What happens to Expenses Incurred before Incorporation?

What happens when you incur expenses before you have incorporated your company? There are three basic types: organizational, startup, and operational.

1. The organization costs and start up costs. These are the costs of setting up and forming the corporation. They have to be capitalized, a certain portion of each can be deducted, the balance having to be amortized. See https://www.irs.gov/publications/p535#en_US_2017_publink1000208919
In basic terms, up to $ 5,000 of organization and $ 5,000 of start up costs can be deducted in the year incurred, the balance amortized over 15 years. If the amount of either type of costs exceeds $ 50,000, then the 1st year write-off is phased out, $1 for $1. At $ 55,000 of costs, the particular costs ( start up or organizational) are fully phased out and can only be amortized.

2. The operational costs of running a business which existed before incorporation. In other words, you and some friends or you by yourself start a company. It’s an unincorporated entity that has expenses of operation before you decide to incorporate. I think your question is, what do I do with these expenses that aren’t start up and aren’t organization expenses.
Expenses which aren’t start-up expenses, which are ordinary and necessary are deductible. But we have to be careful here, because unless you are earning revenues, these same expenses might be classified as start up expenses.

So, the case may very well hinge on whether you have revenues. If you have a retail store and you open for business, the instant you have sales you are no longer in start up mode. You’re open for business. Any expenses you have after that point are clearly not “start up” expenses. It gets somewhat gray the further back before that first sale we go. If you open the doors and are totally ready for that first customer, could we argue that you were actively trying to earn revenues and thus, you were in business? Probably. But let’s take the case of a restaurant client I had. They had a trial run, where they invited all the influentials in the neighborhood (gee, I was invited!) to come and have a pre-opening dinner, at half off the regular menu price. This was to be sure that everything worked, that the staff knew what to do, that the cook was ready, and that the cash register system worked. It was a trial run. Were they open for business? Not really. Those costs were all start up costs. A week later they did their “soft opening” which was mostly a “word of mouth” (pun intended) affair, again, mostly wanting to be sure all systems were go before the grand opening. At that point were they open for business? I think so. Were those costs deductible? Sure. Now how about the costs up to that “soft opening?” Were they deductible? Big gray area… I think most would say not, that those costs were still start up costs.

OK, so we’ve kind of figured out the difference between operational costs and start up costs. What do you do with them when you aren’t incorporated yet? The answer is not simple. Maybe you were advancing those expenses on behalf of the corporation which was in formation. They might legitimately be expenses of an entity which was not yet completely formed. More likely, however, they would be considered your expenses, and the accompanying revenues your revenues. In other words, you would have a schedule C reporting them on your personal return. If there were more than one founder, then it’s a partnership, and you have a partnership return to file.
I would stress, however, that this situation of deductible expenses (and includable income) is going to be rare. In the vast majority of cases, the expenses incurred before incorporation are either organization costs or start up costs, and those are going to end up capitalized on the corporation books ( and shown as a contribution of capital by the owners).

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