Tax Savvy for Small Business: Start Up Expenses

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Under the tax code, these start-up expenses must be deducted ratably over the first 60 months you are in business. Technically, the tax code calls these deductions amortization of expenses. (For sole proprietors, partners and limited liability company members, these deductions are claimed on IRS Form 4562, Depreciation and Amortization.) This can be a bit of a shock, since these are the costs that can be immediately deducted as expenses once you are open for business.

EXAMPLE: Bill and Betty set up Mandingos Consulting Partners (MCP). During the first three months of 2002, they locate and fix up office space (with the help of a handyman) and have brochures printed and mailed to prospective clients. MCP spends $6,000, before April 1st, when it opens for business. Tax result: all of the pre-April costs are capital expenditures and as such are deductible at the rate of $100 per month over the first 60 months MCP is in business. Therefore, in 2002, $900 can be deducted for the nine months the business was open, $1,200 in 2003, and so on until 60 months elapse. Expenses incurred after the business is in operation—April's rent and most other recurring monthly costs—are 100% deductible in 2002.

You can work around this limitation. If it would benefit you to deduct start-up costs in the first year rather than pro rata over five years, then consider:

• delaying paying pre-opening costs until you start serving customers. (Whether or not your suppliers and workers will allow you this much time to pay is another matter.) The IRS may challenge this tactic if you are audited, however.

• doing a trivial amount of business before you are officially open. That will probably be enough to satisfy an IRS auditor. Make a $75 sale to a friend or give a few people a bargain, just to get some activity on the books.

Before trying to take start-up cost deductions all in the first year, make sure it really helps. If, like many businesses, you have low gross receipts or even losses the first few years of operation, you might be better off taking this deduction over 60 months.

Costs of Not Going Into Business

What happens if, after incurring start-up expenses, you back out and never go into operation? Your costs may or may not be deductible, depending on the tax rules you fall under.

The tax code (IRC § 195) divides expenses of trying, but failing, to establish a business into two categories:

• costs of investigating whether to start a business. Any expenses for a general search or preliminary investigation are not deductible.

• costs of attempting to acquire or start a specific business. These are classified as investment expenses and can qualify as itemized deductions on Schedule A of your individual income tax return. As such, they don't provide as much tax benefit as do start-up type expenses.