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What tax deductions can you take for the money you spend before opening the doors to your new venture?
These costs are commonly referred to as start-up costs.
There are three start-up tax rules to choose from, and one bonus rule. Run the numbers trying each of the rules discussed below to see which produces the greatest tax benefit. Most people like to deduct as much as possible right away and would opt for rule one. However, sometimes this doesn’t give you the best long-term tax benefit—for example, you think you’ll start slow and then be more profitable in future years. In that case, it might be better to choose Rule Two. Few people choose Rule Three.
You can deduct up to $5,000 of your start-up costs the first year you are in business.
Anything over $5,000 must be amortized (deducted) over the following 15 years. There are restrictions on this deduction if your start- up expenses exceed $50,000 for the year. If your first year wasn’t profitable and your second year looks iffy, then you might be better off choosing Rule Two.
EXAMPLE: Sasha starts up Rox, a shop for rock climbers. She spends $14,000 on ads, travel, and business consultants before opening Rox’s doors in September. Sasha can deduct $5,000 for that tax year, and ¹⁄₁₅ of the remaining $9,000 ($600) each year thereafter for the next 15 years.
You can deduct (“amortize” in tax lingo) your start-up costs pro rata over 15 years.
EXAMPLE: Sasha chooses to deduct $933 per year over 15 years ($14,000 ÷ 15). So, if Rox was in business eight months in Year One, Sasha’s start-up deduction would be 8 ÷ 12 × 933, or $622 for that year.
You don’t deduct any start-up costs; instead, you recover these expenses when you sell the business or close down operations.
EXAMPLE: Sasha picks Rule Three when she sells her sole proprietorship after two years of operation. Sasha nets $20,000 on the sale before considering her start-up expenses. Tax result: Sasha’s recovery of start-up costs of $14,000 is treated as a (nontaxable) return on her investment in Rox. The balance of $6,000 Sasha received is a taxable gain on her investment in the business. (The tax treatment of this is explained in Chapter 18.)
Get an extra up-to-$5,000 deduction for small business organizational expenses. This deduction is only for business entities—meaning corporations, partnerships, and limited liability companies, not sole proprietors. To get the deduction, your total start-up expenses can’t exceed $50,000. This deduction is in addition to the start-up cost deduction discussed above.
EXAMPLE: Sasha pays $1,250 to a lawyer to form Rox, Inc., $440 in state fees for incorporating, and another $100 for a corporate records book. She gets an organizational cost deduction of $1,790 in Year One. This is in addition to her start-up cost deduction of $5,000, using either Rule One or Two, above.
(For more details, see IRC §§ 195 and 208.)
Business-related fees paid to tax pros, lawyers, and business consultants are always deductible, but sometimes the deduction must be spread over future years.
Professional fees regarding onetime business deals or sales are deductible immediately.
EXAMPLE: Yona hires Carlos, a CPA, to help her prepare payroll tax forms for her business. The $275 she pays Carlos is a deductible business expense in the year paid.
Professional fees that provide a benefit beyond the present year—legal advice on a commercial lease or long-term service or supply contract, for example—must be deducted over the period of the expected benefit.
EXAMPLE: Jackson pays a lawyer $600 to negotiate a two-year contract to provide cleaning services for the Oakland Coliseum. Jackson must deduct that fee over the 24 months that the lease will last. He can deduct ½ of the $600 per month, or $25 per month. That gives him a deduction of $300 for each of the two years that the contract will last.
You can deduct up to$5,000 immediately for fees paid to consultants, lawyers, and accountants as long as you begin operations before the end of the same year. Anything over $5,000 must be amortized (another term for deducted) in equal amounts over the next 180 months or the term of the benefit if that’s less than 180 months. If you go out of business in the interim, the balance can be deducted in the final year.
EXAMPLE: Maddy, a sole proprietor, pays her attorney $600 to negotiate a five-year lease on a mall kiosk to sell Italian charm bracelets. The legal fee can be deducted fully that year or in equal yearly amounts of $120 over five years, or it can be added to the cost of establishing the business. If Maddy sells her business at a gain of $600 or more, this last choice would reduce the tax bite.
Small business owners’ personal and business tax concerns are almost always inseparable, so one tax pro can handle an owner’s personal and business issues. These fees, whether business or personal related, are always deductible, but different rules apply. The accountant’s or tax pro’s bill should always split out the business and personal portions. The two separate fees are then deducted on different schedules of the same tax return.
What happens if, after spending money to set up a new business, you back out before opening day? Taxwise, your costs aren’t deductible as business expenses, but they may be deductible as investment expenses. Expenses of trying, but failing, to go into business fall into two tax categories (IRC § 195).
The costs of a general search for a business to buy or of investigating whether to start a business are not deductible at all—not as business expenses or investment expenses.
EXAMPLE: Bubba is thinking about opening a fried chicken restaurant, so he travels the state for two weeks stopping at every KFC, takes photos of the operation, and samples all the menu items. After spending $1,244, battling indigestion, gaining ten pounds, and thinking about the long hours, Bubba forgets about it. Result: No tax deduction.
The costs of attempting to acquire or start a specific business are deductible as investment expenses.
EXAMPLE: Francine, an experienced hairdresser, sees an ad for a Hair Today, Gone Tomorrow (HTGT) franchise for sale 600 miles away. She travels to meet with the owner, hires an attorney, and signs a contract to buy it. HTGT’s home office doesn’t approve the transfer because Francine isn’t a licensed beautician in this state. Francine is out of pocket $3,100. She can deduct this not as a business expense, but as a “miscellaneous expense,” on Schedule A of her Form 1040 individual tax return.
EXAMPLE: Aaron goes to Bridget, his accountant, for tax preparation and advice on how to reduce his family’s income taxes. His self-employed income is from the model airplane newsletter he publishes as a sole proprietor. His wife Clarinda is employed as an architect. Bridget’s statement for services of $800 shows $550 for Aaron’s business and $250 for the couple’s personal tax matters. Tax result: $550 is tax deductible for Aaron’s business (Schedule C) and $250 for miscellaneous items (Schedule A) on Aaron and Clarinda’s joint tax return.
Maxing out the tax professional fee deduction
Ask your tax pro to apportion his or her bill to attribute the lion’s share to the business expense. While the personal part may be deductible on your individual tax return, it is subject to limitations.
You can deduct items like paper clips, brooms, coffee, and snacks. Just categorize them as “office” or “supplies” on your business tax schedules and returns. To be 100% immediately deductible, they should be used up within the year they are bought. While this is the law, the IRS knows it is impractical to expect a business to run out of its supplies on New Year’s Eve, so auditors rarely question these types of items.
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