Startup costs and expenses deductions: tax treatment considerations

You had the great idea for a revolutionary product. You pulled all-nighters to develop and test the alpha (and the beta) version. Maybe you went back to the drawing board a few times to get it right. You surveyed the market and honed your messaging. Finally, you’re ready to launch. Congratulations, you’ve started a business. And you no doubt spent a fair amount of money to do it. 

Fortunately, the IRS allows new businesses to deduct or amortize up to $50,000 in qualifying expenses when filing their first corporate tax return. Curious whether your business could benefit? In this article, we’ll learn what kinds of purchases count as ‘startup costs’ and how to use them to reduce taxable income. We’ll also go over what to do if you’re exploring multiple businesses or decide not to create a business after all. 

What are startup costs? 

Startup costs are the initial expenses associated with getting a new business up and running, such as supplies and equipment, marketing costs, permit or licensing fees, and office rentals. 

Because the IRS considers startup expenses as investments in the future of your business, you’re allowed to record them as capital expenditures on your corporate tax return and deduct or amortize most of them costs to reduce your tax burden. This approach helps new businesses get their financial feet on the ground by spreading the tax impact of big purchases over time. 

8 tax-deductible startup costs

Tax deductions for startup costs fall into two categories: business costs and organizational costs. Essential purchases that help bring your business from idea to reality, like laptops and software licenses, are business costs. The money you spend to establish your business and get your finances in order counts as an organizational cost. 

Business costs 

Business costs cover expenses directly related to getting the business off the ground, like renting an office space, purchasing office supplies, or hiring your first team members. This includes:

• Prototype testing: Developing an early version of your product to ensure it functions correctly
• Surveys for market research: Conducting surveys to identify opportunities and refine your target market
• Advertising: Promoting your product or service across multiple channels
• Professional and consultant fees: Partnering with third-party experts to develop or refine key elements of your business plan

During your first year in business, you can deduct up to $5,000 in business costs, provided your total startup costs don’t exceed $50,000. However, if you spend more than $55,000, you’ll distribute the extra costs across several years, a process known as amortization. 

Organizational costs  

Organizational costs are those connected to setting up your business’ legal presence, such as hiring a lawyer to draft company bylaws or paying a state licensing fee. Examples include:

• Partnership fees: Creating and formalizing a partnership
• Meeting costs: Hosting meetings for new partners, investors, or other essential personnel
• Legal fees: Retaining the services of an attorney to prepare critical documents like incorporation papers
• Temporary directors: Appointing interim leadership or management to meet legal requirements while you search for the best talent

Organizational costs follow the same rules as business costs when it comes to deductions. For the first year of business, you’re eligible to deduct $5,000 in organizational costs, provided your total startup costs are less than $50,000. If you spend more than $55,000 starting your business, you’ll amortize all of your costs rather than taking a deduction.

Non-deductible startup costs

Not all expenditures associated with starting a business qualify for deduction or amortization. If it doesn’t directly support operations or generate income, your purchase isn’t tax deductible under IRS rules. Non-deductible startup costs include:

• Personal expenses: Making purchases to benefit yourself or another team member, rather than the business itself
• Incorporation fees: Incorporating in a state that includes non-deductible compliance or incorporation costs in the legal registration process
• Costs incurred before a specific business decision: Experimenting with different business concepts or evaluating industries without a clear business plan
• Fines and penalties: Paying fines, penalties, and other regulatory consequences for infractions
• Lobbying expenses: Making political contributions or engaging in lobbying activities to influence legislation

Startup costs and expenses amortization

Amortizing business startup costs is a way to distribute your first year’s operating expenses over a longer period–typically 15 years. By spreading out the costs, you avoid a big financial hit when you’re just starting out. 

When you amortize a business expense, you divide it up and subtract a portion each year on your annual tax return. This isn’t the same as a deduction, which allows you to subtract the entire cost from your first corporate tax return.

Example: Taylor spends $10,000 to open FunCakes Bakery: $5,000 on ovens, mixers, and other equipment, and $5,000 on advertising and marketing. FunCakes takes off, reporting a business income of $100,000 on its first tax return. Because the total startup costs were less than $50,000, Taylor can deduct the $5,000 spent on equipment. The remaining $5,000 spent to promote the business will be amortized, so FunCakes will subtract $333 from its annual tax bill for the next 15 years. 

How to calculate startup cost deductions

Investing in financial management software before you’re fully operational might feel premature, but it can help ease your tax burden while you grow your business in its first year. In addition to consolidating documents like invoices and receipts so you can accurately track spending and quickly reconcile transactions, some specialized software can help you prepare for tax season with custom reports that make it easier to generate an income statement and assess your tax obligations. 

Step 1. Determine the yearly deduction amount 

To understand how much you can deduct, you need to calculate how much you spent on essentials related to setting up shop. A spend management system can help you stay on top of how much cash you’ve invested and consolidate documents you’ll need for an accountant or tax advisor, like receipts and invoices.

Example: Last year, Morgan and Alex opened a cleaning company. Invoices show that they spent $900 monthly to lease a van, $2,500 to purchase industrial cleaning supplies, and $2,000 to advertise their services. Total startup costs are $15,300. Per IRS guidelines, Alex and Morgan deduct $5,000 from the company's first year of income. 

Step 2. Calculate the monthly amortization amount

Provided your startup costs are less than $50,000, you can deduct $5,000 on your first business tax return. Spent more than $5,000 in startup expenses? You can amortize the rest over a number of months set by the IRS.

Example: After deducting $5,000 from their total startup costs, Alex and Morgan have $10,300 to distribute over the next 180 months. That works out to around $57 per month or $687 per year. The next time they file a corporate tax return, they’ll use Form 4562 to claim those amortized costs.

Step 3. Determine your total deductions and amortizations for your first year

To correctly amortize your business and organizational costs over $5,000, you’ll need to calculate monthly amounts based on when you began operations. For example, a business launched in March will have three more months to distribute costs than one launched in June.

Example: Morgan and Alex officially incorporated and began serving clients in April of the previous year. That means they can claim amortization over nine months. Based on the monthly rate of $57 per month and a $5,000 initial deduction, Alex and Morgan can reduce the business's taxable income by $5,513 in its first year.

How to claim startup costs tax deductions

You’ll claim any startup cost deductions and amortize others on your business’ income tax return. The specific form you use to report your profits, losses, claims, and deductions to the IRS depends on the structure of your business.

If you’re a sole proprietor, you’ll attach Schedule C to your Form 1040 to report business income and claim deductions. Partnerships use Schedule K-1, while corporations file a Form 1120. After your first year in business, you’ll use Form 4562 to claim any amortized startup costs. The form you use to file determines when your federal tax returns are due, so make sure you’ve chosen correctly and read the instructions thoroughly before adding deadlines to your calendar.

What if I don’t start the business?

Not every business idea comes to fruition, but that doesn’t mean you can’t recoup some of what you spent attempting to launch. To understand whether or not you can deduct a particular expense, consider both the nature of your purchases and when they happened.

Expenses you incur while still refining your concept and before you develop a business plan generally aren’t eligible for deduction or amortization. Because they aren’t tied to a specific project, the IRS considers these personal expenses.

If, on the other hand, you purchased a domain name, manufactured a prototype, hired a lawyer to prepare documents, or made other purchases directly related to a particular idea, you can deduct those costs. Since you never started the business and won’t be filing a corporate tax return, you won’t write these off as startup expenses. Instead, you’ll report them as capital losses on Schedule D to Form 1040. 

Easily manage startup expenses and costs with Rippling

Rippling HCM eliminates the friction from starting and running a business. It has every application your business needs across HR, IT, and finance in one place, empowering you to automate, streamline, and customize essential processes so you can focus on scaling your operations. Offload administrative tasks like payroll, compliance, benefits administration, and expense tracking to help your small business grow fast and lean.

With Rippling you get:

• Payroll guaranteed 100% error-free
• Automated payroll tax calculation, withholding, and filing
• Centralized benefits administration
• Automated onboarding and employee self-serve benefits

Startup costs deduction FAQs

Can I deduct costs for investigating different businesses?

Yes, you can deduct costs for examining potential business ideas if each business has a thought-out plan. However, if you’re just putting out feelers in the market or doing casual research, those costs are personal. Remember that for businesses that don’t reach the viability stage, you’ll deduct any qualifying expenses as capital losses, not startup costs.

Are organizational costs treated the same as startup costs?

Organizational and business startup costs are similar in that both are capital expenses for a new business setup. While organizational costs relate to forming a company’s legal structure, startup costs cover initial business expenses like salaries and the purchase of assets. Both are partially deductible or amortizable in the tax year the business begins.

How are startup costs treated in accounting? 

Startup costs for a new business are capital expenses. Business owners can deduct a portion in their first year and amortize the remainder over the following 15 years.

Can you deduct startup costs with no income?

Yes, you can deduct startup costs even if your business earns no income in its first year of operations.

This blog is based on information available to Rippling as of November 11, 2024.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.