When you launch your business and incur expenses before your business is "open for business," then you have start-up costs. Start-up costs are not deductible until your business begins. Your business begins when it is first open for business - meaning it is ready to service customers.
First, make sure you actually have a business. Here are nine (9) factors to determine if you really own and operate a business:
1. You carry on the activity in a businesslike manner.
2. The time and effort you put into the activity indicates that you intend to make it profitable.
3. You depend on income from the activity for your livelihood.
4. Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business).
5. You change your methods of operation in an attempt to improve profitability.
6. You, or your advisors, have the knowledge needed to carry on the activity as a successful business.
7. You were successful in making a profit in similar activities in the past.
8. The activity makes a profit in some years, and how much profit it makes.
9. You can expect to make a future profit from the appreciation of the assets used in the activity.
It's also important to remember that when they begin, most new businesses lose money. In fact, the average business will lose money for the first three years. You will want to make sure you can take advantage of those losses by offsetting them against your other income. If that happens, you can roll the loss forward into the future until you start making money. This is referred to as a net operating loss.
What are start-up costs? Planning to get the most out of any new business venture begins with making sure you get the greatest possible tax advantages for your investigation costs, start-up expenses, and other organization costs. These include costs such as advertising, salaries and wages of employees-in-training, travel and other expenses of lining up customers, suppliers, and distributors, and fees paid for consultants and professional services.
How are start-up costs deducted? You may assume that all of these start-up expenses are deductible as business expenses in the year you pay them, but that is not the case. Such expenses are not considered to be business expenses because they are not incurred in a business that has actually started. Instead these start-up costs have special rules.
A taxpayer may elect to deduct up to $5,000 of start-up costs in the tax year that the business opens for business. The catch, however, is that the $5,000 amount must be reduced by the amount of start-up expenditures that exceed $50,000. If an election is made, start-up expenses that are not deductible in the year the business opens for business as a result of the phase-out must be ratably amortized over 180 months (15-years) beginning in the month that the business opened for business.
Who can deduct start-up costs? Another complication with start-up costs is that they are deductible or amortizable only by the person who incurs them. If your new business is going to be a sole proprietorship, that won't be a problem. However, if the venture is to be a corporation, you can't personally deduct the costs you incur before incorporation. Those costs are part of your investment in the corporation's stock, which is not a great tax position. This can be avoided through proper planning. For example, you may want to contribute the funds to the corporation and let the corporation incur the expenses so that it can deduct or amortize them.
Are any expenses excluded from start-up costs? It's also important to know that some expenses are treated more favorably than the regular start-up costs we have been talking about, and some less favorably. Start-up costs for interest, taxes, and research costs usually can be deducted in the year paid. The cost of tangible property purchased for use in the business can be recovered by way of accelerated depreciation deductions over various periods, depending upon the type of asset, but generally faster than if considered under the general start-up cost umbrella.
Expansion costs are not start-up costs. If you are expanding an existing business, rather than starting a new one, you may be able to deduct the expansion costs currently.
Important note about start-up costs An election must be made on the business tax return to properly claim start-up costs. Be sure to discuss this with your tax preparer.
Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative force behind Provision Wealth Strategists. In addition to his management responsibilities, Tom likes to coach clients on wealth, business, and tax strategies. Along with his frequent seminars on these strategies, Tom is an adjunct professor in the Masters of Tax program at Arizona State University. For more information, visit http://www.provisionwealth.com.