Pre-Operating Expenses

For many would-be investors, the cost of building a business from the ground up can be daunting–if only by virtue of the sheer amount of money it takes to launch a formidable venture. But the mental work needed to stake a sum of cash on an enterprise is only part of the prep-work; equally important is knowing how all that money spent factors into your books in the form of pre-operating expenses.

Defining Pre-Operating Expenses

As a general rule, purchases that would normally qualify as operating expenses but were incurred before the start of business (i.e. before charging rent, serving customers, etc.) are considered pre-operating expenses for the purposes of tax and accounting. As we’ll discuss later in this entry, these expenses are “capitalized” or subject to a treatment similar to depreciation.

It bears emphasis that these transactions are made before the official start of business, meaning rent-free periods for new apartment buildings and similar incentives for initial customers and clients are charged as pre-operating. Likewise, it’s important to note that capital expenses made before the start of business simply list as capital expenses, as do fees incurred in acquiring capital goods.

Common examples of pre-operating expenses include:

• Recruitment and training of staff before opening
• Market research
• Site visits
• Regulatory expenses (e.g. permits, licenses)
• Administrative expenses (e.g. office rental, stationery)
• Tuition for training programs, seminars, and other educational services
• Minor, pre-opening repair work on buildings for rent

If you can distinguish between capital expenses and operating expenses, you should have no problem in accounting for this –simply note what OPEX transactions were made prior to the beginning of business.

Tracking Pre-Operating Expenses

You would track pre-operating expenses much in the same way as you would regular business expenses. Be diligent in keeping your receipts, and above all else, hire a competent accountant to do most of the heavy lifting.

It’s highly recommended that one keep a separate ledger for these expenses, if not solely for the sake of managing an organized set of books, then for its utility further down the line, should you choose to expand your business or start a new one from scratch.

Why Track Pre-Operating Expenses?

One major component of a successful venture is a firm grip on your business’ vital statistics. The amount of money a business spends before servicing the general public is no different, and plays an important role for a variety of reasons.

The most significant reason would be that special tax rules apply to this classification of spending. The next section will feature a more exhaustive explanation of how pre-operating expenses factor into a business’ taxable profit. For now, note that a particular level of pre-opening spending can save a business thousands of dollars in taxes in their first year.

Just as important is the fact that these expenses are a reliable reference point for businesses looking to expand. Whether you have a long-term plan to branch out into more locations, or are already on the verge of doing so, referring to the cost of setting up an earlier site is a good way to prepare for expansion and to do so more efficiently than before.

Finally, pre-operating expenses are necessary for calculating the EBITDA of a new venture. Earnings before interest, tax, depreciation, and amortization is a tool used by financial speculators and entrepreneurs alike to measure the strength of a business’ operations without having to factor in how said business navigates funding and expansion.

You have to account for amortization to get a view of how your business is doing in terms of the management end of things, and you have to see things from this perspective to troubleshoot and optimize your operation.

Pre-Operating Expenses and Taxation

As we’ve mentioned earlier, the IRS treats pre-operating expenses in a similar way to capital expenses. It can’t all be deducted in a single tax year, but there are significant deductions allowed at certain levels of spending.

If your start-up expenses amount to $50,000 or lower, you can take a $5,000 deduction on taxable profit in your first year of business. If your start-up expenses are greater than $50,000 but less than $55,000, you can take an immediate deduction amounting to the difference between your start-up expense and $50,000. Finally, if your start-up expenses are greater than $55,000, you take no immediate deduction. In any case, what remains of your start-up expenses after subtracting the immediate deduction will be divided and deducted over the next 15 years.

The following table should make this easier to understand:

As you can see, in order to get the most out of the conditions set by the IRS, it’s ideal that a new venture spend up to a maximum of $50,000 before formally opening up shop. A $5,000 deduction for a business that’s just started out can be a big deal, and offer that a slightly wider safety net and flexible spending.

One important caveat to this is that while we’ve been able to go through very basic, very general principles of how taxation works vis-a-vis pre-operating expenses, its practice can get very intricate. For example, if part of your expenses before opening includes a permit valid for one year, would it make sense to amortize it over the life of your business? In this instance, the value can be matched to the life of the asset and expensed accordingly (i.e. deducted in total within the first year of operation)–making the rules on taxation much more complicated.

The best way to go about taxation is, and always will be, to keep a CPA on your payroll.