Here’s what you need to know about deducting start-up costs, along with
a real-life example of how the Tax Court applied the rules.
Internal Revenue Code Section 162 allows current
deductions for “ordinary and necessary” business expenses. Section 162 expenses
are basically routine expenses incurred in operating an up-and-running
business. Examples include employee wages, rent, utilities and advertising.
Section 162 expenses can generally be deducted in the year when they’re paid or
incurred.
Many taxpayers are unaware that Section 162-type
expenses incurred by a start-up can’t necessarily be deducted right away.
That’s because these expenses are classified as Section 195 start-up expenses
until the “active conduct” of business begins.
Once a taxpayer meets the active-conduct standard,
Section 162-type expenses become Section 162 expenses, and the taxpayer can
deduct them currently. (This assumes that other provisions — such as the
passive activity loss or at-risk basis rules — don’t come into play and prevent
current deductibility.)
Deduct or Amortize Section 195
Expenses When Business Commences
Section 195 start-up expenses are Section 162-type
expenses that are incurred before the
business actively commences operations. Start-up expenses can include costs
incurred:
- To investigate the creation or
acquisition of a business,
- To create a new business, or
- To engage in any for-profit activity
before the active conduct of business begins, in anticipation of such an
activity becoming an active business.
Common examples of Section 195 start-up expenses
include employee training, rent, utilities and marketing expenses incurred
prior to opening a business.
In the tax year when active conduct of business
commences, the Section 195 rules allow taxpayers to elect to amortize start-up
expenses. The election potentially allows an immediate deduction for up to
$5,000 of start-up expenses. However, the $5,000 deduction allowance is reduced
dollar-for-dollar by the amount of cumulative start-up expenses in excess of
$50,000. Any start-up expenses that can’t be deducted in the tax year the
election is made are amortized over 180 months on a straight-line basis. Amortization
starts in the month in which the active conduct of business begins.
A taxpayer is deemed to have made this election in the
tax year when active conduct of business commences unless, on a timely filed
tax return for the year, the taxpayer elects instead to capitalize start-up
expenses.
