How to amortize startup costs

You have an exciting idea and the determination to turn it into a thriving startup. As you kickstart your venture, you'll spend money on things like market research, creating your product, training employees, and getting advice from consultants. 

Dealing with the IRS's specific rules about spreading out these startup costs over time can be tricky, especially if you're not well-versed in accounting or taxes. In this article, we'll simplify amortizing startup expenses. 

By the end, you'll have a better understanding of how to handle these startup expenses on your tax return, boosting your confidence in the process.

What is amortization?

Amortization is a concept similar to depreciation. It refers to capitalizing amortizable costs and then slowly deducting them over a set period. 

Amortization typically applies to intangible assets, like patents or goodwill. However, businesses can use amortization for some startup expenses.

Usually, amortization occurs on a straight-line basis. Under the straight-line basis, you expense an equal amount of your capitalized expenses through cost recovery. The IRS provides a 180-month or 15-year allowance for qualified startup expense amortization.

Why is amortization relevant for startups?

Most business owners incur direct costs before selling products or services to consumers. Some expenses may fall under the IRS's definition of startup costs, which you must amortize over time. 

Understanding amortizable expenses and the tax implications of your startup costs can help you visualize how they'll impact your tax liability.

Steps to amortize startup costs

It's best to follow several steps when analyzing startup costs. Breaking the process into different phases makes it easier. Here are four steps to follow.

Identify and classify startup costs

The IRS has strict rules concerning startup costs and their deduction. To meet the initial qualifications, the type of costs you incur must be business-related. You must incur or pay the expense before your business opens. Examples of startup costs include:

• Analyzing business conditions and markets, products, labor availability, or transportation facilities
• Advertising your company's opening day
• Costs of employee training
• Travel to secure vendors, customers, or suppliers
• Consulting fees or executive salaries

Not every cost you incur before starting your business will qualify as a startup expense. For instance, you can't include interest or business taxes as a startup cost. Variable costs like office supplies and materials don't meet the criteria.

If you incur expenses that don't meet the IRS definition of startup costs, that doesn't mean you can't deduct or amortize them. Instead, they may fall under other types of costs, like property or intangibles. Both property and intangibles are capital expenses. They may be depreciated or amortized.

Note that corporations and partnerships can amortize organizational costs. Organizational costs are expenses incurred to create a corporation or partnership, like accounting fees and incorporation expenses.

Determine the amortization period

Business owners who start their company after September 8, 2008, can deduct some startup expenses in their first year of business. They must capitalize the remainder and expense them over 180 months, or 15 years, for tax purposes.

Amortization begins in the month you open your business to customers. Thus, if you incur $30,000 in startup costs in 2023 and open your business in November 2024, you can begin amortizing the expenses in November 2024. You can't amortize them beforehand.

Calculate amortization expense

The maximum allowed first-year deduction of startup expenses is $5,000. Anything more must be capitalized and amortized. However, if the company incurs more than $50,000 in startup expenses, the $5,000 initial deduction is reduced by every dollar that startup costs exceed the $50,000 limitation.

For instance, assume you have $52,000 in startup expenses for a business you open in December. You can deduct $3,000 in startup expenses automatically. You'll need to amortize the remaining amount of your startup costs over the subsequent 180 months.

Record amortization entries

Organizations that must amortize their startup costs will need to make the appropriate journal entries in their accounting books. Accurate entries help ensure that you have a record of your business assets and document how you treat them.

You can claim the monthly amortization on your yearly income tax return for 15 years.

Compliance and tax considerations for amortizing startup costs

Proper compliance can ensure you don't encounter any problems when it comes time for a financial audit.

• Understand accounting standards: U.S. companies follow Generally Accepted Accounting Principles (GAAP), which sets rules for the amortization and depreciation of capital assets. Accounting rules for startup costs may differ from their tax treatment.
• Startup cost eligibility: Not all expenses will meet the definition of 'startup costs.' Interest on loans and taxes generally don't qualify for special treatment. Capitalizing software development costs has its own specific rules
• Store records: Keep receipts, contracts, and other documentation of the actual costs of all your financial transactions, including startup costs. You'll need it during financial audits or reviews.

There are additional tax considerations that may apply to your startup costs. A few to keep in mind include the following:

• Deductibility: Some expenses you incur may not be startup costs. They may be part of the ordinary cost of doing business, or you may be able to capitalize them under other classifications. Proper classification of your expenses is vital.
• Capitalization: Qualifying startup costs are amortized over 180 months. If a startup cost doesn't meet IRS eligibility criteria, it may be subject to amortization or depreciation as other types of capital costs.
• Potential tax credits: Some expenses may qualify for special tax credits that can reduce your tax liability. A knowledgeable tax advisor can alert you to tax benefits your company is eligible for.

Leverage amortization for strategic Planning and forecasting

Amortizing startup expenses over the long run can reduce your future tax liability but may also impact prospective profits. Strategic financial planning can help you forecast your amortization over the long term, helping you make informed business decisions that positively affect your organization.

Fortunately, you don't need to invest in an in-house financial planning team for your small business — you can reap similar rewards with proper accounting software that has forecasting capabilities.