Deducting Start-Up Costs for Federal Tax Purposes

There's been a significant increase in new business applications in recent years. Finance company NerdWallet estimates that 2.8 million new business ventures have started since 2021.

If you've started a new business this year — or you're contemplating launching one soon — you may have questions about the tax treatment of start-up expenses. Let's take a closer look at the details.

The Basics

Internal Revenue Code Section 162 allows current deductions for "ordinary and necessary" business expenses. Deductible Sec. 162 expenses include those incurred to operate an established business, such as employee wages, rent, utilities, and advertising expenses.

So, established companies can generally deduct Sec. 162 expenses in the tax year in which they're paid or incurred (subject to certain special rules and limitations). In other words, they get near-instant tax gratification from these expenses.

Start-ups, however, can't necessarily deduct many business expenses 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, Sec. 195 expenses qualify for current deductions. (This treatment assumes that other provisions — such as the passive activity loss or at-risk basis rules — don't come into play and prevent current deductions.)

Current Deduction Rules

Essentially, Sec. 195 start-up expenses are Sec.162 expenses that are incurred before the business actively commences operations. Typically, start-up costs may include:

• Wages paid to employees and instructors for their training
• Fees for consultants and payments for professional services
• Surveys of potential markets, products, labor supply, and transportation facilities
• Advertisements for opening the business
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers

In the tax year, when active conduct of the business commences, a taxpayer can choose to deduct start-up expenses currently. 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 cumulative start-up expenses above $50,000. For example, if your start-up costs $50,500, your deduction is limited to $4,500.

Any start-up expenses that can't be deducted in the tax year the election is made must be 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 the taxpayer elects instead to capitalize start-up expenses on a timely tax return. Your tax advisor can further explain these concepts.

Important: Sec. 195 start-up expenses don't include interest expense, taxes, or research and development costs. These expenses are subject to specific rules that determine the timing of the deductions. Sec. 195 start-up expenses also don't include corporate organizational costs or partnership or limited liability company organizational costs. However, the tax treatment of those expenses is similar to the treatment of start-up expenses. 

Will Your Start-Up Succeed?

Start-ups can be risky business. According to data from the U.S. Bureau of Labor Statistics, roughly one in five new businesses close within a year. And it doesn't necessarily get easier from there. For example, the agency's data shows that, of all the companies that opened in March 2013, only 34.7% remained open in 2023.

Lack of planning and undercapitalization are two common problems. Here are some tips to create a solid foundation:

Create a formal business plan. You'll need to map out your mission and vision statements, business concept, marketing plan, and financial projections. The plan should show that you've considered potential threats and risks, such as seasonal cash flow shortages and hidden costs. A comprehensive written plan is especially important to raise capital from investors and lenders. 

Monitor cash. Once you receive an influx of capital — from your savings or external sources — you'll need to watch every penny out the door because it can disappear quickly. Starting a new business usually requires substantial working capital to buy inventory, pay employees, and cover other expenses. If cash tightens, you may need to raise additional capital before receiving customer money.

Build your team. Entrepreneurs usually can't do everything on their own. If you do reach out to investors and lenders, they'll assess the quality of your management team — including their employment histories and areas of expertise. You may need to hire a small staff to bridge any skill gaps you (and any other owners) don't have. Consider how much power to give employees to make tough decisions when you're not available.

Lastly, any start-up's team should include outside legal, financial, and tax advisors. These professionals can help you cover all the bases and ensure your new business has long-term staying power.

Time It Right

When you incur business start-up expenses, keep two key points in mind. First, start-up expenses can't always be deducted in the year when they're paid or incurred. Second, no deductions or amortization write-offs are allowed until the year when active conduct of the business commences. That usually means the year when the business has all the pieces to begin earning revenue.

Timing may be critical if you have start-up expenses that could be currently deducted. Contact us to discuss your situation.

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