New businesses, which are vital to a healthy economy, usually incur costs before they begin active conduct of their intended business operations. These costs are frequently generically referred to as startup costs of a business. Typical examples of these costs include expenditures to investigate whether to create or acquire a particular business and, for a business operated through a partnership or corporation, the organization costs to form the entity; however, costs incurred before a business begins active operations can include a wide variety of types of costs.
For financial accounting purposes, these costs are generally included in the category of startup costs and are all treated the same way. However, for tax purposes, costs that are financial accounting startup costs may be required to be further subdivided into smaller more specific categories, each of which is treated differently. This article discusses how these costs incurred by a business before it begins its active operations are treated for financial accounting and tax purposes.
STARTUP COSTS FOR BOOK PURPOSES
For book purposes, startup costs are costs a business incurs in its activities in preparing to begin its active conduct. Under ASC Section 720-15-20, startup activities include:
- Opening a new facility;
- Introducing a new product or service;
- Conducting business in a new territory;
- Conducting business with an entirely new class of customers ... or beneficiary;
- Initiating a new process in an existing facility;
- Commencing some new operation.
Financial accounting standards also treat the costs of organizing a corporation or partnership as startup costs rather than as separate costs (ASC Paragraph 720-15-15-2).
Although companies refer to startup costs using varying terms, including preopening costs, preoperating costs, organization costs, and startup costs, financial accounting standards refer to these costs only as startup costs (ASC Paragraph 720-15-15-3). For financial accounting purposes, a business must expense startup costs as incurred (ASC Paragraph 720-15-25-1). Example 1 shows the financial accounting treatment of these costs.
Example 1: ABC Corp. incurred $65,000 of startup costs. It records the startup costs using the following entry:
Startup expense $65,000
STARTUP COSTS FOR TAX PURPOSES
The treatment of preoperational startup costs is potentially much more complex for tax purposes than financial accounting purposes. Costs that are startup costs for financial accounting purposes must be analyzed and possibly subdivided into smaller categories, each of which is treated differently for tax purposes. Making things more confusing, one of these smaller categories for tax purposes includes the costs described in Sec. 195, which commonly are referred to as startup costs in tax discussions.
The other categories that financial accounting startup costs might fall into for tax purposes are organizational costs, syndication costs, Sec. 197 intangible costs, and tangible depreciable personal property costs. The different book and tax treatment is reconciled on an attachment to the federal tax return using Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return.
SEC. 195 STARTUP COSTS
For tax purposes, Sec. 195 defines startup costs as costs incurred to investigate the potential of creating or acquiring an active business and to create an active business. To qualify as startup costs, the costs must be ones that could be deducted as business expenses if incurred by an existing active business and must be incurred before the active business begins (Sec. 195(c)(1)). Startup costs include consulting fees and amounts to analyze the potential for a new business, expenditures to advertise the new business, and payments to employees before the business opens. Startup costs do not include costs for interest, taxes, and research and experimentation (Sec. 195(c)(1)). Once a taxpayer decides to acquire a particular business, the costs to acquire it are not startup costs (Rev. Rul. 99-23), and the taxpayer must capitalize the acquisition costs (Sec. 263(a) and INDOPCO, Inc., 503 U.S. 79 (1992)).
A taxpayer may elect to deduct a portion of startup costs in the tax year in which the active conduct of the business to which the costs relate begins and to amortize the portion of the startup costs not deducted over a 180-month period under Sec. 195(b)(1)(A). A taxpayer is deemed to make the election to deduct and amortize startup costs unless it affirmatively elects to capitalize startup costs by attaching a statement to the taxpayer's timely filed tax return, including extensions, for the tax year in which the active conduct of the business begins (Regs. Sec. 1.195-1(b)). The deemed election to deduct and amortize startup costs or the affirmative election to capitalize them is irrevocable (Regs. Sec. 1.195-1(b)).
A taxpayer that elects to deduct and amortize startup costs may deduct up to $5,000 of startup costs in the year the active conduct of the business begins (Sec. 195(b)(1)(A)). The taxpayer amortizes any startup costs over the deduction limit for 180 months beginning in the month the active conduct of the business to which the costs relate begins (Sec. 195(b)(1)(B)). Because costs that qualify as startup costs will be deductible as ordinary and necessary business expenses when the business becomes active, a taxpayer might want to begin the active conduct of the business before startup costs exceed $5,000. This will help the taxpayer avoid having to amortize costs rather than taking a current deduction.
In addition, if the startup costs related to the business exceed $50,000, the taxpayer must reduce the $5,000 limit on the deduction (but not below zero) by the startup costs over $50,000 (Sec. 195(b)(1)(A)). If the startup costs are $55,000 or more, the taxpayer cannot deduct any of the startup costs except as an amortization deduction. Example 2 illustrates the tax treatment for a corporation that incurred more than $50,000 but less than $55,000 of startup costs.
Example 2: The startup costs for XYZ Corp. are $52,000. XYZ may deduct $3,000 ($5,000 — [$52,000 — $50,000]) of these costs currently. XYZ amortizes the remaining $49,000 ($52,000 — $3,000) of startup costs over 180 months, beginning in the month it begins the active conduct of its business (Sec. 195(b)(1)(B)). The entry to record the startup costs for tax purposes is:
Startup costs expense $ 3,000
Deferred startup costs $49,000
The IRS is authorized to issue regulations to clarify the date a new business is considered to have begun for amortizing startup costs (Sec. 195(c)(2)(A)), but it has not yet done so. However, the IRS believes that for the amortization period for startup costs to begin, the business must be a going concern for which its expenses would be deductible as ordinary and necessary business expenses under Sec. 162(a) (Technical Advice Memorandum 9027002 and IRS Letter Ruling 9047032).
If a taxpayer acquires a business, Sec. 195(c)(2)(B) deems the acquired business to have begun on its acquisition date. Example 3 shows the tax treatment of startup costs for a sole proprietor who incurred less than $50,000 of startup costs.
Example 3: Assume T incurred startup costs of $23,000 on April 1, 2014, and began business on May 1, 2014. T may deduct $5,000 immediately and the remaining $18,000 of startup costs at the rate of $100 a month ([$23,000 — $5,000] ÷ 180). The entry to record the startup costs for tax purposes is:
Startup costs expense $ 5,000
Deferred startup costs $18,000
At the end of calendar year 2014, T would record $800 in amortization expense (8 months × $100 per month) for the deferred $18,000 startup costs:
Amortization expense—startup costs $800
Deferred startup costs $800
In 2015 and later years until T has fully amortized the startup costs, she records $1,200 (12 months × $100 per month) in amortization expense for the deferred startup costs:
startup costs $1,200
Deferred startup costs $1,200
A taxpayer claims the amortization deduction on Form 4562, Depreciation and Amortization, and then carries the total deductions to the appropriate return. In Example 3, T would show the amortization deduction on Form 4562 and then carry the deduction to Schedule C, Profit or Loss From Business, of Form 1040 because T is a sole proprietor.
If the taxpayer sells or abandons the business before deducting all the startup costs, the taxpayer may deduct the remaining startup costs as a loss (Secs. 165 and 195(b)(2)). Example 4 illustrates this rule.
Example 4: After recording 40 months of amortization of the deferred startup costs, T sold the business. T may deduct $14,000 ($18,000 — [40 × $100]) as a loss. The entry to record this loss for tax purposes is:
Loss on deferredstartup costs $14,000
Deferred startup costs $14,000
EFFECT OF NEW REPAIR REGULATIONS ON STARTUP COSTS
The new tangible property regulations (often called the repair regulations (T.D. 9636)) might require some repair costs to be capitalized as costs of depreciable property. Those costs might have been deducted immediately in the past as startup costs. To be a startup cost, the cost must be deductible if the business was an active business (Sec. 195(c)(1)(B)). Some repair costs that were previously deductible may now have to be capitalized under the new repair regulations. In that case, if the business incurs such a capitalized repair cost before beginning the active business, the cost cannot be a startup cost. The business may be able to recover the cost more or less quickly as a capitalized repair cost than as a startup cost depending on the depreciable life of the asset for which the business capitalizes the cost.
TANGIBLE DEPRECIABLE PERSONAL PROPERTY
The breadth of the definition of startup costs for book purposes means that some of the costs included in book startup costs may be costs for tangible depreciable personal property. The taxpayer should be careful to account for the costs of this property separately. A taxpayer recovers the costs of tangible depreciable property through depreciation (cost recovery) deductions over the depreciable life of the property. A small business may be able to deduct some of the cost of tangible depreciable personal property immediately under Sec. 179, and the depreciable life for tangible depreciable personal property is generally less than 15 years. Thus, any costs properly classified as tangible depreciable personal property can usually be recovered more quickly than costs classified as startup, organization, or Sec. 197 intangible costs that must be amortized.
ORGANIZATION COSTS FOR TAX PURPOSES
For partnerships and corporations, organization costs for tax purposes are costs incurred in forming a partnership or corporation, including the legal fees for drafting a partnership agreement or corporate charter and bylaws, necessary accounting services in forming the entity, filing fees, and costs of organizational meetings of stockholders and directors (Sec. 709(b)(3) and Regs. Secs. 1.709-2(a) and 1.248-1(b)(2)). Corporate reorganization costs are not organization costs unless they directly relate to the creation of a new corporation (Regs. Sec. 1.248-1(b)(4)).
The organization costs of a partnership or corporation are generally not deductible until the business liquidates (Wolkowitz, 8 T.C.M. 754 (1949)), but, as with startup costs, a partnership or corporation may elect to deduct up to $5,000 of organization costs and amortize the remainder of its organization costs over 180 months beginning in the month the entity begins business. The regulations deem a corporation or partnership to have made this election (Regs. Secs. 1.248-1(d) and 1.709-1(b)(2)) unless the entity affirmatively elects to capitalize the organization costs by attaching a statement to a timely filed return, including extensions, for the tax year in which the entity begins business. The partnership or corporation must reduce the $5,000 maximum deduction (but not below zero) by the amount of the total organization costs over $50,000 (Secs. 248(a)(1) and 709(b)(1)(A)). Example 5 shows the tax treatment of organization costs for a corporation that incurred more than $50,000 but less than $55,000 of organization costs.
Example 5: DEF Corp. incurred $51,800 in organization costs; it may deduct $3,200 ($5,000 — [$51,800 — $50,000]) of these organization costs. The entry to record the organization costs on its tax books is:
Organization costsexpense $3,200
If the partnership or corporation deducts up to $5,000 of organization costs it paid or incurred, it must amortize any remaining organization costs over 180 months beginning in the month the entity begins business (Secs. 248(a)(2) and 709(b)(1)(B)). Example 6 illustrates the amortization of the organization costs of a corporation.
Example 6: DEF Corp. amortizes its remaining $48,600 ($51,800 — $3,200) of organization costs at the rate of $270 ($48,600 ÷ 180) per month for 180 months beginning in the month it begins business. The entry it makes to record the amortization of its organization costs for one year ($270 × 12 = $3,240) for tax purposes is:
organization costs $3,240
If a partnership or corporation incurs $55,000 or more in organization costs, it may not deduct any of them immediately. The entity amortizes all organization costs over 180 months beginning in the month it begins business (Secs. 248(a) and 709(b)(1)(B)).
If a partnership or corporation liquidates before it has deducted all the deferred organization costs, it may deduct the unamortized organization costs as a loss (Secs. 165(a) and 709(b)(2), and Regs. Sec. 1.709-1(b)(3)). Example 7 illustrates this rule.
Example 7: When DEF Corp. liquidates 68 months after it began amortizing the remaining $48,600 of organization costs, it recognizes a deductible loss of $30,240 ($48,600 — [68 × $270]). The entry to record this loss for tax purposes is:
Loss on unamortizedorganization costs $30,240
If a corporation merges with another corporation and does not dissolve, it may not deduct its unamortized organization costs as a loss (Citizens Trust Co., 20 B.T.A. 392 (1930)). Instead, the unamortized organization costs are a capital cost of the new corporation (Vulcan Materials Co., 446 F.2d 690 (5th Cir. 1971), and Regs. Sec. 1.248-1(b)(4)).
Organization costs do not include the syndication costs of a partnership, which are the costs of issuing and marketing ownership interests in the partnership. Syndication costs are treated differently for tax purposes. Unlike organization costs, syndication costs are not eligible for an immediate deduction or amortization, and instead must be capitalized (Regs. Sec. 1.709-2(b)). Similar to partnership syndication expenses, the expenditures a corporation incurs issuing stock and transferring assets to itself are not organization costs and are not deductible or amortizable (Regs. Sec. 1.248-1(b)(3)). A partnership may not claim a loss for unamortized syndication costs (Regs. Sec. 1.709-1(b)(3)).
Sec. 197 Costs
Another category of costs for tax purposes that may be included in startup costs for book purposes is Sec. 197 intangibles. Among other things, under Sec. 197(d) these include:
- Going concern value.
- Workforce in place.
- Business books, records, and operating systems.
- Trade secrets.
- Trade names.
- Covenants not to compete.
The rules for recovering the costs of Sec. 197 intangibles are similar to the rules for recovering startup costs, but there are significant differences. One difference is that while a taxpayer may deduct up to $5,000 of startup costs, a taxpayer may not deduct any cost for goodwill or other intangible assets listed in Sec. 197 except through amortization. A taxpayer amortizes the startup costs not eligible for an immediate deduction over 180 months. Likewise, a taxpayer amortizes goodwill and other intangibles listed in Sec. 197 over 15 years (Sec. 197(a)).
Another difference is if a taxpayer disposes of any Sec. 197 intangible before fully amortizing its cost, the taxpayer may not deduct a loss (Sec. 197(f)(1)(A)(i)). Instead, the taxpayer adds the unamortized cost to the adjusted basis of retained intangibles (Sec. 197(f)(1)(A)(ii)).
For financial accounting purposes, the treatment of costs a business incurs before the beginning of the active conduct of its business operations is relatively straightforward, with all the costs falling into one category and all being treated the same way. However, for tax purposes, things are potentially much trickier, with the various costs possibly falling into several categories that are treated differently. For some of the costs, a taxpayer may have a choice as to how the costs are treated. Thus, it is important to correctly account for startup costs to ensure that the costs are treated appropriately for tax purposes and in the manner that is most beneficial to the taxpayer.
Organization costs are subject to the same deduction and amortization rules as startup costs. However, a taxpayer must account for them separately.
- See more at: http://www.journalofaccountancy.com/issues/2015/nov/startup-costs-book-vs-tax-treatment.html#sthash.d8NddL05.dpuf
Thanks to Allen Campbell, CPA for pulling this interesting material together!