The general rules for business deductions require that deductions are taken only for expenses incurred in an existing trade or business. This poses a problem for startup expenses, as they are incurred prior to the start of a business.
However, startup expenses and organizational costs can be deducted and amortized if these expenses result in the formation of an active business. Some portion of these costs may be deducted in the first year, while the remaining costs can be amortized over a period of 180 months starting with the month in which the business commences operation.
Up to $5,000 of qualifying startup costs can be deducted in the first year. However, the first year deduction begins to phase out if expenses exceed $50,000. The lesser of the following may be deducted in the year of business commencement:
- The actual expenses incurred in starting the new business.
- $5,000, reduced on a dollar for dollar basis by any amount by which startup expenses exceed $50,000. Thus, if startup expenses reach or exceed $55,000, the first year deduction is $0.
Any remaining startup costs not attributed to the first year deduction must be amortized over a period of 180 months following commencement of the business.
Qualifying expenses include investigational expenses (including those relating to general and specific business conditions, such as market or product research for feasibility), site selection expenses, and costs of creating a business (including advertising, wages, salaries, professional fees, and consulting fees). Non-qualifying expenses include interest, real estate taxes, research, and experimental expenses otherwise allowed as deductions.
Organizational expenses may also be deducted or amortized utilizing the same rules as for startup expenses. These include costs for organizing a business including a corporation, partnership, or LLC, such as incorporation fees, fees for legal documents, or attorney fees.
Partnership startup expenses incurred by the partners normally cannot be deducted by the partners or the partnership. However, if the partnership elects to deduct and amortize the startup costs under the same rules as for sole proprietors, these expenses may be reported to the partners on their Schedule K-1 forms and deducted by the partners utilizing the same startup expense rules. If this election is not made by the partnership, then the startup and organizational costs are added to the cost basis of the partners’ partnership interests and recovered once the partnership interests are sold or dissolved, thus reducing the resulting capital gains or increasing the resulting capital losses.
If a business is not started after incurring startup costs, those costs incurred in the general investigation of business feasibility are considered personal costs and cannot be deducted. Whereas, those costs incurred in an attempt to start or purchase a specific business may be deducted as nonbusiness capital losses.