There are several ways to deduct business expenses from your small business revenue to lower your tax bill. In some instances, business deductions can reduce your revenue 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 operating expenses. To understand how business startup deductions work, you need to know which expenses are deductible and how to take them at tax time.
- The IRS allows certain tax deductions for creating, launching and setting up a business.
- Internal Revenue Service. "Publication 535: Business Expenses." Accessed Oct. 2, 2020.
- 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 very exciting. 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, limits may apply. Business expenses incurred during the startup phase are capped at a $5,000 deduction in the first year. This limit 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 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 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 a schedule, 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 you spend money to research creating a business but then decide not to move forward, the expenses you incurred would be considered personal costs. Unfortunately, these expenses are not deductible. However, expenses incurred in your attempt to start a business could fall 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 might feel you know enough to navigate the process, it's always a good idea to consult with a tax advisor who specializes in small business taxation. This person can help you overcome any obstacles so you get it right at tax time.