GAAP Versus Tax Considerations for Growing Companies

Financial reporting and time saving tips for startups

Starting a new business, product line, service, manufacturing process, or facility involves a variety of expenditures. Understanding the accounting needs and classifications of common costs related to these activities is key to complying with generally accepted accounting principles (“GAAP”) financial reporting and saving time during tax filing.

Startup costs

One key disparity between GAAP and tax accounting lies in the treatment of startup expenses. Startups often incur significant costs during their initial stages.

GAAP considerations for startup costs

Startup costs, also referred to as pre-opening costs, pre-operating costs and organization costs, are costs incurred prior to a business opening its doors or actively selling its product or service. Under GAAP (ASC 720-15-20) startup costs include:

• Organizational costs (e.g., incorporation fees)
• Legal and consulting fees
• Feasibility studies to determine potential profitability
• Travel costs (e.g., for meeting potential investors, distributors, suppliers, or customers)
• Recruiting, training, and compensating employees
• Costs of opening a new facility
• Depreciation and amortization of assets

Expenditures that should not be included under startup costs are those accounted for by other GAAP rules, such as those incurred for Research and Development (“R&D”); capitalizable costs (i.e. costs of acquiring long-lived, intangible, or inventory assets), loan-origination; raising capital (“fund-raising”); advertising; and customer acquisition costs (ASC 720-15-15).

Under GAAP (ASC 720-15-15), startup costs are expensed as incurred and may be recorded in a single category.

Tax considerations for startup costs

The treatment of pre-operational costs is more complex for tax purposes. For example, IRC Section 195 defines startup costs as those incurred to investigate the potential of creating or acquiring an active business. Startup costs are incurred prior to the decision to acquire a business, and include costs of consulting fees, analyzing the new business’s potential, advertising the new business, and paying employees. Startup costs do not include costs of acquiring the new business, interest, taxes, or R&D.

For tax purposes, costs incurred in forming a business are considered organization costs, under Section 248 and 709. The tax law distinguishes these from startup costs.

As a result, it is helpful to segregate costs by tax category, as they are recorded, to easily identify which tax category the expenses belong under. If startup costs or organization costs exceed a certain threshold, they are non-deductible but may be amortized 15 years for tax purposes.

Research and development costs

R&D expenses also pose challenges when it comes to aligning GAAP and tax accounting. Many startups heavily invest in R&D activities to develop innovative products or improve existing ones.

GAAP considerations for R&D costs

R&D costs include indirect and direct, non-routine expenditures relating to a company’s efforts to develop, design, and significantly enhance its sales-generating products, services, technologies, or manufacturing techniques/processes.

Under GAAP (ASC 730-10-25), due to uncertainty of future economic benefit, R&D costs which have no alternative future use are expensed as incurred (“period expense”). Costs with an alternative future use (in R&D or otherwise) should be recorded as assets (e.g., materials, equipment, facilities, software or purchased intangibles).

Additionally, GAAP (ASC 985-20-15) states that costs for “computer software to be sold, leased, or otherwise marketed as a separate product or as part of a product or process, whether internally developed and produced or purchased”, incurred prior to establishing technological feasibility are R&D period expenses. “Technological feasibility […] is established when the entity has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements” (ASC 985-20-25-2).

Tax considerations for R&D costs

For tax purposes, Section 174 and Reg. 1.174-1 broadly defines R&D costs as expenditures incurred in connection with the taxpayer‘s trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product. The term includes the costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.

Beginning in 2022, tax laws require R&D costs to be capitalized and amortized over five years (or 15 years for foreign expenditures).  See our blog article about these 2022 R&D tax changes for more information.

For income tax purposes, certain R&D expenditures may be allowable in computing an income tax credit.

While R&D costs are largely the same for tax and GAAP purposes, costs of certain GAAP R&D activities do not meet the aforementioned criteria and are not R&D expenditures for tax purposes. Additionally, there are special tax rules for Software Development costs. Therefore, it’s helpful to segregate these costs by tax category as they are recorded.

Capitalizable costs

GAAP and tax accounting follow similar rules regarding the capitalization of costs. Costs that should be capitalized during the startup stage, are the same as those that would be capitalized if the business were in operations.

Conclusion

Taking steps now to separate common costs amongst GAAP and tax accounting categories, can help startups ensure accurate financial reporting under GAAP and save time during tax filing. It is crucial for startups to consult with accounting professionals and tax advisors to navigate these complexities and make informed decisions.

For more information about GAAP considerations for your emerging or growing business, please contact your Opportunity Advisor or Email | Phone: 804.747.0000.