In the restaurant and retail industries, looks are everything. In an age where everything you want can be purchased in the palm of our hands on our mobile devices, it takes extra effort to draw consumers through your doors. In order to stay competitive, it isn’t uncommon for these types of businesses to refresh or remodel their premises routinely. In the wake of the overhaul to the tangible property regulations, the IRS has issued a Revenue Procedure that makes it as easy as ordering an Uber to determine whether these items need to be capitalized or can be expensed.
In this Revenue Procedure, the IRS has provided a safe harbor for those taxpayers operating a retail or restaurant business that incur costs for a refresh or remodel of their space. Revenue Procedure 2015-56 was released in late November 2015, and it outlines the rules and requirements for taxpayers to take advantage of the safe harbor.
Ignoring the new safe harbor, if you remodel your retail store, you would either deduct the amounts incurred or capitalize them and depreciation them. An item is deductible under Code Sec. 162, if it is considered an ordinary and necessary expense paid or incurred during the tax year in carrying on any trade or business, including the costs of repairs and maintenance. Reg. § 1.162-4 allows taxpayers to deduct amounts paid for repairs and maintenance of tangible property if the amounts aren’t otherwise required to be capitalized. An item would be required to be capitalized under Code Sec. 263(a) or Code Sec. 263A, depending on which situation applies. Under Code Sec. 263(a) , taxpayers must generally capitalize amounts paid to acquire, produce, or improve tangible property. Various regulations were issued that define the unit of property that must be analyzed, and define an improvement 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. Code Sec. 263A requires the capitalization of the direct and indirect costs of real or tangible property produced by a taxpayer for use in its trade or business or acquired for resale.
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. These analyses become especially difficult in situations where, as part of their remodel-refresh projects, taxpayers adapt portions of space to a new and different use. Moreover, the application of the improvement rules to particular buildings can be complex because remodel-refresh projects vary so much in frequency, quality, and degree. Consequently, taxpayers and IRS frequently encounter questions on whether the costs for a particular remodel-refresh project should be characterized as repairs, maintenance, or an improvement of the taxpayers’ property, causing taxpayers and the IRS to expend significant resources on this factually intensive issue.
In response to this very complicated issue, Rev Proc 2015-56 provided us with a safe harbor approach to which qualified taxpayers may determine the part of their remodel and refresh costs that may be deducted or required to be capitalized under Code Sec. 263A or 263(a). The safe harbor eliminates the need to determine if the item is considered a repair or an improvement to the property. It even goes further to eliminate the need to analyze the refresh or remodel against each unit of property, as the safe harbor considers the entire building and its structural components as the unit of property. The only necessary consideration of the RABI rules that we have come to know is to make sure that the amount paid for the refresh/remodel does not adapt more than 20% of the total square footage of the building to a new or different use.
Under the safe harbor, a qualified taxpayer must treat 75% of its qualified costs paid during the year as amounts deductible under Code Sec. 162(a) and must treat the remaining 25% of its costs as improvements to a qualified building or costs for the production of property for use in a trade or business under Code Sec. 263(a) or 263A. In order to qualify for the safe harbor the taxpayer must meet certain conditions:
- Have an Applicable Financial Statement
- Be in the trade or business of selling merchandise to customers at retail, for which the taxpayer reports or conducts activities within NAICS codes 44 or 45, with the exceptions of the following:
- Automotive dealers or other motor vehicle dealers (Code 4411 and 4412)
- Gas stations (Code 447)
- Manufactured home dealers (Code 45393); and
- Nonstore retailers (Code 454)
- Be in the trade of business of preparing and selling meals, snacks and beverages to customers for immediate on-premises and/or off-premises consumption, for which the taxpayer reports or conducts activities within NAICS code 722 with the exception of those who are:
- In the trade of business of operating hotels and motels
- Civic or social organizations
- Amusement parks, theatres, casinos, country clubs or similar recreational facilities; and
- Those taxpayers that primarily report or conduct activities within code 7223 (special food services, i.e., food service contractors, caterers, and mobile food services
- The taxpayer must own or lease the qualified building that incurs the remodel/refresh costs that meets the following requirements:
- Property used by the taxpayer primarily for selling merchandise to customers at retail or primarily for preparing and selling food or beverages to customers for immediate on-premises and/or off-premises consumption.
To calculate the amount of the refresh or remodel that is subject to the safe harbor you must exclude the items listed in the Rev Proc, some of which are listed below:
- Section 1245 property
- An intangible under Reg. Sec. 1.263(a)-4(b), including the creation or maintenance of computer software
- Land
- Initial acquisition costs or build-outs
- Costs incurred during a temporary closing
Author: Sara Palovick | [email protected]
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