Tax Treatment of Startup Expenses

Are you starting a new business?

If so, your “start-up” expenses generally can’t be currently deducted. You can, however, elect to deduct a limited amount of start-up costs for the tax year in which the active trade or business begins (up to $5,000 ($10,000 for a tax year beginning in 2010), reduced by the amount by which the start-up costs exceed $50,000 ($60,000 for a tax year beginning in 2010)), with the remainder amortizable ratably over a 180-month period beginning with the month in which the active trade or business begins. This election is only available for start-up expenses that relate to an active trade or business, and not to investments.

One way to avoid or minimize start-up expenses that are nondeductible or which must be amortized over a 180-month period is to buy an activity that has already been developed by another taxpayer to the point of being an active trade or business. Once an active business is acquired, amounts spent to expand it generally won’t be subject to the special rule barring the deduction of start-up expenses.

“Start-up” expenses subject to the special election include those incurred in: investigating the acquisition or creation of an active trade or business; creating an active trade or business; or carrying on an activity engaged in for profit before the activity becomes an active trade or business, in anticipation of the activity becoming an active trade or business.

The rule generally barring the current deduction of start-up expenses ceases to apply once the business becomes active, nor does the prohibition apply at any time to certain interest, taxes and research expenditures. Also, the rule generally barring the current deduction of start-up expenses doesn’t apply to the cost of expanding an already existing active trade or business.

Has your business reached the “active” stage?

The rule barring current deduction of start-up expenses only applies to expenses incurred before the activity becomes an active trade or business. Also, 180-month amortization begins with the month in which this happens and the election to amortize must be made with the return for the tax year in which the business reaches the active stage.

Generally speaking, if the activities of a taxpayer have advanced to the extent necessary to establish the nature of its business operations, the taxpayer will be considered to have begun an active business. For example, the acquisition of operating assets which are necessary to the type of an active business contemplated may constitute the beginning of an active business. On the other hand, the receipt of income, in and of itself, doesn’t necessarily mean that the active business stage has been reached. And even if all necessary business assets are on hand, IRS and some courts may require something more under certain circumstances before an activity is deemed to be an active business, for example, the commencement of marketing activities or the actual operation of business assets.

The time at which an activity becomes an active business is an important determination because a miscalculation on this point can cause the loss of important tax benefits. For instance, the election to deduct/amortize start-up expenditures must be made not later than the due date of the taxpayer’s return (including extensions) for the tax year in which the active business begins. If a taxpayer has any doubt as to when the active business began, an election should be made in the year the expenditures are paid or incurred, or at least in the first year there is any reason to believe IRS might take the position that business began. Otherwise, the right to make the election would be lost if IRS successfully claimed that the business actually began in an earlier year.

Do you expect to pay interest, taxes or research expenses in starting a new business?

Otherwise deductible interest, taxes and research expenses aren’t subject to the rule that generally bars the current deduction of start-up expenses.

Do you plan to expand an already existing active business?

Ordinary and necessary business expenses incurred in expanding an already existing active trade or business (whether purchased or created by the taxpayer) aren’t subject to the special limits on start-up expenses and are generally deductible.

Whether a taxpayer is expanding an old business or starting a new one can be a tricky determination in certain cases, especially where there is a change in the kind of business done as well as in the size of the old business.

If in doubt, consider treating the outlays in question as start-up expenses while making the amortization election. In the event that it’s later determined that you were in fact expanding an old business (and not creating a new one), it’s possible that you will still be able to deduct the expenses by filing an amended return. On the other hand, if the election isn’t made and the outlays are later determined to be start-up expenses, you will be stuck with expenditures that have to be capitalized and can’t be amortized.

If the intention is to expand an old business through a new and different entity (for example, through a newly organized partnership or corporate subsidiary), the expenses generally can’t be currently deducted.

Do you plan to expand an old business through a new entity?

If so, the special exception for expenses incurred to expand an old business may not apply. This is because the trade or business activities of one tax entity can’t be attributed to another for this purpose. For instance, if a partnership incurs expense to create additional branches or units for its already existing business to be carried on by separate tax entities, for example by newly organized corporations to be owned by the partnership, the expenses won’t qualify under the exception. One solution to this problem would be to have the partnership or other original entity first transfer part of its old business to the new corporation, then have the new corporation expand it. Or buy an old corporation that’s already in the same line of business and then have the old corporation expand that business. In either case, the corporation would be able to deduct the expansion outlays.

In the case of a corporate parent-subsidiary situation, a special rule may allow the deduction of expansion expenses incurred before the sub comes into existence if (1) the parent and the sub are in the same business, (2) the customers of the sub have the right to obtain goods or services from the parent if the sub can’t provide them, and (3) gross receipts from the expansion are reported as income on the affiliated group’s consolidated return. This might apply, for example, to a chain of health clubs.

Does the contemplated business require a license or franchise or other outlay that ordinarily must be capitalized?

The deduction/amortization election only applies to outlays that would be currently deductible if it weren’t for the start-up expense limitation. As a result, items that ordinarily have to be capitalized, such as the cost of acquiring a license or a franchise, don’t qualify for the election. However, the cost of a license or franchise may be amortizable.

Do you expect to incur syndication or organizational expenses?

Starting a new business may involve partnership or corporation organization expenditures. You can elect to deduct a limited amount of these expenditures (up to $5,000, reduced by the amount by which the organizational expenses exceed $50,000), with the remainder amortizable over a 180-month period beginning with the month in which the active trade or business begins. If the election isn’t made, no deduction would generally be allowed until the organization goes out of existence. Also, the deduction/amortization election doesn’t apply to partnership syndication expenses, which must always be capitalized.

Have you tried to start a new business, then given up on the project?

The deduction/amortization election doesn’t apply to unsuccessful search, investigatory, or pre-opening expenditures for a new business or a for-profit investment transaction. In the case of a corporation, these fruitless start-up costs can be deducted as a loss when the project is abandoned. But the unsuccessful start-up expenses of noncorporate taxpayers not engaged in a trade or business when the start-up costs are paid or incurred are, with one exception discussed below, treated as nondeductible, personal expenses.

Where a noncorporate taxpayer has gone beyond a general search for a new business to focus on a specific enterprise, the unsuccessful start-up expenses are deductible as a loss.

Noncorporate taxpayers contemplating substantial expenditures in investigating a new business should consider organizing a small business corporation to undertake the search and, if successful, to conduct the new business. If the search or investigation proves fruitless, the stockholders are entitled to an ordinary loss deduction on their small business corporation stock.

Do you plan to use depreciable assets in starting a new business?

Ordinarily, depreciation deductions are not available until the asset is placed in service in the taxpayer’s trade or business. However, elective deduction/amortization is available for amounts that would be deductible if paid or incurred in an existing business. Thus, the cost, for example, of a computer or word processor used to train new employees or to set up an accounting system, to the extent depreciable during the start-up period, should qualify for the deduction/amortization election.