Anyone who grew up having water balloon fights knows that only 10% of the time is actually spent throwing water balloons. The other 90% is spent painstakingly filling them up, one at a time.
That’s how it feels starting a new business. Just replace brightly colored water balloons with accountants, realtors, attorneys, suppliers, and a mounting pile of bills.
Your bank account bleeds money before you ever earn a dime. Luckily, these startup costs come in handy when it’s time to file your business taxes for the first time. Sometimes, you can even deduct them before you have any income.
What are startup costs?
Startup costs are expenses you have when you start or buy a new business. These expenses are different from most write-offs because of when they occur.
Startup costs are regular business write-offs, except you pay for them before your business becomes officially active. Normally, you can’t claim a write-off if you paid for it before officially starting your business. (More on what counts as your start date below!). But if that was a hard-and-fast rule, it would discourage the entrepreneurial spirit.
That’s why the IRS allows taxpayers to write off some of the expenses they paid for before the business actually existed.
What does this mean for you? Here’s the simple answer: the first year you file taxes for your business, you can actually claim write-offs from several years before.
When can you start claiming your startup costs?
Taxpayers have gotten in lots of trouble for not understanding the most important thing about startup costs: You can’t start writing them off until your business is officially active.
The problem: It isn’t always super clear when that is. Here’s how to figure it out.
For freelancers and sole proprietors
Your business’s official start date is either:
- The day you actually start receiving income, or
- The day you start contracting work or actively bidding on projects
Note: Being officially “active” doesn’t have to mean you’re earning income yet. It’s not uncommon for sole proprietorships to not have any income for a while after starting. If that’s your situation, you can still write off your startup costs.
The key thing is, if the IRS were to come knocking, you’d need to prove you were trying to acquire business. Here are some things you could show to demonstrate:
- Bidding on jobs through apps like UpWork or Fiverr
- Active marketing to attract potential customers
- Using LinkedIn and other referral networks to find clients
- Cold-calling potential customers
- Offering discounts or free trials to attract new customers
The emphasis here needs to be on what you’re actively doing to get business. Handing out the occasional business card or creating a website isn’t going to cut it.
For partnerships and corporations
Your official start date is easier to find. It’s usually just the filing date on your formation documents.
What counts as a startup cost?
Startup costs fall into two primary categories: investigative costs and organizational costs.
Investigative costs refer to money you spend figuring out whether a product or service is viable. In other words, can you make money off of this idea?
To figure that out, you usually have to spend some money first.
For example: if you want to open a hair salon, what are some questions you have to answer before you can start operating?
Are there spaces available to open your salon?
You can’t cut hair on the sidewalk. You’ll need to find a place that can accommodate your salon. When looking for storefronts, you might have to hire a realtor or put down non-refundable security deposits at several locations.
How are you going to get customers?
Knowing there’s demand for a new hair salon isn’t enough to get customers. You’ll need to actively raise awareness that your salon is opening. That might mean spending money on advertisements, business cards, and signs.
What supplies do you need to offer your services?
Before the doors open, you’ll need to have a range of haircare products on hand. That means meeting with various suppliers and purchasing samples and test products.
Will you need help running your salon?
Hair salons are difficult to operate alone. If you hire staff, they’ll need to be trained prior to opening day, which involves payroll expenses and accounting fees.
These expenses are necessary for a successful launch even though your business hasn’t started yet. That’s why they’re included under the umbrella of startup costs.
But the list doesn’t end there. Your investigative costs can also include:
- 📊 Market research
- 👩💼Consulting fees
- 🏬 Office rent
- 💡Office utilities
- ✈️ Travel costs for finding distributors, customers, or suppliers
- 🤑 Costs related to buying another business
- 💵 Wages and labor costs during training
As long as you incurred the expense while trying to lay the groundwork for your business, it most likely counts.
Just like your regular business deductions, you have to keep track of your startup costs in order to claim them. If you’re planning to start a new business this year, get started on the Keeper app so you don’t miss any of your startup write-offs. The app will automatically keep track of them for you so they’re all ready for you to claim once you’re officially in business.
These startup costs might be more appropriately called “hazing costs.” They’re inescapable and just might make you quit before you’ve even started.
In a nutshell, organizational costs are bureaucratic expenses related to actually opening your business. They could include things like:
- ⚖️ Legal fees to file startup paperwork
- 📃 Partnership filings and agreements
- 🧮 Preliminary accounting services
- ✒️ Business registration fees
- 🏷️ Registering for seller’s permits
- 🍩 Cost of organizational meetings
For freelancers and sole proprietors, these are less common. Many even wait to register for their business licenses until they’re actually making money.
What doesn’t count as a startup cost?
Some purchases fit the technical description of a startup cost, but the IRS specifically prevents you from writing them off.
In many cases, it’s because these costs are already eligible for some kind of special tax treatment. In other cases, they’re just not deductible.
Here’s a list of these expenses. If there’s a checkmark next to them, it’s because you can deduct them on your taxes some other way. If there’s an X, you can’t deduct them at all.
✓ Interest payments
These can’t be included in your startup costs because the IRS has special rules and limitations on deducting business interest. Most small business owners don’t have to worry about these rules, but they still have to split out their interest for reporting purposes.
Other types of interest — like credit card interest — can’t be claimed unless the business is already formally operating.
Taxes typically can’t be treated as startup costs, all for various reasons. Sales tax on equipment you bought would be included in the price of the equipment and capitalized.
Other taxes — such as real estate taxes — can’t be written off at all unless they happen while the business is formally active.
Payroll taxes are the one exception. If they’re incurred while training staff prior to opening, they can be included with your startup costs.
✓ Equipment and other depreciable assets
You can’t include large assets like equipment in your startup costs because they’re most likely going to be written off at a different rate than your other startup costs.
Why? You’ll have to depreciate them. That means you write them off little by little over a set number of years, based on how long their “useful life” is considered to be.
Let’s go back to our example of the hair salon. The sinks and dryers you install prior to opening day have a pre-assigned useful life of five years. Most startup costs, though, have to be spread out over fifteen years due to how they’re amortized. (Don’t worry, we’ll get into this later!)
✓ Product research and development
The money you spend researching and developing a specific product needs to be amortized over five years, so you wouldn’t include them in startup costs.
In addition, the money spent on research and development is often eligible for various business credits, so it’s better to keep them separate when reporting them.
Note: The research referred to here is product-specific research, such as lab tests and experimentation. Market research to determine customer interest is included in startup costs.
✘ Qualification fees
Money you spend getting credentialed to work in a particular field can’t be included in startup costs (and are generally not tax-deductible).
For example, if you want to open a real estate company, you can’t deduct the cost of acquiring your real estate license.
✘ Failed acquisition
If you try to buy another business and it doesn’t pan out, the costs you incur along the way can’t be included in your startup expenses. (This is true whether you were trying to buy their entire business — staff and all — or just the product or service they offer.)
Only registered C corporations can write off failed business ventures. Sole proprietors are out of luck.
Claiming startup costs on your taxes
The time, money, and effort put into laying the groundwork for a new business is valuable. That's why it gets special treatment at tax time.
Instead of writing off these costs all at once, they have to be “capitalized” and “amortized” over 15 years.
Let’s break down what that means.
Capitalization and amortization
Capitalization is just a fancy way of saying, “This is worth something valuable, and it’ll benefit you for a long time.” Expenses that have to be capitalized can also be referred to as “fixed assets.”
Because of their value, capitalized startup costs are “amortized” over a 15-year period. Meaning, the write-off is spread out over multiple years rather than taken all at once.
Capitalization and amortization in action
For example, if you have $30,000 in startup costs, you could claim about $2,000 as a write-off your first year ($30,000 / 15 years = $2,000/year).
The actual calculation is a bit more complicated than that, but you get the idea.
Think of it this way. If you’re offered a glass of Johnnie Walker Blue Label — priced at $350 a bottle — you wouldn’t shoot it like it’s a $25 Jack Daniels. That would be rude. Instead, you’d sip slowly over the course of the evening.
Startup costs are your fancy whiskey. They’re too valuable to take all at once, so you write them off slowly.
First-year bonus amortization
For those of you who are only here for the buzz, I have some good news.
On your first year return, the IRS will let you take up to $5,000 of your startup costs as a write-off. Sure, it’s not the same as being able to claim it all at once, but it’s better than nothing.
For startup costs over $50,000
There is one caveat. If your startup costs exceed $50,000, the bonus begins to phase out, dollar for dollar.
If you have $53,000 of startup costs, your “bonus” would be $2,000. That’s because $53,000 is $3,000 more than the limit of $50,000, and $5,000-$3,000 is $2,000.
Once your startup costs reach $55,000 or more, you can’t claim any bonus at all.
What happens to your startup costs if business closes down?
If you end up closing your business before 15 years are up, you can claim the remainder of your startup costs on your final business tax return.
If your startup costs generate a loss, the loss can be “carried forward” to lower your regular income in future years.
Can you claim startup costs for a business that never started?
Unfortunately, no. You can’t write off startup costs if your business ended up not getting off the ground.
Sometimes, you end up spending time, money, and energy looking into a business — only to determine that it won’t work out.
Unless you registered as a corporation, those costs aren’t tax-deductible. Otherwise, there would be taxpayers every year trying to claim “startup costs” on their tax returns.
Leave it to the few bad eggs to spoil a good thing for the rest of us.
This is one of those areas where the IRS has to work with the lowest common denominator — assuming the worst from all taxpayers.
While it might not have the same sweet satisfaction of smacking your sister with an extra-large water balloon, startup costs are a nice tax break for young business owners. Keeper can help you keep track of these expenses from day one. Our app will automatically scan and record all your eligible write-offs for you, so when it’s time to file, you’re ready to go.
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At Keeper, we’re on a mission to help people overcome the complexity of taxes. We’ve provided this information for educational purposes, and it does not constitute tax, legal, or accounting advice. If you would like a tax expert to clarify it for you, feel free to sign up for Keeper. You may also email firstname.lastname@example.org with your questions.