Starting your business is exciting but the tax and corporation formalities can easily mar the sentiment. 

Well, fear not!

As an entrepreneur, you can write off different startup costs, like company formation fees, as it is tax deductible. 

But then again, what businesses qualify for these deductions and how can you claim them? Are there any eligibility requirements or special business categories that you should be aware of? 

Here’s a detailed breakdown of all that you need to know as an entrepreneur in terms of tax deductions.

Which Business Costs Qualify for Deductions?

The IRS recognizes and allows for deductions of “ordinary and necessary” expenses incurred during the formation process. This can provide a significant tax benefit in your first year of operation. These deductions are decided as per the industry of the business operations and the main deductible categories include – direct expenses, indirect expenses, and interest on debt.

Let’s take a deeper dive into the specific categories of company formation costs that qualify for different types of tax deductions.

Government Filing Fees

The fees levied by your state for registering your LLC or corporation fall under this category. These typically include filing fees for the initial formation documents, name reservation fees (if applicable), and any other business license fees that are mandatory as per your state.

It is important to note that all the receipts for these government filings serve as crucial documentation for claiming deductions. So, you should keep them for record and documentation purposes.

State Registration Costs

All the expenses associated with registering your business with your state’s Secretary of State or a similar agency fall under this category. These costs are also eligible for deduction, and include registration fees, annual report fees (in some states), and any other charges levied by the state for official business registration.

Professional Service Fees

Any fees you pay to qualified professionals, such as attorneys and accountants, who assist with the legal and accounting aspects of your company formation, are generally deductible and come under this category. This includes costs associated with drafting legal documents like operating agreements or articles of incorporation, filing paperwork with the state, and any consultations regarding the formation process. 

As suggested above, all the receipts and invoices for these fee submissions should also be kept safe for documentation and record-keeping purposes. While there are some deductions that you can claim without receipts, having proper records of transactions always makes audits easier. Also, ensure that the invoices are detailed and outline the services rendered for accurate filing and deductions. Identifying and managing all these costs and planning the expenses such that you can maximize your deductions can be daunting, especially if you need to be better versed in the technicalities of tax filings. 

This is where professional tax management and business formation services like doola can prove extremely useful. 

doola’s Total Compliance Package streamlines the entire process of company formation, from the paperwork and incorporation documentation to legalities and tax filings. The platform handles all the necessary filings and registration with the state while ensuring that the state you choose for business offers the best tax dedications for that particular industry.

You can easily get proper documentation to claim the formation costs as deductions on your tax returns and avail of clear and concise records of all fees associated with the services, simplifying the process of substantiating your deductions.

Points to Remember

• The IRS may not allow deductions for personal expenses incurred during the formation process, such as travel or meals.  

• Any promotional or marketing expenses associated with launching your business typically fall outside the scope of deductible company formation costs.

• Consulting with a professional or investing in a total compliance platform like doola can help you maximize your deductions based on your specific business structure, formation expenses, and overall financial situation.

• Expenses incurred by a business in the form of bribes, lobbying costs, penalties, fines, and contributions made to political parties or candidates are not eligible for deductions.

• The IRS limits the deductions on costs associated with gifts, meals, and entertainment. Usually, business owners are allowed to deduct 50% of the cost of providing meals to employees, while certain meals may be fully deductible.

How to Claim Company Formation Fees on Your Tax Returns

Now that you have had a complete overview of the various costs and deductions, let us move on to find out how you can navigate the claim process and maximize your deductions.

Gather All Documentation Related to Formation Fees

Make meticulous record-keeping a habit, since this will go a long way to keep your filings clutter-free, organized, and accurate for coming years, and not only for just the first time. The IRS requires proper documentation to substantiate your deduction claims and detailed invoices with proper charging and services recorded require minimal processing.

Collect all the government filing receipts that the state government issued for registering your LLC or corporation. This includes filing fees for the initial formation documents (articles of organization/incorporation), name reservation fees (if applicable), and any business license fees mandated by your state.

Obtain detailed invoices from attorneys, accountants, or any other professional who assisted with the formation process. As mentioned above, ensure that these invoices are detailed and clearly outline the services rendered, associated fees for each service, and relevant dates of service. 

Collect the documents or receipts from your state’s Secretary of State office or similar agency confirming your business registration. Common documents that fall into this category are registration fee receipts, annual report fees (in some states), and any additional documentation associated with official business registration.

Navigating Form 1040 Schedule C for Deduction Claims

Depending on your business structure, sole proprietorship, LLC, C Corp, or S Corp, you’ll use Form 1040 Schedule C to report your business income and expenses on your tax return (Form 1040).

On Schedule C, locate the section titled “Expenses.” This is where you’ll claim your company formation fees as a business deduction. There will be different categories, such as “Professional Fees”, “Legal & Accounting”, etc. Check all the categories, submit your expenses accordingly, and ensure that you attach proper supporting documents for all of them.

Form 1040 Schedule C Deductions – Key Considerations

Next, we share some considerations that you should keep in mind while claiming the deductions.

Itemized Deductions vs. Standard Deduction

The standard deduction offered by the IRS might be higher than the total amount of your company formation fees. Hence, it is important to evaluate and compare both options and opt for the more beneficial one. Check the official IRS resources for more detailed information on this. 

State-Specific Variations

Some states may have additional filing requirements or specific company formation deductions. Hence, we recommend getting in touch with a professional tax consultant to maximize your deductions. 

The Impact of Business Structure on Deducting Formation Costs

The deductibility and treatment of company formation fees can vary depending on your business structure. Understanding these nuances can also help you maximize your deductions and make a substantial difference in your tax liability. 

Here’s a comprehensive breakdown of tax deductions for business structures.

Limited Liability Companies (LLCs)

For LLCs classified as disregarded entities by the IRS (typically single-member LLCs), formation costs are considered startup expenses under IRC Section 195. These costs can be fully deducted in the year the business started operating. This allows business owners to get a full deduction of the incorporation expenses in the very first year of business operation.

You can check our guide for more detailed information on tax deductions for LLC owners.

For multi-member LLCs (with two or more members), the deductibility of formation expenses is treated similarly to partnerships (discussed below).

S Corps and C Corps 

For corporations, formation costs come under IRS Section 248 and are typically categorized as organizational expenses. These costs are spread out over 15 years for tax purposes. 

Thus, the deductions for corporations work differently as compared to LLCs and are smaller. However, you can file for deductions throughout the corporation’s lifespan.

Partnerships

Similar to LLCs, partnerships can fully deduct formation costs during the year the business starts operating, as per the IRC Section 709 regarding partnership deductions.

Choosing the Right Structure: Beyond Formation Costs

While the deductibility of formation expenses is important, it’s not the only criterion for selecting a business structure. 

Here are some additional considerations to keep in mind, while choosing a business structure:

• LLCs and corporations offer limited liability protection to their owners, protecting their personal assets from business debts and liabilities. On the other hand, partnerships do not provide this protection.

• Corporations have a more complex management structure with boards of directors and officers. However, they are also taxed as separate entities from their owners. 

• Compared to Corporations, LLCs offer more flexibility in management and are typically taxed as pass-through entities, where profits and losses pass through to the owners’ personal tax returns. 

• Finally, partnerships share profits and losses as per the partnership agreement and are also pass-through entities.

Common Mistakes When Claiming Company Formation Deductions

Claiming deductions for company formation costs can be a smart way to reduce your tax burden, but the complexities of IRS regulations and technicalities related to company formation can be a minefield. 

Here are some common pitfalls to avoid:

• Many entrepreneurs mix personal and business expenses, whereas the IRS requires a clear separation between both of them. Hence, keep dedicated records for all formation-related costs, such as receipts, invoices, and canceled checks. 

• Incorrect record keeping is another mistake that you should avoid. Maintain a dedicated system for tracking your formation expenses as incomplete or disorganized records can raise red flags during audits and lead to disallowed deductions.

• Don’t misunderstand deductible costs. Not all formation-related expenses qualify for deductions. Focus on claiming costs directly related to the formation process, such as filing fees, legal consultations regarding formation documents, and state registration charges. If you are unsure, it is advisable to consult with a tax advisor to determine if a specific expense qualifies for deduction.

• Incorrect business structure classification can lead to claiming deductions incorrectly. So, we recommend consulting with an accountant or tax advisor to ensure proper filing.

FAQs

Can I deduct company formation fees on my tax return?

Yes! Company formation fees like filing fees and legal costs can be tax-deductible business expenses in the year your business starts or over a period of time. Consult your tax advisor or official IRS resources for specifics.

How do I determine which business costs qualify for tax deductions?

Businesses can deduct “ordinary and necessary” expenses incurred in running the business. This often includes startup costs like filing fees and legal fees for formation. The industry and business structure-specific costs can vary across states so check with your tax consultant.

Does the business structure impact the eligibility of deducting formation costs?

Yes, business structure impacts deducting formation costs. LLCs and partnerships often deduct fully in year one, while corporations spread the deduction over 15 years.

What are the steps to claim company formation fees on my tax returns?

To claim company formation fees on your tax return, gather receipts for filing fees, legal services, and state registrations. Then, itemize these deductions on Schedule C of your Form 1040.