Amortization is a way of deducting specific capital costs over a certain period of time, and applies to intangible property such as goodwill, inasmuch that it results in the excess of the purchase price of a business over the value of its net assets. Goodwill refers to the reputation of a business, and is considered to be an asset.
The concept of amortization bears some similarities to that of depreciation, which is a means by which you can recover the cost or basis of a tangible asset over the useful life of the asset. Another comparable concept is that of depletion, which permits an owner to account for the decrease of a product’s reserves. Depletion is used most frequently in such industries as mining, timber, and petroleum.
Under tax law, amortization is explained in 26 U.S.C. §§197(c)(1) and 197(d), and applies to property that is held for use in a trade or business, or for property intended to produce income. According to §197, the majority of intangible assets must be amortized over a period of 15 years, or 180 months.
If you paid or incurred business start-up or organizational costs after September 8, 2008, you are allowed to deduct a certain amount of those costs. The costs that are not deducted can be amortized over a period of 180 months. Specifically, you can amortize the following business start-up costs:
- The amount you paid or incurred in creating a trade or business, or
- The amount you paid or incurred in your investigation of the formation or acquisition of a trade or business.
Start-up costs consist of amounts paid or incurred in relation to an activity with a profit motive, and regarding the production of income in expectation of a change in the activity to an active trade or business. However, the expenses you incur in trying to buy a certain business are considered to be capital expenses that you are not allowed to amortize.
Start-up costs are amortizable provided that they comply with the following requirements:
- They are costs you can deduct if they were paid or incurred to operate a current active trade or business in the same practice area as the one in which you entered.
- They are costs you paid or incurred prior to the day on which your active trade or business began.
Qualifying start-up costs include the following:
- A study or survey of possible markets, products, sources of labor, etc.
- Marketing activities to advertise the start date of the business.
- Employees’ salaries and wages.
- Salaries and wages of employees’ instructors.
- Costs of travel for obtaining potential distributors, suppliers, or clients.
- Salaries paid to executives and consultants.
The following expenses are excluded from start-up costs:
- Deductible interest
- Product research and experimental costs
If you dispose of your business prior to the conclusion of the amortization period, you are allowed to deduct any deferred start-up costs that are outstanding. Nevertheless, you are permitted to deduct such deferred start-up costs only to the degree to which they are eligible to be a loss from your business.
The direct costs incurred in forming a corporation are considered to be amortizable organizational costs. In order to be eligible to be an organizational cost, it is required to be:
- For the formation of the corporation,
- Able to be charged to a capital account,
- Amortized throughout the life of the corporation provided that the corporation was marked by a fixed life, and
- Incurred prior to the end of the initial tax year in which the corporation is an active business.
A corporation that utilizes the cash method of accounting is permitted to amortize costs that arise in the initial tax year, even if those expenses remain unpaid in that year.
Some organizational costs that can be amortized are:
- The cost of having temporary directors
- The cost of arranging organizational meetings
- State incorporation fees
- The expenses incurred in obtaining legal services for the business
Among the organizational costs that cannot be amortized are:
- Expenses incurred in the issue and sale of stock or securities. Such costs include commissions, professional fees, and the cost of printing services.
- Expenses incurred in transferring assets to the corporation.
In order to make the election to amortize your start-up or organizational costs, you are required to complete and attach to your tax return Form 4562 for the initial tax year in which your company is an active business. In addition, you may have to attach a statement to your return.
If you are starting a business and have concerns about electing to amortize your start-up or organizational costs, you should consult a tax attorney. A tax lawyer can help you determine exactly which costs you can amortize and can assist you with any legal issues that arise in connection to amortizing certain costs.