How to Deduct Sec. 195 Start-Up Costs

Launching a new business involves expenses incurred long before the first dollar of revenue is earned. These initial outlays, from market research to staff training, are categorized for tax purposes as start-up costs. Section 195 of the Internal Revenue Code provides the rules for how entrepreneurs can recover these pre-opening expenditures. This allows for a portion of the costs to be deducted immediately, with the remainder deducted over time.

Identifying Qualifying Start-Up Expenditures

Start-up expenditures under Section 195 are costs that would be deductible as ordinary and necessary business expenses if they were paid or incurred by an existing active trade or business. These costs must relate to investigating the creation or acquisition of a business, or creating an active trade or business. This creates two primary categories of expenses to track before the official start date.

The first category is investigatory costs, which are incurred while exploring the feasibility of a business concept. Examples include:

• Costs for market analysis or surveys of potential product demand
• Labor supply studies
• Visiting potential business locations
• Travel for securing prospective distributors, suppliers, or customers

The second category consists of pre-opening costs. These are expenses paid or incurred after the decision to establish the business has been made but before it begins to operate. Common examples include wages paid to employees during their training period, advertising to announce the business’s launch, and fees for consultants or professional services.

Start-up costs must be distinguished from other expenses treated differently under the tax code. Section 195 excludes interest, taxes, and research and experimental expenditures, which are covered by Section 174. Organizational costs, such as legal fees for drafting corporate documents or state filing fees, are also not start-up costs and are addressed by Section 248.

Calculating the Deduction and Amortization

The calculation for deducting start-up costs begins in the tax year the business commences operations. A taxpayer can elect to immediately deduct up to $5,000 of their total start-up expenditures, providing an immediate tax benefit.

This $5,000 deduction is subject to a phase-out limitation. The deduction is reduced on a dollar-for-dollar basis for businesses whose total start-up costs exceed $50,000. For example, if a new venture incurs $52,000 in start-up costs, the immediate deduction is reduced by $2,000, resulting in a first-year deduction of $3,000. If total costs reach $55,000, the immediate deduction is eliminated.

Any start-up costs not deducted in the first year must be capitalized and amortized. The remaining balance is deducted in equal amounts over a 180-month period (15 years). The amortization period begins in the month that the active trade or business starts.

To illustrate, a business with $40,000 in qualifying start-up costs can deduct $5,000 immediately. The remaining $35,000 is then amortized over 180 months. This results in a monthly deduction of approximately $194.44, which is claimed for each month the business is active during that first year and for subsequent years until the full amount is recovered.

Making the Section 195 Election

The election to deduct and amortize start-up costs is made on a timely filed federal income tax return for the tax year in which the business begins its operations. A taxpayer is generally deemed to have made the election unless they affirmatively choose to capitalize the costs instead.

The election does not require a specific IRS form. Instead, it is made by attaching a statement to the tax return that provides:

• A detailed description of the trade or business
• The total amount of start-up expenditures incurred
• The month the business officially began
• An explicit declaration that the taxpayer is electing to apply the provisions of Section 195

If a taxpayer does not make a timely election, all start-up costs must be capitalized. This means the costs cannot be deducted or amortized and can only be recovered when the business is sold or otherwise disposed of, significantly delaying any tax benefit. The election is irrevocable once made.

Treatment of Unrecovered Costs

The 180-month amortization period is lengthy, and business circumstances can change. If a business is sold, shut down, or otherwise disposed of before the end of the 15-year amortization schedule, any unamortized start-up expenditures can be deducted in full in the final year of the business. This deduction is treated as a business loss.

A different scenario arises if an entrepreneur abandons the venture before it becomes an active business. The tax treatment of investigatory costs depends on how far the process went. Expenses from a general search for a business are considered personal and cannot be deducted. However, if the costs are related to the attempted creation or acquisition of a specific business, they can be deducted as a capital loss in the year the venture is abandoned.