How to Handle Organization Costs Amortization

When forming a new business, entrepreneurs incur a variety of expenses before the company officially opens its doors. These initial expenditures, known as organizational costs, are the investments required to legally establish a corporation or a partnership. The Internal Revenue Service (IRS) provides specific guidance on how businesses can recover these costs. Instead of a one-time expense deduction, these costs are deducted over several years through a method called amortization.

Identifying Qualifying Organizational Costs

To properly handle the amortization of formation expenses, a business must first distinguish which costs qualify under IRS regulations. Qualifying organizational costs are those directly tied to the creation of the corporate or partnership entity. These include expenses such as legal fees for drafting the corporate charter, bylaws, or partnership agreement, accounting fees for setting up the initial books, and state filing fees for incorporation. The costs of temporary directors and expenses for initial organizational meetings also fall into this category.

Differentiating these organizational costs from other types of pre-opening expenses is necessary. For instance, the costs associated with issuing or selling shares of stock or other securities, such as commissions, professional fees, and printing costs, do not qualify as organizational costs. Expenses related to the transfer of assets to the newly formed business are not considered organizational expenditures, as these types of costs have their own distinct tax treatment.

A point of confusion is the distinction between organizational costs and start-up costs. While both are incurred before a business begins active operations, they are defined differently under the tax code. Organizational costs pertain strictly to the legal act of forming the entity. In contrast, start-up costs relate to investigating the potential of creating or acquiring a business and the expenses incurred to get it ready for its opening day, such as employee training, marketing analysis, and securing suppliers.

For example, the fee paid to a state to file articles of incorporation is an organizational cost. The expense of analyzing a potential market for a new product before the business is formed would be a start-up cost. Understanding this distinction is important because while the calculation for the deduction is similar, the underlying costs being analyzed are separate.

Calculating the Amortization Deduction

Once the qualifying organizational costs have been identified, the next step is to calculate the allowable tax deduction. The tax code provides a method that allows for a portion of these costs to be deducted in the first year of business, with the remainder being written off over an extended period.

The rules permit a business to deduct up to $5,000 of its organizational costs in the same tax year it begins active operations. This upfront amount provides a direct reduction in the company’s taxable income for its first year.

This initial $5,000 deduction is subject to a limitation. If a company’s total organizational costs exceed $50,000, the first-year deduction is reduced on a dollar-for-dollar basis by the amount of that excess. For example, if a corporation incurs $52,000 in total organizational costs, the first-year upfront deduction is reduced to $3,000. If the total costs were to reach $55,000, the entire initial deduction would be eliminated.

Any organizational costs that are not deducted in the first year under this initial allowance must be amortized. These remaining costs are deducted in equal amounts over a 180-month period (15 years). This amortization period begins in the month that the business officially starts its operations. A new corporation that incurs $53,000 in qualifying organizational costs and begins business in July has its initial deduction reduced to $2,000 ($5,000 – ($53,000 – $50,000)). The remaining $51,000 ($53,000 total – $2,000 initial deduction) is then amortized over 180 months, resulting in a monthly deduction of $283.33 ($51,000 / 180). For its first tax year, the corporation would have six months of amortization (July through December), totaling $1,700 ($283.33 x 6). The total first-year deduction is $3,700 ($2,000 initial deduction + $1,700 amortization).

Making the Amortization Election

For both corporations and partnerships, the election is considered made by simply claiming the allowable deduction for organizational costs on the business’s first federal income tax return. There is no need to attach a separate formal statement to make this election. As long as the costs are correctly calculated and deducted on a timely filed first return (including extensions), the IRS considers the election to be in effect.

A business can choose not to deduct these costs and instead capitalize them. The business must opt out of amortization by attaching a statement to its first tax return to capitalize the organizational expenditures. If a business chooses to capitalize these costs, they are treated as an intangible asset. This means the expenses cannot be recovered through deductions until the business is eventually sold or dissolved.