Did you start a business this year? If you started a business in 2018, any startup expenses you incurred for planning, researching, or outfitting your office may be eligible to be claimed as a business startup deduction to take in 2018 and claim it on your 2018 return.
Let’s begin with determining your start date. Just because you’ve filed incorporation papers (such as articles of incorporation or articles of organization) and have been issued a Federal Tax ID number or Employer Identification Number (EIN) doesn’t necessarily mean you have started a business. Your business officially starts when the business begins operations and has the potential to make a profit.
For an e-commerce business, that means your website is ready to take orders. For a retail store or a restaurant, it means you’ve opened your doors for business. For a service business, it means you’re ready to take on clients. You don’t have to have actually made a profit in 2018 (startups rarely do immediately), but you must have the potential to make a profit. That said, the year the business starts is more important than the actual date, as that will be considered the first tax year of the business.
Now, let’s begin to explore business startup costs and which business startup expenses maybe used as tax deductions.
What Counts as Startup Expenses That May Be Business Tax Deductions?
The IRS has two rules to qualify an expense as a startup expense (a capital cost):
- The expense was paid or incurred before the day your active trade or business began.
- The expense would be deductible for your business if you were already operating the business. (Note: the actual business you open has to be in the same field as the business you had in mind when you incurred the expenses. For example, if you incurred a startup expense when you were planning to open an ice cream shop, but later changed course and opened a retail boutique, you can’t deduct the expenses related to the ice cream shop.)
Categories of Business Startup Expenses
Costs associated with starting a new business must be either “investigative” or“opening-a-business” expenses.
Investigative Startup Costs
Some examples of investigative startup costs include:
- Market surveys
- Background checks
- Site selection
- Industry research
- Professional fees (Professionals aren’t just lawyers and accountants—you might have also used the services of business coaches, software developers or engineering firms.)
Subscriptions and dues for trade associations are also a deductible startup expense. Pay for them now but be aware that under a special 12-month tax rule, you can deduct only the portion of subscriptions and dues that will be used by the end of next year.
Opening a Business Expenses
Expenses related to opening a business include:
- Advertising (online and offline) and marketing for the opening of the business. This could include hiring a marketing consultant or graphic designer, paying freelance writers for content marketing, the costs of both online and offline advertising, and print marketing materials such as flyers, brochures, etc.
- Travel expenses related to the costs of securing distributors, suppliers or customers. Even if you’re just driving around town using your personal vehicle to meet with potential customers, don’t forget to keep track of your mileage during the times you use your car for business. (The current mileage deduction is 5 cents per mile of business driving.)
- Any salaries and wages for trainers and their trainees (employees)
- Expenses related to setting up your office such as mortgage or lease costs, utilities, office supplies, cleaning services and internet service. Website design and development also falls into this category. If you started your business in your house, calculate the square footage of your home office as a percentage of your home’s total square footage. Your deductible startup expenses are the corresponding percentage of home costs like internet service, utilities, mortgage and repairs.
- Although leasing office equipment is a deductible startup expense, purchasing office equipment is not. Instead, long-term assets (that is, items that will last a year or more) such as computers, office equipment, vehicles and machinery must be depreciated over several years or deductible in one year under Section 179 of the tax code.
Purchasing inventory is not considered a startup expense. Inventory is a reduction of your gross receipts. If you’ve purchased inventory and have yet to sell anything,that cost is reported as a loss on your business taxes.
If you set up a retirement plan during your startup year, you may be able to claim a tax credit for some of the costs of starting a SEP, SIMPLE IRA or other qualified plan. A tax credit reduces the amount of taxes you owe on a dollar-for-dollar basis. This includes costs incurred to set up and administer the plan and the cost of educating your employees about the plan.
Business Formation Expenses
Your business’s legal structure also has deductible startup costs associated with the formation’s paperwork and filing fees. Expenses are the direct costs for creating a corporation, an LLC or partnership. To qualify as an organization cost, the IRS requires the expense to be:
- For the creation of the corporation
- Chargeable to a capital account
- Amortized over the life of the corporation if the corporation had a fixed life, and
- Incurred before the end of the first tax year in which the corporation is in business.
Examples of startup tax-deductible expenses related to forming a company include state incorporation fees, legal fees, organizational meetings, and salaries for temporary directors.
Costs that do not qualify as deductions include costs for issuing and selling stock or securities (e.g.commissions, professional fees, and printing costs)and costs associated with the transfer of assets to the corporation.
Because the 2018 Tax Reform favors C corporations, you may want to consider incorporating.Before the new law, corporate tax rates were similar to individual tax rates and varied depending on profits and income. Under the new tax law, however, C Corps will be taxed at a flat rate of 21%. Also, under the new law, S Corporations, Limited Liability Corporations (LLCs),partnerships, and sole proprietorships will be taxed at individual rates, minus a deduction of up to 20%.
As far as startup capital costs go, for your first year in business if the costs are less than $50,000, you can have a business tax deduction of up to $5,000 in startup expenses; any additional costs over $5,000 must be amortized.
Finally, keep detailed records of all your business expenses to protect yourself in case of a tax audit. And make sure to keep your business and personal finances and activities separate so you don’t risk piercing that ever-important corporate veil. As with any tax-related issues, I strongly encourage you to talk to an accountant or tax advisor to discuss your specific situation. A licensed tax professional can offer further explanation, provide expert advice, and answer your startup business tax deduction questions.