If you started a new business during the COVID-19 pandemic, you’re not alone. According to U.S. Census Bureau data, from 2019 to 2022 new business applications increased by 44%.
Many of these businesses were formed by people who found themselves unemployed in the early months of the pandemic or by entrepreneurs who saw business opportunities in the remote working environment. Although the surge has leveled off a bit, the current rate of new business creation remains substantially higher than before the pandemic.
Starting a new business isn’t cheap, and many expenses are incurred long before the business officially opens. Here are answers to frequently asked questions about deducting start-up costs for federal income tax purposes.
What are start-up costs?
Start-up costs include those incurred:
- In connection with creating an active trade or business, and
- In investigating the creation or acquisition of an active trade or business.
Generally, start-up costs are capital expenses that can’t be recovered until you sell or otherwise dispose of the business — although the cost of certain assets may be recovered through depreciation. However, you can elect to deduct up to $5,000 in eligible start-up costs after the business is up and running and amortize any remaining start-up costs over 180 months (15 years).
Note that the $5,000 deduction is reduced dollar-for-dollar (but not below zero) to the extent that your total start-up costs exceed $50,000. For example, if you have $53,000 in eligible start-up costs, you can deduct $2,000 in the year the business goes active. The remaining $51,000 must be amortized over 15 years. If your eligible start-up costs are $55,000 or more, you must amortize the full amount.
What can be deducted or amortized?
Start-up costs qualify for deduction/amortization if they’d be currently deductible as business expenses by an active business and are paid or incurred before your business becomes active. Eligible costs include amounts paid for:
- Researching potential markets, products, labor supplies and transportation facilities,
- Advertising the opening of your business,
- Wages for employees being trained, as well as for instructors,
- Travel and related expenses for finding customers, suppliers and distributors, and
- Fees for consultants or other professional services.
Eligible start-up costs don’t include interest expense, taxes, or research and experimental costs (although these costs may be recovered under separate tax code provisions). Also, if you’re acquiring an existing business, deductible/amortizable start-up costs are limited to costs associated with a general business search or with a preliminary investigation of a target business to decide whether to purchase it. Costs incurred in connection with purchasing a specific business are capital expenses.
Keep in mind that expenses that wouldn’t otherwise be currently deductible by an active business — such as the cost of real estate, equipment, furniture or other depreciable assets — aren’t considered start-up costs.
When can you take the deduction?
You can deduct start-up costs on your tax return for the year in which the business becomes active. Amortization begins in the month the business becomes active.
Under current rules, the election to deduct/amortize start-up costs is deemed to be made automatically. However, you can affirmatively opt out and elect to capitalize these expenses.
Are organizational costs deductible?
The costs associated with organizing a corporation or partnership aren’t considered start-up costs. However, similar rules apply.
Indeed, you can elect to deduct up to $5,000 in qualifying organizational costs in the year your business becomes active, reduced to the extent your total organizational costs exceed $50,000. As with start-up costs, nondeductible organizational costs may be amortized over 180 months.
What if you’re unsuccessful?
If you fail to acquire or launch a business, investigative costs associated with evaluating investment options or identifying potential targets are considered nondeductible personal expenses. Costs associated with starting or acquiring a specific business, however, may be deducted as capital losses.
Get a head start
If you’re starting a new business, learn which start-up costs are deductible or amortizable. That way, you’ll be ready to claim those costs once your business opens its doors. Your tax advisor can help with the details.