Starting a new business can be very exciting — and expensive. Yet, that initial financial investment should not scare you away from pursuing your dream. It is a common cost shared by most new business owners, and it’s one you can spread across many years in order to help lower your tax burden.
When I started my first business, there were all kinds of associated costs: computers, desks, chairs, printers, lamps, supplies, website development, branding, cards and more.
The IRS has defined what qualifies as startup costs, describing them as the following:
"Start-up costs include any amounts paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational costs include the costs of creating a corporation or partnership."
Usually, startup costs are capital-related, but they can also be soft costs such as research, making a business plan, logo design, website and so forth. These little things can really add up when building a startup and should be tracked by using reliable accounting software.
Many owners are understandably tempted to write off their startup costs right after their first year. However, that may be a costly mistake.
Here are three things to think about when considering when to write off your startup costs:
Don't expect a first-year profit.
Go into your first year knowing that you are likely to take a loss -- and keeping in mind that it could take up to two years to be profitable.
Regardless, if you take your business seriously and find a customer base, then you can likely show growth the following year, and even more the year after that. However, the more your startup grows, the more you will pay in taxes. Here is an example of what you might anticipate paying as your business grows:
• Year one: 10%
• Year two: 15%
• Year three: 25%
In short, the more money your business makes, the greater percentage of profits go to Uncle Sam, and therefore, the more valuable it will become for you to deduct those startup costs later.
Consider using a startup write-off when you need to show lower earnings.
My third year in business, I made so much money that I also owed a huge tax liability, which I was unprepared to pay. The cash just wasn't there, and I could have really used $3,000 to write off as startup deductions. However, I had already deducted my startup costs when I only had a 10% tax liability. It would have made an almost $700 difference if I had waited to use this deduction when I was in the 33% bracket! That's the value of a 15-year statute of limitations.
Your startup cost write-offs can do you more good when you've grown your business to a higher tax bracket, so hang on to those startup costs until it benefits you to show lower earnings. When it comes time, the most current rules to be aware of, as of this writing, include the following:
• You can't deduct more than $5,000 in startup costs in your first year.
• You need at least one sale before you can deduct ANY startup costs.
• You have up to 15 years to make these deductions.
Don't forget to track your tax bracket.
Startup costs are your friend, so you should use them when your business has grown to a new tax bracket, and you want to lower your reported earnings.
A good strategy is to correctly categorize your startup costs using a dependable accounting app that includes features such as bank account reconciliation and categorization. Here are some ideas you can use right away:
• Get in the habit of mentally categorizing what you pay for. Every time you make a business purchase, some part of your brain should be asking, "Is this a startup cost?"
• Find accounting software that will let you categorize your expenses. As soon as you make a startup purchase, jot it down in that software with both a category and a note so your accountant can understand how you used the item.
• Remind your accountant that you're not planning to claim all of your startup costs this year and that you want to look at a situation where you can spread them out over a few years in order to mitigate your tax liability over time.
Taking these steps can help make startup costs your friends and help your business grow the way it deserves to.
