Starting a brand new business usually requires the expenditure of money on things like:
- legal and accounting fees
- licenses, permit, and other fees
- the cost of investigating what it would take to create a successful business, including research on potential markets or products
- advertising costs, including advertising for your business opening and creating a business website
- office rent and utilities paid before the business begins operating
- rental of business equipment such as computers and office supplies
- costs for employee training before the business opens, and
- expenses related to obtaining financing, suppliers, customers, or distributors.
Once your business begins, the cost of all of such items are deductible as business expenses. However, they are not so easily deducted if they are incurred before your business starts. Such business start-up expenses are capital expenses—costs that you incur to acquire an asset (a business) that will benefit you for more than one year. Normally, you can’t deduct these types of expenses until you sell or otherwise dispose of the business. However, a special tax rule allows you to deduct up to $5,000 in start-up expenses the first year you are in business, and then deduct the remainder, if any, in equal amounts over the next 15 years. (I.R.C. § 195.)
Example: Diana Drudge is sick of her office job. She decides to start a fashion design business.
Before her business begins, she spends $20,000 of her life savings on advertising. Her business finally starts on July 1, 2014. Because such advertising is a start-up expense, she can’t deduct the full cost in her first year of business—instead, she can deduct $5,000 of the expenses the first year she’s in business and the remaining $15,000 in equal installments over 15 years (assuming she’s in business that long). This means she may deduct $1,000 of the remaining $15,000 for each full year she’s in business, starting with the first year. However, Diana’s business is open for only six months her first year, so she may deduct only $500 of the $15,000 that year, plus the initial $5,000 she’s entitled to. Her total first year total deduction is $5,500.
Obviously, you want to spend no more than the first-year ceiling
on start-up expenses so you don’t have to wait 15 years to get all your money back.
Special Rules for Some Expenses
There are some costs related to opening a business that are not considered start-up expenses. Many of these costs are still deductible, but different rules and restrictions apply to the way they are deducted.
The largest expense many home business people incur before they start their businesses is for inventory—that is, buying the goods (or the materials to make them) that they will sell to customers. For example, if you decide to start an eBay business selling items you buy at flea markets, you would treat the items you purchase for resale as inventory. You deduct the cost of inventory as it is sold or if it become unsalable.
Long-term assets are things you purchase for your business that will last for more than one year, such as computers, office equipment, cars, and machinery. Long-term assets you buy before your business begins are not considered part of your start-up costs. Instead, you must treat these purchases like any other long-term asset you buy after your business begins: You must either depreciate the item over several years or deduct the cost in one year under Section 179. However, you can’t take depreciation or Section 179 deductions until after your business begins.
Research and Development Costs
The tax law includes a special category for research and development expenses. These are costs a business incurs to discover something new (in the laboratory or experimental sense), such as a new invention, formula, prototype, or process. They include laboratory and computer supplies, salaries, rent, utilities, other overhead expenses, and equipment rental, but not the cost of purchasing long-term assets. Research and development costs are currently deductible under Section 174 of the Internal Revenue Code, even if you incur them before the business begins operations.
Costs you incur to form a partnership, limited liability company, or corporation are technically not part of your start-up costs. However, the rule for deducting these costs is the same as for start-up expenses. (I.R.C. § 248.) But, if you form a one-member LLC, you get no deduction at all if your start-up expenses exceed $5,000
When Does a Business Begin?
Once your business begins, the same expenses that were start-up expenses before your business began become currently deductible business operating expenses. For example, supplies you purchase after your business starts are currently deductible operating expenses, but supplies you buy before your business begins are start-up expenses.
So, just when does a new business begin? The courts have held that a new business begins for tax purposes when it starts to function as a going concern and performs the activities for which it was organized. (Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965).) The IRS says that a venture becomes a going concern when it acquires all of the assets necessary to perform its intended functions and puts those assets to work. In other words, your business begins when you start doing business, whether or not you are actually earning any money.
For example, if your business involves providing a service to customers or clients—
such as accounting, consulting, financial planning, or law—your business begins when you first offer your services to the public. No one has to hire you; you just have to be available for hire. For example, a consultant’s business begins when he or she is available for hire by clients.
If you’re a knowledge worker—for example, a writer, artist, photographers graphic designer, computer programmer, app developer—your business begins when you start using your business assets to make saleable products. The products don’t have to be completed, nor do sales have to be solicited or made. Thus, an inventor’s business begins when he or she starts working on an invention in earnest, not when the invention is completed, patented, or sold. Likewise, a writer’s business begins when he or she starts working on a writing project.