This post was originally published in 2018. It has been updated recently to include new links and the latest information, so you can use these tax breaks as you start your new business.
It costs money to get even the simplest business up and running from scratch. And if you’re like most aspiring entrepreneurs, you’re bootstrapping your business. You’re watching every dollar going out while there’s not yet much money coming in.
So you need every possible break you can get.
And that’s where two special $5,000 tax deals come in.
When you’re starting a business, you’ll have business expenses. That includes your start-up phase when you’re shelling out money even though you may not technically be in business yet. And the IRS treats those organizational and start-up costs differently than the expenses you’ll have once you launch.
Pre-Business Expenses Are Different
Before you actually open up for customers, you won’t have any revenues (sales) coming in. Expenses, on the other hand, will be adding up quickly – but you’ll have nothing to deduct them against (yet).
So the IRS treats those as “capital expenses,” meaning they count as assets instead of expenses. Assets are things your business owns – think desks, delivery vans, and computers – and will use for a long time.
The IRS lets your business deduct the cost of some assets over time, a little bit each year. That’s what would normally happen with your pre-business expenses.
But thanks to special rules, new business owners like you can deduct up to $5,000 of your start-up costs AND $5,000 of your organizational costs – a total of $10,000 – right away.
That can turn into significant tax savings… extra important when you’re focused on preserving cash.
What Counts as Organizational Costs?
Every business has a legal form, also known as its business entity. Whether you’re running a freelance copywriting business from your dining room or a chain of 10 independent bookstores, your company has an official legal structure (you can learn more about that here).
Even if you haven’t thought about this at all, and just jumped in, your business has its own legal existence. There are 4 main legal business structures:
- sole proprietorship
- partnership
- LLC
- corporation
If you decide to start your business as a formal entity, meaning anything other than a sole proprietorship, there are costs involved. And sometimes even sole props have to pay state fees in order to legally run their businesses.
These count as organizational expenses because they’re for creating the organization. So even though you’ll be paying them before your company officially starts up, they aren’t considered start-up costs by the IRS.
You can deduct up to $5,000 of your organizational costs for the first year your company is in business. Those include things like:
- Legal fees to create the entity and any organizational documents (like partnership or shareholder agreements)
- Accounting fees to set up your books and account for money spent before the official start date
- State filing fees
If it costs more than $5,000 to organize your business, you can deduct the rest over the next 15 years.
What Counts as Start-up Costs?
Expenses you pay before your company’s official start date count as start-up costs. That’s true even though they’d count as regular business expenses if you paid them on day one.
So what kinds of expenses would that include? Anything you spend while you’re figuring out if, how, where, and when you’re going to start the business counts (like market research or realtor fees). Add to that any costs you incur to actually get your business up and running, everything from Wi-Fi to envelopes to apps.
Some common start-up costs include:
- Travel expenses when you’re scouting a location
- Advertising for your grand opening
- Employee hiring and training costs
- Any money you spend to attract customers, woo lenders, or connect with suppliers
- Business licenses and permits
- Professional fees for lawyers, accountants, consultants, coaches, etc.
- Regular expenses like phone, utilities, rent, insurance that you paid before the official start date
Most of the things you spend money on before your company’s official start date can be included here.
But some costs are specifically excluded and can’t be deducted under this special rule. Those include inventory, long-term assets (like delivery trucks, for example), organizational costs (like we talked about earlier), or research and development costs.
What’s My Business Start Date?
For sole proprietors, your start date is the day your company “starts to function as a business,” whether or not you’re earning any money. For all other entities, go by the organization date on your organization documents.How Do These Tax Deductions Work?
Tax deductions – deductible business expenses – reduce your company’s taxable income. They work sort of like the way the standard deduction or itemized deductions work on your personal tax return.
These deductions work the same way no matter what legal form your business uses. They just show up on different tax forms based on the entity.
If you’re a sole proprietor or have a single-member LLC (the two most common business structures), you’ll take both deductions – up to $5,000 each – on your Schedule C under the “other expenses” category. That Schedule C becomes part of your regular personal tax return. If you’re unsure how to manage this, hiring a tax preparer to help you will count (at least partially) as another deductible business expense.
If you have a partnership, corporation, or multi-member LLC, use a professional to prepare the business tax return. Truly, you’ll be glad you didn’t try to DIY this.
There’s a Catch
Of course, like all things IRS-related, these deductions come with a catch.
If either the organizational or start-up costs run more than $50,000 during the year, you can’t take the full $5,000 first year deduction for that expense type. Instead, you have to reduce your deduction for the amount that exceeds $50,000.
Let’s look at an example with the math.
Let’s say you paid $52,000 in start-up costs. That’s $2,000 more than the $50,000 allowed maximum, so you’d have to subtract the excess $2,000 from the first-year deduction. Your year one tax deduction would be reduced to $3,000 [$52,000 – $50,000 = $2,000 and $5,000 – $2,000 = $3,000].
I know it seems ridiculous, but that’s just the way this tax law works. And you could still take the full $5,000 in organizational costs if those came to less than $50,000.
The Bottom Line:
Taking advantage of these two special tax deductions can help you preserve more precious cash while you’re beginning to build your business.
Want More Information About Starting Your Own Business?
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