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Simplified Tax Treatment for Retail and Restaurant Remodel/Refresh Costs

December 3, 2015

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Is your store or restaurant in need of a facelift? On November 20, 2015, the IRS released Revenue Procedure 2015-56, which established a safe harbor for retailers and restaurants to treat a portion of their remodel/refresh costs as deductible, current-year expenses. This safe harbor provides a simplified method for calculating the portion of the qualifying costs that can be expensed, but has several requirements that may limit its practical application. The revenue procedure is effective for taxable years beginning on or after January 1, 2014.

Background

The Tangible Property Regulations that were finalized in September 2013 established a new standard for determining whether business expenditures are capital costs (which have to be depreciated over several years) or current-year expenses. Under the Tangible Property Regulations, businesses that perform remodels to their facility have to go through a multi-step process to determine capitalization/expense treatment based on the “Unit of Property” being remodeled. Given the complexity of the Unit of Property definitions, there could potentially be multiple Units of Property being remodeled as a result of what would normally be considered a single remodel project. This means a business owner would have to perform multiple analyses to determine which parts of the remodel were deductible in the current year as repairs and which had to be capitalized as improvements. This is often an administrative burden for the business owner and/or the remodel contractor, who could be required to separate costs into various categories based on Unit of Property definitions they are not familiar with, and which are often ambiguous. This administrative burden would be especially heavy for businesses that perform remodel activities on a frequent basis; i.e., retailers and restaurants. In response, the IRS released Revenue Procedure 2015-56, which provides a simplified method for determining which remodel costs are deductible in the current year.

Revenue Procedure 2015-56

Under the Revenue Procedure, qualifying retail and restaurant businesses can expense 75 percent of qualifying remodel or refresh costs, and must capitalize the remaining 25 percent of qualifying costs, without having to go through the improvement analysis set forth in the Tangible Property Regulations.

In order to qualify as a retail business under the revenue procedure, you have to report your activity under NAICS code 44 or 45. However, those who report under 4411 and 4412 (automotive and other motor vehicle dealers), 447 (gas stations), 45393 (manufactured home dealers), and 454 (nonstore retailers) are not permitted to use the safe harbor.  Qualifying restaurants include those filing under NAICS code 722, except hotels, motels, civic or social organizations, amusement parks, theaters, casinos, country clubs, and those who file under code 7223 (special food services).

The safe harbor can be applied by qualifying tenants or by building owners who lease facilities to qualifying tenants.

The revenue procedure defines a remodel-refresh project as a planned undertaking by a qualified taxpayer on a qualified building to alter its physical appearance and/or layout for one or more of the following purposes:

  1. To maintain a contemporary and attractive appearance
  2. To more efficiently locate retail or restaurant functions and products
  3. To conform to current retail or restaurant building standards and practices
  4. To standardize the consumer experience if a qualified taxpayer operates more than one qualified building
  5. To offer the most relevant and popular goods within the industry
  6. To address changes in demographics by changing product or service offerings and their presentations

Remodel-refresh projects do not include undertakings solely to clean or repaint the interior or exterior of a qualified building.

Remodel-refresh costs are 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. However, there are several categories of costs that are excluded from this definition under the revenue procedure including, among others, initial build-outs, land, Section 1245 property, and intangible assets.

Qualified buildings are buildings used by a qualifying taxpayer primarily for selling merchandise to customers at retail, or primarily for preparing and selling food or beverages to customer order for immediate on or off-premises consumption.

Restrictions

In order to elect the safe harbor, the taxpayer must have an Applicable Financial Statement as defined in the Tangible Property Regulations. An Applicable Financial Statement is an audited financial statement, a financial statement required to be filed with the Securities and Exchange Commission, or a financial statement required to be filed with a federal or state government or government agency.

If the taxpayer made a partial disposition election for any portion of a qualified building and has not properly revoked that election under this revenue procedure, they cannot apply the safe harbor to prior year costs. Instead, they would have to apply the safe harbor prospectively. In addition, once the safe harbor is elected, the taxpayer cannot make the partial disposition election for any portion of the qualified building.

Implementation

In order for a taxpayer to use the safe harbor, they must change their method of accounting by filing form 3115 (and take a full 481(a) adjustment). Under the revenue procedure, a taxpayer who uses the safe harbor is required to use it for all of its qualified costs until they secure permission from the IRS to use another method of accounting.

In addition, if you use the safe harbor, you have to document your qualifying costs in a specific manner as set forth in the revenue procedure, including the creation of certain supporting work papers. You also have to make a general asset account election under I.R.C. section 168(i)(4) to include in a general asset account the capitalized portion of the remodel-refresh costs, any qualified building, and prior year improvements made to a qualified building.

The portion being capitalized has to be depreciated over 39 years, unless it is considered a qualified leasehold improvement, qualified restaurant improvement, or qualified retail improvement, under which it may be eligible for a shorter depreciable life.

Consider All the Factors

Although Revenue Procedure 2015-56 will allow certain taxpayers to reduce the administrative burden of applying the Tangible Property Regulations to certain costs, taxpayers should consider other factors before implementing the safe harbor. In addition to the requirements mentioned above, you may be limiting the amount you can expense in the current year. Please contact CSH to discuss whether electing the safe harbor makes sense for your business.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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