NEW YORK — One of the most frustrating tax issues for entrepreneurs has been startup costs — they pour thousands of dollars into market research, advertising and other expenses to get their companies up and running, but have had little in the way of immediate relief from the government.
But, with a change in the Internal Revenue Code that took effect Oct. 22, 2004, companies — including many filing their first tax returns this year — are now allowed to deduct $5,000 of their startup costs. Any expenses above that amount must be amortized, or depreciated, over the next 15 years — the method that applied to all startup costs in the past.
Startup costs include many of the expenditures a company makes before it actually starts doing business. Market research, advertising, employee recruiting, lawyers, accountants, consultants, rent, office supplies typically are part of a new concern’s startup costs.
Until 2004, the government theorized that the money paid to start a business was an investment; once a company was actually transacting business, it had operating expenses (which can also include all the above-mentioned outlays) that were fully deductible up front. The change in the law is designed to benefit small businesses, allowing them more immediate tax relief during their initial stage of operation, a particularly vulnerable time for many enterprises.
Claiming the deduction — known as a Section 195 deduction after the tax code provision that authorizes it — involves a little more paperwork than more typical business deductions entail. Companies need to file Form 4562, Depreciation and Amortization and declare that they are electing to take the deduction for startup costs. Without this form, they cannot claim the deduction. The instructions for the form explain what you need to do; you can find them on the IRS Web site, www.irs.gov.
There is a catch to the Section 195 deduction, tied to the intent of Congress that it be used by small businesses, not larger concerns. Companies start losing the $5,000 deduction when their startup costs go over $50,000; they must reduce the deduction by the amount that exceeds the $50,000 threshold. For example, a business with $51,000 in costs can deduct only $4,000, and a business with costs over $55,000 loses the deduction entirely.
Remember, even if you can’t take advantage of the deduction, you can still amortize your costs over 15 years.
Many business owners have struggled over the years with a key question surrounding startup costs — when do those costs turn into fully deductible operating expenses? The answer turns on when the company actually starts being “in business.”
“It’s when the company begins doing what their intentions are in business,” said Frank Lamanna, a principal with the accounting firm Ison & Decosimo in Memphis, Tenn.
Lamanna noted that with companies that do business with the public, such as a retailer, it’s pretty clear when they start being in business. The starting date can be a little more vague for some companies that are involved in business-to-business activities, he said.
But if you have a signed a contract or start taking in revenue, clearly, the business is operating, and your expenses are fully deductible. If you’re a manufacturer and you start producing goods, you’re also considered to be in business.
Most small businesses are likely to go for the deduction, but some might find they’ll do better by forgoing it and amortizing all their startup expenses.
“It might make sense where you’re going to lose money in the next year or two,” to have a larger amount to amortize, said Fred Daily, a tax attorney and author of “Tax Savvy for Small Business.”
Daily likened the startup deduction to the Section 179 deduction that allows small businesses to deduct rather than depreciate up to $105,000 of certain kinds of equipment. It might make sense for some companies not to take that deduction either.
If you do decide to use the Section 195 deduction, you need to go through your expenses carefully and be sure that you deduct only what the government considers to be startup costs. Some of your expenditures should be claimed under other tax code provisions — for example, equipment you bought must be claimed under a Section 179 deduction. Research and development costs also fall under a different provision, Section 174 of the tax code.
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