Expenses that you incur for your business before you are actually open for business are called start-up expenses. Start-up expenses are those that would be deductible as business expenses if your business were up and running. As long as your business eventually opens, you may deduct at least some of your start-up expenses. Even if the business never gets off the ground, you might be able to recover some of your costs. This post explains the tax consequences of starting and running your own business. Although starting a business certainly adds a new level of complexity to your tax return, it also provides a rich source of deductible expenses. As a result, many starters find that they can deduct many of the costs of pursuing an activity that they love—and perhaps, earn some good money in the bargain.
You don’t have deductible business expenses until you are actually running a business. Generally, if you haven’t yet opened for business or offered your services to the public, then you aren’t yet in business and the expenses you incur are not business expenses. Of course, it can be difficult to get a business off the ground without spending some money. For example, suppose you need to do some market research. Maybe you need to scout out some office space and put down a deposit. Maybe you do a little advertising to see if anybody out there is interested in what you have to offer before you take the big plunge.
Deducting Start-Up Expenses
You may deduct up to $5,000 of start-up expenses that you incurred before your business officially began. However, you must wait and deduct them on your return for the year your business actually begins. Even if it takes several years to get your business off the ground, you may not deduct any of your costs until the first year your business is up and running.
If you spend more than $5,000 to get your business going, the excess is not lost. You may amortize the rest over the next 180 months (15 years), beginning with the month your business began. Example: You opened your new batik T-shirt business on July 1 of the current year. Your start-up expenses total $8,600. You may deduct $5,000 of those start-up expenses in the current year. You must amortize the remaining $3,600 over 180 months, which means you may claim a deduction for $20 per month ($3,600/180), beginning July 1 of the current year.
In the current year, your total deduction is $5,000 plus $120 ($20 per month x six months of business), or $5,120. You may continue to deduct $20 per month until you have deducted all of your start-up expenses.
Those with very high start-up expenses are subject to a phase out. If your start-up expenses exceed $50,000, you may not deduct $5,000 of them in your first year of business. Instead, the $5,000must be reduced, dollar for dollar, by the amount by which your start-up expenses exceed $50,000. If you have start-up expenses of $55,000 or more, you won’t be able to claim any part of the $5,000 deduction for the first year. You can still recover your start-up expenses (including any part of the $5,000 you can’t claim in the first year), but you must do so by amortizing the expenses over 180 months.
Electing to Claim Start-Up Expenses
To claim start-up expenses as a deduction, you must make an election to do so, which you then submit with your tax return. This election is a written statement that you attach to your income tax return for the year business begins.
The statement must declare that you are making an election under Section 195 of the tax code. It must also include all of the following:
- a statement that you elect to deduct the first $5,000 of start-up expenses
- a statement that you are electing to amortize the remaining expenses (if any) over 180 months beginning in the month business began, and
- a list of your start-up expenses, including a description, dollar amount, and date for each expense incurred.
CAUTION: Don’t miss the deadline to claim start-up expenses. Generally, you must make your Section 195 election when you file your income tax return for the year your new business begins. If you request an extension of time to file your return, you may submit the election with the return by the extended due date. But even if you don’t make the election with the appropriate return, you have a six-month grace period to file an amended return and make the election. The six-month period begins on the due date of your return (not including extensions). If you don’t file an amended return within the six-month grace period, you may not deduct your start-up expenses.
When Does Business Begin?
Because you may not deduct any start-up expenses until your business actually begins, you’ll need to know when the IRS believes that moment has arrived. By IRS measures, a business begins when it starts to function as a going concern and perform the activities for which it was organized. The start date is not measured by when you bring in your first dollar of revenue.
In the case of a retail operation, business begins when you offer items for sale. If you are providing a service, business begins when you offer that service. If you purchase another business that is already a going concern, you are deemed to be in business from the moment you become the new owner. If you are a writer, you are deemed to be in business from the moment you begin writing, not when you submit your finished product to a publisher.
What If Your Business Never Begins?
One of the reasons you might spend time and money before actually starting a business is to determine whether or not your business idea is viable. Spending a little money up front might save you more money and heartache later.
Because start-up expenses are deductible only after business begins, expenses for a business that never gets off the ground will never be deductible. A couple of important exceptions might allow you to recover some of your costs, however.
- Start-up expenses related to a specific business—as opposed to a general search for an unspecified new business—might be deductible as a capital loss (reported on Schedule D). For example, assume you were hoping to sell batik T-shirts to boomers galore. You paid market research fees and put down a nonrefundable rental deposit on a store front. When you discovered that you were hopelessly inept as a batik artist, you gave up on your plan. Although your attempt to start a new business was unsuccessful and you never opened shop, the IRS is likely to allow you to claim a loss because you attempted to start a specific business.
- If you purchase assets for a business that never opens its doors, you may recover those costs if and when you sell the assets. At that time, you will add your costs to the basis of the property, which will reduce your taxable gain or increase your loss when the assets are sold.
What If You Close the Business After a Few Years?
Suppose your business opens its doors, but eventually shuts them again. This is fairly common: After all, half of all businesses fail in the first five years. Even if your business is wildly successful, you might decide to get out. Perhaps you’ve decided to move on to the more leisurely phase of your retirement.
No matter why you decide to close your business, you might have unclaimed start-up expenses. Perhaps you were amortizing some of those expenses over 180 months and closed your business before 15 years had passed. Fortunately, the IRS allows you to recover all of your remaining start-up expenses in the year you close your business.
How to Claim Start-Up Expenses
You calculate your current year deduction for start-up expenses on Form 4562, Depreciation and Amortization. You then claim the deduction on Schedule C, Profit or Loss From Business, under “Other Expenses”. In addition, you must attach your Section 195 election to your tax return for the year you start your new business.
Once your business is up and running, most of what you pay to operate it is deductible. For the most part, these expenses are easy to identify. The IRS ’s Schedule C, on which you report your income and expenses, provides a helpful guide. Some of the most common categories of expenses include:
- commissions and fees
- contract labor employee benefits, such as health care premiums you pay for employees (but not for yourself); contributions to a retirement plan fall into a separate category
- insurance (other than health), such as business liability insurance or business property insurance
interest on business loans
- fees for legal or other professional services
- office expenses, such as janitorial service, telephone answering service, coffee or water delivery service, or window washing
- retirement plan benefit (this includes contributions for employees but not for you)
- rent you pay for business equipment or office space
- repairs and maintenance
- taxes and licenses, including business taxes or license fees you might be required to pay to the city in which you do business
- meals and entertainment (these are not deductible in full)
- utilities (include this expense if you have an office outside the home and pay the utilities for the office)
- wages you pay employees, and
- other expenses, such as postage, Internet access fees, or telephone expenses.
Some business expenses require special treatment. For example: if you purchase equipment or other assets, you might be required to depreciate them. Home office expenses are also subject to certain restrictions. This section covers a few additional categories of expenses for which you might need to follow special rules: continuing education, meals and entertainment, business gifts, and travel.
Unfortunately, the IRS is not willing to subsidize a career move by allowing you to deduct training or education in a new field. Suppose you have just retired from your job as a software engineer and now you want to sell real estate. You may need to take some courses to prepare for your new career. Those expenses are not deductible as business expenses, because you are acquiring the basic skills necessary to enter a new profession.
On the other hand, you are permitted to deduct the cost of business-related education that helps you maintain or improve skills that you already have and that are required for your existing business. If you are legally required to take courses to maintain a professional license, for example, those education expenses are deductible.
You may also deduct the cost of conventions, seminars, or professional meetings related to your business activity. Other deductible expenses include tuition, fees, books or other materials, and travel expenses.
Meals and Entertainment Expense
If you take a client out to dinner, take customers to a ball game or concert, or host a company holiday party, you probably have incurred costs for business-related meals and entertainment. As long as you engage in these activities for the purpose of pursuing new business or reinforcing the goodwill and loyalty of existing customers, you may deduct the expenses.
Perhaps because it can be difficult to separate business from pleasure, the law limits your deduction to half of your business related meals and entertainment expenses. In order to claim any deduction at all, the activity (dining or other entertainment) must clearly be business-related and you must be able to substantiate that fact along with the expenses themselves.
It can be difficult to show that meals and entertainment are business-related, and unfortunately the burden of proof is on your shoulders. Although the IRS provides guidance, it can be somewhat murky. For a portion of the cost to be deductible, your meal or entertainment activity should satisfy one of these two tests:
You must conduct or discuss business before, during, or after the meal or entertainment activity.
The activity itself must be directly related to conducting business or must occur in a clear business setting. For example, you might pay for a catered lunch for prospective clients at your place of business, so you can display the batik T-shirts you want to sell. As with any expense that could be either personal or business related, you must keep detailed records of your meal and entertainment expenses, the purpose of the activity, and the nature of the business you discussed.
A gift might be a business expense if the purpose of making the gift is to promote your business or perhaps to thank a customer for continued loyalty. You may deduct business gifts, but your deduction is limited to $25 per person, per year [even if you spend much more].
The rules are a little fuzzier when you give to employees. For example: suppose you give your sole employee a bonus at the end of the year. If you treat the bonus as compensation, then it is fully deductible, along with the wages you pay. If you give your employee a $200 fruit basket, it looks like a gift, and you might have to work a little harder to convince the IRS that you intended it to be part of your employee’s compensation. If you cannot convince the IRS it is compensation, your deduction will be limited to $25 even though you spent $200. Bear in mind that items treated as compensation will be subject to all of the usual compensation-related rules, such as payroll tax requirements.
Also potentially confusing is the treatment of event tickets. Suppose you purchase opera tickets to give to a customer. You might consider them a business entertainment expense, rather than a gift. But how do you know for sure? The IRS says that if you accompany your client to the opera, the tickets are an entertainment expense.
If you do not, then you may choose to treat the expense as either entertainment or a gift.
Bear in mind that entertainment expenses are limited to 50% of your cost. Gifts, on the other hand, are limited to $25 per person.
So your best course of action might depend on how much you spend. But beware of this additional limit: If you give a customer two tickets—so the customer can bring along a spouse or friend, for example—you are deemed to have given only one gift, and your deduction is limited to $25.
Auto and Travel Expenses
Your business travel expenses are treated differently for tax purposes depending on whether you are traveling locally or you are traveling out of town and will be gone overnight.
Local Travel Expense
When you travel around town to take care of business or to meet with a customer or client, the cost of your local travel is deductible. However, you may not deduct the cost of your meals when you’re away from your office or other business location. Meals (and lodging) are deductible only if you must be away from home overnight.
Local travel expenses might include the cost of a bus, taxi, or similar transportation. Those costs are fully deductible when the travel is for business. When you use your car for such travel, however, calculating your deductible expense becomes quite a bit more complicated. There are two ways to calculate your travel expense from use of your own car:
Option 1: Actual expenses
Your first option is to track your actual expenses. Any expenses that are directly related to your business—such as the cost of parking at your office or tolls paid when you drive to call on clients—are fully deductible. For expenses that you must pay to maintain and service your car (such as insurance, repairs, gas, and registration fees), you must calculate the portion of those costs that are attributable to your business use of the car.
To do this, you must determine how much you use the car for business as opposed to personal use. Typically, you will allocate by mileage. For example, if you drove 10,000 miles during the year and you put 2,000 of those miles on the car while driving to and from your hot-air balloon launching site, then the expenses of operating and maintaining the car would be allocated 20% to your business and 80% to personal use (which is not deductible).
Option 2: Standard mileage rate
If you don’t want to bother with extensive record keeping, you can use the standard mileage rate. Although the actual expense method often yields a larger deduction, it also requires you to keep meticulous records of all of your car expenses and mileage. If you choose to use the standard mileage rate to compute your deduction, you need only keep track of the miles you travel for business. Each year, the IRS provides the amount you may deduct for each business mile traveled. (For 2008, it’s 50.5 cents per mile for the first half of the year and 58.5 cents for the second half of the year.) In addition, you may deduct expenses for business parking and tolls, personal property taxes you pay on the value of your car, and the business portion of your car loan (if any); these costs are not included in the standard mileage rate.
As long as you elect to use the standard mileage rate in the first year you use your car for business, you may choose whichever method gives you the larger deduction in all subsequent years.
However, if you chose to use the actual expense method in the first year, you must continue to use it for as long as you use that car in your business. Also, you may not use the standard mileage rate if you have ever claimed depreciation on the car and used a depreciation method other than straight line. There are a few other situations in which you may not use the standard mileage rate; see IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, for more information.
Out-of-Town Travel Expenses
If you travel out of town for business, you may deduct the full cost of your travel and lodging, and half of what you spend on meals. However, you may not deduct your travel expenses if the primary purpose of your trip is personal. For example: suppose you go to Montana with your spouse to spend a week on a dude ranch, learning how to ride and getting away from it all. If you just happen to have a customer nearby and take a day to go visit him, you can’t deduct the entire trip. If you actually conduct business with your customer, however, you may deduct the cost of your side trip to meet with him. If the primary purpose of your trip is business, but you spend more than 25% of your time on personal activities, you must allocate your travel expenses (including meals and lodging) between business and pleasure.