Startup costs for micro-businesses and home-based businesses typically run under $5,000, although that's not a hard and fast rule. Your costs may include research, legal work, logo design, finding a building, buying equipment and paying your employees during the period before you open. In your business accounting, you treat most of these costs as expenses, but tax accounting treats them differently.
TL;DR (Too Long; Didn't Read)
Under Generally Accepted Accounting Principles, you report startup costs as expenses incurred at the time you spend the money. Some of your initial expenses, such as buying equipment, are not classified as startup costs under GAAP and have to be capitalized, not expensed.
Defining a Startup
Startup costs are commonly known by other names, such as pre-opening costs, pre-operating costs and organization costs. Under the Generally Accepted Accounting Principles (GAAP) for U.S. financial accounting, they're formally referred to as startup costs. GAAP startup costs refer to the money you spend not only on a new business but also on any sort of new business venture, including:
- Opening a new facility, such as a restaurant or a factory
- Introducing a new product line
- Entering a new territory
- Conducting business with a new class of customers
- Initiating a new process in an existing facility
- Commencing a new operation
Under GAAP, startup costs are only those you incur before your new business opens its doors. After that, they're just costs.
GAAP Startup Costs
Starting a business, launching a new product line or opening a new retail store can involve a huge variety of expenses, including buying furniture, paying employees and buying inventory. While accounting for GAAP startup costs is simple, the definition sometimes confuses people. Only some of the costs when you're starting up are classed as GAAP startup costs.
GAAP startup costs include:
- Legal costs
- Paying employees
- Training employees
- Feasibility studies: Can this new venture turn a profit?
- Recruiting costs
- Consulting fees
- The costs of opening a new facility
- Travel costs, for example, when you're meeting with potential suppliers or investors
- Organizational costs such as incorporation fees
Other expenses are not classed as startup costs under GAAP. These include loan-origination costs, customer acquisition costs, R&D, taxes and purchasing capital assets.
Accounting for Startup Costs
Good news: Once you identify your startup costs, accounting for them is simple. You enter all the different types of expenses as one category in your ledgers under Startup Expense. For example, suppose you're opening a landscaping company:
- You spend $3,000 researching the feasibility, $600 recruiting employees, and $500 visiting plant suppliers.
- You form your business as an S-corporation for $800.
- After you find a suitable office, you spend $1,000 to open it.
- Finally, you spend $800 paying your employees for the period right before you open.
You enter the expenses in your ledger when you incur them. By the time you open, you have $6,700 recorded in the Startup Expense category. You make corresponding entries in Cash or Accounts Payable, depending on whether you've paid the bill yet.
When to Capitalize Startup Costs
Money you spend to start your business that isn't classed as GAAP startup costs gets a different treatment. How you account for them depends on the sort of expense it is. You capitalize a startup cost if you'd capitalize the expense after your business was open.
Say, for example, that you're launching a new restaurant. You spend $4,000 finding the right location and another $5,000 in rent before the actual opening. That's $9,000 you record in the Startup Costs category.
However, you also spend $78,000 on kitchen equipment. You capitalize this startup cost rather than treating it as an expense. You enter the equipment in your ledgers as a capital asset and claim the cost by depreciating it over time, like any other asset.
Buying a Business
Buying an established business is another special case. While you can write off the transaction costs as an expense, you allocate the purchase price to the assets you've acquired and deduct it by depreciation rather than claiming an expense.
A further complication is that it makes a difference whether you're buying a business or buying assets. If you're buying assets, for example, you don't record transaction costs as an expense but capitalize them as part of the asset price.
As a practical matter, you may not see any difference between spending $24,000 on a business and $24,000 to buy its assets. Because the accounting treatment is different, you have to go over the relevant standards to determine whether you made a business purchase or an asset purchase.
Aside from the GAAP startup expenses rules, there are practical advantages to distinguishing startup costs from operating expenses. Suppose that, after a year, you sit down and crunch numbers to measure your startup's performance. It makes sense to focus on what you've spent since you opened.
When you're calculating your pretax earnings to show the bank, the bank may be willing to let you add the startup expenses back in. Because they're one-time expenses that won't recur, they don't reflect your underlying profitability.
Classifying Expenses for Taxes
Under GAAP, startup costs all go into the same category in your accounting. When it comes time to write them off on your taxes, you'll find the IRS breaks them down differently. For that reason, it's worth tracking your expenses in more detail when you incur them, so that when it's time to file taxes you know which deductible expense falls into which tax category.
GAAP Startup Costs vs. IRS
If you keep your account books according to GAAP rules, you have to redo them when it's time to file your tax return. U.S. tax law doesn't follow GAAP, so GAAP startup costs and federal Section 195 startup costs are not the same.
Under federal tax rules, Section 195 startup costs are money you spend to investigate the potential of buying or creating a business and to actually create the business. Startup costs must be ones you could write off as business expenses if you were already up and running, but that you incurred before the business opens. They include:
- Consulting fees to study the potential for a new business
- Advertising for the new business
- Employee pay from before the business opens
The cost of buying a business does not count as a startup cost.
Section 195 Startup Costs
You can capitalize your Section 195 startup costs and depreciate them over time. Alternatively, you can deduct up to $5,000 of costs the year you open your business and amortize the rest over 180 months, equal to 15 years.
- If your startup costs are $50,000 or less, you can deduct the full $5,000.
- If they're over $50,000, you deduct the excess from the $5,000 maximum. If you have $53.000 in costs, for instance, you could deduct $2,000.
- If the startup costs are $55,000 or more, you can't deduct any Section 195 costs and have to amortize the lot.
If you spend $52,000 getting your business ready, under GAAP, you'd report that as one $52,000 startup expense. For your taxes, you'd report $3,000 as startup expense and $49,000 as deferred startup expense, the part you amortize. You could amortize $272 a month over the 180 months until the $49,000 was completely written off.
Startup Organization Costs
Fees to incorporate or set up a partnership are GAAP startup expenses. In tax accounting, you can claim your organization costs as a deduction but separate from Section 195 startup costs. Like Section 195 expenses, you can claim $5,000 of organization costs as a write-off upfront and amortize the rest. You reduce the size of the initial deduction if the costs go over $50,000.
If you have to close your business before you completely deduct the Section 195 or organization costs, you can take the rest as a loss. Suppose you close your doors after three years with $12,000 in Section 195 costs and $2,000 in organization fees still to be written off. You can claim two losses for a total of $14,000 as a write-off against your taxes.
The IRS definition of organization costs is another area that gets complex. Some costs, such as the expense of issuing corporate stock, count as syndication costs for tax purposes, not organization costs. Syndication costs don't get any immediate deduction: You have to depreciate them.
Section 179 Expenses
If you buy assets for your new business venture, the tax rules may allow you to write them off the first year rather than depreciating them over several years. The Section 179 deduction applies to machinery, equipment, computers and some improvements to buildings, such as a new HVAC system.
Under the Section 179 rules, you may be able to claim up to $1 million in equipment purchases as a business deduction. For example, if you buy $3,000 in computer equipment for business, that's a $3,000 write-off. Under GAAP, you capitalize and depreciate the purchase, regardless of the tax treatment.
Section 197 Intangibles
Section 197 intangibles include intangible assets that GAAP and tax accounting treat differently. When you purchase an existing company, the intangibles may include:
- Having the company's trained workforce in place instead of having to recruit employees
- Goodwill, the value of buying a company with a positive reputation
- Going concern value, the worth of having a business that stays open, instead of having to liquidate
- The company's records, accounts and operating systems
- Do-not-compete agreements
- Licenses or franchise fees allowing you to operate
- Patents, trademarks, copyrights and trade secrets
These all count as GAAP startup costs that you can record in your ledgers as startup expenses. Tax accounting requires you to amortize the costs over 180 months, without any initial deduction. If the company goes out of business, you get no write-off for any Section 197 costs that you haven't amortized yet.
Startup Tax Strategy
To gain the maximum benefit from your deductible startup expenses, you need to spend some thought on your tax strategy. For example, suppose you have $25,000 in Section 195 startup costs. You can claim $5,000 and amortize $20,000, or you can amortize the full amount.
If you need the write-off for your first year of business, it makes sense to take it. If, however, you generate little or no taxable income, it might be worth amortizing everything. That way, you get a slightly larger deduction in later years when your taxable income has grown.
Another tax tactic is to speed up opening your business. As soon as you open your doors, the IRS no longer treats any of your spending as startup costs. If by opening early you can keep below the $50,000 limit, that frees you to take the full $5,000 deduction the first year.
- Business News Daily: Startup Costs: How Much Cash Will You Need?
- BPlans: Estimating Realistic Startup Costs
- Journal of Accountancy: Startup Costs: Book vs. Tax Treatment
- BDO: Why Should I Segregate Pre-Opening Costs?
- Accounting Tools: Accounting for Start-Up Costs
- Patriot Software: Accounting for Startup Costs (Plus How to Handle Taxes)
- GAAP Dynamics: Navigating ASC Topic 805
- IRS: IRS Issues Guidance on Section 179 Expenses
- LaPorte: Deducting or Amortizing Start-up Costs and Organizational Costs