Understanding the Small Business Start-Up Deduction
In the past any small business’ start-up costs were spread out, or amortized, over the first 60 months of the business’s life, providing little relief for owners. Originally passed in October 2004 and modified in the Small Business Jobs Act of 2010, Section 2031 of the Jobs Act now allows small business owners to take an immediate $10,000 deduction against qualifying start-up costs by filing for a 195 deduction on IRS Form 1120, 1120S, or 1065 or as an “Other Expense” on the Schedules C or F of the 1040 form. The “downside” of Section 195 is that the amortization period for start-up costs was extended from five years (60 months) to 15 years (180 months).
The reason for this change was to correct a disparity in the tax treatment of start-up expenses resulting from "carrying on a trade or business," according to the IRS. The requirement discouraged taxpayers from investigating the creation or acquisition of new trades or businesses by not allowing the deduction of start-up expenses until well after the business was established. Section 195 was enacted, in part, to minimize this disparity and thereby encourage formation of new businesses by providing an amortization deduction for eligible investigatory expenses prior to the business' opening.
Section 2031 of the Jobs Act allows a deduction for any qualified start-up expenses up to $10,000 but requires a dollar for dollar reduction if the expenses exceed $60,000. Typically, what qualifies as a start-up expense includes any costs related to the business prior to opening. These can include:
- marketing research,
- human resources,
- legal fees,
- employee recruiting,
- consultant fees,
- office supplies, and
The term "start-up expenditure" does not include any amount with respect to which a deduction is allowable under Sections 163(a), (interest), 164 (taxes) or 174 (research and experimental expenses). The purchase of equipment prior to the opening of a business is also not considered a “start-up expenditure” but rather falls under the Section 179 deduction.
Business owners must be cautious about which expenses to deduct and what will qualify as a start-up expense versus a traditional business operation expense. The line delineates when the venture begins operating as a full-fledged business rather than one just starting in the development and planning stage.
Traditionally, a taxpayer incurring costs to investigate the expansion of an existing business generally could deduct those costs under Section 162, Trade or Business Expenses. The expenditure must be:
- paid or incurred during the taxable year, and
- made to carry on a trade or business) assuming the other requirements of that section were met.
Ordinary or Capital Expense?
The expenditure must be an ordinary expense under Section 162, and not a capital expenditure, to be considered start-up expenditures. Section 195 did not create a new class of deductible expenditures for existing businesses but rather re-qualified those expenses under the umbrella of start-up versus existing business costs. In order to qualify under Section 195, the expenditure must be one that would have been allowable as an ordinary and necessary deduction by an existing trade or business when it was paid or incurred.
When an active trade or business is purchased, allowable start-up costs include only those costs incurred in the course of the general search for or preliminary investigation of the business. Costs related to the attempt to actually purchase a specific business are viewed as capital expenses and are not amortizable under IRC Section 195. The nature of the cost must be analyzed based on all the facts and circumstances of the transaction to determine whether it is an investigatory cost incurred to facilitate the business or an acquisition cost incurred for business operation.
A Word of Warning
The 195 deduction may not always make financial sense to utilize, so review your expenses carefully. Businesses start losing the $10,000 deduction when their start-up costs exceed $60,000 and then must reduce the deduction dollar for dollar by the amount exceeding the $60,000 threshold.
For example, a business with $56,000 in start-up expenses can take an immediate $10,000 deduction per IRC 195 and then a portion of the remaining $46,000 amortized monthly over the next 180 months. Conversely, if the business exceeds the $60,000 threshold the news is entirely different. A business with start-up expenses of $69,500 would only receive a $500 deduction per IRC 195 (that's the $69,500 less the $60,000 max) and then receive a portion of the remaining $69,000 ($69,500 less the $500 deduction) amortized over the following 180 months.
If you think your small businesses will see a loss for the next few years, talk with your small business accountant or tax professional about whether you should forgo the deduction and amortize the business deductions accordingly.
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