There are several ways to deduct business expenses from your small business revenue to reduce your tax bill. Certain business deductions can reduce your revenue dollar for dollar in most instances. You can also deduct certain expenses incurred during the startup phase of your business, but the rules are not as straightforward as those for deducting business expenses while operating your business. To understand how business startup deductions work, you need to know which expenses are deductible and how they may be deducted on your tax forms.
Allowable Business Startup Deductions
The Internal Revenue Service (IRS) allows certain tax deductions in three specific categories of business startup costs:
- Creating the business, or the cost of investigating the creation of an active trade or business, including feasibility studies, the cost of market and product analysis, surveying the competition, examining the labor supply, travel for site selection and other costs involved in creating a new business.
- Launching the business, or any costs associated with getting your business operational, including recruiting, hiring and training employees, expenses related to securing suppliers, advertising, and professional fees. The costs for equipment purchases are not included, as they are depreciated under normal business deduction rules.
- Business organization costs or the costs of setting up your business as a legal entity, such as a corporation, limited liability company (LLC) or a partnership can be included. These costs would include state and legal fees, director fees, accounting fees, and expenses for conducting any organizational meetings.
How to Take Business Startup Deductions
Business expenses incurred during the startup phase are limited to a $5,000 deduction in the first year. If your startup expenses exceed $50,000, your first-year deduction will be reduced by the amount over $50,000. For example, if your startup expenses totaled $53,000, your first-year deduction will be reduced by $3,000 to $2,000. If your expenses exceed $55,000, you would lose the deduction entirely. Starting in the second year of operation, you could then amortize the remaining expenses and deduct them in equal installments over 15 years.
Claiming the Deduction on Your Tax Forms
If you choose to take the first-year deduction, it needs to be reported on your business tax form. That would be Schedule C for a sole proprietor, or K-1 for a partnership or S corporation, or Form 1120 of a corporate tax return. In subsequent years, the amortized deduction is claimed on IRS Form 4562, Depreciation and Amortization. It is then carried over to your Schedule C under other expenses if you are a sole proprietor, or to your partnership or corporate income tax form. You can continue to claim it under other expenses throughout the amortization period.
When Should You Claim the Deduction?
The business startup deduction can be claimed in the tax year that the business became active. However, if you anticipate showing a loss for the first few years, consider amortizing the deductions to offset profits in later years. This would require filing IRS Form 4562 in your first year of business. You can choose from different amortization schedules, but once you have selected it, you can't change it. Consult with your tax advisor before making this decision.
What If You Don't Start the Business?
If, after spending your money to create a business, you decide against it, the expenses you incurred for investigating it would be considered personal costs, which are not deductible. However, all of the expenses incurred in your attempt to start a business could come under the category of capital expenses, which could be claimed as a capital loss.
Writing off business startup expenses is not nearly as straightforward as deducting business expenses once your business is underway. Consult with a tax advisor who specializes in small business taxation while your business is still in the startup phase.