Whether you’re a successful restaurant concept opening a new location, or a brand new restaurateur opening your very first storefront, a shiny new restaurant is always exciting! While you’re probably thinking a lot about your dollar return on investment and what profits will look like, you may not be so focused on how the startup costs will affect your after-opening financials. Let’s discuss what pre-opening or startup costs include, and how to account for pre-opening expenses.
Define Pre-Opening Expenses
Pre-opening expenses are, as you might imagine, costs that are incurred before the date that the restaurant begins selling food, made the website public, or simply attempted to market or sell food. Common pre-opening expenses include legal expenses to create or acquire a restaurant, costs to obtain or secure and prepare the space and storefront, amounts paid to obtain the kitchen and dining space equipment and furniture, hiring and training costs to staff the restaurant, fees paid to establish the necessary certifications to prepare and serve food to the public, and advertising or marketing expenses to announce the restaurant’s opening. You may hear a lot of different terms thrown around – pre-opening costs, pre-operating expenses, organization costs, startup costs – but they all mean the same thing: expenses incurred before the day you made your first sale.
Pre-Opening Expenses Treatment
We recommend keeping your books as close to GAAP as possible and on an accrual basis to get the most representative financial statements and KPIs. I mention this because your pre-opening expenses are treated differently on your books than for tax purposes. Here are the ways to account for pre-opening expenses:
Pre-Opening Expenses – On Your Books
Let’s start with how pre-operating costs are handled on your books. Financial accounting standards (Sec 720-15-15-2) lump all of these pre-opening expenses into one “startup cost” category because they’re all treated the same way: direct expense on the Profit & Loss Statement (P&L), in the year incurred. We recommend adding the following pre-opening expense accounts to your chart of accounts below the operating income section of your P&L:
9300 Other Expenses
- 9325 Pre-opening expenses
- [Optional] Sub-accounts:
- 9325.1 – Pre-opening expenses – Wages
- 9325.2 – Pre-opening expenses – Taxes & Benefits
- 9325.3 – Pre-opening expenses – Cost of Goods Sold (COGS)
- 9325.4 – Pre-opening expenses – Recruiting/Training
- 9325.5 – Pre-opening expenses – Utilities
- 9325.6 – Pre-opening expenses – Marketing
- 9325.7 – Pre-opening expenses – Supplies/Smallwares
- 9325.8 – Pre-opening expenses – Paper Supplies
- 9325.9 – Pre-opening expenses – Permits/Licenses
- 9325.10 – Pre-opening expenses – Travel/Lodging
- 9325.11 – Pre-opening expenses – Occupancy
- 9325.12 – Pre-opening expenses – Professional Fees
The exception is fixed assets. Fixed assets are their own breed of expense. If you purchase fixed assets such as capitalizable kitchen equipment or dining floor furniture, make significant capital or building/leasehold improvements, or spend a capitalizable investment in your restaurant’s POS system, those expenses are capitalized and depreciated over the useful life of the asset according to your fixed asset policy.
Pre-Opening Expenses – On Your Tax Return
As you might expect, the tax code makes this approach to pre-opening costs a little more complicated. Unlike the expenses you incur after opening, your pre-opening costs accumulate on your balance sheet, except for the small amount you may be allowed to deduct in the first year. Your pre-opening expenses for tax purposes must be separated into the following categories and treated as such:
Organizational Costs
Organizational costs are incurred for forming the legal entity, including but not limited to legal fees for drafting an operating agreement and filing an article of organization/incorporation with the Secretary of State and accountant professional fees for advising on the legal structure and forming a capitalization table. A restaurant may deduct up to $5,000 of organization costs in the year the restaurant opens or becomes an active trade or business, and the remainder gets amortized over 180 months. The $5,000 upfront deduction is reduced dollar for dollar for any amount over $50,000. In other words, if organizational costs exceed $55,000, the entire amount gets amortized over 180 months for tax purposes beginning in the month the active restaurant begins. If a restaurant doesn’t open or fails, the organizational costs generally can be written off as a loss in the year of abandonment or failure.
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- Example A: You incur $3,000 in state incorporation fees and fees paid to your lawyer for their hourly counsel. You can deduct $3,000 as organizational costs in the year you begin business.
- Example B: You incur $7,000 in state incorporation fees, fees paid to your attorney, and an HR service to set up your payroll tax accounts. You can deduct $5,000 in organizational costs in the year you begin business. You can deduct $11.11 monthly ($2,000/180 months) for 180 months after that.
- Example C: You incur $53,000 in state incorporation fees, registered agent fees, fees paid to your attorney for revisions to existing agreements to allow for your new restaurant concept, and for an HR service to set up your payroll tax accounts. In the year you begin the business, you can deduct $2,000 as organizational costs ($5,000 limit – ($53,000 org costs-$50,000 threshold)), and $283.33 (($53,000 org costs – $2,000 first-year deduction)/180 months) each month for 180 months after that.
Syndication costs incurred to market and solicit capital from investors are not considered organizational costs for book or tax purposes. Syndication costs can occur before or after the restaurant opens and are treated differently from all other pre-opening costs and, therefore, are out of the scope of this article.
Start-up Costs
Start-up costs (Sec 195) are costs incurred for investigating the creation or acquisition of an active restaurant before the day the active conduct restaurant begins. They are expenses that would otherwise be deductible (under section 162 of the IRC) if paid or incurred in the operation of an existing restaurant. These costs are typically incurred after the restaurant has been formed (granted a legal name and EIN) but before the restaurant opens (becomes an “active trade or business”). For example, insurance expenses, travel for securing vendors and distributors, licenses, permits, salaries, wages paid for training employees, and any consulting or marketing fees to plan the opening menu and advertise the opening. Kitchen equipment, such as a new walk-in, is not a start-up cost because it’s capitalized as a fixed asset and depreciated over its useful life.
According to IRS revenue ruling 77-254, expenses incurred during a general search or investigation of a business to determine whether to purchase a business and which business to purchase are investigatory costs. However, once a taxpayer has decided to acquire a specific business, expenses related to an attempt to buy that business must be capitalized. The nature of the cost must be analyzed to determine whether it is an investigatory cost incurred to facilitate the decisions or an acquisition cost incurred to facilitate the consummation of the acquisition. For example, assume you spend $5k on travel, an appraisal, and an accountant to analyze 2 to 3 potential restaurant acquisitions. You buy restaurant A and pay $700k for its lease, equipment, liquor license, and goodwill, plus another $6k to an attorney to draft the final paperwork. The $5k would be considered investigatory expenses considered Sec 195 Start-up costs, while the $700k purchase price plus $6k to the attorney would get categorized into the other cost categories discussed in this article. We suggest reading through IRS Revenue Ruling 99-23 if you have acquired a restaurant and are unsure whether your pre-acquisition costs are considered sec 195 start-up costs. The same principles apply to creating a new restaurant. For example, if you spend $5k researching and investigating a few different leases and properties to open a new restaurant, these costs would be considered start-up costs.
After the investigatory process has ended and before the restaurant opens, many expenses will be incurred to prepare the restaurant for operations. The expenses incurred during this period that would otherwise be deductible as operating expenses if the restaurant were already open, are also considered sec 195 start-up costs. This includes but is not limited to the following:
- Advertising
- Employee salaries
- Travel
- Benefits
- Utilities
- Repairs
- Accounting
- Legal
- Rent
- Payroll Processing
- Paper supplies
A restaurant may deduct up to $5,000 of start-up costs in the year the restaurant opens or becomes an active trade or business, and the remainder gets amortized over 180 months. The $5,000 upfront deduction is reduced dollar for dollar for any amount over $50,000. In other words, if start-up costs exceed $55,000, the entire amount gets amortized over 180 months for tax purposes beginning in the month the active restaurant begins. If a restaurant is acquired, the upfront deduction ($5k) for start-up costs and monthly amortization expense deductions start on the acquisition date. Finally, if a restaurant doesn’t open or fails, the start-up costs generally can be written off as a loss in the year of abandonment or failure. Please be aware that if start-up costs are not incurred by an established legal entity (LLC, Corporation, etc.), or a legal entity was not established by the time it is abandoned, then the costs will be considered nondeductible personal expenses. For example, you may pay $5k personally to search for a potential restaurant to acquire and never find the right target. The $5k would be considered nondeductible personal expenses unless you registered an LLC during or before your investigatory period.
Intangibles
Intangible Costs (Sec 197) are a little more nebulous than other expenses because they often relate to acquiring an existing restaurant or lease, key-money deals, purchasing trade names, trademarking your branding and design, franchise agreements, and trade names. Unlike start-up costs, there is no specific first-year deduction, but the cost of intangible assets is amortized over 15 years, beginning with the month the business begins.
Fixed Assets
Fixed Assets include equipment, furniture, vehicles, and capital improvements with a useful life of more than 1 year. Fixed assets are capitalized as costs are incurred, and depreciated over the fixed asset’s useful life beginning on the year the asset is placed in service. Each fixed asset category has a different depreciation method and useful life for tax purposes. You may be able to use Sec 179 or bonus depreciation to reduce taxable income, but those are unrelated to pre-opening costs. Discussing tax depreciation is out of the scope of this article.
Pro tip: it’s beneficial to classify as many start-up costs as fixed assets during the pre-opening stage if they qualify because fixed assets typically have a shorter depreciable life than the 180 months required for intangible assets such as start-up costs.
Final Thoughts on Pre-Opening Costs
Pre-opening costs have a significant impact on your financial reports and taxes. For financial reporting purposes, pre-opening expenses should show up on your P&L as a non-operating expense so you can clearly and accurately understand how much you are spending on your new location and how it affects your overall profitability. For tax purposes, you must be able to bifurcate your pre-opening expenses between sec 195 start-up costs, sec 248 organizational costs, and sec 197 intangibles to minimize taxes while staying compliant.
