State fees, Legal fees paid for formation, meeting expenses, feasibility study expenses etc.
Scenario 1: Start-up cost is more than $5,000 but less than $50,000
Let’s say you have identified $25,000 as start-up costs and $4,000 as Organizational expenses for your new entity in 2019. Here’s how the deduction might work:
- You can deduct the entire $4,000 as organizational expenses in your first year of filing tax return.
- You can also deduct $5,000 of your start-up costs on your 2019 business tax return.
The remaining $20,000 of the start-up costs must be amortized over the following 15 years, as required by the IRS.
Scenario 2: start-up cost is $50,000 – $55,000
Start-up costs – $52,000, Organizational cost – $8,000
- First year start-up cost would be = $5,000 – (52,000-50,000) = $3,000.
- Remaining $49,000 start-up costs will be amortized for 180 months.
First year organizational expenses would be $5,000. The remaining $3,000 would be amortized for 15 years.
Scenario 3 – Start-up cost is more than $55,000
Start-up costs – $60,000, Organizational cost – $8,000 First year start-up cost would be = $0. The total $60,000 start-up costs will be amortized for 180 months. First year organizational expenses would be $5,000. The remaining $3,000 would be amortized for 15 years. Further, the cost of new line of business, or a new branch opening can also have start-up costs which will follow the above rules in identification and reporting.