Business startup costs and organizational costs are the expenses incurred before you actually begin business operations. Your business startup costs and organizational costs will depend on the type of business you are starting, but generally include the costs for setting up your business. These costs are generally capital expenses.

Organizational costs or startup costs can be deducted up to $5,000 (reduced by the amount of the cost over $50,000, with full phaseout at $55,000), with the remainder amortized over 180 months (and any unamortized amount fully deducted upon termination of the entity), unless an election is made on a timely filed federal income tax return (including extensions) to forgo the upfront deduction and the amortization.

Organizational Costs

The term organizational expenditure means any expenditure which:

• is incident to the creation of the partnership,
• is chargeable to a capital account, and
• are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would be amortizable over such life.

A partnership is deemed to have made an election to amortize organizational costs unless an affirmative election is made to capitalize all organizational costs on a timely filed federal tax return (including extensions) for the taxable year in which the partnership begins business. The election either to amortize organizational expenses or to capitalize organizational expenses is irrevocable and applies to all organizational expenses of the partnership.

In the taxable year in which a partnership begins business, an electing partnership may deduct an amount equal to the lesser of the amount of the organizational expenses of the partnership, or $5,000 (reduced (but not below zero) by the amount by which the organizational expenses exceed $50,000). The remainder of the organizational expenses are deductible ratably over the 180-month period beginning with the month in which the partnership begins business.

Startup Costs

The term startup expenditure means any amount paid or incurred in connection with:

• investigating the creation or acquisition of an active trade or business, or
• creating an active trade or business, or
• any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.

Expenditures falling into one of these categories are deductible only if an existing active trade or business (in the same field as the trade or business being started), would be allowable as a deduction for the taxable year in which paid or incurred.

A taxpayer is deemed to have made an election to amortize startup expenditures for the taxable year in which the active trade or business to which the expenditures relate begins. A taxpayer may choose to forgo the deemed election by affirmatively electing to capitalize its startup expenditures on a timely filed federal income tax return (including extensions) for the taxable year in which the active trade or business to which the expenditures relate begins. The election either to amortize startup expenditures or to capitalize startup expenditures is irrevocable and applies to all startup expenditures that are related to the active trade or business.

In the taxable year in which a taxpayer begins an active trade or business, an electing taxpayer may deduct an amount equal to the lesser of the amount of the startup expenditures that relate to the active trade or business, or $5,000 (reduced (but not below zero) by the amount by which the startup expenditures exceed $50,000). The remainder of the startup expenditures are deductible ratably over the 180-month period beginning with the month in which the active trade or business begins.

Investment Funds

Investment fund entities (mostly partnerships) typically elect to forgo the upfront deduction and the amortization of organizational costs or startup costs, which usually gives rise to portfolio deductions that are not deductible by partners that are individuals, estates, and trusts. However, there are exceptions to the common practice.

Operating entities (e.g., management companies) would be able to deduct the upfront deduction and the amortization of organizational costs or startup costs as ordinary business expenses, and thus, would not want to elect to forgo the deduction and the amortization.

Investment partnerships with significant ownership by domestic corporations may not want to elect to forgo the upfront deduction and the amortization of organizational costs or startup costs, which may be deductible by the domestic corporate partners.

Certain foreign partnerships do not file U.S. tax returns and only issue pro forma Schedule K-1s to assist their partners in their U.S. tax compliance. Since such foreign partnerships are not filing U.S. tax returns, they cannot elect to forgo the upfront deduction and the amortization of organizational costs or startup costs, and therefore, must prepare pro forma Schedule K-1s with the upfront deduction and the amortization of organizational costs or startup costs by default.

The Takeaway

Investment fund taxation can be quite nuanced, especially when forming and incurring either organizational costs or startup costs, depending on the entity structure. It is important to work with a tax expert specializing in this area.

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