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Are you aware of business start-up deductions? If you’re not, you should find out right away! You don’t want to miss out on these tax-deductible activities that are only valid when you’re starting a new business. In fact, you don’t have to start your own business; you can get these tax benefits from simply buying a business. Fortunately, this article deals you in on the details.
It Pays to Plan
Before you even purchase your new business, you can start keeping track of your deductible expenses. That’s right, you are eligible for deductions related to merely thinking about your soon-to-be business. Here’s an example. Let’s say you invite a friend to dinner because she purchased her business only a few years ago, and you’d like to find out more about what goes into starting a newly purchased company. That dinner is deductible because you have a business purpose for the expense—you are seeking necessary information for your venture. These expenses are called “start-up expenses”.
Whether you create or buy a business, you will by necessity go through an investigatory phase. If you don’t do this, you may want to reconsider going into business for yourself! However, the rules about how deductions work are a little different in each situation, so we’ll stay focused on the process for purchasing an existing company.
Basically, you are going to incur expenses while you analyze your options and make a decision about what kind of (and then which) business to buy. That is the extent of the investigatory phase. After that, start-up expenses stop, and you begin tracking business expenses.
Here’s a breakdown of the steps and what expenses you may be looking at:
- Investigating Possible Businesses—First of all, let’s make clear that when we say “buy a business”, we are talking about actually purchasing an active business, not buying corporate stock. If during this period, you spend $41,000 to analyze and review your options, you can begin writing off those expenses the day the escrow closes on your purchase. You get a $5,000 write-off on the first day, and $200 each month after for the 180 months.[1]
- Identifying Your Prospective Business—In order to take advantage of the expenses for your investigatory phase, you must identify the business you plan to purchase. If after investigating the possibilities, you do not identify a target business, you will not be eligible for any deductions. At the point when you identify your target business, your investigative expenses stop. In the event that you identify a target business but do not end up buying it, you are still eligible for acquisition and facilitative costs, but not the investigative costs.
- Buying the Business—Once you have identified the business and move forward with purchase, any additional expenses are considered capitalization rather than start-up costs. These are costs that you cannot benefit from until you later sell or leave your business. The IRS has what is called a “bright-line rule” regarding the date your research of possible businesses ends and acquisition activities begin.[2] It is either 1) the date of your letter of intent (or similar documentation), or 2) the date that a binding written contract is executed between you and the target business (unless board approval is required, in which case it’s the date terms are approved by the board or its authorized committee). The IRS will go with whichever of these two dates is earlier.[3]
Take a look at that last bit about the bright-line rule. That means that if you hire an accounting firm, for instance, to investigate your target company, the firm may continue to provide services to you after you submit a letter of intent. The accounting firm will make a financial analysis in the investigatory phase, but it also could review the target company’s books and records after that point. Only the services provided before submission of your letter of intent count as start-up costs.[4] The additional services are capital costs.
Of course, the IRS never makes things easy, so there is an exception to the above bright-line rule. It wouldn’t be tax law if there weren’t, right? You see, some expenses are inherently facilitative, meaning they cannot be counted as investigatory expenses. What about the bright-line date, you may say. It doesn’t matter. Facilitative expenses are capital costs regardless of the date you incurred them. Here are some examples that are inherently facilitative to a purchase:[5]
- Appraisal costs
- The cost of a formal written evaluation of the transaction
- The cost to have a purchase agreement prepared
- Any costs necessary to obtain shareholder approval
- Costs for negotiating the transaction
- Costs for structuring the transaction
- Any costs for conveying property, such as title registration or transfer taxes
When Corporations Are Involved
Things are always a little trickier when corporations are the entities making the transaction. You may find yourself in one or both of the following situations: you could be purchasing a corporation, and/or your corporation may be the buyer. Let’s look at a few scenarios.
- You Only Buy Common Stock—If you take over a corporation through common stock, any investigatory expenses are not deductible. This is because you have gained an investment rather than an actual business or trade interest.[6]
- You Buy Stock Plus Assets—If stock purchase is included in the process to fully take over a corporation, that is a different matter. When you acquire a business’s assets, even when stock is also exchanged, you are eligible for start-up deductions and amortization.
- Your Corporation Is the Acquirer—Unlike the sole proprietor, who claims start-up expenses on the Schedule C, an S or C corporation will claim these expenses on the corporate tax return. Always keep in mind that your corporation is a separate entity from you. Do not pay any of the costs incurred by your corporation. If you do, make sure the corporation reimburses you. Doing otherwise will cause headaches with your taxes.
- You Form the New Business as Corporation—When you do this, you incur organization expenses for setting up your company’s entity structure. This can include fees paid to incorporate, legal services required to set up the corporation, accounting services, and expenses related to organizational meetings for directors or stockholders. These costs are separate from investigatory costs and capitalization costs.[7] The good news is that they can be amortized just like start-up expenses. You claim up to $5,000 in the first year and amortize the remainder over 180 months.[8]
Now you know what to do as far as acquiring your business, but what if the business fails or is sold before you finish seeing the full benefits of amortization? No worries. For sole proprietors, you deduct the remaining (unamortized) costs as a business loss.[9] For corporations, both the unamortized start-up and organization costs are deducted on the corporation’s final tax return.[10]
Tax law is not written to slow down businesses, despite the fact that it can get complicated. On the contrary, legislators know that the opening of new businesses benefits the whole economy. That’s why your able to write-off expenses like the ones discussed here. Take advantage of it! The benefits are available so that you and your business can succeed.