As a small business, there are many deductions you can take to maximize the amount of money you get to keep. One of the most important, yet least understood, involves startup costs: The IRS lets you deduct up to $10,000 if it meets certain criteria.
Part of what can make this deduction confusing and easy to miss are the arcane instructions surrounding it. Let’s take a moment to explain the opportunity in detail so that, if you qualify, you can properly take advantage of it this year.
Available for new and acquired businesses
Business owners are used to deducting expenses as we incur them and depreciating capital costs for property or equipment over time.
For new businesses, most costs are supposed to be amortized and deducted over 180 months, with one important exception: The IRS allows a deduction of up to $5,000 for each of two categories in the business’s first tax year.
The first deduction-eligible category covers expenses that help you get your business launched.
Examples include:
- Analyzing markets, products, or labor supply
- Advertisements for the opening of the business
- Salaries and wages for employees or instructors involved in training
- Travel costs to secure suppliers, distributors, or customers
This deduction doesn’t just apply to starting a new business from the ground up. Costs you incur reviewing and analyzing an existing business for acquisition can also be deducted this way. The IRS, however, distinguishes between researching a business category versus a specific business; the former isn’t deductible.
There are some important exclusions to this list. For example, you can’t deduct interest, taxes, or research costs that are deductible under another category. And, as mentioned, any property or equipment purchases must be depreciated. But note that the IRS offers a separate accelerated deduction for equipment costs, known as Section 179. (Learn more about it here.)
The second category of deductible costs includes organizational expenses.
For example, if you set up your business as a partnership or corporation before the end of your first year in business, you may be able to deduct up to $5,000 in legal, filing, and accounting fees for setting up a partnership agreement. Other relevant expenses might include other legal fees, state organizational fees, and travel expenses for organizational meetings.
How to calculate startup cost deductions
Between these two categories, the IRS allows you to deduct up to $10,000-but only if the total of all these costs is $50,000 or less. If your total costs for either category are greater than $50,000, the amount of your allowable deduction will be reduced by the difference.
For instance, if your startup costs are $52,000, you would lose $2,000 of your initial deduction and only be allowed to deduct $3,000 in your first year. And if your startup costs are more than $55,000, you’ll be disqualified from the first-year deduction and will need to amortize the entire $55,000 over 15 years.
Once you’ve calculated your first-year deductions, any remaining expenses should be amortized annually in equal amounts over the next 15 years. If you close or sell your business before the end of the amortization period, you can still deduct the outstanding amounts.
If you miss out on these deductions, you can file an amended return within six months of the due date of your return, minus extensions.
When less is more
While these deductions can be helpful, note that taking the maximum deduction in the first year isn’t the most sensible path for all filers-and it’s possible to spread your deductions over a few years if you decided to do so from the start.
Many independent contractors and small businesses experience losses their first few years in business. Best tax practice is to take bigger deductions in the years you have the most income (or profits) so as to minimize the taxes you owe. If you operate a business making little or no profit, you’ll probably want to skip the first-year windfall and spread the deduction over more years to better offset later profits. If you’re in this category, you’ll want to file IRS Form 4562 with your first year’s tax return.
Form 4562 allows you to amortize qualified startup and organizational costs separately over a longer period, and it doesn’t have to be on the same amortization schedule as other new business costs. But keep in mind that once you choose the periods for each deduction, the IRS will not allow them to be changed.
Even with a strong awareness of the opportunities for startup and organization tax deductions, there are many complexities, exceptions, and rules involved. Consult a tax professional who can help you maximize your tax savings and avoid IRS difficulties later.