Startup and Organizational Costs: What You Can Deduct Before Opening Day

The first dollars a new business owner spends are often the least documented. Market research, legal fees, website development, training, and travel to meet suppliers all happen before there is any revenue. The tax code has specific rules for what to do with these pre-opening costs, and they differ from the rules for expenses of an operating business.

The basic principle

A business expense is deductible when the business exists. The IRS regards a business as beginning when it is ready to serve customers, not merely when you have formed an entity or decided to start. Costs incurred before that date are called startup costs (or pre-opening costs). They are generally treated as capital expenditures, not immediately deductible, but the tax code provides a special election that allows a partial upfront deduction and amortization of the remainder.

Startup costs

Startup costs are amounts paid or incurred to investigate creating or acquiring an active trade or business, or to create an active trade or business, that would be deductible if paid in connection with an existing business in the same field. Common examples:

Market and feasibility research.
Analysis of potential locations, products, or services.
Advertising before opening, including grand-opening promotion.
Costs to recruit and train employees before opening.
Travel to line up suppliers, distributors, or customers.
Consulting and professional fees for planning.
Wages and other costs for employees during pre-opening training.

Not included: costs to acquire depreciable property (equipment, vehicles, buildings), which are capitalized and recovered through depreciation; inventory purchases; interest, taxes, and research costs that are treated under other rules.

Organizational costs

Organizational costs are the costs of creating a corporation or partnership. For LLCs taxed as partnerships or corporations, the corresponding rules apply. Examples:

Legal fees for drafting articles, bylaws, or an operating agreement.
State filing fees.
Organizational meeting costs.
Fees for temporary directors.
Accounting fees for setting up the entity.

Not included: costs of issuing or selling stock or interests (capital raising costs), costs of transferring assets to the entity, and costs that relate to the entity's operations. Some of these are treated as reductions of capital or capitalized.

Single-member LLCs that are disregarded entities generally do not create an organizational cost category in the same way. The costs may be treated as startup costs or as other capitalized costs. Ask your adviser how to classify.

The $5,000 deduction and phase-out

The tax code permits an immediate deduction of up to $5,000 of startup costs and up to $5,000 of organizational costs in the year the business begins. The $5,000 amount is reduced dollar-for-dollar when total startup costs exceed $50,000 (and similarly for organizational costs). If startup costs exceed $55,000, the immediate deduction is fully phased out. The remaining costs are amortized over 180 months (15 years) beginning with the month the business begins.

You generally are treated as electing to deduct and amortize unless you choose to capitalize the costs. Keep a schedule showing the costs, the amount deducted in year one, and the monthly amortization.

Example with invented numbers

An owner spends $8,000 on pre-opening costs: $2,000 for market research, $1,500 for training courses related to the new service, $2,500 for a pre-launch marketing campaign, and $2,000 for travel to meet suppliers. Separately, the owner pays $1,200 in legal and state fees to form an LLC taxed as a partnership. Under general rules, the owner may deduct $5,000 of startup costs in the first year of operation, with the remaining $3,000 amortized over 180 months, and may deduct all $1,200 of organizational costs. Amounts differ with facts.

When does the business "begin"?

The date matters. It affects when deductions start and how costs are classified. Generally, a business begins when it has started the activities for which it was organized and is functioning as a going concern, for example, when you first offer services or sell products. Not simply when you obtain a license or buy equipment. If you spend money and never start the business, startup costs are generally not deductible except in certain limited cases for costs of investigating the acquisition of a specific business. Track the date you first open for business or first bill a customer.

Costs after opening

Once the business is operating, ordinary expenses are deductible as they are incurred. The pre-opening rules do not apply. An expense that happens right after opening (say, advertising in the first month) is a normal deduction. Do not treat ongoing costs as startup costs.

Equipment, inventory, and assets

Property with a useful life beyond the year is generally capitalized and depreciated when placed in service, or expensed under provisions such as Section 179 or bonus depreciation, subject to limits. Small items may be deductible under de minimis rules. See Section 179 and depreciation basics. Inventory costs are recovered as goods are sold.

Record-keeping for a new business

Open a business bank account before spending, if possible, and run pre-opening expenses through it or track them with reimbursements to yourself. See separating personal and business finances.
Keep receipts and invoices for every pre-opening cost.
Tag costs as startup, organizational, or asset in your bookkeeping software or a spreadsheet.
Record the business start date.
Save formation documents and invoices from attorneys and filing agents. See how to form an LLC.
Keep a schedule of amortization in your workpapers.

Interaction with hobby rules

If the activity does not qualify as a business (because you do not have the intent to make a profit), the expense rules change. See is it a business or a hobby.

If the business is sold or closed

If you dispose of the business before amortization is complete, the remaining unamortized amounts may generally be deducted as a loss in the year of disposition, subject to rules. Coordinate with your tax adviser.

Common mistakes

Deducting everything immediately in the year of spending, when pre-opening.
Failing to track costs before the business began.
Classifying equipment as startup costs.
Not tracking the start date.
Missing the amortization schedule in later years.
Deducting capital-raising fees as organizational costs.
Forgetting to include pre-opening costs paid personally as contributions or reimbursements.

For help classifying your pre-opening costs, AE Tax Advisors can assist, and a discovery call is an easy way to get started.