In spite of COVID-19 restrictions many entrepreneurs are considering possible new or additional business opportunities. So, if you are planning a new business start-up and are incurring some expenses, you probably anticipate deducting those expenses in the first year of the business’s operation. Unfortunately, it is a little more complicated than that. Expenses a business incurs in the beginning can include equipment purchases, vehicle purchases and use, leasehold improvements, organizational costs and start-up expenses, and each receives a different tax treatment.
Even before you begin incurring expenses for equipment, leases and the like, you must decide what type of business entity you are going to establish. The type of business entity you choose will determine which tax form has to be filed. The most common types of business entities are the sole proprietorship, partnership, corporation, and S corporation, some of which may also be structured as a limited liability company. The choice of entity will affect the tax outcome of your business for years to come.
How the business you operate is structured will determine what taxes must be paid and how you pay them. The four general types of business taxes are the income tax, self-employment tax, employment taxes, and sales or excise tax.
An employer identification number (EIN) is used to identify a business entity. Most businesses need an EIN, and your business will definitely need one if you hire employees, regardless of the type of business entity selected.
Each taxpayer must also use a consistent accounting method, which is a set of rules for determining when to report income and expenses. The most commonly used accounting methods are the cash method and accrual method. Under the cash method, income is generally reported in the tax year it is received, and expenses are deducted in the tax year they are paid. Under an accrual method, income is generally reported in the tax year it was earned, even if payments for the goods or services of the business are not yet received, and expenses are deducted in the tax year they are incurred, even though they are not yet paid.
Once you have decided upon a business entity and you are ready to begin acquiring the assets needed to conduct the business, you can begin planning your purchases and other expenses to fit your particular circumstances and business entity. Here is a rundown on how these expenses can be deducted.
Start-up Expenses – For new businesses, you can deduct up to $5,000 of the start-up expenses in the first year of the business’s operation. This is in lieu of amortizing and deducting the expenses over 180 months (15 years).
Generally, start-up expenses include all expenses incurred to investigate the formation or acquisition of a business or to engage in a for-profit activity in anticipation of that activity becoming an active business. To be eligible for the election, an expense must also be one that would be deductible if it were incurred after the business actually began. An example of a start-up expense is the cost of analyzing the potential market for a new product.
As with most tax benefits, there is always a catch. Congress put a cap on the amount of start-up expenses that can be claimed as a deduction under this special election. Here’s how to determine the deduction: If the expenses are $50,000 or less, you can elect to deduct up to $5,000 in the first year, plus you can amortize the balance over 180 months. If the expenses are more than $50,000, then the $5,000 first-year write-off is reduced dollar-for-dollar for every dollar in start-up expenses that exceeds $50,000. For example, if start-up costs were $54,000, the first-year write-off would be limited to $1,000 ($5,000 – ($54,000 – $50,000)).
The election to deduct start-up costs is made by claiming the deduction on the return for the year in which the active trade or business begins, and the return must be filed by the extended due date.
A qualifying start-up cost is one that would be deductible if it were paid or incurred to operate an existing active business in the same field as the new business and the cost is paid or incurred before the day the active trade or business begins. Not includible are taxes, interest, and research and experimental costs. Examples of qualified start-up costs include:
o Surveys/analyses of potential markets, labor supply, products, transportation facilities, etc.;
o Wages paid to employees and their instructors while they are being trained;
o Advertisements related to opening the business;
o Fees and salaries paid to consultants or others for professional services; and
o Travel and other related costs to secure prospective customers, distributors, and suppliers.
For the purchase of an active trade or business, only investigative costs incurred while conducting a general search for or preliminary investigation of the business (i.e., costs that help the taxpayer decide whether to purchase a new business and which one to purchase) are qualified start-up costs. Costs incurred attempting to buy a specific business are capital expenses that aren’t treated as start-up costs.
Organizational Expenses – If the new business involves a partnership or corporation, the business can elect to deduct up to $5,000 of organizational expenses in the first year of a business. This is in addition to the election for start-up expenses. Like start-up expenses, the $5,000 amount is reduced by the amount of the start-up costs in excess of $50,000. If the election is made, the start-up costs over and above the first-year deductible amount are amortized over 15 years. If the election is not made, the start-up costs must be capitalized. Organizational expenses include outlays for legal services, incorporation fees, temporary directors' fees and organizational meeting costs, etc.
Next we can look at the various ways your business acquisitions can be deducted. These rules also apply to existing businesses.
Equipment Purchases – The equipment you buy can’t be deducted until it is placed in service. For that reason, you can’t make any equipment deductions until the business is actually functioning. However, deductions for most equipment purchases offer several options:
o Depreciation – Depreciation is the normal accounting way of writing off business capital purchases by spreading the deduction of the cost over several years. The IRS regulations specify the number of years for the write-off based on established asset categories, and generally for small business purchases the categories include 3-, 5- or 7-year write-offs. The 5-year category includes autos, small trucks, computers, copiers, and certain technological and research equipment, while the 7-year category includes office fixtures, furniture and equipment.
o Bonus Depreciation – Instead of depreciating the cost of certain business property, the tax code allows a business to deduct 100% of the cost of most tangible property in the year it is placed in service. This is sometimes referred to as first-year bonus depreciation, and it is a temporary provision that is available only through 2026. The deduction rate phases out and drops to 80% for eligible property acquired and placed in service in 2023, 60% in 2024 and so on until it is 0% in 2027 or later.
o Expensing – Another option provided by the tax code is an expensing provision for small businesses that allows a certain amount of the cost of tangible equipment purchases to be expensed in the year the property is first placed into business service. This tax provision is commonly referred to as Sec. 179 expensing, named after the tax code section, that sanctions it. The expensing is limited to an annual inflation adjusted amount, which is $1,040,000 for 2020 and $1,050,000 for 2021. To ensure that this provision is limited to smaller businesses, whenever a business has purchases of property eligible for Sec 179 treatment that exceed the year’s investment limit ($2,590,000 for 2020 and $2,620,000 for 2021), the annual expensing allowance is reduced by one dollar for each dollar the investment limit is exceeded.
However, the deductible Sec 179 amount is limited to taxable income from all the taxpayer’s active trades or businesses (including a spouse’s active trades or businesses if married and filing jointly). Income from trades also includes W-2 income.
An undesirable consequence of using Sec. 179 expensing occurs when the item is disposed of before the end of its normal depreciable life. In that case, the difference between normal depreciation and the Sec. 179 deduction is recaptured and added to income in the year of disposition.
o Mixing Methods – A mixture of Sec. 179 expensing, bonus depreciation and regular depreciation can be used on a specific item, allowing just about any amount of write-off for the year for that asset.
For most small businesses, this means the entire cost of equipment and office furnishings can generally be written off in the year of purchase, if that is also the year when the equipment is put into service, using the bonus deprecation or the Sec 179 expensing election.
Sometimes it may not be appropriate to write off the entire cost in the first year, depending on your business and personal circumstances. This is part of the planning required to maximize tax benefits.
Vehicles – Automobiles and small trucks that are purchased for use by the business are treated like equipment, as above, except their recovery period is 5 years and they are subject to the so-called luxury auto rules. These rules limit the depreciation to a maximum of $10,100 for passenger autos, and light trucks and vans for the first year. The $10,100 amount may be different for 2021, as it is subject to inflation adjustment. If bonus depreciation is elected, add $8,000 to the first-year maximum.
Leasehold Improvements – Generally, leasehold improvements are depreciated over 15 years. But bonus depreciation may be elected, allowing up to 100% of the cost of interior qualified improvements to non-residential property after the building is placed in service to be deducted in the first year. In addition, the Sec 179 expense deduction is allowed for qualified improvement property as well as any of the following improvements to nonresidential real property placed in service after the date the property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems. However, not eligible for Sec 179 treatment are improvements for the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.
Material & Supply Expensing – IRS regulations allow certain materials and supplies that cost $200 or less, or that have a useful life of less than one year, to be expensed (deducted fully in one year) rather than depreciated.
The foregoing is an overview of some of the start-up and expense issues in a business’s first year. As you can see, major decisions and elections need to be made that can have a lasting impact on a new business or even an existing one for that matter. Contact us to help you plan and establish your business. We can also help with your accounting, bookkeeping, payroll or sales tax reporting, or other federal, state, and local licensing and compliance issues.
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