Organizational Expenses – Types and Tax Implications

Organizational Expenses

Prior to initiating operations, every business spends money to develop the idea and create the legal entity. These types of costs are referred to as ‘Organizational Expenses’. There are several different types of organizational expenditures. These include research and development, legal and start-up costs. The following sections explain these expenses and how they are treated for income tax purposes. 

 

Start-Up Expenses 

Those costs expended in the investigating or acquiring a business are generally deductible for tax purposes for starting up a business. These costs include the following:

  • Purchase of research material
  • Costs to travel and provide lodging prior to actual operations
  • Costs related to negotiations including counsel from professionals (accountants, lawyers, engineers)
  • Initial Advertising
  • Employee Training 

The key to the above is that the expense must be necessary and ordinary. To help you understand this concept, I suggest reading: IRS Definition of an Expense. The business may not accumulate those expenses such as interest, taxes, or experimental fees which would normally be allowed in determining the operational income. A good example is the business license during the first year of operations. This is not a start-up expense, it is a normal operational fee paid to the local or state government authorizing normal operations of the business entity.  

Section 195 of the Internal Revenue Code regulates start-up expenses. In general, the first $5,000 can be fully deducted in the first tax return as an amortizable expense. This is done as an election to Form 4562 on page 2 at the bottom. You simply attach a statement stating the full amount of the accumulated start-up expenses and then an election to expense the first $5,000 or the actual amount up to the $5,000. Any remaining balance is then amortized over 15 years under Section 195. This amortization amount is allocated on a monthly basis and the taxpayer is allowed to take their respective share for the first year of operations.  

If you begin actual operations in February of the tax year, any remaining balance after the $5,000 one-time election is divided by 180 and then multiplied by 11 for the number of months of actual business in the current year. The following is an example: 

Joan invested $11,285 to purchase manuals, pay for training and the associated travel costs, and she paid an accountant to prepare the business plan. She began operations in September of the prior calendar year and is a calendar year taxpayer. On her attached statement to Form 4562, she documents the following: 

Attachment to Form 4562, Part VI – Joan’s Wonderful Business – EIN ZZ-ZZZZZZZ

Section 195 Election to Expense the First $5,000 of Start-up Expenses:
  Research Manuals and Documents                 $3,485
  Training                                                            1,998
  Travel, Lodging, Meals                                    1,214
  Business Plan Preparation (Professional)         4,588
  Gross Start-Up Expenses                                          $11,285
Election to Expense First $5,000                                (5,000)
Balance Remaining for Amortization                             6,285
Monthly Amortization Amount (180 Months)              $34.92
Amortization Expense to Line 42:
  Election Amount from Above                        $5,000
  Section 195 Amortization (4 Months)                 140
  Total Amortization Expense                           $5,140 

On Line 42 of Form 4562 (Page 2, Part VI), the accountant inserts the description as Start-Up Expenses, under the Date, the accountant inserts the start date from September then the total amortization Amount of $11,285, Code Section 195, and for the period, he inserts 180 Months. Under Column (f), the accountant inserts $5,140. 

In the line underneath, the accountant inserts ‘See Attached Statement’ for clarification of the value calculated. 

A very common mistake is businesses including organizing expenses in the start-up category. There is a difference between the two types of organizational expenses. The key is to realize that Organizational Expenses are sub divided into two distinct types. The first are start-up expenditures and the second are organizing expenses. 

Organizing Expenses 

When someone decides to go into business, the first thing they do is to try and decide on the legal format of the business. They spend time meeting with their attorney and CPA. Once determined, there are some initial meetings with potential directors/officers or investors. Afterwards, there is the filing of the forms with the state to recognize the business. The most important relationship of the expenditure and status as an organizing expense is the connection to the life of the business. If the expenditure relates to the long life of the business, it will most likely be an organizing expense. The types of costs include the following: 

  • Legal Counsel and Accounting Fees related to Organizing the Business
  • Drafting of Documents
  • State Fees for Recognition as a Legal Business Entity
  • Costs of Certificates or Contracts to Recognize Investors (Stock Certificates, Partnership Agreements, etc.)
  • Organizational Meetings 

Remember one important characteristic of business life, corporations are certified without any life expectancy, partnerships have a defined life term. 

Section 248 of the Code regulates the amortization of organizing expenses. Just like Section 195, the taxpayer is allowed to take a $5,000 one-time expense of organizing expenses. Any excess of $5,000 must be amortized over 180 months. Just as illustrated above, the taxpayer reports these costs in a very similar presentation format.  

Other Issues – Organizational Expenses

One of the more common issues that arise in starting a new business relates to the costs of issuing the stock certificates. This is typically more common at the public stock offering level whereby the brokerage firm charges some fees to receive the money and issue the corresponding documents. These types of costs are not organizing costs, they are capitalizing costs. As such they are used to offset the proceeds of the stock sale.  

There is one common type of capitalizing cost that is not an organizing or start-up cost. This is the cost related to the transfer of the physical asset. A common example of this at the small business level is the titling a vehicle into the company name. It is normal for investors to transfer physical assets instead of cash into the business. When the business titles the asset into its name, this is a traditional expense and it offsets the actual equity account for the company. It is not classified as either start-up or organizing expenditures.  

Another typical starting cost relates to syndication fees. These fees are not classified as organizing or start-up expenditures. Syndication expenses relate to raising capital for a partnership. Therefore, they are covered under Section 709 of the Code. 

One other expenditure relates to franchising; many new businesses pay a franchising fee when purchasing the rights to operate a franchise. These types of expenditures to get into business are regulated under Code Section 197.  Notice that start-up costs are Section 195, franchise costs are really a right to conduct business and therefore they are separated from start-up expenditures. They are commonly included in the family of Intangible Assets. Section 197 requires 15 year amortization but there is no $5,000 one-time election available.  

As an owner of a new business, it is helpful to understand the nuances involved in the differences between start-up expenses and organizing expenses. Both are a function of Organizational Costs. Act on Knowledge.

Value Investing

Do you want to learn how to get returns like this?

Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.

There are four key principles used with value investing. Each is required. They are:

  1. Risk Reduction – Buy only high quality stocks;
  2. Intrinsic Value – The underlying assets and operations are of good quality and performance;
  3. Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
  4. Patience – Allow time to work for the investor.

If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above. 

Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:

  1. Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
  2. Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
  3. Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.

Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:

  • Lessons about value investing and the principles involved;
  • Free webinars from the author following up the lessons;
  • Charts, graphs, tutorials, templates and resources to use when you create your own pool;
  • Access to existing pools and their respective data models along with buy/sell triggers;
  • Follow along with the investment fund and its weekly updates;
  • White papers addressing financial principles and proper interpretation methods; AND
  • Some simple good advice.

Value Investment Club

Please Signup
*
Username
Username can not be left blank.
Please enter valid data.
This username is already registered, please choose another one.
This username is invalid. Please enter a valid username.
*
First Name
First Name can not be left blank.
Please enter valid data.
This first name is invalid. Please enter a valid first name.
*
Last Name
Last Name can not be left blank.
Please enter valid data.
This last name is invalid. Please enter a valid last name.
Website (URL)
Website (URL) can not be left blank.
Invalid URL
Invalid URL
*
Email Address
Email Address can not be left blank.
Please enter valid email address.
Please enter valid email address.
This email is already registered, please choose another one.
*
Password
Password can not be left blank.
Please enter valid data.
Please enter at least 6 characters.
    Strength: Very Weak
    Select Your Payment Gateway
    How you want to pay?
    Payment Summary

    Your currently selected plan : , Plan Amount :
    , Final Payable Amount:
    Submit
    Please follow and like us: