Organizational Expenses – Types and Tax Implications
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.
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
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.
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.
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