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—in most instances, on a dollar-for-dollar basis. 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.
- The IRS allows certain tax deductions in three specific categories—creating, launching, and setting up the business.
- Business owners in the startup phase are limited to a $5,000 deduction in the first year and only applies to startup costs that are $50,000 or less.
- The first-year deduction must be reported on your business tax form.
- You can't claim the startup costs if the business doesn't take off and you aren't able to start it.
Allowable Business Startup Deductions
Starting a new business can be a very exciting venture. Despite the fervor that accompanies a startup, there are certain costs associated with getting a new business running. You may be able to reduce the amount of tax you pay based on these expenses. The Internal Revenue Service (IRS) allows certain tax deductions in three specific categories of business startup costs:
- Creating the business. These are costs associated with investigating the creation of an active trade or business, including feasibility studies, 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.
There's one thing you must keep in mind. You can only write off these expenses if you actually opened up the business. This means that any costs incurred from businesses that didn't actually get off the ground don't qualify for a deduction.
How to Take Business Startup Deductions
Although you may be able to deduct certain startup costs associated with your business, there are certain limits that may apply. Business expenses incurred during the startup phase are limited to a $5,000 deduction in the first year. This limit only applies if your costs are $50,000 or less. So if your startup expenses exceed $50,000, your first-year deduction is reduced by the amount over $50,000. For example, if your startup expenses total $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. You may then amortize the remaining expenses and deduct them in equal installments over 15 years starting in the second year of operation.
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, 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. The deduction 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.
Make sure you consult with a qualified tax professional or tax advisor before you make any decisions about claiming your startup costs.
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. Unfortunately, these expenses 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 you may be able to claim as a capital loss.
The Bottom Line
Writing off business startup expenses is not nearly as straightforward as deducting business expenses. This is especially true once your business is underway. Although you may feel as though you know enough to navigate the intricacies of the process, it's always a good idea to consult with a tax advisor who specializes in small business taxation while your business is still in the startup phase. This person can help guide you and help you overcome any obstacles you may face when it actually comes to tax time so you get it right the first time.