While start-up mania has been in full swing for a while now, and new companies from Silicon Valley to Washington D.C. have been heralded as the saving grace of a growing U.S. economy, the American Tax Code has been sluggish in keeping up with start-up business trends. Especially in the area of deductions, there is a lot of debate amongst startup professionals about what constitutes a deductible expense. However, recent tax court decisions have clarified some of the basic rules of deducting expenses for startup businesses. Here’s the most important rules to keep in mind when deducting start-up expenses
- 162-type Deductions Can’t Be Made Immediately
Every business owner could rattle off a handful of their regular section 162 deductible expenses, as the broad area of the tax code covers everything from rent to advertising costs. Any payment made as an “ordinary and necessary” expense of running a business can be considered for deduction under regular business conditions. But in startup situations, when the regular course of business hasn’t started yet, 162 deductions can’t be made.
In the eyes of Tax Court, things that would usually fall into the realm of 162 deductions can only be made when “active conduct” of business has started. For start-ups, that means when efforts are made to seek a profit. Rent, advertising, and other fees paid while a business is still in the conceptual phase and not pursuing profits can not be deducted under regular 162 principles.
- 195 Expenses Can Be Deducted Retroactively
While 162-type expense can’t be deducted immediately by startup businesses, costs that fall into this category can be deducted once active business begins. Once a start-up starts pursuing profits and operates under the principles of “active conduct,” deductions can be made retroactively for expenses made before full business commenced.
However, not all expenses can typically be deducted immediately. Anything over $5000 worth of expenses will be amortized over a period of up to 180 months, meaning your deductions could take quite some time to effect your bottom line depending on how many expenses your startup incurred before entering the active conduct phase.
- Ask Your Tax Professional Where Immediate Deductions Can Be Made
The rules of deductions for start-ups are still getting ironed out, and recent Tax Court rulings always have an effect on what is fair game for businesses to deduct. The only way to be sure that you are deducting everything you can today is to consult a tax professional with your individual situation.