Startup costs and taxes: What to know before filing

If you’re among the thousands of budding entrepreneurs who launch a business in the U.S. each month, you might not be familiar with the tax requirements that await – or that many of the expenses incurred by start-ups can’t currently be deducted on your return. The way you handle some of your initial expenses can make a large difference in your federal tax bill.

How to treat expenses for tax purposes

If you’re starting or plan to launch a new business, here are three rules to keep in mind:

Start-up costs include those incurred or paid while creating an active trade or business or investigating the creation or acquisition of one.
Under the tax code, taxpayers can elect to deduct up to $5,000 of business start-up costs and $5,000 of organizational costs in the year the business begins. And the $5,000 deduction is reduced dollar-for-dollar by the amount your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
No deductions, including amortization deductions, are allowed until the year when “active conduct” of your new business begins. Generally, this means the year when the business has all the necessary components in place to start generating revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity with the intention of earning a profit? Was the taxpayer regularly and actively involved? And did the activity begin?

Expenses that qualify

In general, start-up expenses are those you incur to:

Investigate the creation or acquisition of a business
Create a business
Engage in a for-profit activity in anticipation of that activity becoming an active business

To qualify for the limited deduction, an expense must also be one that would be deductible if incurred after the business began. One example is money you spend analyzing potential markets for a new product or service.

To be eligible as an “organization expense,” an expense must be related to establishing a corporation or partnership. Some examples of these expenses are legal and accounting fees for services related to organizing a new business, and filing fees paid to the state of incorporation.

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