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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

3 ways to deduct business startup costs

Dear Dollar Diva,
I am developing a Web business and have spent close to $20,000 on expenses so far. I have not made any money because we're still in the developing stage, but I am in the process of licensing and incorporating the company.

Can I deduct some of these costs? Can you give me some advice to prepare myself before I see my tax planner?
Hugo

Dear Hugo,
Congratulations on your burgeoning Web venture. It takes a lot of courage to put $20,000 on the line, and you want to get all the tax benefits you're entitled to. The good news: You will be able to deduct your expenses. The bad news: You won't be able to deduct your expenses as quickly as you'd like. The Diva will explain the rules.

There are three types of costs that you need to understand: startup costs, operating costs and Section 179 depreciation.

Startup costs
Startup costs (aka organizational costs) are expenses incurred before business operations actually begin. To the IRS, startup costs are capital costs, so they are depreciated or amortized over more than one year. The depreciation or amortization doesn't begin until you open your doors for business.

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The two most common types of startup costs are:

  • Assets that you depreciate: Buildings, computers and office furniture fall into this category. Different classes of assets get depreciated over different periods of time; IRS Publication 946, How to Depreciate Property unlocks the secrets.
  • Assets that you amortize: Surveys of potential markets, office rent, travel, professional, filing and incorporation fees, and salaries for employees who were in training before the business became operational fall into this category. These costs are amortized over five years.

Diva alert: The five-year amortization period requires an election on Form 4562, Depreciation and Amortization accompanied by a statement detailing the costs being amortized. Forget to make this election and your startup costs get suspended in nondeductible limbo until you dispose of the business.

For an in-depth discussion of startup costs read IRS Publication 583, Starting a business and keeping records, and Publication 535, Business Expenses.

Operating costs
Operating costs kick in when you step out of the startup stage and into the operating stage. Expenses such as advertising, travel and salaries get written off right away; capital expenses such as buildings, equipment and leasehold improvements get depreciated over more than one year.

In order to deduct them, costs need to be both "ordinary" and "necessary" expenses of carrying on your trade or business. Here are the definitions:

  • Ordinary: An expense that is common and accepted in the particular business activity. In a Web business like yours, computers, Webmasters' salaries, car expenses and office supplies would be ordinary.
  • Necessary: An expense that is appropriate and helpful to the taxpayer's business. An expense does not have to be indispensable for the IRS to accept it as a necessary expense. You may believe that dinner at Sardi's is necessary to attract and keep high-rolling clients and sending your salesmen to Cancun for a conference is necessary to keep them motivated and productive.

You want to be in a position to fight for every deduction you're entitled to, so save your receipts. And don't get greedy, or you'll learn the hard way that pigs get fed but hogs get slaughtered.

Section 179 depreciation
Be sure to talk to your tax planner about the glorious Section 179 depreciation: it rocks.

The IRS describes it as follows: Section 179 of the Internal Revenue Code allows you to elect to deduct all or part of the cost of certain qualifying property in the year you place it in service. You can do this instead of recovering the cost by taking depreciation deductions over a specified recovery period. There are limits on the amount you can deduct in a year.

The Diva translates: An operating business can write off the cost of assets such as laptops, desks and telephones, up to a whopping $24,000 for 2001.

-- Posted: Dec. 31, 2001

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See Also
Tax timing of business equipment purchases
Penalties for filing late with the IRS
Rules for writing off auto expenses
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