Opinion: Restaurants may benefit from IRS Safe Harbor

The Springfield restaurant market is well known for offering many great dining options. While this is one of the many benefits of living in the Queen City, the competition presents a great challenge for restaurant owners. Local operators must refresh and update their menus and locations to stay ahead of competitors.

With an improving economy and borrowing costs still historically low, many operators are investing in remodeling locations. The costs to remodel can be significant, so restaurant owners should consult with a certified public accountant to work through the accounting treatments and complex income tax rules for these projects. Specifically, the income tax analysis should identify what expenditures can be immediately expensed versus those expenditures that must be capitalized and expensed over time through depreciation. The larger the investment for a restaurant, the more its cash flow is affected, e.g., income taxes.

Safe-harbor candidates
There are some general rules for restaurant remodels.

It’s no secret to CPAs that the IRS released long-awaited final regulations for capitalizing specific expenses for tangible property in September 2013. This broad set of rules, which affected nearly all business taxpayers, took effect Jan. 1, 2014. However, IRS guidance for the retail and restaurant industries wasn’t complete at that time. Near the end of 2015, the IRS released Revenue Procedure 2015-56, which provides a safe harbor method of accounting for eligible renovation expenditures incurred by certain taxpayers operating retail or restaurant establishments. This revenue procedure was effective Jan. 1, 2016.

Under the new safe harbor, an eligible taxpayer treats 75 percent of qualified costs paid during the year as deductible, and capitalizes and depreciates the remaining 25 percent of qualified costs as improvements. Not everyone will qualify.

A qualified taxpayer is one that sells merchandise to customers in a retail environment or is in the trade or business of selling made-to-order meals, snacks or beverages for on- or off-premise consumption. A building owner who leases or sublets space to an otherwise qualifying taxpayer also may adopt the safe harbor for qualifying expenses.

However, there’s another significant hurdle: A qualified taxpayer must have an applicable financial statement. Broadly speaking, this is an audited financial statement. An audit excludes financial statements that are reviewed or compiled. As such, this hurdle will very likely exclude most locally owned restaurants and many smaller franchisees.

Safe harbor also was intended for retailers. However, the IRS has excluded certain retailers from adopting it, including auto or other motor vehicle dealers; hotels and motels; theaters, casinos and country clubs; and some food services.

Knowing this background, it appears this safe harbor isn’t helpful for locally owned restaurants. Although it’s true many local restaurant owners and retailers won’t be eligible, this revenue procedure does give taxpayers insight into the IRS’ approach on this topic. In addition, although a taxpayer’s situation is outside the safe harbor, taxpayers still can establish a reasonable method of accounting for renovation projects.

Qualified expenses
It’s important to understand which expenses can be considered. Qualified expenses are incurred as part of a planned undertaking by the taxpayer on a qualified building to alter its physical appearance or layout for one or more of these purposes:

1. Maintains a contemporary and attractive environment.

2. Increases efficiency by relocating products or functions.

3. Conforms to industry standards and practices.

4. Standardizes the customer experience across multiple locations.

5. Offers the most relevant and popular goods within the industry.

6. Addresses changes in demographics by changing offerings or their presentation.

The revenue procedure provides a list of typical remodel, refresh, repair, maintenance or similar activities that would qualify under the safe harbor, as well as excluded renovation costs. Notable excluded costs include:

• tangible personal property;

• land and land improvements;

• expenses to adapt more than 20 percent of a building’s total square footage to a new or different use;

• expenses that increase or augment a building’s footprint or external structural aspects; and

• rebranding activities incurred within two years of initial purchase or occupancy.

There are moving parts involved in adopting this revenue procedure’s provisions. Restaurant franchisers, franchisees, nonchain-owners/operators, retailers and their related landlords should consult their tax advisers to seek guidance and take advantage of the IRS’ new and complex rules.

Jim Ashley, CPA, is a director with BKD LLP. He can be reached at jashley@bkd.com.