Start-Up Costs Deduction: How the $5,000 Section 195 Deduction Works

What Counts as a Start-Up Expenditure

Under §195(c)(1), a start-up expenditure is an amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business, creating an active trade or business, or certain pre-opening profit-seeking activity, and that would be deductible if it were paid or incurred in connection with an existing business in the same field.

Typical examples include market research, travel to evaluate locations or suppliers, advertising before opening, training employees before opening, and consulting or professional fees for setting up operations.

Some pre-opening costs are not start-up expenditures:

• Equipment, furniture, vehicles, and other capital assets are capitalized and depreciated, or may qualify for §179 expensing or bonus depreciation, once placed in service.
• Inventory costs are recovered through cost of goods sold when the inventory is sold.
• Interest, taxes, and research expenditures deductible under §§163(a), 164, 174, or 174A are excluded from the definition.
• Costs of organizing a corporation or partnership are “organizational expenditures,” which have their own rules, discussed below.

The $5,000 Deduction and the $50,000 Phase-Out

Under §195(b), in the tax year the active trade or business begins, a taxpayer can deduct the lesser of its start-up expenditures or $5,000, reduced dollar for dollar by the amount by which total start-up expenditures exceed $50,000. Whatever is not deducted is amortized ratably over 180 months, beginning with the month the active trade or business begins.

Because of the phase-out, a business with $55,000 or more of start-up expenditures gets no immediate deduction and amortizes the entire amount.

Examples

For example, a business that begins operating in January with $12,000 of start-up expenditures can deduct $5,000 in its first year. The remaining $7,000 is amortized over 180 months, about $38.89 per month, or about $467 for a full first year, for a first-year total of about $5,467.

If the same business began operating in July instead, the $5,000 deduction would be unchanged, but only six months of amortization, about $233, would be allowed in the first year.

A business with $52,000 of start-up expenditures can deduct only $3,000 immediately ($5,000 minus the $2,000 by which its costs exceed $50,000) and amortizes the remaining $49,000 over 180 months.

No Separate Election Is Usually Needed

Under Treas. Reg. §1.195-1(b), a taxpayer is deemed to have elected to deduct and amortize start-up expenditures for the year the active trade or business begins. A taxpayer that prefers to capitalize them instead must affirmatively elect to do so on a timely filed return, including extensions, for that year. Either choice is irrevocable and applies to all start-up expenditures related to that business.

Organizational Expenditures

Corporations and partnerships, including LLCs taxed as partnerships, have a parallel rule for the costs of forming the entity, such as legal fees for drafting the organizing documents and state filing fees. Under §248 for corporations and §709 for partnerships, the entity can deduct up to $5,000 of organizational expenditures in the year it begins business, reduced by the amount by which those expenditures exceed $50,000, and amortize the rest over 180 months. This is a separate $5,000 allowance from the start-up expenditure deduction. Under §709, costs of promoting or selling partnership interests, known as syndication costs, are not deductible.

If the Business Ends Early

If a trade or business is completely disposed of before the end of the amortization period, any remaining unamortized start-up expenditures may be deducted to the extent allowable under §165 (§195(b)(2)).

California

The Franchise Tax Board lists start-up expenses under §195 among the areas where federal and California depreciation and amortization rules can differ, so the California deduction should be checked separately rather than assumed to match the federal amount.

The Bottom Line

Section 195 converts what would otherwise be nondeductible pre-opening costs into a first-year deduction of up to $5,000 plus 15-year amortization, with the deduction phased out for start-up costs above $50,000. Separating start-up costs from capital assets, inventory, and organizational costs, and documenting when the business began, are the keys to applying the rules correctly.