What expense category is Business Start-up Costs?

When launching a new venture, entrepreneurs incur many expenses before the doors even open. These initial costs, ranging from market research to training new employees, are essential for launching a business. However, the IRS treats these pre-opening expenses differently from regular operating expenses.

Instead of being immediately deductible, they are considered "capital expenditures"—costs that provide long-term benefits. The good news is that a special tax election allows you to deduct a portion of these costs in your first year of business and amortize the rest. This guide breaks down what qualifies as a business startup cost and explains the specific tax rules you need to know.

What Qualifies as a Business Startup Cost?

The IRS defines startup costs as specific expenses you pay or incur for either creating an active trade or business, or investigating the creation or acquisition of an active trade or business. 

To be eligible, a cost must meet two tests:

1. It must be a cost that would be deductible if it were incurred to operate an existing, active business in the same field.
2. It must be a cost that is paid or incurred before the day your active trade or business begins.

These costs can be broken down into two main phases:

Investigating a Business

These are costs associated with a general search or preliminary investigation of a business or investment opportunity. They are expenses incurred while you are deciding whether to start a business and what type of business to start.

Creating a Business

These are the costs you incur after you've made the decision to go into business but before you officially begin operations. This includes costs for securing suppliers, distributors, and customers, as well as fees for professional services.

Important Considerations for Classifying Startup Costs

Correctly classifying pre-opening expenses is crucial for maximizing the available tax deductions.

Startup Costs vs. Organizational Costs

It is important to distinguish between startup costs and organizational costs.

• Startup Costs are for investigating or creating an active business.
• Organizational Costs are the direct expenses incurred when establishing a formal business entity, such as a corporation or a partnership. This includes expenses like state incorporation fees and legal fees for drafting a partnership agreement.

While both categories have similar deduction and amortization rules, they must be accounted for separately.

What Expenses Are NOT Startup Costs?

According to IRS Publication 535, certain costs cannot be treated as startup costs, even if they are incurred before the business opens. These include:

• Deductible interest.
• Deductible taxes.
• Research and experimental costs.

These items are generally deducted under their own specific rules.

When Does a Business Officially "Begin"?

The date a business begins is critical because the amortization period starts in the month the "active trade or business begins". This is not necessarily the date of legal formation. It is the date the business has all it needs to begin generating revenue.

Examples of Business Start-up Costs

IRS Publication 535 provides several examples of costs that can be included as business startup expenses:

• An analysis or survey of potential markets, products, labor supply, or transportation facilities.
• Advertisements for the opening of the business.
• Salaries and wages paid to employees undergoing training and to their instructors.
• Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
• Fees for executives, consultants, and other professional services.

Tax Implications and Reporting Requirements

The IRS offers a specific method for recovering startup costs, which combines an immediate deduction with long-term amortization.

The Deduction and Amortization Election

For costs paid or incurred after October 22, 2004, you can elect to do the following:

• Deduct up to $5,000 of your business startup costs in the first year of business.
• This $5,000 deduction is reduced dollar-for-dollar by the amount your total startup costs exceed $50,000. If your startup costs are $55,000 or more, you cannot take the immediate deduction.
• Any remaining startup costs must be amortized (deducted in equal amounts) over a 180-month period (15 years), beginning with the month your active business begins.

How to Make the Election

The election to deduct and amortize startup costs is made by claiming the deduction on your income tax return for the year in which your active business begins. The return must be filed by the due date, including extensions. If you timely file your return without making the election, you can still make it by filing an amended return within six months of the original due date (excluding extensions).

What If Your Attempt to Go Into Business Is Unsuccessful?

If you incur costs but ultimately do not start the business, the tax treatment depends on the nature of the costs.

• Costs from a general search or preliminary investigation are considered personal and are not deductible.
• Costs incurred in an attempt to acquire a specific business are treated as capital expenses and can be deducted as a capital loss.

How Fyle Can Automate Tracking for Startup Costs

Startup expenses are often incurred over several months from multiple sources, long before a formal accounting system is established. This makes tracking them for tax purposes a significant challenge. Fyle helps founders and their accountants capture and organize every eligible cost from day one.

Capture Expenses on the Go

Founders can use the Fyle mobile app to instantly capture receipts for all preliminary costs, such as travel to meet potential suppliers or fees for market research reports. This creates a real-time, digital record, ensuring no expense is forgotten or lost.

Centralize All Documentation

Fyle creates a single, organized repository for all startup-related expenses. Whether it's a consultant's invoice emailed to Fyle or a picture of a receipt for supplies, all documentation is stored and easily accessible, providing the necessary proof to substantiate the costs for your tax election.

Streamline Accounting and Amortization

All expenses can be categorized under the "Startup Costs" category. When Fyle syncs directly with your accounting software, such as QuickBooks, Sage Intacct, NetSuite, or Xero, it’s simple to make the correct journal entry to deduct the first $5,000 and to set up the proper 180-month amortization schedule for the remaining balance, ensuring full compliance with IRS rules.