If you are an inventor, and plan to sell or license products based on your inventions, you will need to pay various up-front costs before getting your business off the ground. Start-up expenses are expenses you incur before you actually begin your invention business. Such expenses have tax ramifications.
Unlike business operating expenses, start-up expenses cannot all be deducted in a single year. This is because the money you spend to start an inventing (or any other) business is considered a capital expense. It is, in other words, an expenditure that will benefit you for more than one year.
Normally, you cannot deduct these types of capital expenses until you sell or otherwise dispose of the business. However, a special tax rule allows you to deduct up to $5,000 in start-up expenses for the first year you are in business, and then deduct the remainder, if any, in equal amounts over the next 15 years. See IRC Sec. 195.
Start-up expenses include any costs you could deduct once your business begins. These might include license fees, fictitious business name registration fees, advertising costs, attorney and accounting fees, travel expenses, market research, website registration and design, and office supply expenses.
They do not include currently deductible research and experimentation expenses. The cost of long-term business assets is also not a start-up cost. These costs are either expensed or depreciated once the business begins.
You cannot elect (claim) a deduction for start-up expenses until the month your inventing business begins operation. This leads to the question of when a business begins for tax purposes. This is easy to answer for many businesses. For example, a restaurant owner’s business begins when the restaurant’s doors open and the restaurant is ready to serve food to customers. At this point, the owner can currently deduct all his or her ordinary and necessary business expenses.
However, it is not always so clear-cut when an inventor’s business passes through the start-up stage and begins formal operation. If you’re a well established independent inventor who has patented several inventions and earned money from selling or licensing them, your business has clearly begun and you’re undoubtedly “carrying on” the business of being an inventor.
But, what if, like most independent inventors, you haven’t reached this point yet? Rather, you have been developing an invention, but have not yet begun to earn any money from it? What if you haven’t even obtained a patent yet? Unfortunately, there is no definitive answer to when the "start date" occurs.
The general rule is that a manufacturing or similar business begins when the business begins using its assets to produce products for sale, even if the products are not completed or any sales actually made.
Thus, for example, courts have held that a writer’s business begins when he or she starts working on a writing project. The act of production itself is “carrying on” the trade or business of writing. Similarly, courts have found that inventors who worked on inventions, but never completed or patented them, were still carrying on a business.
Under the logic of these court decisions, your inventing business begins for tax purposes on the day you actually begin developing an invention. Thinking or dreaming about an invention is not sufficient. You must do real work on it, even though it is not necessary for you to finish it, patent it or make money from it. A thorough and complete inventor’s notebook documenting your work is the best evidence you can have to prove when you started working on your invention.
At one time, inventors had to attach a separate statement to their tax return to claim start-up expenses as a current deduction. Now, however, you are automatically deemed to have made the election for the year in which your business began. All you must do is list your start-up costs as “Other expenses” on your Schedule C (or other appropriate return if you are not a sole proprietor). You do not need to specifically identify the deducted amounts as start-up expenditures in order for the election to be effective.
One reason for this change is that the IRS is trying to encourage electronic filing, and you cannot include a separate written statement with an electronically filed return.
If you do not want to deduct your start-up expenses for the first year, you can forgo the deemed election by clearly capitalizing your start-up expenses instead. You must do this on your federal income tax return for the tax year in which your business began. Your return must be filed on time (including any extensions) and this election is irrevocable.
If you decide not to currently deduct your start-up costs, these costs become part of the tax basis of your business. This might be a good idea if you do not expect your business to earn a profit for many years, or you want to reduce your deductions in order to show a profit. Deducting your start-up expenses will decrease your business profits for the first 60 months, because they are deducted from your business income. Forgoing the deduction will therefore increase the profit your business earns over that time. This might be advisable, for example, if you fear that the IRS will claim that your inventing activity is a hobby and not a business. Earning profits is the best way to show that an activity is a real business.