How to Deduct and Capitalize Your Startup Expenses

The Internal Revenue Service (IRS) has specific guidance for the tax treatment of costs incurred before a business officially launches. These pre-opening expenditures are not treated the same as regular operating expenses, and specific rules govern how and when they can be deducted. Understanding the regulations for startup and organizational costs helps prevent complications with the IRS.

Identifying Qualifying Costs

To properly account for initial expenditures, a business must distinguish between two primary categories of pre-launch costs: startup costs and organizational costs. Each category has a specific definition and set of rules that determine its tax treatment.

Startup expenses, defined under Internal Revenue Code (IRC) Section 195, are costs for investigating the creation or acquisition of an active business. These are expenses related to exploring a business concept’s feasibility before it becomes a functional enterprise and would be deductible if incurred by an already operating business.

Common startup costs include:

• Analyses of potential markets, products, or labor supplies
• Fees paid to consultants for their expertise during the planning phase
• Wages paid to employees for training before the business opens
• Travel expenses for securing prospective distributors, suppliers, or customers
• Advertising costs related to the opening of the business

Organizational expenditures are governed by IRC Section 248 for corporations and Section 709 for partnerships. These are costs directly tied to the legal formation of the business entity, such as creating the legal structure that will house the business.

These costs include payments for legal services to draft documents like the corporate charter or a partnership’s operating agreement. State filing fees to register the business and necessary accounting fees for setting up the entity are also qualifying organizational costs.

What Costs Do Not Qualify

Certain expenditures do not qualify as startup or organizational costs because they have their own distinct tax treatment. Including them with startup or organizational costs can lead to incorrect deductions and potential tax issues.

The following costs must be handled separately:

• Interest expenses on loans used to finance the startup
• Deductible taxes, such as state and local taxes paid during the startup phase
• Research and experimental costs, which must be capitalized and amortized over 5 years for domestic research or 15 years for foreign research
• Costs associated with the issuance or sale of stock or partnership interests, such as commissions or printing costs

The Deduction and Amortization Rules

After identifying and totaling qualifying costs, a business can deduct them using a combination of an immediate, limited deduction and a long-term amortization schedule. This process allows a business to recover these costs over time, providing an initial tax benefit in the first year of operation.

A business can deduct up to $5,000 in startup costs and a separate $5,000 in organizational costs. This deduction is available for the tax year in which the business begins its active trade. A new venture could potentially deduct up to $10,000 in its first year if it incurred sufficient costs in both categories.

This upfront deduction is subject to a phase-out. The $5,000 first-year deduction for startup costs is reduced dollar-for-dollar by the amount that total startup costs exceed $50,000. The same rule applies independently to organizational costs. If total startup costs reach $55,000, the first-year deduction for those costs is eliminated.

Any costs not deducted in the first year must be capitalized and amortized. Amortization is the process of deducting costs in equal increments over a set period. For both startup and organizational costs, the amortization period is 180 months (15 years), beginning in the month that the active business commences.

For example, a business with $53,000 in startup costs must reduce its initial $5,000 deduction by $3,000 (the amount over $50,000). This leaves a first-year deduction of $2,000. The remaining $51,000 ($53,000 – $2,000) is amortized over 180 months, resulting in a monthly deduction of $283.33.

Making the Proper Tax Election

The ability to deduct and amortize these costs is not automatic. A business must make a formal election to apply this tax treatment, otherwise the benefit is significantly delayed, impacting cash flow in its early years.

Failing to make a timely election requires all startup and organizational costs to be permanently capitalized. These expenses cannot be deducted annually and can only be recovered upon the sale or dissolution of the business.

The election is made by claiming the deduction on a timely filed federal income tax return for the first year the business is in active operation, including any valid extensions. A separate formal statement is not required; simply claiming the deduction on the return is sufficient.

A business must maintain records that support the deduction. This documentation should include:

• A clear description of each cost
• The date the cost was incurred
• The total amount of the costs
• The month the business officially began

The annual amortized amount is calculated and reported on Part VI of IRS Form 4562, Depreciation and Amortization. This form is filed along with the main business tax return, such as a Schedule C for a sole proprietorship or the appropriate corporate or partnership return.

Determining When Business Begins

The date a business officially begins is the dividing line for expense treatment. Costs incurred before this date are subject to the startup and organizational cost rules. Costs incurred on or after this date are treated as regular operating expenses that can be deducted in the current year.

According to the IRS, a business begins when it starts to function as a going concern and performs the activities for which it was organized. This is the point at which the business is ready to engage in its primary revenue-generating activities, not necessarily the date the legal entity was formed.

A retail store begins business when it opens its doors to the public. Preliminary activities like signing a lease, purchasing inventory, or hiring staff are considered startup activities. A service-based business, such as a consulting firm, begins when it has secured its first client and is ready to provide services.

All investigatory and setup activities, such as market analysis or drafting legal documents, fall into the pre-opening cost categories. Once the business is operational, subsequent expenses like rent, utilities, and payroll are treated as ordinary business expenses. These are deductible in the year they are incurred under the business’s chosen accounting method.