Companies starting out have a lot of expenses but little if no revenue. How do you handle this dilemma? Hopefully, a start-up has raised sufficient capital to carry it through the early days and get it to the time when revenue starts to come in. In addition to having sufficient start-up funding, there are some important tax rules that can be helpful to nascent businesses. Here are 3 areas in which tax rules may be helpful.
Writing off start-up costs
When you start up a business, you may incur a variety of expenses. Ordinarily, these are capital expenditures that are not currently deductible. They are expenses incurred to acquire a capital asset, namely, your business. However, the tax law allows you to write off start-up costs within in limits:
- You can elect to deduct $5,000 in the first year, with the balance of start-up costs amortized over 180 months.
- If costs exceed $50,000, the $5,000 immediate deduction is reduced dollar-for-dollar. For instance, if start-up costs are $52,000, your initial deduction is $3,000 ($5,000 – $2,000 excess over $50,000). The balance is amortized over 180 months.
- If start-up costs exceed $55,000, there is no immediate deduction; all start-up costs must be amortized over 180 months.
Generally, you think of start-up costs as expenses you pay during the first few years of your business. But for tax purposes, the term “start-up costs” has a very specific meaning. These include amounts paid before the business opens its doors to customers that would otherwise be treated as ordinary and necessary business expenses that are currently deductible if the business were in operation. Expenses treated as start-up expenses include:
- Advertisements for the opening of the business
- Analysis of available facilities, labor, supplies, and transportation facilities
- Salaries and fees for consultants and executives, and fees for professional services
- Salaries and wages for employees who are being trained and their instructors
- Survey of potential markets
- Travel and other expenses incurred to get prospective distributors, suppliers, or customers
Of course, not all pre-opening costs are deductible start-up expenses. Some are treated as part of the cost of acquiring a capital asset—the business. For example, legal fees to prepare contracts for the purchase of a business are not start-up fees but, rather, are expenses that must be added to the cost of the business. And you can’t deduct the value of your time spent in exploring a prospective business and getting it ready to open.
Note: Similar amortization applies to corporate and partnership organizational expenses.
Using the research credit as an employment tax offset
If you’re a tech start-up, you may have obtained seed money for your enterprise. And, by engaging in research and experimentation, you may be able to claim a credit of 20% of increased research activities (increased costs this year compared with a base period). For start-ups, the base period is 3 years of a fixed base period (“start-up company rule”).
There’s an alternative simplified credit, which works best for a company that had little or no R&D spending in the previous 3 years (i.e., a start-up). This credit is 14% of the amount of current-year R&D spending that exceeds 50% of the average spent in the previous 3 years. This alternative is figured without regard to gross receipts.
To benefit from a tax credit, you need tax liability, and in order to have tax liability, you need to have revenue in excess of expenses. There may be no tax liability for start-ups, maybe for years. So, for start-ups, instead of claiming the research credit as an offset to income taxes, you may use the credit to offset up to $250,000 of the employer’s share of Social Security taxes and up to $250,000 of the employer’s share of Medicare taxes, for a total offset of up to $500,000. To be eligible to use the credit as a FICA offset, the business must:
- Be a corporation or partnership, as well as any other person (such as a sole proprietor), with gross receipts for the current year of less than $5 million. If you carry on multiple businesses, gross receipts are aggregated for this purpose.
- Have no gross receipts for any years prior to the 5 taxable years before the current year.
Using equity compensation
Like any business, you want the best employees. But how can you pay them what they’re worth when you are just starting out? Again, good initial funding can go a long way. Another option to consider is using equity compensation. This means giving employees an ownership interest in the business in lieu of cash compensation. The shares given are taxable compensation to the same extent as cash compensation, assuming there’s no restrictions or forfeiture possibilities. This means the stock is taxable compensation to employees and subject to employment taxes. The business takes a deduction for the value of the stock included on the employee’s Form W-2. Different tax rules apply in the case of restricted stock.
The big benefit to employees who accept stock instead of cash is the opportunity for a serious tax break. If the stock is held more than 5 years and then sold at a profit, gain can be fully tax free up to $10 million. The issuing company must be a C corporation and meet certain conditions for individuals to claim this tax break. This exclusion of gain related to what is known as Section 1202 stock, or qualified small business stock. You can find more about the conditions for this stock in an old SBA blog of mine; the conditions haven’t changed and are applicable today.
Final thought
Starting a business can be an exciting and scary time, with many, many challenges to handle. Dealing with taxes is one of them. A good place to start to learn about taxes when starting a business is the IRS Small Business and Self-Employed Tax Center. The best thing to do is get professional advice and be sure to consider tax breaks that can ease your tax burden.
If you’d like to read more blogs about managing business expenses, find them here.
