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IRS Issues Safe Harbor Method for Restaurant and Retail Store Remodeling Projects.
(Parker Tax Publishing November 23, 2015)
The IRS has issued guidance providing certain taxpayers engaged in the trade or business of operating a retail establishment or a restaurant with a safe harbor method of accounting for determining whether expenditures incurred to remodel or refresh a qualified building can be deducted currently or must be capitalized. Rev. Proc. 2015-56.
The new procedures, issued by the IRS on Thursday, should benefit many restaurants and retail stores that either are, or will be, renovating their space. Rev. Proc. 2015-56 provide a safe harbor method aimed at reducing disputes on the deductibility or capitalization of remodel-refresh costs. Under the safe harbor, restaurant and retail store owners may determine the portions of their remodel-refresh costs that may be deducted or must be capitalized. The new rules will minimize the need to perform a detailed factual analysis to determine whether each remodel-refresh cost incurred during a remodel-refresh project is for repair and maintenance or for an improvement.
In addition, because the new safe harbor method applies to the entire building unit of property, it eliminates the need to apply these rules separately to each building structure and each building system designated as a unit of property under the capitalization rules. Moreover, the safe harbor eases the factual inquiry into determining whether costs incurred during a remodel-refresh project adapt property to a new or different use, requiring qualified taxpayers to exclude from the safe harbor only amounts that adapt more than 20 percent of the total square footage of the building to a new or different use.
OBSERVATION: To properly apply the capitalization rules, many businesses engage firms to prepare cost segregation analyses since CPAs don't have the credentials or time to prepare such an analysis. Thus, the new rules have the added benefit of saving restaurant businesses money they might otherwise have to spend such an analyses.
Practice Tip: Rev. Proc. 2015-56 is effective for tax years beginning on or after January 1, 2014. Practitioners will want to review these rules if they have restaurant clients that have recently incurred remodel-refresh costs and have already filed returns to see if amended returns are in order.
In order to use the safe harbor, taxpayers must have an applicable financial statement, which for many taxpayers means an audited financial statement.
Background
Taxpayers operating in the retail and restaurant industries regularly incur expenditures to remodel or refresh their buildings (a "remodel-refresh project"). Generally, a retail or restaurant taxpayer undertakes a remodel-refresh project to remain competitive and to improve the customer experience.
These projects typically involve a planned undertaking to alter the physical appearance and layout of the building to maintain a contemporary and attractive environment, to more efficiently locate different functions and products, to conform to current industry standards and practices, to standardize the customer experience, to offer the most relevant goods, food, or beverages, and to address changes in demographics by changing offerings and their presentation. Typically, taxpayers also perform routine repairs and maintenance during a remodel-refresh project.
Code Sec. 162 generally allows a deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the costs of repairs and maintenance. Code Sec. 263(a) generally requires the capitalization of amounts paid to acquire, produce, or improve tangible property.
Reg. Sec. 1.162-4 allows taxpayers to deduct amounts paid for repairs and maintenance of tangible property if the amounts are not otherwise required to be capitalized. Reg. Sec. 1.263(a)-3 generally requires taxpayers to capitalize amounts paid to improve a unit of property. Reg. Sec. 1.263(a)-3(d) defines improvements as amounts paid that are for a betterment to a unit of property, that restore a unit of property, or that adapt a unit of property to a new or different use.
In addition, Code Sec. 263A requires the capitalization of the direct and allocable indirect costs of real or tangible property produced by a taxpayer for use in its trade or business or acquired for resale. Thus, the rules under Code Sec. 263A require taxpayers to apply an additional analysis to their remodel-refresh projects to determine which costs must be capitalized.
Because remodel-refresh projects frequently involve work performed on building structures and a variety of building systems, the tangible property regulations generally require taxpayers performing remodel-refresh projects to apply separate legal analyses to many different components of the building. Consequently, taxpayers frequently encounter questions regarding whether the costs for a particular remodel-refresh project should be characterized as repairs, maintenance, or an improvement of the taxpayers' property, causing taxpayers to expend significant resources on this factually intensive issue.
To reduce disputes regarding the deductibility or capitalization of remodel-refresh costs, Rev. Proc. 2015-56 provides a safe harbor approach under which qualified taxpayers may determine the portions of their remodel-refresh costs that may be deducted or must be capitalized for purposes of Code Secs. 162(a), 263(a), and 263A(b)(1).
Compliance Tip: Taxpayers wishing to avail themselves of the safe harbor must use the automatic change procedures in Rev. Proc. 2015-13.
Taxpayers Qualified to Use the Safe Harbor
The Rev. Proc. 2015-56 remodel-refresh safe harbor applies to a qualified taxpayer that pays qualified costs in the course of performing a remodel-refresh project on a qualified building. Definitions for those terms are as follows.
For purposes of the safe harbor, a qualified taxpayer is one who has an Applicable Financial Statement (as defined under Reg. Sec. 1.263(a)-1(f)(4)), and that:
(1) Is in the trade or business of selling merchandise to customers at retail; or
(2) Is in the trade or business of preparing and selling meals, snacks, or beverages to customer order for immediate on-premises and/or off-premises consumption.
Qualified taxpayers do not include motor vehicle dealers, manufacture home dealers, nonstore retailers, taxpayers primarily in the trade or business of operating hotels, amusement parks, casinos, and caterers and food service contractors.
A qualified building is each building unit of property used by a qualified taxpayer primarily for selling merchandise to customers at retail or primarily for preparing and selling food or beverages to customer order for immediate on-premises and/or off-premises consumption.
A remodel-refresh project means a planned undertaking by a qualified taxpayer on a qualified building to alter its physical appearance and/or layout in order to, among other reasons, maintain a contemporary and attractive appearance, more efficiently locate retail or restaurant functions and products, and to conform to current retail or restaurant building standards and practices.
A remodel-refresh project does not include a planned undertaking solely to repaint or to clean the interior or exterior of an existing qualified building.
Remodel-refresh costs mean amounts paid by a qualified taxpayer for remodel, refresh, repair, maintenance, or similar activities performed on a qualified building as part of a remodel-refresh project.
Remodel-Refresh Safe Harbor Method
The remodel-refresh safe harbor method of accounting determines the amount of the qualified costs that are deducted under Code Sec. 162 and the amount of such costs that are required to be capitalized under Code Secs. 263(a) and 263A. The safe harbor also provides for the treatment of the capitalized amount for depreciation and disposition purposes. Subject to certain exceptions, the remodel-refresh safe harbor applies to all of the qualified taxpayer's qualified costs paid during the tax year, and in general a taxpayer who uses the remodel-refresh safe harbor is required to use the method for all of its qualified costs.
To use the remodel-refresh safe harbor, the qualified taxpayer must comply with six separate requirements.
First, the qualified taxpayer must treat 75% of its qualified costs paid during the tax year as amounts deductible under Code Sec. 162(a) ("the deduction portion") and must treat the remaining 25% of its qualified costs paid during the tax year as costs for improvements to a qualified building under Code Sec. 263(a) and as costs for the production of property for use in the qualified taxpayer's trade or business under Code Sec. 263A ("the capital expenditure portion").
Second, the qualified taxpayer must document its qualified costs in a manner substantially similar to the standard set forth in Appendix A of Rev. Proc. 2015-56.
Third, the capital expenditure portion must be charged to a capital account. The capital expenditure portion for each qualified building is a separate asset or assets for depreciation purposes and is depreciated under Code Secs. 167 and 168 beginning when the capital expenditure portion is placed in service by the qualified taxpayer. The qualified taxpayer must make an election to include the capital expenditure portion in a general asset account.
Fourth, a qualified taxpayer must not make the partial disposition election under Reg. Sec. 1.168(i)-8(d)(2) for any portion of an original qualified building or any portion of any improvement or addition to an original qualified building. If a qualified taxpayer had previously made the partial disposition, prior to the first tax year that the qualified taxpayer uses the remodel-refresh safe harbor, the qualified taxpayer must revoke that partial disposition election.
The fifth requirement applies to a qualified taxpayer that recognized a gain or loss upon the disposition of a component of a qualified building, a structural component of a qualified building, or a component of such structural component (1) under Reg. Sec. 1.168(i)-1T or Reg. Sec. 1.168(i)-8T if that component or structural component is not an improvement or addition, or (2) in a tax year beginning before January 1, 2012, if that component or structural component is MACRS property. Such qualified taxpayer must change its present method of accounting to be in accord with Reg. Sec. 1.168(i)-1(e)(2)(viii) or Reg. Sec. 1.168(i)-8(c)(4) (determination of asset disposed of), on or before the first tax year that the qualified taxpayer uses the remodel-refresh safe harbor, and take the entire amount of the Code Sec. 481(a) adjustment into account in computing the qualified taxpayer's taxable income for that year of change.
Six, a qualified taxpayer must make a general asset account election under Code Sec. 168(i)(4) and Reg. Sec. 1.168(i)-1(l) to include in a general asset account any asset that is MACRS property and that comprises a qualified building.
Amounts paid to which the qualified taxpayer applies the remodel-refresh safe harbor are not capitalized separately under Code Sec. 263A(a)(1)(B) and (b)(1) as a direct or indirect cost of producing property used in the qualified taxpayer's trade or business.
A qualified taxpayer that uses the remodel-refresh safe harbor may not elect to apply the safe harbor for small taxpayers under Reg. Sec. 1.263(a)-3(h), nor the safe harbor for routine maintenance under Reg. Sec. 1.263(a)-3(i) for amounts paid for costs that are subject to the remodel-refresh safe harbor method. (Staff Editor Parker Tax Publishing)
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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