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Columns by June Walker: IPs Face Unique Tax Challenges Tax Deductions Are There For The Taking You Say You're Self-Employed -- Will the IRS? Do You Have a Business or a Hobby? Proving That You're a Business Keeping Records -- It's Not Just for Taxes Three Ways to Expand Your Business Deductions Can I Deduct Disneyland and Other Questions Mixing Business with Pleasure and Other Gray Areas Getting There is Half the Battle Getting Credit and Taking Allowances Advertising: Do It, Then Deduct It The Subtle Art of Advertising Deductions Billy Bridesnapper's Start-up Saga Giving Gifts, Taking Deductions
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Billy Bridesnapper's Start-Up SagaBilly Bridesnapper was getting itchy about his job at Phil's Photos. He traipsed all around the county, in Phil's van, hauling Phil's equipment, getting shots that wowed everyone, yet he was earning only a small hourly wage and a small percentage of each photo shoot he did. Phil made the big bucks. Over the course of several years Billy had learned a lot, mostly through observation, about the management end of the business; and via word-of-mouth he'd become known for his unusual black-and-white wedding and Bar Mitzvah photos. Friends and colleagues encouraged him to strike out on his own, but, being a savvy businessperson, he decided to do some thinking and planning first. For example, Billy didn't feel right going into direct competition with Phil, yet all his contacts were in the same geographic location. There were a lot of things to consider before he could set up shop. Many of the expenses that Billy incurred in the organizing and planning stage of his new venture may be classified as start-up costs. They include items as diverse as a survey of potential markets, advertisements for his grand opening, and the legal fee he paid for a review of his rental lease contract. What the IRS Says About Business Startup Costs Business startup costs are the costs you incur when investigating the possibility of creating or acquiring a trade or business, or they are the costs of setting up a trade or business. To qualify they must meet all the following guidelines:
Startup Expenses Are Many and Varied, and Fall Into Two Types: Exploratory or General: A person looking to go into business for himself might explore various fields of endeavor, as well as general questions of self-employment such as tax advantages, pension consequences, and workspace problems. Investigative or Specific: After determining that self-employment is a viable and reasonable course for him to pursue, he might then investigate a specific business by traveling to a potential location or paying for a market survey. A Sampling of Business Startup Expenses The list of possible startup expenses is as long and varied as a list of expenses for an existing business. The following is a small sample:
What's the Big Deal? Keep in mind that any expense that would qualify as a business deduction once you are working qualifies as a startup cost if you incur it before you launch your new venture. That's pretty simple, isn't it? You may be thinking: if it's that simple, and if the criteria for regular business expenses and startup expenses are the same, then why classify them as startup costs? Why not just deduct them along with all the other business expenses? Because the IRS won't let you, that's why. You can deduct all of your regular business expenses in the year they are paid or incurred, but to the IRS, startup costs are not regular business expenses; they are considered capital expenses. Capital expenses cannot be deducted in the year you pay them; instead they become part of the basis of your business. And because of that they have to be deducted in a different way: sometimes over a period of years, sometimes not until you sell or dispose of your business. Before going any further into startup costs it will be helpful to introduce you to two more accounting terms. Tax Know-How: Capital Expenses and Basis. Your basis in something is simply what it cost you. If you paid $100 for a bicycle, your basis in that bike is $100. If you paid $200,000 for a warehouse your basis in that building is $200,000. The bike would be a capital asset of your messenger service business; the warehouse would also be a capital asset. Your business is a capital asset. Its basis is another way of saying how much your business cost you, and whether we're talking about a million-dollar widget-manufacturing venture or a $5,000 cookie-making venture, each person who lays out money for capital assets has a basis in his business. A capital expense is a cost related to the buying of a capital asset. The purchase of the bicycle is a capital expense, as are the snakeskin straps that you bought to attach to the pedals, thus becoming part of the basis (cost) of the bike. The warehouse is a capital expenditure, as are the legal fees associated with its purchase, all adding to the basis of the building. Startup costs are capital expenses. There are certain costs, even though incurred before you embark on your new enterprise, that are not classified as startup costs. They are business costs and are deductible in a different fashion on your tax return than are startup costs. They are:
For more information on these expenses please see forthcoming columns that will cover each subject in detail. Billy Bridesnapper Goes Solo Now let's get back to Billy Bridesnapper. When Phil announced he was going to sell the business to his brother Phineas, Billy really got busy, because he knew he didn't want to work for Phineas. In a few short months Billy spent $7,200 on locating and doing some repair work on a studio, as well as printing high-quality promotional literature which stressed the merits of his exclusive use of black-and-white photographs for all his assignments. Note: Billy's decision to concentrate exclusively on black-and-white photography sets him apart from and avoids competition with Phineas; he can send customers who want the color treatment to Phineas, who can reciprocate by sending to Billy those interested in black-and-white photos. This decision in place, they shake hands, part company, and Billy heads out on his own. Will Billy Get to Deduct All His Startup Costs? Because Billy's investigation and planning were successful and resulted in an up-and-running business, he can deduct all those pre-opening expenses -- but because they are startup costs he can't deduct them all at once. Billy must divide his total startup costs by five years (60 months). If he started his business on January 1st, he would get to deduct one-fifth of his expenses in the first year -- and then one-fifth every year for the next four years until he deducted all his startup costs. This is called amortization. Billy's expenses totaled $7,200. If we divide that by 60 months we get $120 per month. One year's worth is $1,440 (12 x $120 = $1,440), or Billy's yearly deduction. January 1st is a good day to open a photography business, because there are a lot of weddings in February. However, Billy had everything in place by November and was hoping to get some of the holiday trade, and so his grand opening was November 1st. Since his amortization period begins with the month in which his business opened, he gets to deduct only $240 in his first year (for two months' worth of expenses, November and December). He gets a full 12 months' deduction the following year. Selling the Business If Billy disposes of his business before the end of the amortization period, his leftover startup costs remain as part of the basis of his business. Let's hope that Billy sells his business at a profit, in which case the remaining startup costs would help to reduce his gain. If, however, he gives up and walks away from the business, or sells it at a loss, the remaining startup costs would help to increase his loss. (c) 2000 June Walker. All rights reserved. We'd love to hear your feedback about this column, or put you in touch with June Walker if you like. You may also like to see her biography. |
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