The Internal Revenue Service (IRS) released Revenue Procedure (Rev. Proc.) 2015-56 on November 19, 2015, which provides a safe harbor method that taxpayers engaged in the retail and restaurant industries may use to determine whether costs paid or incurred to refresh or remodel a qualified building are currently deductible, must be capitalized as improvements, or must be capitalized as property produced for use in the taxpayer's trade or business. Procedures for obtaining IRS's automatic consent to change to the safe harbor method of accounting are provided. This article highlights the issue that has been in negotiations with the Retail Industry Leaders Association (RILA), a trade group representing the retail industry, its member companies, and the IRS for more than four years, as well to provide a summary of the new guidance provided in Rev. Proc. 2015-56.
IRS Offers Safe Harbor for Store and Restaurant Repairs
Rev. Proc. 2015-56, issued on November 19, 2015, provides a safe harbor method that taxpayers engaged in the retail and restaurant industries may use to determine whether costs paid or incurred to refresh or remodel a qualified building are currently deductible, must be capitalized as improvements, or must be capitalized as property produced for use in the taxpayer's trade or business. Procedures for obtaining IRS's automatic consent to change to the safe harbor method of accounting are provided. The end result of the new guidance is to eliminate the confusion over which costs of store remodels and refreshes should be expensed and deducted immediately, or must be capitalized and depreciated over time.
The final tangible property regulations include rules regarding when costs incurred to acquire, produce or improve tangible property, must be capitalized or may be deducted, and rules regarding full and partial dispositions of tangible depreciable property.
Taxpayers operating in the retail and restaurant industries regularly incur expenditures to remodel or refresh buildings that are used in their business. A project to remodel or refresh a retail establishment or a restaurant is generally referred to as a "remodel" or a "refresh," depending upon the extent of work performed (collectively referred to as 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.
Current Rules and Regulations
Taxpayers are generally allowed a current 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 if the amounts aren't otherwise required to be capitalized.
Taxpayers must generally capitalize amounts paid to acquire, produce, or improve tangible property. The regulations generally require taxpayers to capitalize amounts paid to improve a unit of property. Improvements are defined 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. The regulations provide detailed criteria for determining whether amounts fall into any of these categories. The regulations provide for the application of these criteria to a building unit of property by applying the criteria separately to the building structure and specifically designated building systems.
In addition, the regulations require the capitalization of the direct and allocable indirect costs of real or tangible property produced by a taxpayer for use in its business or acquired for resale. These rules apply to a retail or restaurant taxpayer's self-constructed property and, as such, require the capitalization of the direct and allocable indirect costs of property constructed, built, installed, or improved during a remodel-refresh project.
Because remodel-refresh projects frequently involve work performed on building structures and a variety of building systems, the 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 the IRS would 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 extremely factually intensive issue.
Rev. Proc. 2015-56 provides a safe harbor approach under which qualified taxpayers may determine the part of their remodel-refresh costs that may be deducted or must be capitalized. The safe harbor method minimizes 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. Because the safe harbor method is applied to the entire building unit of property, the safe harbor method also eliminates the need to apply these rules separately to each building structure and each designated building system. The safe harbor also eases the factual inquiry into 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% of the total square footage of the building to a new or different use. Further, the safe harbor removes the qualified taxpayer's requirement to complete a separate analysis to determine whether any remodel-refresh costs, including interest, must be capitalized as direct and allocable indirect costs of producing property used in its business.
Under the safe harbor, a qualified taxpayer must treat 75% of its qualified costs paid during the tax year as currently deductible ("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 and as costs for the production of property for use in the qualified taxpayer's business ("the capital expenditure portion").
The remodel-refresh safe harbor applies to all of the qualified taxpayer's qualified costs paid during the tax year. A qualified taxpayer who uses the remodel-refresh safe harbor must use the method for all of its qualified costs until the qualified taxpayer secures IRS's consent to use another accounting method.
The Rev. Proc. provides a non-exclusive list of 18 types of costs incurred as part of a remodel-refresh project, which is a planned undertaking by the taxpayer in order to alter the appearance of a building that is used primarily for selling merchandise to customers at retail or for preparing and selling food or beverages, that are eligible for the safe harbor. These costs include among other things: painting, relocating departments within the existing footprint, nonstructural change to the exterior, and replacing or adding walls, doors, windows, and light and plumbing fixtures within the existing footprint of the qualified building.
In addition, the Rev. Proc. lists 12 specific types of costs that could be incurred during a remodel-refresh project that are excluded from the safe harbor. These include, for example, costs related to: Section 1245 property (e.g., personal property whether tangible or intangible that is or has been subject to depreciation or amortization), land or land improvements, initial buildout of leased building for a new lessee, activities to rebrand a building performed within two years of the acquisition or initial lease, material additions to the building, costs incurred in projects where the store closes for more than 21 days, and costs to adapt more than 20% of the building to a new or different use.
Costs incurred by an eligible taxpayer at a building not used primarily for retail or restaurant (i.e., office headquarters) or that are not made as part of a remodel-refresh project are not included in the safe harbor method. For example, costs incurred in connection with the initial opening of a retail or restaurant establishment would be excluded from the safe harbor.
Taxpayers that want to apply the remodel-refresh safe harbor are not permitted to make the partial disposition election provided in the final tangible property regulations 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 made the partial disposition election under the regulations for any portion of an original qualified building, or any portion of an improvement or addition to an original qualified building, prior to the first taxable year that the qualified taxpayer uses the remodel-refresh safe harbor, the qualified taxpayer must revoke that partial disposition election. Rev. Proc. 2015-56 provides the time and manner of revoking a prior year’s partial disposition election. A taxpayer that is revoking a partial disposition election must take the entire § 481(a) adjustment into account in computing taxable income for the year of change.
In addition, to use the remodel-refresh safe harbor, qualified taxpayers must make a retroactive general asset account election to include the cost of the original building and improvements incurred in years prior to the safe harbor, and must include the capital portion of any expenditures under the safe harbor in general asset accounts going forward. Such election will not allow the taxpayer to take dispositions on any portion of the building (or improvements) unless it was a qualifying disposition under the tangible property regulations, which is generally a disposition of the entire building or leasehold interest. Rev. Proc. 2015-56 provides that, for purposes of using the safe harbor, making a late general asset account election for the building and any previous improvements is a change in method of accounting, which is included as part of the method change to the safe harbor.
The Rev. Proc. defines a qualified taxpayer as one that has an Applicable Financial Statement as defined in the final tangible property regulations and that-
Is 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. Automotive dealers, other motor vehicle dealers, gas stations, manufactured home dealers and non-store retailers are excluded from the safe harbor, or
Is in the trade or business of preparing and selling meals, snacks, or beverages to customer orders for immediate on-premises and/or off-premises consumption, for which the taxpayer reports or conducts activities within NAICS code 722. Those taxpayers that are primarily in the trade or business of operating hotels and motels, civic or social organizations or amusement parks, theaters, casinos, country clubs, or similar recreation 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) are excluded from the safe harbor, or
Owns, or leases, a qualified building that is leased, or sublet, to a taxpayer that meets the requirements of (1) or (2), above, and incurs remodel-refresh costs.
A qualified building under the Rev. Proc. means 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. For these purposes, selling merchandise to customers at retail includes the sale of identical goods to resellers if the sales to resellers are conducted in the same building and in the same manner as retail sales to non-reseller customers (e.g., warehouse clubs, home improvement stores).
For purposes of Rev. Proc. 2015-56, a building unit of property is comprised of each building and its structural components. The Rev. Proc. makes reference to the investment tax credit regulations for the definition of buildings and structural components. Under these regulations the term “building” generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. In the case of an individual unit in a building with multiple units (such as a condominium), the building unit of property is each individual unit owned by the qualified taxpayer and the structural components that are part of the unit. In the case of an interest in a cooperative housing corporation, the building unit of property is the portion of the building in which the qualified taxpayer has possessory rights and the structural components that are part of the portion of the building subject to the qualified taxpayer's possessory rights. In the case of a lease of an entire building to a qualified taxpayer, the building unit of property is the building and its structural components subject to the lease. In the case of a lease of a portion of a building (such as a store, a floor, or certain square footage) to a qualified taxpayer, the building unit of property is the portion of the building and the associated structural components subject to the lease.
Accounting Method Changes
Rev. Proc. 2015-56 provides for two new automatic method changes under Rev. Proc. 2015-14: one to change to the remodel-refresh safe harbor with a late general asset account election and one to revoke a partial disposition election. For these method changes, Rev. Proc. 2015-56 temporarily makes certain eligibility rules inapplicable for filing automatic method changes for the first or second taxable year beginning after Dec. 31, 2013, meaning that taxpayers who filed a method change for the same item within the last five years or who are in their final year of a trade or business are eligible to make these method changes for those two years. A qualified small taxpayer (i.e., a taxpayer whose average annual gross receipts for the three preceding years is less than or equal to $10,000,000) is required to calculate any required § 481(a) adjustment and complete certain specifically designated sections of Form 3115.
The Rev. Proc. also instructs a qualified taxpayer using the remodel-refresh safe harbor to maintain appropriate books and records, including work papers that document the use of this method. Appendix A attached to the Rev. Proc. describes the nature of the required documentation.
Retailers have welcomed the safe harbor. A 75% expense mechanism certainly provides welcome relief to the industry. The release of Rev. Proc. 2015-56 concludes more than four years of negotiations between RILA, its member companies and the IRS aimed at eliminating the confusion about which costs of store remodels and refreshes should be expensed and deducted immediately, or must be capitalized and depreciated over time. If you think your business is eligible to apply the remodel-refresh safe harbor method you will want to consult your tax advisor to determine next steps for implementing the new guidance. Please contact Paul Helderman, Stacy Gilbert, or your Citrin Cooperman contact partner/director for further assistance and guidance with application of this exciting new development.