Deducting Start-Up Costs for Federal Tax Purposes

There's been a significant increase in new business applications in recent years. Finance company NerdWallet estimates that 2.8 million new business ventures have started since 2021.

If you've started a new business this year — or you're contemplating launching one soon — you may have questions about the tax treatment of start-up expenses. Let's take a closer look at the details.

The Basics

Internal Revenue Code Section 162 allows current deductions for "ordinary and necessary" business expenses. Deductible Sec. 162 expenses include those incurred to operate an established business, such as employee wages, rent, utilities and advertising expenses.

So, established companies can generally deduct Sec. 162 expenses in the tax year in which they're paid or incurred (subject to certain special rules and limitations). In other words, they get near-instant tax gratification from these expenses.

Start-ups, however, can't necessarily deduct many business expenses right away. That's because these expenses are classified as Section 195 start-up expenses until the "active conduct" of business begins.

Once a taxpayer meets the active-conduct standard, Sec. 195 expenses qualify for current deductions. (This treatment assumes that other provisions — such as the passive activity loss or at-risk basis rules — don't come into play and prevent current deductions.)

Current Deduction Rules

Essentially, Sec. 195 start-up expenses are Sec.162 expenses that are incurred before the business actively commences operations. Typically, start-up costs may include:

• Wages paid to employees and instructors for their training,
• Fees for consultants and payments for professional services,
• Surveys of potential markets, products, labor supply and transportation facilities,
• Advertisements for opening the business, and
• Travel and other necessary costs for securing prospective distributors, suppliers or customers.

In the tax year when active conduct of the business commences, a taxpayer can choose to currently deduct start-up expenses. The election potentially allows an immediate deduction for up to $5,000 of start-up expenses. However, the $5,000 deduction allowance is reduced dollar-for-dollar by the amount of cumulative start-up expenses above $50,000. For example, if your start-up costs total $50,500, your deduction is limited to $4,500.

Any start-up expenses that can't be deducted in the tax year the election is made must be amortized over 180 months on a straight-line basis. Amortization starts in the month in which the active conduct of business begins. A taxpayer is deemed to have made this election in the tax year when active conduct of business commences unless the taxpayer elects instead to capitalize start-up expenses on a timely tax return. Your tax advisor can further explain these concepts.

Important: Sec. 195 start-up expenses don't include interest expense, taxes, or research and development costs. These expenses are subject to specific rules that determine the timing of the deductions. Sec. 195 start-up expenses also don't include corporate organizational costs or partnership or limited liability company organizational costs, though the tax treatment of those expenses is similar to the treatment of start-up expenses.

Time It Right

When you incur business start-up expenses, keep two key points in mind. First, start-up expenses can't always be deducted in the year when they're paid or incurred. Second, no deductions or amortization write-offs are allowed until the year when active conduct of the business commences. That usually means the year when the business has all the pieces in place to begin earning revenue.

Timing may be critical if you have start-up expenses that could be currently deducted. Contact your tax advisor to discuss your situation.