Lots of startups run up bills before they open their doors. There may be incorporation fees, market research, research and development of the products, employee training and leasing an office. Recording these expenses under generally accepted accounting principles, or GAAP, is simple enough. Tax accounting for these organizational costs is more complicated.
TL;DR (Too Long; Didn't Read)
Under GAAP, you report organizational — or startup — costs as an expense when you incur them. If you spend $5,000 on employee training prior to opening, you'd record $5,000 as a startup expense and reduce your cash account by $5,000. When you make out your taxes, the accounting for startup costs is more complicated.
Organizational Costs vs. Startup Costs
Startup costs are the expenses you incur when starting a business. They are also known as organizational costs, organization costs, preopening costs and preoperating costs. They include:
- The costs to prepare and open a new factory, office or other facility
- Introducing a new product or service. Even if your company is off the ground, this falls into the startup cost category.
- Moving into a new territory
- Starting a new process in an existing facility
- Dealing with a new class of customers
- Training employees
- Conducting a market research survey
- Filing fees for incorporation or another business structure
- Travel costs for meeting with distributors and suppliers
No matter what name you call these expenses, when it comes time to record them in your accounts, GAAP says they're all identified as startup costs. Federal tax law treats various organization costs differently, so when you make out your tax return, you may have to handle these expenses differently than you do under GAAP.
What Is GAAP?
You can classify and record costs any way you want as long as it's for your own personal information. When you're showing your financials to investors, lenders or auditors, though, it's important you all speak in the same accounting language. In the United States, that language is the rules known as generally accepted accounting principles.
Based on the standards of several financial bodies, GAAP spells out the rules for a common accounting language:
- What items should be reported and recognized in financial statements as assets, liabilities or expenses
- What amounts should be reported. Under accrual accounting, for instance, you report money you've earned as income even if you haven't been paid yet.
- How to display line items and totals in the financial statements
- Whether there's added information you need to disclose
Accounting for organizational costs under GAAP enables anyone reading your accounts or financial statements to correctly interpret them and their effect on your bottom line.
Accounting for Organizational Costs
Accounting for organizational costs under GAAP is simple. You record them when you incur them in the expense category called "startup costs". For example, if you've spent $23,000 preparing your new office and $25,000 on market research, you record $48,000 in startup costs. You balance that with a reduction of $48,000 to your cash account.
However, it's important to separate organizational costs from costs that GAAP treats separately. Suppose you're trying to improve or upgrade an existing product or facility as part of your business venture. This doesn't count as a startup cost even if you do it before you open a new business.
Merger costs do not count as startup expenses even if you plan to reopen the merged companies as an entirely new business. It's important to separate these costs from startup costs so you give them the correct accounting treatment.
GAAP and Taxes
Generally accepted accounting principles don't always work for taxes. Federal tax rules may require you to include items in taxable income sooner or delay claiming expenses compared to when you report them under GAAP.
Publicly traded corporations have to release GAAP-compatible financial statements, but they also have to keep accounts that comply with tax laws. Private companies have the option to do all their accounting on tax principles rather than GAAP. Either way, it's important to understand the differences and make clear to anyone reading your financial statements whether you're using GAAP.
Tax Accounting for Organizational Costs
Accounting for organizational costs under GAAP is one of the areas where tax accounting treats expenses differently. Federal tax rules don't treat your startup expenses as a single expense category. If you normally use GAAP for your accounts, you'll have to go over your expenses and, if necessary, break them down into different categories that receive different tax treatments.
- Startup costs in tax accounting consist of money paid or incurred to create an active trade or business or to investigate the feasibility of acquiring or creating a business.
- Acquisition costs: Tax law treats the money you spend buying a business separately from investigating whether to buy a business.
- Organizational costs are the costs incurred in forming a partnership or corporation. They include the legal fees for drafting a partnership agreement or corporate charter, accounting services necessary to set up the company, state filing fees and the cost of organizational meetings. In tax accounting, these expenses aren't startup costs.
- Tangible personal property: This includes machinery, equipment, printing presses, lab equipment, cash registers, gas tanks and office furniture. It's a separate category from "real" property such as land and buildings.
- Intangible assets: These include goodwill, patents, trade secrets, licenses, trademarks and noncompete agreements.
GAAP lets you expense all of these as startup costs. Tax accounting requires you to handle the different categories separately.
Writing Off Startup Costs
One tax option is to deduct some of your startup costs and then amortize the rest over 180 months. Like depreciation, amortization lets you write off costs gradually over time. The maximum you can write off immediately is $5,000, reduced for startup costs exceeding $50,000.
- If your startup costs reached $27,000, you can take a deduction for $5,000 and amortize the remaining $22,000. You'd report this in your tax accounting as $5,000 in startup expenses and $22,000 in deferred startup costs.
- If your costs reached $51,500, you can claim a deduction of $3,500. The remaining $48,000 has to be amortized.
- If your startup costs are $56,000, you can't deduct anything. You can only amortize.
- If your total startup costs are $5,000 or less, you can write off all of them.
If you're hovering close to the $50,000 limit, crunch some numbers. Would it be worth opening earlier than planned so that you can claim the full $5,000 write off this year?
Amortizing Startup Costs
The alternative to deducting some of your costs is to amortize all of them. This gives you less of a deduction the first year. If you expect to lose money or make very little the first year, though, amortizing may make sense.
For example, say you anticipate ending your first year marginally in the black and then seeing profits steadily increase. If you amortize, you'll be able to take a portion of the cost off your taxes every year until the 180 months are up. Amortizing $4,000 in startup costs gives you a small extra write off year after year.
Either alternative is acceptable under tax accounting rules. It's up to you to choose the path that gives your business the best deal.
Once you've decided to buy a business, your expenses are no longer part of your startup costs. A typical cut-off point is when you send a letter of intent stating that your goal is to purchase the company.
For example, suppose you spend $42,000 investigating the purchase of a small company and $125,00 to actually purchase it. You can claim $5,000 of the investigation cost as a deduction and amortize the remaining $37,000, or you can amortize the entire amount of $42,000. Tax rules don't give you a choice with acquisition costs; you have to add them to the tax basis of your new assets and then amortize them.
The costs of financing the purchase and issuing stock in a company get yet another tax treatment. You'll have to go over your expenses carefully to determine which spending falls into which category.
Some businesses don't have to worry about organization costs. Sole proprietorships don't need any legal paperwork to exist, and some partnerships get by without any. C and S corporations, however, can't exist without extensive filings and paperwork to establish them as a legal entity separate from their owners.
You have two ways to write off your startup's organization costs. One is to treat them like startup costs, deduct $5,000 and amortize the rest. For your tax accounting, you break this down into organization costs expense and deferred organizational costs.
If you don't specify anything different, the deduct-and-amortize approach is the default. Otherwise, you can elect to capitalize and amortize the entire cost. If you liquidate your business with some of your costs not yet amortized, you can claim them as a deductible loss.
Tangible Personal Property
Under GAAP, you expense tangible personal property you buy before your business opens as a startup cost. When you turn to your tax accounting, you may be able to deduct some or all of these items under the Section 179 rule for writing off business assets.
Section 179 allows you to deduct the entire cost of tangible personal property as a business expense for the year you put the property into service. The maximum deduction is $1 million, indexed to inflation.
If you depreciate tangible personal property instead, the schedule for depreciating personal property lets you recover your costs quicker than the 180 months required for startup costs.
Unlike startup and organization costs, intangible property doesn't allow for any immediate deduction. You have to amortize all of it. If you dispose of the property or close the company before you've completely amortized the cost, you don't get to take a loss.
What if You Fail?
The accounting rules change again if things don't work out for you. Say you research a business opportunity, but instead of buying in, you decide it's not right, or say you spend money trying to buy or launch a company, but it never gets off the ground.
In each of these situations, your options for a tax write off are different.
- Money you spend before you commit to buying or starting a business is a personal expense as far as the IRS is concerned. If you don't start the business after all, there's no deduction you can take for any market research, travel costs or other expenses.
- Once you decide to go ahead with your startup or acquisition, the rules change. You can write off any startup costs from that point on as a capital loss on your taxes.
- If you bought any assets as part of your unsuccessful startup, you can't get a write off for them. Instead, you'll have to recover the cost of the assets when you dispose of them. If you spent $10,000 on equipment, that becomes your basis in the asset. You use that to reduce the taxable gain you get when you sell the asset.
- AccountingTools: Organizational Costs
- Journal of Accountancy: Startup Costs: Book vs. Tax Treatment
- Financial Accounting Foundation: About GAAP
- Patriot Software: Accounting for Startup Costs (Plus How to Handle Taxes)
- AccountingTools: Accounting for Startup Costs
- IRS: Publication 946 (2018), How To Depreciate Property
- IRS: Publication 535 (2018), Business Expenses
- Meaden & Moore: Accounting for Merger and Acquisition Transaction Costs
- Wolters Kluwer: Start-up Costs and Organizational Expenses Are Deducted over 180 Months
- LaPorte: Deducting or Amortizing Start-up Costs and Organizational Costs
- IRS: IRS Issues Guidance on Section 179 Expenses and Section 168(g) Depreciation Under Tax Cuts and Jobs Act
- Marks Paneth: GAAP vs. Tax-Basis Reporting: Choosing the Right Model for Your Business
- Strafford: Reconciling Book/Tax Treatment of Startup Costs: Deferred TaxAssets and Liabilities, Schedules M-1 and M-3, Partnership Provisions
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com