When the Rolling Stones play Start Me Up, we’re pretty sure they aren’t singing about business startups. However, the tax rules for startup costs can make a grown man cry. Let’s take a close look so you can have some satisfaction in your understanding of this important startup business issue. And maybe you can save a few dollars of income taxes along the way. Let’s roll right into it so you can get this subject under your thumb!
What time period is your business in?
The IRS divides your business into two time periods: startup mode and the active trade or business period.
A business becomes an active trade or business when it’s ready and able to do business the way that it’s intended to. In other words, when your business is ready to start selling its core products or services, it becomes an active business. Before that, it’s in startup mode.
Startup mode often ends when the first sale is made—but not always. Sometimes miscellaneous income is earned but the business continues to be in startup mode. For example, the business might earn some interest income or might sublet out extra space and get some rent income. Such a business is still in startup mode until it is able to earn income from its core business activities. Other times, even though it hasn’t made a sale yet, a business is no longer a startup in the eyes of the IRS because it’s ready to fulfill its primary business purpose—it’s ready to do business.
Why does the startup period of your business matter?
During startup mode deductions are limited to interest, taxes and research and experimental (R&D) costs. All other deductions are considered startup costs, and these deductions are put on hold until the business becomes active in the eyes of the IRS. The startup costs are then deducted over a steady stream—tax people would say they’re amortized — for fifteen years. If the business shuts down, any remaining un-deducted startup costs are fully deductible on the final year tax return.
Let’s say your business incurs $150,000 of startup costs. When it becomes active, you’ll start deducting these costs at a rate of $10,000 per year. These deductions were locked and are then released over a steady stream for fifteen years. One possible tax strategy, if you expect to be profitable quickly, is to defer some expenses until after startup ends, expenses that can wait until your business is active. In that case, you’d have less startup costs and get those deductions in full in the year incurred, rather than lock them into a fifteen-year deduction schedule.
There’s more to this, but the heart of it is what we laid out above. Some extra food for thought you’ll also want to consider is:
- If you have less than $55,000 of startup costs, you can deduct up to $5,000 during startup mode. This $5,000 amount phases out between $50,000 and $55,000, so if the total is more than $55,000, you’d need to defer the entire amount and spread it out over fifteen years.
- Organization costs, the costs of setting up your business entity, follow a similar set of rules and are treated separately from startup costs.
- During startup mode, you might be eligible for an R&D credit along with the payroll tax offset which reduces payroll taxes so it saves you cash in the short-term.
- Feeling good with startup taxes? Take a much deeper dive into this IRS resource.
It’s commonly known, when it comes to taxes, you can’t always get what you want—but with the help of the inDinero tax team—you can get what you need.