As many different startups as there are in the world, they all share one thing in common: they all require financial investment to get their ideas off the ground. Can I deduct business startup expenses, you might be wondering – and we have the answers for you right here.
The IRS allows for up to $5,000 in deductibles for startup expenses and a further $5,000 in organizational expenses that can also be deducted in a business’ first year of operation. However, as with the IRS, there are many complicated and complex processes to follow in order to benefit from those tax breaks.
Determine Your Startup Expenses
There are three categories of startup expenses that are eligible for tax deductions. Every startup needs to strictly follow these in order to not miss out on the benefits.
These three scenarios are:
- When creating a trade or business (or investigating the creation or purchasing of an active trade or business). These startup expenses are mostly for market surveys, analysis of products, labour, and scouting of potential business locations.
- When preparing to open the business. Simply, these are the preliminary costs you would collect before opening the doors of your business for operation. These expenses usually include equipment, training and education (limited to the specific industry and business you are to operate, but it doesn’t include education for courses such as studying for a real estate license or graphic design studies, etc), travel expenses incurred to scout and research securing suppliers and distributors, for advertising your business’ opening, and for professional services such as lawyers and accountants and bookkeepers.
- When establishing the organization. These are for expenses for the organization of your startup into a LLC (Limited Liability Company), or Organization, Partnership, etc, with legal fees, your state organization fees, other legal costs for structuring your business, salaries, and for accounting and bookkeeping fees.
We all know that most startups don’t turn a profit in their first few years. For this, the IRS allows for startups to repay the tax deductions of these startup expenses over a period of years to enable businesses to take advantage of the tax breaks to better succeed in business.
After all, the more successful your startup is, the more taxes the IRS can collect from you. This amortization of startup expense deductions means that you can take the same deductions each year for up to 15 years until the expense is recovered.
To benefit, you will need to complete the IRS Form 4562 along with your business’ first-year tax returns and submit to your local IRS office. As mentioned, these startup expenses and organizational expenses can be amortized over a 15-year period and over different time periods too, but once you have begun the process you cannot change the time periods. If you’re thinking this is a tricky process, you’re right.
We recommend you seek the expert advice of a tax specialist to help you to setup the best plan and structure to suit your business plan.
Track and Record Your Startup Expenses
The best way to prepare for these tax deductions is to prepare a startup expenses worksheet along with your business plan. This worksheet will help you to determine what your startup expenses would likely amount to as well as the likely tax deductions you could score.
Startup planning is crucial to the success of your business venture: startups need financial statements to plot their progress and development. In your preliminary research, it is best to rather overestimate the startup expenses and organization expenses and underestimate the likely income of your startup to give you an outline of your future.
You can create this startup expenses worksheet yourself in Microsoft Excel or you accounting software package of your choice. List all your startup expenses and organize them under Facilities; Equipment; Supplies; Advertising; Miscellaneous; Labour; and other categories relevant to your startup’s industry.
With those expenses totalled up, you can then get a handle on your likely startup expenses you will experience. Of course, save all those receipts so you can recover the bulk of those expenses through your business’ first-year tax breaks.
Timing is Important to Your Startup for Deducting Startup Expenses
It is important to determine when your business will start for tax purposes. This means that you need to set your business’ start date as close to a full tax year period and as close to your prelimary expenses so that you can deduct the most from your startup’s expenses as possible.
For instance, when you investigate the feasibility of a new startup, you can go back as far as one year to recover those research and preliminary expenses.
It is important to note that a startup’s business owner can only claim its startup expenses in the first-year of its operation.
Are Capital Expenses Deductible?
Your financial investment can be considered as “Capital Expenses” by the IRS because those startup expenses are used for a long time by the business – and they are deductible.
Apart from capital expenses, a startup’s expenses can also be defined as “Intangible Assets” – and both of these can be spread out for repayment over a period of 15 years, as we have already mentioned.
What many startups aren’t aware of in the beginning stages of their entrepreneurship is that startup costs won’t be fully recovered into the pockets of business owners until they actually sell their business or close the business.
What Exactly are Capital Expenses?
Capital Expenses are assets bought by the startup to either create products or to provide services. The next step is that these items – capital expenses – provide value to the startup and they are then considered capital assets.
Capital Assets include equipment, cash, inventory, vehicles, trademarks, patents, copyrights, real estate. You’ve likely come across the phrase “to capitalize” – and that is when a business spends money on capital assets rather than on expenses (which are on-going costs such as rent, website hosting, etc).
When a business owner buys machinery, tooling, equipment that improves the productivity of their business, these are recognized as capital expenses. On paper, the business’ value grows but in reality that extra financial outlay increases the business’ liabilities and debts.
How are Startup’s Capital Expenses Deducted?
Assets lose their value over time and the process of reducing their value is called depreciation. Depreciation is considered an expense for startups – but, because this is the IRS, they like to make everything complicated and complex, these expenses are considered a non-cash expense because they don’t have to be paid for with cash.
In fact, only land increases in value while the rest of capital assets depreciate.
Through a clever system of accounting, the IRS encourages a startup’s growth. Using the business’ capital assets, they can help business owners offset those expenses through what they call “Accelerated Depreciation Benefits”.
Simply put, what this does is it enables a business to actually take on more credit and expenses through two deductions. The first deduction that can be employed is the “Section 179 Deductions” in which a business is allowed to deduct up to $1 million in expenses for certain assets that are put into production for that business.
The second form of deductions is a bonus, in that it enables a business owner to claim for additional deductions due to the real estate bought for the business in the first year.
What’s more, the maintenance of assets is considered operating costs and are therefore not eligible for deductions. However, repairing and improving assets (for instance, to improve production) is considered a capital expense and is eligible for deductions.
When a business owner sells either the business or one of its capital assets, the taxable amount that is due to the IRS is calculated differently. If a capital asset is sold at a profit or loss, and whether that capital asset’s original value has either increased or decreased, determines the taxable value.