When starting a new business, tax issues – along with everything else – can feel overwhelming and unsurmountable. But in spite of COVID-19 restrictions, many entrepreneurs are still considering new or additional business opportunities. If you are planning a new business start-up and are incurring expenses, here are some specific tax issues to be aware of.
You probably anticipate deducting those start up expenses in the first year of the business’s operation. However, tax planning can end up being a bit more complicated than that. The expenses a business incurs in the beginning can include equipment purchases, vehicle purchases and use, and leasehold improvements. Also business expenses like organizational costs and start-up expenses. Each expense receives a different tax treatment.
First things first, you must decide what type of business entity you are going to establish. The type of business entity you choose will determine which tax form has to be filed. The most common types of business entities are the following:
- sole proprietorship
- partnership
- corporation
- S corporation
In addition, these could also be structured as a limited liability company. The choice of entity will affect the tax outcome of your business for years to come.
Business Structure Affects Taxes
How your business is structured will determine what taxes must be paid and how you pay them. The four general types of business taxes are the income tax, self-employment tax, employment taxes, and sales or excise tax.
To identify a business entity, we use an employer identification number (EIN). Most businesses need an EIN, and if you hire employees, and EIN is essential.
It’s also very helpful to use an consistent accounting method. The most commonly used accounting methods are the cash method and accrual method. Here are the differences:
- Cash method
Income is reported in the tax year it is received, while expenses are deducted in the tax year paid.
- Accrual method
Income is reported in the tax year it is earned; even if the payments for goods/services have not yet been received. Expenses are deducted in the tax year incurred, even though they are not yet paid.
New Business Expenses and Deductions
Once you have decided upon a business entity, you can begin acquiring the assets needed to conduct the business. It’s best to plan what the purchases and expenses may be to fit your circumstances and business entity.
Below is an example on how common expenses can be deducted.
Start-up Expenses
For new businesses, you can deduct up to $5,000 of the start-up expenses in the first year of the business’s operation. This is in lieu of amortizing and deducting the expenses over 180 months (15 years).
Generally, start-up expenses include all expenses incurred to investigate the formation or acquisition of a business. Or expenses to engage in a for-profit activity in anticipation of that activity becoming an active business. To be eligible for that election, an expense must also be one that would be deductible if it were incurred after the business actually began. An example of a start-up expense is the cost of analyzing the potential market for a new product.
As with most tax benefits, there is always a catch. In this case, the amount of start-up expenses that can be claimed as a deduction was capped by Congress.
How to determine if a deduction will apply
Here’s how to determine if the deduction will apply. If the expenses are $50,000 or less, you can elect to deduct up to $5,000 in the first year, plus you can amortize the balance over 180 months. If the expenses are more than $50,000, then the $5,000 first-year write-off is reduced dollar-for-dollar for every dollar in start-up expenses that exceeds $50,000. For example, if start-up costs were $54,000, the first-year write-off would be limited to $1,000 ($5,000 – ($54,000 – $50,000)).
The election to deduct start-up costs is made by claiming the deduction on the return for the year in which the active trade or business begins. The return must be filed by the extended due date.
What qualifies as a new business start up cost?
A qualifying start-up cost is one that would be deductible if it were paid to operate an existing active business in the same field as the new business. The start up cost is paid or incurred before the day the active trade or business begins. Not included are taxes, interest, and research and experimental costs.
Examples of qualified start-up costs include:
- Surveys/analyses of potential markets, labor supply, products, transportation facilities, etc.;
- Wages paid to employees and their instructors while they are being trained;
- Advertisements related to opening the business;
- Fees and salaries paid to consultants or others for professional services; and
- Travel and other related costs to secure prospective customers, distributors, and suppliers.
The rules change when you purchase an active trade or business. In this case, only investigative costs are qualified start up costs. Investigative costs include costs while conducting a general search or preliminary investigation of the business. For example, costs that help the taxpayer decide whether to purchase a new business and which one to purchase. Any costs incurred attempting to buy a specific business are capital expenses. These are not treated as start-up costs.
Organizational Expenses
- As a partnership or corporation, the business can elect to deduct up to $5,000 of organizational expenses in the first year of a business. This is in addition to the election for start-up expenses. Like start-up expenses, the $5,000 amount is reduced by the amount of the start-up costs in excess of $50,000. If the election is made, the start-up costs over and above the first-year deductible amount are amortized over 15 years. Start-up costs must be capitalized if the election is not made. Organizational expenses include outlays for legal services, incorporation fees, temporary directors’ fees and organizational meeting costs, etc.
Deducting business acquisitions
You can deduct business acquisitions in a variety of ways. These rules also apply to existing businesses.
Equipment Purchases
Newly purchased equipment can’t be deducted until it is placed in service. For that reason, you can’t make any equipment deductions until the business is actually functioning. However, deductions for most equipment purchases offer several options:
Depreciation
Depreciation is the normal accounting way of writing off business capital purchases. It works by spreading the deduction of the cost over several years. IRS regulations specify the number of years for the write-off are based on established asset categories. These are generally for small business purchases and the categories include 3-, 5- or 7-year write-offs. The 5-year category includes autos, small trucks, computers, copiers, and certain technological and research equipment. While the 7-year category includes office fixtures, furniture and equipment.
Tax Issues to Consider
- Bonus Depreciation
Allows a business to deduct 100% of the cost of tangible property the year it’s placed in service. AKA bonus depreciation. It is a temporary provision that is available only through 2026. The deduction rate phases out and drops to 80% for eligible property acquired and placed in service in 2023. Then changes to 60% in 2024 and so on until it is 0% in 2027 or later.
- Expensing
Expensing allows a certain amount of the cost of tangible equipment purchases to be expensed in the year the property is first placed into business service. This tax provision, referred to as Sec. 179 expensing, is named after the tax code section, that sanctions it. The expensing is limited to an annual inflation adjusted amount. ($1,040,000 for 2020 and $1,050,000 for 2021.) To ensure that this provision is limited to smaller businesses, whenever a business has purchases of property eligible for Sec 179 treatment that exceed the year’s investment limit ($2,590,000 for 2020 and $2,620,000 for 2021), the annual expensing allowance is reduced by one dollar for each dollar the investment limit is exceeded.
New Business Tax Issues Regarding Deductible / Sec 179
However, the deductible Sec 179 amount is limited to taxable income from all the taxpayer’s active trades or businesses (including a spouse’s active trades or businesses if married and filing jointly). Income from trades also includes W-2 income.
An undesirable consequence of using Sec. 179 expensing occurs when the item is disposed of before the end of its normal depreciable life. In that case, the difference between normal depreciation and the Sec. 179 deduction is recaptured and added to income in the year of disposition.
- Mixing Methods – A mixture of Sec. 179 expensing, bonus depreciation and regular depreciation can be used on a specific item, allowing just about any amount of write-off for the year for that asset.
For most small businesses, this means the entire cost of equipment and office furnishings can generally be written off in the year of purchase. Only if that is also the year when the equipment is put into service, using the bonus deprecation or the Sec 179 expensing election.
Tax Planning : Items that can be deducted on taxes over time
Sometimes it may not be appropriate to write off the entire cost in the first year, depending on your business and personal circumstances. This is part of the planning required to maximize tax benefits.
Vehicles – Automobiles and small trucks that are purchased for use by the business are treated like equipment, as above, except their recovery period is 5 years and they are subject to the so-called luxury auto rules. These rules limit the depreciation to a maximum of $10,100 for passenger autos, and light trucks and vans for the first year. The $10,100 amount may be different for 2021, as it is subject to inflation adjustment. If bonus depreciation is elected, add $8,000 to the first-year maximum.
Leasehold Improvements – Generally, leasehold improvements are depreciated over 15 years. But bonus depreciation may be elected, allowing up to 100% of the cost of interior qualified improvements to non-residential property after the building is placed in service to be deducted in the first year. In addition, the Sec 179 expense deduction is allowed for qualified improvement property as well as any of the following improvements to nonresidential real property placed in service after the date the property was first placed in service:
- roofs
- heating
- ventilation,
- and air-conditioning property;
- fire protection and alarm systems;
- and security systems.
However, not eligible for Sec 179 treatment are improvements for the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.
Material & Supply Expensing – IRS regulations allow certain materials and supplies that cost $200 or less, or that have a useful life of less than one year, to be expensed (deducted fully in one year) rather than depreciated.
Knowledge can help you overcome all new business tax issues
So there’s an overview of some of the start-up and expense issues in a business’s first year. As you can see, a bit of initial tax planning can have a lasting impact on a new business or even an existing one.
If you’d like more help in tax planning for your business give us a call at 360-778-2901. We can assist you with your accounting, bookkeeping, payroll or sales tax reporting, or other federal, state, and local licensing and compliance issues.
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