A new business owner incurs start-up costs before beginning the business. Under Section 195(c)(1), start-up costs are costs the taxpayer incurs to investigate the creation or acquisition of a business or in creating a business. The costs must be costs that would be deductible as an ordinary and necessary business expense if the taxpayer was actively conducting the business.

In general, a taxpayer may not deduct start-up costs until the taxpayer sells the business. That is the default rule of Section 195(a). However, for start-up costs paid or incurred after October 22, 2004, a taxpayer may elect to deduct start-up costs to the extent allowed by Section 195(b)(1)(A). Under Section 195(d)(1), a taxpayer has until the due date of the tax return, including extensions, to make the election.

A taxpayer makes the election by claiming the deduction on the appropriate form. For example, a taxpayer who is a sole proprietor would claim the deduction on Schedule C of Form 1040. The taxpayer should attach a statement to the form showing the start-up costs for which the taxpayer is making the election.

If a taxpayer failed to make the election when the taxpayer filed a timely tax return, the taxpayer has six months to file an amended return and make the election under Regulations Section 301.9100-2(b). The IRS has no authority for allowing any other late elections.

If the taxpayer elects to deduct start-up costs, the taxpayer may deduct up to $5,000 of startup costs in the year the taxpayer begins the active conduct of the business. However, if the start-up costs exceed $50,000, the $5,000 limit on the deduction for start-up costs is reduced by the amount by which start-up costs exceed $50,000.

For example, assume that the start-up costs are $52,000. The taxpayer may claim an immediate deduction of $3,000 [$5,000 - ($52,000 - $50,000)]. If the start-up costs are $55,000 or more, the taxpayer may not deduct any of the start-up costs in the year the taxpayer begins the active conduct of the business except as an amortization deduction as explained below.

The taxpayer may deduct the remaining start-up costs ratably over 180 months beginning in the month in which the taxpayer begins the active conduct of the business under Section 195(b)(2). For example assume that a taxpayer's start-up costs were $23,000. The taxpayer may deduct $5,000 immediately. In addition, the taxpayer deducts the remaining $18,000 of start-up costs at the rate of $100 a month [($23,000 - $5,000) / 180].

The ratable deduction of start-up costs over 180 months is called an amortization deduction. A taxpayer claims an amortization deduction on Form 4562 and then carries the total deductions on Form 4562 to the appropriate form.

If the taxpayer sells the business before deducting all of the start-up costs, the taxpayer may deduct the remaining start-up costs as a loss as allowed by Sections 165 and 195(b)(2).

A taxpayer should take advantage of these rules to ensure the highest possible tax deductions. Because the time for making the election is quite limited, a taxpayer should be sure to make the election in a timely manner.