By Shannon VonEye, CPA
The VonLehman Company
Q: How Are My Start-Up Expenses Deducted?
A: Individuals starting a new business or acquiring the assets of an existing business often incur start-up expenses, which can be considerable, in the investigation and acquisition phase before actual business operations begin. Most start-up expenditures can be segregated into two broad categories: (a) investigatory expenses and (b) business preopening costs.
Taxpayers can immediately deduct up to $5,000 of start-up expenses in the year when active conduct of a business begins. However, the $5,000 instant deduction allowance is reduced dollar for dollar by cumulative start-up expenses in excess of $50,000 for the business in question. Start-up expenses that cannot be immediately deducted in the year a business begins must be capitalized and amortized over 180 months on a straight-line basis. In many cases, start-up expenses for small businesses will be modest enough to qualify for immediate deduction under the $5,000 instant deduction allowance in the year when active conduct of business commences.
Example: Claiming the deduction for start-up expenses — Susan (a calendar-year taxpayer) incurs $4,200 of start-up expenses in 2015 before opening her new car wash in November of 2015. Suzie’s 2015 deduction is $4,200. Since her start-up expenses did not exceed $50,000, she can deduct the entire $4,200 in 2015.
Note: A taxpayer is not considered to be engaged in carrying on a trade or business until the business has begun to function as a going concern and has performed the activities for which it was organized.
Q: As a new business owner, how do I know what to pay myself?
A: It’s important for owners to pay themselves what the IRS calls a “reasonable” salary. S corporation owners, in particular, can get into trouble if their salaries are too low, such as in the time of an economic downturn, or as the business is just launching and revenues are low.
Owners who pay themselves generously should also beware. In a recent Tax Court case, Multi-Pak Corp. v. Commissioner, the IRS challenged a C corporation owner for paying himself excessive compensation to reduce his company’s tax liability.
You should, therefore, try to strike a balance between under- and overpaying yourself.
Start-Ups
If you’re just starting out, setting your salary is relatively easy. Pay yourself enough to cover your bills and living expenses — and no more. You can increase your salary as your business grows by pegging it to profit growth.
Even if you have another source of income, resist the urge to pay yourself nothing. Lenders and investors expect to see salary projections in your financial statements. It helps them estimate when you’ll be profitable and able to repay debt, and it shows them you’re realistic about what it costs to run a business over the long term.
Mature Businesses
If your company is safely in the black, determining your salary can be more complicated. This is particularly true if you run an S or C corporation, where the owner’s compensation affects tax liability.
Some owners set their salary based on informal metrics, such as what they were paid as an employee elsewhere, what they think they’re worth or even what their friends and business peers would expect them to earn. A more reliable method is to incorporate factors that the Multi-pak court considered when determining reasonable compensation. Consider, for example:
Consider your role. Take into account your responsibilities, hours worked and the value you bring to the business, such as your reputation and customer relationships.
Research what others pay. Find out what owners in your industry, in your geographic region and of similar-size companies pay themselves.
Review character and condition. Consider your company’s size as measured by sales, net income or capital value; the complexities involved in running it; and general economic conditions.
Maintain internal consistency. Compensation should be fairly consistent year to year. Dramatic increases or cuts can be an IRS red flag. Your salary also should bear some relationship to those of your employees.
Avoid potential conflicts of interest. The IRS looks out for C corporation owners who disguise nondeductible corporate distributions as compensation. S corporations raise red flags for doing the opposite — reducing salaries and bonuses and instead paying owners via distributions. By taking a lower salary, the owners are able to reduce, often significantly, their payroll tax liability.
Stay in control
Don’t let salary issues jeopardize your business’s — or your own — future. Given the complexities, owners of C or S corporations need to get professional tax advice when determining the amount, form and timing of their compensation.
Shannon VonEye is a CPA with The Von Lehman Company. For more information on this topic or many other tax, business and investment topics, contact your CPA, Business Advisor, or Shannon VonEye,, CPA at svoneye@vlcpa.com.
DISCLAIMER: The technical information in this article is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS.