There is a lot involved in starting a business, and most of what you have to do doesn’t come cheap. But every dollar you put in is an investment in your future, and that’s always worthwhile.
Startup costs are often steep, and it might take time before you start seeing any return. As a new small business owner, you’re probably already looking for ways to optimize and reduce costs—but did you know that many of your startup costs can be written off?
It’s true! Much of that initial investment can be leveraged against your taxes to lower the amount you have to pay. And unless your last name is Bezos or Branson, you’ll probably need all the help you can get.
So today, we’re going to look at startup costs for new small business owners—what they are, which ones you can deduct, and how to claim them on your income tax.
What are the main startup business expenses?
Startup business costs are the funds you invest into getting your company off the ground.
There will be plenty of costs to shoulder before you even open your doors. Your business plan, market research, feasibility reports, marketing, recruiting, and various other activities must be accomplished before launching.
Then, depending on the industry you’re in, you’ll have other startup costs to consider. These could include lease or rental fees, office equipment, computers, furniture, renovation costs, machines you need to produce your product, equipment leases, vehicles, uniforms, utilities, insurance, payroll costs, legal fees, accounting costs, business licenses, certifications, incorporation fees, software, signage, and more.
Hard costs, prime costs, and one-time purchases will vary significantly depending on your business model. Different business structures have different startup requirements, too; for example, incorporation fees are significantly higher than sole proprietorships. A brick-and-mortar retail store requires inventory, while a tech startup might not even need a physical location.
All in all, it’s a costly and often highly nuanced process, but if you plan well and know what you can and can’t deduct, it might not seem so overwhelming. Most startup costs can be written off, and for new small business owners, every little bit counts.
Allowable small business tax deductions
Many business startup expenses can be deducted from your taxable income. As long as the expense fits the IRS’s criteria of allowable expenses, it’s eligible. It should be noted that allowable tax-deductible expenses differ based on your business structure, but we’ll get into that.
The IRS allows you to write off $5,000 of eligible startup costs, plus $5,000 of organizational startup costs. If your startup costs are greater than these limits, you can amortize the costs over the next 15 years.
If your company won’t be profitable or at revenue in your first year, you might consider amortizing all startup costs over 15 years instead of taking the startup tax deductions the first time you file. Once you claim those amounts, you won’t be able to claim them again, so you might as well make the most of it.
Either way, it’s $10,000 in taxes you won’t have to pay—provided your costs fall into these categories:
Costs related to creating your business
These pre-launch expenses are integral to business success and can be written off as startup costs:
- Market research
- Product analysis and testing
- Feasibility studies
- Competitor analysis
- Labor studies
- Location scouting and prospecting costs
Costs to launch your business
These costs are incurred in the process of getting your business ready to open:
Hiring and training new employees
- Business licenses and permits
- Technology, such as computers, software, and machines
- Costs of borrowing (interest on business loans or business expenses)
- Marketing, advertising, and promotion
- Supplies and equipment
- Rent or lease costs
- Business travel costs
These expenses are incurred while setting up your legal business entity:
- Legal fees
- Incorporation fees
- State and federal fees
- Consultant fees
- Professional fees
- Expenses related to meetings conducted in the interest of organizing the business
It should be noted that startup costs aren’t all deducted in your first year in business. What you don’t deduct on your first return can be charged to a capital account and amortized over the duration of your business.
Here are some specific startup write-offs you’ll need to look at:
How to write off your car expenses
There are several areas in which you can write off vehicle expenses on your income tax. If you use your car for business only, you can deduct the entire cost of ownership and operation. If you use your personal car for business purposes only sometimes, you’ll write off only the business portion. Keeping meticulous records helps as it will tell you (and your accountant) what’s eligible.
Here’s what the IRS allows you to write off under vehicle expenses:
· Mileage. The current rate is 57.5 cents per mile. If you are being reimbursed for mileage, say if you charge your customers back for that amount, you can still write it off at that rate. That said, there are a few scenarios where you can’t use the standard mileage rate. If you have more than five cars or if you claimed certain depreciation tax deductions, you might not be eligible to claim the standard mileage deduction. There is a maximum amount you can claim, so claiming depreciation might put you over that limit.
· Depreciation. You can write off a portion of your new vehicle purchase to depreciation.
There are three ways to calculate your depreciation:
- The straight-line method
- 200% declining balance over five years
- 150% declining balance over five years
If you’re using one of the declining balance methods, it switches to the straight-line method when it results in a deduction equal to or more than the declining amount. If you sell or dispose of the vehicle at any point, you are entitled to deduct a half-year of depreciation.
Other allowable vehicle expenses include:
- Licenses and registration
- Lease payments
- Interest on lease payments
- Tolls and parking
- Garage rental
- Insurance payments
You can also write off certain car upkeep expenses, such as car washes and detailing if your vehicle is used to carry customers or is in front of the public in any way.
14 small business tax deductions and benefits
If you are your business—in other words, if you’re a self-employed person, contractor, sole proprietor, or a member of an LLC with pass-through taxation—there are specific tax deductions and benefits you should be aware of. Knowing these items will help you calculate your installments more accurately.
1. Self-employment tax
This is related to Medicare and Social Security, and all employers must pay into it. If you are a freelancer or an independent contractor, you share this rate with your employer. However, if you are fully self-employed, you must pay the entire amount yourself at the rate of 15.3%. There are additional premiums if your income is above certain thresholds, and your marital status can also impact your rate.
2. Home office expenses
These can be deducted as a percentage of the cost of your domicile, including mortgage payments, interest, home depreciation, insurance, repairs, utilities, and so on. If you use 20% of your home for business purposes, you can deduct 20% of these costs. Usually, the percentage is determined by a square footage calculation at $5 per square foot. You’ll claim this using IRS Form 8829.
3. Utilities, phone, and internet
You can deduct these as a business expense, but if the accounts are shared with your household, you’ll only deduct the business portion, as in item #2. If you have a dedicated line for your business, that’s 100% deductible.
4. Health insurance premiums
You can also deduct these if they're not paid by an employer (either your or your spouse’s). If you pay for your own insurance and your spouse and children are covered under your policy, you can also deduct that.
5. Business meals
Business meal deductions have changed somewhat over the last few years, but currently, meals when traveling, at a conference, or entertaining a client are covered 100% as long as the meal and beverages are provided by a restaurant. In other words, you can’t write off the pizza you have at your desk.
6. Business travel expenses
These are 100% deductible, except for meals, which are 50%. The trip must have a specific business purpose and be outside of the area where your business or home is located. Allowable expenses include transportation to and from, taxis, rental cars, lodging, and meals.
7. Vehicle use
When you use your car for business purposes it's tax-deductible (see section above). Be sure to compare methods of deducting to ensure you’re claiming the maximum you’re entitled to.
8. Interest on business expenses
This includes anything on loans and company credit cards.
You can write off trade publications, magazines, journals, books, or any materials as long as they are directly related to your business activity.
10. Training and education are deductible as long as they are related to improving or upgrading your current business focus.
11. Insurance premiums
Lower your tax bill for liability, car insurance on a business vehicle, fire or flood insurance, and health insurance are all deductible.
12. Rental or lease costs
Costs that apply to your business premises or equipment you rent or lease are 100% deductible. However, you can’t deduct rental costs for the property you own.
13. Advertising costs
Deduct taxes for things like social media ads, print ads, flyers, posters, direct mail.
14. Retirement plan contributions
Don't forget that these contributions are 100% tax-deductible up to annual limits. You can contribute up to 25% of your self-employment earnings towards your self-employed retirement plan.
Form 4562: depreciation and amortization
If you need to purchase equipment, machinery, or other assets for your business, you can’t write off the total cost of the item in the first year of purchase. You can, however, make tax deductions on some of the costs each year through IRS Form 4562, which covers depreciation deductions. A separate form must be filed for each asset, including buildings, machinery, or any other tangible assets, but cannot include investment property or property owned outside of the United States.
How to deduct a new small business expense on your taxes
If you choose to take advantage of the startup deduction in your first year, here’s what you need to know.
Claiming small business tax deductions
You can claim the startup costs deduction and operational costs deduction in your first filing. Sole proprietors will claim this using Part V of Schedule C (Form 1040 or 1040-SR). You can claim expenses related to business creation, preparing the business to open, and organizational costs.
However, if you expect to operate at a loss for a couple of years, it might be worthwhile to amortize the costs over time. If you choose to go this route, you’ll use IRS Form 4562. It’s a good idea to speak to your tax advisor about this option as you won’t be able to change your mind once you’ve decided.
How to set up a SEP IRA
A SEP IRA is a simplified employee pension plan. If you’re a high-earning sole proprietor, a SEP IRA helps you save money on your taxes by deferring your income into a retirement savings plan. You can put 25% of your income into a SEP IRA up to a maximum of $58,000 (2021 guidelines). You can also use it to benefit your employees.
It’s easy and inexpensive to set up a SEP IRA, and your allowable contributions are much higher than a regular IRA, which translates to significant tax savings. You’ll need to establish IRA accounts for all participants, which can be done through your bank, insurance company, or financial advisor.
How to qualify for the home-office tax deduction
With so many people working from home these days, the IRS has graciously simplified the method of calculating the home office deduction. The standard method of qualifying still applies, but it’s probably worth going through each to see which one will benefit you more.
Startup cost deductions example
You launch your company in 2021 as ABC LLC. Your startup costs are $12,000, and your organizational costs are $2,500.
1. You’ll claim the $5,000 startup cost deduction on your 2021 return
2. You’ll claim $2,500 in operational costs
3. The remaining $2,500 in operational costs is amortized over the next 15 years
When should you claim the tax deduction?
You’re not obligated to claim the startup deduction in your first year. As discussed above, you could choose to amortize startup costs over 15 years if you expect to operate at a loss.
When does a business start?
Knowing your business start date is crucial for tax purposes. In most cases, the start date is the date you register your business or the date you file with the state. You’ll need a federal tax number, and the application will ask you for your start date, so you’ll need to decide.
Some small business owners choose a start date at the beginning of the month or the beginning of the year. If it’s a corporation, your start date is the day you incorporated—at least in the eyes of the IRS.
For the purposes of writing off startup costs, the business start date is important as this is how you’ll determine whether certain costs are deductible. Eligible costs must be incurred before your start date, so you can see why this is a critical concern.
What if I don’t go into business? Are those costs still tax deductible?
Even the best ideas don’t always play out the way we think they ought to. There are two ways this scenario can play out:
· You haven’t established the business as a legal entity. If your expenses are related to preliminary searches, due diligence, or research, they are not deductible as business expenses.
· Your launch was unsuccessful. If your business idea failed, your startup costs could still be claimed or depreciated as if the business was active.
The bottom line on small business tax deductions
If you’re new to the business world, knowing what you can and can’t deduct from your income tax is a way to offset or defer costs and maintain profitability. Though starting a new venture can be costly, writing off your startup costs will give you a little extra peace of mind. Staying on top of your expenses and keeping good records is a must, and Invoice2go can help. Our holistic online tools help you manage customer relationships, improve cash flow, stay organized, and get paid faster, and we’re always here with sound advice when you need it.