Starting a new business and wondering how and when tax deductions will occur? Most important to know is that most expenses incurred before a business begins cannot be deducted or amortized until the year the business becomes active.
Business Expense Basics
Section 162 of the Internal Revenue Code allows current deductions for so-called ordinary and necessary business expenses. Section 162 expenses are essentially garden-variety expenses incurred in operating an up-and-running business, such as employee wages, rent, utilities, advertising, etc. Such expenses can generally be deducted in the year when they are paid or incurred for a pre-existing business. However, Section 162-type expenses incurred by a start-up operation cannot be deducted so quickly.
Section 195 Start-Up Expense Basics
Start-up expenses, which fall under Section 195 of the Internal Revenue Code, are Section 162-type ordinary and necessary business expenses incurred before the active conduct of the business begins. Such expenses include those incurred in connection with:
- Investigating the creation or acquisition of a business;
- Creating a new business; or
- Any activity engaged in for profit before the day when the active conduct of business begins, in anticipation of such activity becoming an active business.
More specific examples include:
- An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
- Advertisements for the opening of the business.
- Salaries and wages for employees who are being trained and their instructors.
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
- Salaries and fees for executives and consultants, or for similar professional services.
The current version of Section 195 allows taxpayers to deduct and/or amortize business start-up expenditures: up to $5,000 of start-up expenses can be deducted in the year when active conduct of the business begins but not before that year. However, the $5,000 allowance is reduced dollar for dollar by the amount of cumulative start-up expenditures in excess of $50,000. Any start-up expenses that cannot be deducted in the year when the active conduct of business begins are capitalized and amortized over 180 months, starting with the month when the active conduct of business begins.
The key takeaway is that most expenses incurred before a business becomes active cannot be deducted or amortized until the year when the business does become active. In general, that means the year when the business begins earning revenue.
If the taxpayer files a return that mischaracterizes Section 195 start-up expenses as garden-variety Section 162 expenses and deducts them too soon, the taxpayer is using an impermissible tax accounting method for those expenses. Then, the taxpayer must make an accounting method change to correct the treatment of those expenses. That requires IRS permission and can be a difficult process. The same hassle applies if the taxpayer makes a wrong determination of the year when the active conduct of business begins and therefore deducts or amortizes Section 195 start-up expenses too soon.
As always, we are happy to help with questions or concerns about this issue. Please visit our website or contact us at 214.696.1922.