1. What Are Startup Expenses?
2. Types of Startup Expenses
3. Organizational Costs
4. Deductibility of Startup and Organizational Costs
5. General Rule of Deduction

Are incorporation fees tax deductible? Yes, the incorporation fees paid to the state agency are tax deductible, subject to the ceiling of $5,000 in the first year. Expenses pertaining to accounting, meetings, and drafting of incorporation documents also qualify for tax deduction.

What Are Startup Expenses?

Startup expenses include the amounts incurred for any of the following:

  • Investigation related to creating or acquiring a business.
  • Creating or setting up an active business.
  • All activities for profit and for generating profits before the beginning of active business, if such expenses would be deductible for an existing business.

In other words, startup costs include all the costs of researching and starting a business. Examples of some common startup expenses include the following:

  • Consulting fees
  • Initial advertising
  • Employee training
  • Travel expenses incurred while finding distributors, suppliers, and customers for the company's products
  • Costs incurred in reviewing feasibility of a business, such as market survey and analysis

Types of Startup Expenses

There are basically two types of startup expenses:

  • Investigation Expenses: These are the costs incurred in investigating a new business opportunity, whether the opportunity pertains to creating a new business or acquiring a new one. Under this category, you can deduct costs like market survey, product analysis, and traveling to the potential business.
  • Creation or Setup Expenses: These are the costs incurred in the course of getting a new business ready. These may include expenses pertaining to employee training, advertising, consultancy, travel, and incorporation or organization.

Organizational Costs

Organizational cost is the cost incurred for setting up an organization. It includes legal fees, cost of incorporation, and other expenses for getting the legal structure of your business ready.

Organizational costs involved in creating a corporation that qualify for deduction are usually capitalized costs. They include the following expenses:

  • Legal expenses for drafting the corporate charter and company bylaws
  • Costs of accounting services for keeping track of incorporation expenses
  • Expenses incurred for temporary directors
  • Costs of holding organizational meetings
  • Filing and incorporation fees paid to state agencies
  • Miscellaneous legal expenses incurred for renewal of state corporate charter of limited duration

The following expenses do not qualify as organizational expenses; they must be capitalized:

  • Underwriting fees, commissions, and other expenses related to issue of stock
  • Expenses connected with transferring of assets to the corporation

Deductibility of Startup and Organizational Costs

Startup and organizational expenses are deductible only if you elect to deduct them as per IRS rules. However, interestingly, unless you expressly forgo your rights, the tax law presumes that you have made such election.

Nevertheless, it's advisable to make an express election by filing IRS Form 4562 instead of relying on the presumed election. Additionally, you should also include a statement in your tax return stating the amount of startup expenses you would like to deduct.

For example, if your startup expenses are $25,000, you can make a statement like “The taxpayer elects to deduct $5,000 of the startup costs under section 195 of the IRC and amortize the remaining $20,000 over a period of 180 months beginning September 2011.” You should then give a breakdown of the startup costs.

Beginning in 2010, if your total startup costs do not exceed $50,000, you can deduct startup expenses of up to $5,000 in the first year of your business operations. Expenses exceeding $5,000 must be amortized over a period of 180 months or longer. However, if your startup costs are more than $50,000, the $5,000 deduction of the first year will be reduced by the amount your startup costs exceed $60,000.

From 2011 onward, you can deduct up to $5,000 of your startup or organization expenses and amortize the remaining amount.

If you don't make enough profits in the first year, you can also claim startup deduction in subsequent years with sufficient profits. Alternatively, you can also deduct the startup costs when you ultimately sell or close your business, but usually business owners do not wait that long.

In addition to the standard deduction of $5,000 for startup costs, LLCs, partnerships, and corporations can also make an additional deduction of $5,000 for organization expenses.

General Rule of Deduction

Deduction can be claimed for purchase of any product or service for your business, provided it is common and reasonable in your industry. The deduction usually falls into the following categories:

  • Business expenses
  • Depreciable property
  • Rent for the home office
  • Using your own vehicle for business
  • Cost of goods sold

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