What’s a Startup Expense?
I know taxes and expenses are not everyone’s favorite topic, but understanding the basics will help you plan. When you start your business, you’re inevitably going to have startup costs. One cost may be the purchase of our startup guide. Other costs may be your LLC filing fees, money paid to Michelle for a logo design or to Lauren for help drafting a killer biz plan.
The IRS has special rules on deducting startup costs. The first thing you have to know is the difference between startup costs and routine business expenses. The IRS says that startup costs are “amounts paid or incurred for:
• Creating an active trade or business; or
• Investigating the creation or acquisition of an active trade or business
Startup costs are considered to be capital expenditures that must be amortized. I know right. That was a lot of key terms. I’ll get to those more in a second. There can be a lot of nuance around what exactly a startup expense is, but for simplicity just think about whatever costs you will incur before you begin operation, so before you sell your first product or retain your first client.
Non-startup costs include regular business expenses like paper, pens, money paid to a virtual assistant, your bookkeeping costs, monthly fees for Adobe, QuickBooks, payroll fees, credit card fees, and other regular costs incurred to operate the business.
What Does This Mean for Your Taxes?
Ok, so now you have a better idea of the difference between startup costs and regular operating expenses. Let’s go back to those capital expenditures and amortization. A capital expenditure is essentially an expenditure for an asset or item that will last for a period longer than a year. Your business will use its logo for its lifespan or until you choose to rebrand. Similarly, an office computer will be used for multiple years. These are an example of capital expenditures. Items that are fully used up in one use or within a year are not capital expenditures. In accounting land, we say that capital expenditures must be amortized. Amortization is the process of deducting a cost over its useful life. The rationale is that if you use a $1,000 computer for five years, the deduction from your income should be $200 per year. In reality, the accounting procedure is a bit more difficult than that, but I won’t bore you with details. The key is to understand what kinds of things, theoretically, must be amortized so that you can better understand the exceptions.
The IRS allows us to fully deduct up to $5,000 in startup costs in our first year of business, meaning we need not amortize the first $5,000 in expenses. The effect is that you get a bigger deduction in year one. Costs in excess of that $5,000 must be amortized.
Let’s look at an example. Lauren pays Michelle $3,000 for a website design. She buys a computer for herself at a cost of $1,500 and a computer for her assistant at $1,500. She also pays $500 for software, $500 for business cards, $1,000 for her LLC fees, and $300 for office supplies.
STEP 1: Determine What is a Startup Expense and What is Not.
• $3,000 for website
• $3,000 for computers
• $500 for software
Regular Business Expenses
• $500 for business cards – marketing expense
• $300 for office supplies – office expense
• $1,000 for LLC – organizational expense
Step 2: Determine the Deductions for Each
The full cost of regular expenses, $800, can be deducted. The first $5,000 of the $7,500 in startup expenses can also be a deduction in year one of the business.
Step 3: Determine What Needs to be Amortized
The majority of people are most familiar with income tax. The tax brackets you have seen are for income taxes where the higher your income, the higher your tax bracket. U.S. individual taxpayers pay an additional tax to fund Medicare and Social Security. The tax for both totals 15.3% of your income (up to certain thresholds). Typically, as a wage employee, the taxpayer pays half of that amount and the employer pays the other half. However, self-employed individuals must pay the full 15.3% on their own. This is called self-employment tax, which is in addition to any income tax you may owe. This concept is important for understanding S corporations.
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You don’t really need to know exactly how all these calculations work. Your tax expert or tax software will do that. The key is really just to understand how much you can deduct in startup costs. If you plan to spend $20,000, know that you don’t get to expense all of that in the first year.
The other takeaway is to track all your deductions. Use an operating account and implement a bookkeeping system.
Check Out More Details in the Guide
This is a snippet of the information provided in the Small Business Start Up Guide. If you are in the beginning stages of your business, we would love to have you as part of our SBSUG fam. If you buy the guide and have follow-up questions, myself, Lauren, and Michelle are happy to answer them in our private Facebook group, which is for SBSUG members only. I’m always happy to chat biz entities with you there.