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Accounting Costs for Start-Ups

Written by: Joseph F. Burnett, CPA
Start-up companies often don’t spend much time thinking about how they’re going to treat their start-up costs for tax purposes. But they should. The decision on when to capitalize these costs can make a big difference in a company’s future bottom line.

Given their limited resources and manpower, start-ups simply aren’t focused on taxes in their early days. Since they have no revenue, they pay no income tax. Besides, they are primarily concerned about developing their product, building the team, raising capital and building a market. 

Still, ignoring basic tax-accounting rules can be short-sighted. Costs involved in starting a business—including legal fees, business planning, market research and creating a place of business—are considered start-up costs, which generally must be capitalized and amortized over a 15-year period. Research and development (R&D) costs are among the handful of costs that are specifically excluded from the definition of start-up costs. But companies can make the optional election to capitalize and amortize these costs as well. For R&D expenses, the amortization period can be as short as five years.

The key tax planning issues include determining what to capitalize and when the amortization period begins. According to the IRS, the start-up period doesn’t end until the company starts generating revenue. The taxpayer, however, usually wants that start-up period to be as brief as possible—typically taking the position that it ends as soon as the company “commences in the activities for which it was organized”. This effectively limits the costs that must be amortized, allowing the company to immediately deduct such costs to reduce taxes rather than spreading them over 15 years.  Any net operating losses that can’t be used immediately can be carried forward for up to 20 years. 

Why is that important? Let’s say your company incurs $2 million a year in start-up costs excluding R&D for the first four years of operation but in the fifth year makes a $10 million profit. The IRS would say that in that fifth year your company can deduct 1/15th of the $8 million spent on start-up costs or about $533,333. You, however, would want to use the full $8 million as net operating losses—thus reducing your taxable income to just $2 million.

What happens when you factor in R&D costs? Assume the company also spent $1 million a year on R&D for the first four years. The company could opt to deduct these expenses, reducing its taxable income to zero and providing it with $2 million in net operating losses which it can carry forward for up to 20 years.  Or the company could amortize the expenses, writing off as much as one-fifth of those expenses annually for five years.

Which approach is best? That depends. Sometimes the IRS position on start-up costs can actually be preferable, particularly for companies with a long development cycle and a continuing need for new investor funding.

Consider an 18-year-old pharmaceutical company that is still awaiting FDA approval and thus has no revenue. If it declared its start-up phase complete just months after organizing, it would soon be bumping into the 20 year carryforward limitation on using its operating losses to offset income. And if it had deducted its R&D costs, thus increasing its net operating losses, there is a risk that the company might be unable to use them. The result would be lost tax benefits.  

If it had taken the IRS approach and also capitalized its R&D, however, it wouldn’t begin to deduct those expenses until it started producing revenue, meaning that every start-up expense dollar would still be available even if the company didn’t turn a profit for another 10 years.

If that same company needs to raise new capital to fund its business, the IRS view would become even more favorable. That’s because ownership changes of 50% or more over a three year period can result in the loss of important tax deductions.  Such changes in ownership can trigger a yearly limitation on the amount of net operating losses that can be deducted in the future. These rules are intended to prevent the purchase of companies simply to acquire their tax losses.

Every start-up faces unique challenges as it moves from initial concept to first sale. Good tax planning early on can make sure that every expenditure during that critical period generates maximum benefit to the company.

For more information about this topic, please contact Joseph F. Burnett, CPA, Tax Senior Manager at 617-428-5494 or jburnett@wolfandco.com.