Strategy: IRS Makes Deducting Start-Up Expenses Easier
Before explaining how the IRS just made your life easier, let’s briefly review what defines a start-up expense.” Basically, a start-up expense is an expense that would not be deductible without this special tax break which allows you to deduct both your “thinking about getting into business expenses” and your “getting your business started expenses.”
Start Up of a New Business
You probably had not thought about deducting your “thinking about getting into” business expenses. Most people don’t. But in the start-up classification, the “thinking about it” expenses qualify.
If you started a business during the last three years, ask yourself these questions: Before beginning the business and while thinking about getting into this business, did you…
- travel to meet with and learn from others who are in the business?
- go to breakfast, lunch or dinner with friends and business acquaintances to find out about the business and learn if you might be good at the business? (If you paid only for yourself at these meals, your Dutch-treat cost qualifies for deduction just as if you had picked up the tab.)
- take classes in or out of town to learn more about the business?
- spend money analyzing the market and how it looks for the future?
- buy books and magazines to find information about the market?
- use your car to make prospecting and other calls before getting your license or meeting the other qualifications necessary to enter the business?
- obtain training for the new business o excluding the training to qualify for entry into the new business, like a law degree or special licensing?
- make long-distance telephone calls to others to learn more about the business and how you might fit into the business?
These types of costs qualify as start-up expenses. The list clearly reveals that without this special write-off provision you would get nothing. This is one of those tax-law rules that makes you like lawmakers.
Start-up expenses also include expenditures you make for any of the following:
- Surveying or analyzing potential markets, products, labor supply, transportation, and other aspects of the business
- Advertisements for the opening of your business
- Salaries and wages for employees you train and their instructors
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers
- Salaries and fees for executives and consultants, or for similar professional services
How Things Got Easier
Now, in addition to thanking lawmakers for start-up deductions, you have the regulatory IRS to thank for making it easier to realize the cash benefits from your start-up deductions. Beginning with start-up expenses incurred after September 8, 2008, you no longer have to make that exacting election under Section 195 to qualify start-up expenses for deduction.
Don’t let that September 8 date throw a roadblock in your path. The “no election needed” requirement is also effective for your prior open tax years. Therefore, if you failed to make the election in a prior year, you can use the new rules in effect after September 8 to amend that prior year if that prior year is an open tax year (generally, the year is open for three years from the day you mail the return to the IRS).
Under the new rules, you do not make an election to write off your start-up expenses. Instead, the regulations make that election for you automatically. You have to love this: the new regulations “deem” that you made the start-up election unless you expressly elect out of these tax-favored start-up write-offs.
Planning tip: We can think of no logical reason not to write off your start-up expenses.
How the Write Off Works
Under the new rules, the write-off method of deducting start-up expenses remains as is. In the taxable year you begin an active trade or business, you deduct the lesser of what you spent on start-up or $5,000 reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000. You deduct the remainder using straight-line amortization over the 180-month period beginning with the month in which your active trade or business started.
Example: You spend $21,740 on start-up. You write off $5,000 on the day the business starts and amortize the remaining $16,740 at $93 a month over 180 months.
If you sell or discontinue the business before the 180 months expires, you write off the unamortized start up at that time.
Now that you know about this new and easy-to-use write-off of start-up expenses, ask yourself these questions:
- Did you deduct your start-up expenses?
- Did you incorrectly claim start-up expenses as business expenses?
If you got either of these wrong, now is the time to get these corrected.
When Does the Business Start?
You begin deducting start-up expenses in the month your business begins. In determining what month your business begins, a good rule of thumb is the month you start making your first sales calls, see your first patients, or have customers come into your place of business.
Example: Sam Jones spent $150,000 over three years to develop a service-assessment system. He deducted the $150,000 on Schedule C. In case the expenses were not deductible, he added a note to his tax return saying that the expenses may be start-up expenses. Jones made zero sales and was constantly changing his product. In technical advice, the IRS ruled that Jones may neither deduct the $150,000 nor treat it as a start-up expense, because he never actually started the business.
Planning note: Had Jones created one product or service then worked at selling that one product or service, he would have had a business and his $150,000 tax write-off, even if he never made any sales.
If you do not qualify to be in business or the law prohibits you from starting the business, you are not in business. A suspended broker did not incur tax-deductible costs when seeking reinstatement, because he was not in business.
Robert L. Duecaster, a high school teacher, attempted to deduct his law school tuition and other costs as start-up costs for his law practice. Wrong! The court ruled that Duecaster gets no deduction for the educational expenses because the education was necessary to qualify him to practice law, not to start a business. The law school expenses were personal.
Ignoring the fact that you cannot deduct your costs of getting the credentials necessary to get into your business, think of how this start-up law grants you benefits for thinking about and investigating the beginning of your business. Lawmakers have made it clear that they want you to get into business and help grow this economy.
What Happens to the Costs of an Unsuccessful Search?
When a corporation abandons an unsuccessful search for a new business, it may deduct the costs of investigating the venture as a loss.
Planning tip: If this loss puts the corporation out of business, your stock in the corporation becomes worthless, and you may claim the worthless stock as a capital loss. In general, stock losses produce capital losses. However, with a Section 1244 election on small business stock, your loss on this stock is a more favorable ordinary loss.
If you, as an individual, abandon your search, you do not receive such favorable treatment. The IRS ruled that individuals may deduct losses for a new business search only when they do more than investigate. You must enter a transaction for profit and later abandon the transaction. The IRS has ruled that you enter a transaction for profit when you go beyond a general investigatory search and focus on the acquisition of a specific business investment.
Thus, you may deduct costs incurred in an unsuccessful search when you identify and focus on a specific business. Documents that help you prove identification include agreements, profitand-loss projections, and advice from professionals about a specific business.
Planning tip: You may not deduct losses incurred in the general investigatory search. The IRS declares that such a loss is personal.
Expansion of Existing Business
You may deduct as current expenses the costs of expanding your existing business. Obviously, the key is to have an existing trade or business that you can expand. The IRS and the courts have ruled that the following costs are deductible as business-expansion expenses:
- Developing a new sales territory
- Promotional activities to increase sales
- Start-up of new equipment for existing business
- Expenses of a residential developer investigating development of industrial sites
- Addition of new branches by a bank
If you start a new line of business, you treat the expenses of start-up under the start-up rules. Defining a new line of business is a question of fact that is not always easily resolved.
Example: Fragrance, Inc., manufactures and imports fragrances and cosmetics. At first it sold its goods only at the wholesale level. Later, to broaden its base, the company opened a retail boutique. The store was a great success. The company then opened 11 more retail stores.
IRS Ruling: In technical advice, the IRS ruled that
- the company’s first retail boutique was a new business; and
- the 11 additional boutiques were simply an expansion of an existing business.
Thus, the company would treat the costs of opening the first boutique as start-up expenses; however, the costs of getting the other 11 boutiques up and running are those most tax-favored ordinary business expenses, deductible as incurred.
Three Cautions for Start-Up Expenses
Caution 1. Purchasing an Existing Business
When you start or enter a business from scratch, you can easily identify start-up expenses as those incurred before you make your first sales calls or list your property for rent. However, when you take over an existing business, your tax life is more complicated. For an existing business, start‑up costs include only the costs that help you seek a business, review businesses, and decide which one to purchase. Once you have identified your target, you incur capital acquisition costs that do not qualify for start-up treatment.
Example: You hire an accounting firm and a law firm to assist you in the potential purchase of
Jimmy Company. The firms research the industry and analyze the financial projections of Jimmy Company. On the basis of this information, you have the law firm prepare and submit a letter of your intent to buy Jimmy Company. The letter states that a binding commitment will result only after a purchase agreement is signed. The law firm and accounting firm continue to provide services, including a review of Jimmy Company’s books and records and the preparation of a purchase agreement. After the review, you sign the agreement to buy Jimmy Company.
You have start-up costs only to investigate the business before submitting the letter of intent. Once you submit the letter of intent, your legal, accounting, and other expenses to purchase this existing business are capital costs.
Caution 2. Failure to Identify and Buy the Business
The expenses are personal if you (1) did not identify or (2) did not buy a specific business. You get no deductions because
- no business exists to produce start-up deductions, and
- no loss exists because you did not identify a specific acquisition.
Caution 3. Investments, Corporations
You must spend money to investigate or create an “active” trade or business. Money you spend to look into investments does not qualify for tax-favored start-up treatment.
In the case of rentals as active businesses, the Senate has said that, in general, your operation of an apartment complex, office building, or shopping center qualifies as an active business. The Senate further stated that rentals in which you furnish significant services incident to the rentals constitute an active business.
The word “active” means that you, your corporation, or your partnership participates in the management of the trade or business. The special treatment of start-up expenses goes to the taxpayer who incurs the start-up costs and enters the trade or business.
A sole proprietor claims start-up costs on his Schedule C for a new business.
A C corporation or an S Corporation claims its start-up expenses on its corporate return.
In general, if you’re starting a business using a corporation, you need to differentiate clearly among investment, start-up, and organization expenses. Start-up and organization costs both qualify for the $5,000 and 180-month amortization, but investment expenses are capital expenditures.
Also, keep in mind that the corporation is a legal entity separate from you. You may not deduct expenses paid on behalf of another, so make sure the corporation pays the corporate expenses. If you pay any of the corporate expenses, make sure that the corporation reimburses you for the expenses.
- IRS Publication 535, Business Expenses (2017), p. 27.
- TD 9411.
- Ibid; Reg. Section 1.195-1T.
- Section 1.195-1T(b).
- Section 1.195-1T(a).
- Marketing efforts are important for deciding when the business starts. In general, if you are consistently making sales calls, you are in business. See Richmond Television Corp. v. U.S., 345 F2d 901 (4th Cir 1965); Technical Advice Memorandum 9027002.
- Private Letter Ruling 9310001.
- Owen v. Commr., 23 T.C. 377 (1954).
- Munroe v. U.S. 65-2 USTC ¶ 9495, 16 AFTR2d 5170.
- Robert L. Duecaster v. Commr., T.C. Memo. 1990-518.
- Harding v Commr., T.C. Memo 1970-179; Revenue Ruling 73-580.
- IRC Section 165.
- Revenue Ruling 57-418.