Definition: An organizational cost or expense is the initial cost incurred to create a company. Organizational costs usually include legal and promotional fees to establish the company with the state and federal government. In other words, organizational expenses are the costs of organizing or incorporating a company.
What Does Organizational Cost Mean?
Before a company exists, the soon-to-be owners of a company meet with an attorney to draft a corporate charter and articles of incorporation (for corporations) or partnership agreement (for partnerships). These legal documents establish the agreements between each one of the shareholders or partners in the new entity. Items that can be addressed in these documents include ownership percentage, stock options, profit share percentage, among others.
Once these documents are drafted, the attorney files them with the applicable government organization and applies for a state business license and ID number. A federal number can then be applied for once the state has granted a business entity license.
As you can imagine, this process is not free. The company has to pay for the legal fees, taxes, and other related fees in order to form a legal entity. For tax purposes, these organization costs are typically capitalized and amortized. The IRS does not want businesses to take large deductions in the first year of business.
They would rather have the deductions be spread out over a period of time. GAAP, however, generally requires that these costs be expensed when incurred because it is difficult determine their future benefits and relation to future revenues (the matching principle). Unless there are large amounts of organizational expenses, they are usually expensed for GAAP and financial reporting purposes.