August 30 , 2009 - Following a recent layoff, I'm researching the idea of starting my own business. Can I deduct the initial costs of researching and starting the business?

Taxpayers who are acquiring or starting up a new business can improve their tax picture by properly allocating costs to categories that are eligible for an expensing election. There are three categories of expenditures, including those incurred in the exploration of a new trade or business, those incurred to organize a corporation, and those incurred to organize a partnership.

Each section requires that the relevant expenditures be capitalized. A taxpayer may deduct the first $5,000 of expenditures incurred in a tax year, unless the total expenditures incurred for all years exceed $50,000. This deduction ceiling is reduced dollar for dollar by the amount by which the total expenditure exceeds $50,000. Expenditures that are not deducted can be amortized at the election of the taxpayer over a period not less than 180 months.

The term start-up expenditure means any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, or creating an active trade or business, or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. The amount must be such that, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred.

Start-up expenditures are those expenses incurred in exploring which trade or business to enter. Once a determination has been made as to which firm to attempt to acquire or which trade or business to enter, subsequent expenses incurred are not start-up expenditures. Consequently, those later costs must be capitalized unless some other provision of the Code permits those expenses to be deducted.

Organizational expenses are defined as any expenditure which is incident to the creation of the corporation or partnership; is chargeable to capital account; and is of a character which would be amortizable over the life of the entity, if that life were limited. All three criteria must be met before an expense can qualify to be expensed.

Expenses that qualify as organizational expenses are expenses concerned with the initial organization of the corporation. Examples of that type of expenses are:

... Legal and accounting services to establish the corporation.
... Cost of drafting the by-laws and establishing stock rights.
... State incorporation fees.
... Director or shareholder meeting expenses.

When does a business begin? None of the expenses discussed above, is amortizable until the entity has commenced doing business. The question of whether a taxpayer has begun a trade or business must be based on the examination of the facts in each case. Generally, the presence of these three elements indicates the existence of a trade or business:

... There must be an intent to make a profit.
... There must be regular and active involvement by the taxpayer.
... Operations must have commenced.

Commencement of operations entails doing those activities the business was established to do. The business need not earn a profit or have sales. However, it must be involved in a regular business activity.

Attention to detail and some planning can yield significant upfront deductions for start-up and organizational expenses. These deductions can result in significant tax savings for a small business. Keep in mind that a good record, as in so many cases, is important.

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