Starting a New Business? Here’s What You Need to Know about Deducting Startup Expenses

As the economy recovers from the COVID-19 pandemic, the number of new businesses being launched has increased significantly. In fact, the U.S. Census Bureau reports that business applications are up 18.6% from June 2020 through June 2021, based on the number of businesses applying for an Employer Identification Number.

Unfortunately, many of the expenses incurred by start-ups aren’t currently deductible. If you’re starting a new business, the way you handle some of your initial expenses might make a significant difference in how much tax you owe this year.

Three tax rules to know 

Here are three rules to keep in mind if you’re starting (or are planning to start) a new business:

1. Start-up costs include the costs incurred or paid while creating an active trade or business, or while investigating the creation or acquisition of an active trade or business. 
2. In the year a new business begins, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs under current tax code. This $5,000 deduction is also reduced dollar-for-dollar by the amount by which your total organizational or start-up costs exceed $50,000—and any remaining costs must be amortized on a straight-line basis over 180 months.
3. New businesses are not allowed to make deductions or amortization deductions until the year the business begins “active conduct”. Typically, this is the year when a new business has all of the pieces it needs to start earning revenue in place. The IRS and courts generally ask the following questions in order to determine if a taxpayer meets this test: 
   1. Was the activity undertaken by the taxpayer with the intent to earn a profit? 
   2. Was the taxpayer actively and regularly involved in the activity? 
   3. Did the activity actually begin?

What expenses are eligible?

Eligible start-up expenses are generally defined as expenses incurred to:

• Create a business
• Investigate the creation or acquisition of a business
• Engage in a for-profit activity with the expectation that the activity will become an active business.

Only expenses that would be also deductible if they were incurred after a business began qualify for the election. Money you spend analyzing potential markets for a new service or product is one example.

Expenses that are related to establishing a corporation or partnership are eligible as “organization expenses”. Filing fees paid to the state of incorporation and legal and accounting fees for services related to organizing a new business are eligible as organization expenses, for example. 

Make a plan today

If you’re planning to start a new business this year and have expenses you’d like to deduct, you’ll need to decide whether you’re going to take the election we described above—and good recordkeeping will be critical. If you need help with the tax or other aspects of your new business, contact us about your start-up plans.