Startup Expenses – What is Deductible

For a growing startup, every dollar counts. Knowing which expenses a business can deduct is not just a compliance task; it’s a core strategy for managing cash flow and increasing tax efficiency.  This guide highlights four essential tax concepts every founder should understand.

Defining an “Ordinary and Necessary” Expense

To be deductible, an expense must pass a two-part test set forth by the IRS – it must be both “ordinary” and “necessary.”

  • Ordinary: Common and accepted in a specific trade or business. It does not have to be a regularly occurring expense but it should be typical within the business’ industry.
  • Necessary: Helpful and appropriate for the business, even if not essential, but only reasonable (e.g., high-speed internet for an e-commerce business).

This standard is intentionally flexible while ensuring personal, lavish, or extravagant costs are not deducted.

Expense vs. Capitalize: The Treatment of Purchases

The core distinction between an expense and a capital purchase is the item’s useful life and its tax treatment.

 

Purchase Type Useful Life Tax Treatment
Business Expense Current tax year Deducted in full in year of purchase
Capital Purchase More than one year Capitalized and recovered over a specified number of years though depreciation or amortization

 

Startups must frequently make significant capital purchases. Two provisions help accelerate the deduction for these purchases.

  • Section 179 Deduction: Allows immediate expensing of certain tangible property.
  • Bonus Depreciation: Qualifying property placed in service on or after January 20, 2025 qualifies for a 100% bonus deduction, effectively allowing businesses to expense large purchases in year one.However, most states require bonus depreciation deductions to be added back to income on state tax returns.

Startup & Organizational Costs: The “First Year” Rules

Expenses incurred before active operations begin are called startup costs. Expenses directly related to the legal formation of a business are called organizational costs. These costs generally must be capitalized for tax purposes. However, the IRS allows for a special, partial, and immediate deduction.

  • First-Year Deduction: Up to $5,000 of accumulated business startup costs, and $5,000 of organizational costs, may be deducted in the first tax year the related trade or business begins.
  • Phase-Out: These deductions each phase out dollar-for-dollar when the total costs in each respective category exceed $50,000 and are completely phased out at $55,000.
  • Amortization: Any remaining startup and organizational costs must be amortized evenly over a 180-month period beginning in the month the business starts.

Accountable Plan Rules for Reimbursements

When employees or owners pay for business expenses out-of-pocket, reimbursements are only non-taxable to the recipient and deductible for the business if made through a reimbursement agreement called an Accountable Plan. The plan must satisfy three core rules:

  1. Business Connection: The expense must have a business purpose, incurred while performing services as an employee.
  2. Adequate Substantiation: Employees must provide adequate records, receipts, or other documentation that substantiates the expense within a reasonable period (typically 60 days).
  3. Return of Excess Amounts: The employee must return any reimbursement that exceeds the substantiated expenses within a reasonable period (typically 120 days).

If the requirements listed above are not met, the reimbursements become taxable wages to the recipient on Form W-2. The amounts would still be deductible by the business as compensation expense.

Partner Reimbursements (LLCs/Partnerships)

Since a partner is not an employee in a partnership, the treatment of ordinary and necessary business expenses incurred by a partner on behalf of the partnership depends on the terms of the partnership agreement.

  1. Reimbursement Required: Generally non-taxable to the partner and deductible by the partnership
  2. Reimbursement Not Required; Partner Still Required to Incur: Potentially deductible on the partner’s personal tax return

Startups should maintain a formal Accountable Plan for employees and clear reimbursement policies for partners to ensure consistency, compliance, and maximum deductions. Don’t leave money on the table! Tax laws affecting accelerated deductions and reimbursements change frequently. We recommend that growing businesses work with a professional tax advisor to explore these issues and ensure that they are capturing the full benefit of their expenses.