The IRS issued a revenue procedure (Rev. Proc. 2015-56) on Nov. 19 that provides retail and restaurant taxpayers with a safe harbor method for determining deductible repairs for remodel-refresh projects. The safe harbor includes not only a methodology for determining the repair versus improvement portion of such costs, but it also covers the application of Section 263A, the disposition rules and general asset account elections for such locations.
This is long-awaited guidance that will provide a simplified approach to analyzing complicated facts related to remodel and refresh projects for restaurant and retail taxpayers.
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 (TD 9636
), and rules regarding full and partial dispositions of tangible depreciable property (TD 9689
). For more on the final tangible property regulations, which are effective for taxable years beginning on or after Jan. 1, 2014, see Tax Flash 2013-13 and Tax Flash 2014-10.
Retail and restaurant taxpayers regularly incur expenditures to remodel or refresh retail or restaurant buildings to remain competitive and to improve customer experience. The IRS acknowledged in the revenue procedure that applying the improvement criteria in the tangible property regulations to these projects is very complicated due to the diverse nature and scope of the work involved, especially when the work involves the building structure and multiple building systems. The revenue procedure provides a safe harbor method for these costs that is effective for taxable years beginning on or after Jan. 1, 2014.
The safe harbor
Under the remodel-refresh safe harbor method, a qualified taxpayer treats 75% of its qualified costs paid during the year as Section 162 repair expenses and treats the remaining 25% of the qualified costs as an improvement under Section 263(a) and Section 263A that is to be depreciated under Section 168.
The safe harbor method minimizes the need for taxpayers and the IRS to perform a detailed factual analysis of each remodel or refresh project. The safe harbor allocation ratio takes into account noninventory Section 263A costs, amounts that adapt a portion of a qualified building to a new or different use, and losses on dispositions of relevant building assets (or portions thereof).
Who is eligible for the safe harbor?
Generally, taxpayers in the trade or business of selling merchandise to customers at retail (NAICS code beginning with 44 or 45) or preparing and selling meals, snacks or beverages to customers for immediate on-premises and/or off-premises consumption (NAICS code beginning with 722) are eligible to use the safe harbor. Additionally, the owners of qualified buildings that lease to the above listed businesses are eligible taxpayers.
However, automotive dealers, motor vehicle dealers, gas stations, manufactured home dealers, nonstore retailers, caterers, food service contractors, mobile food services and taxpayers primarily in the business of operating hotels, civic or social organizations, amusement parks, theaters, casinos, country clubs or other recreation facilities, are not allowed to use the safe harbor.
Additionally, to use the safe harbor a taxpayer must have an applicable financial statement as defined in Treas. Reg. Sec. 1.263(a)-1(f)(4).
What types of costs does the safe harbor apply to?
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 (i.e., a qualified building). 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.
There are 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, 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.
Limitation on partial disposition elections
Taxpayers who wish to use the remodel-refresh safe harbor are not permitted to make the partial disposition election under Treas. Reg. Sec. 1.168(i)-8(d)(2) or the late partial disposition election under Rev. Proc. 2015-14 Section 6.33 (or its predecessor) for any portion of the original building or to any improvement to the original building, or risk having to make the change to the safe harbor on a cut-off basis with respect to the buildings for which the revocation was not made.
The revenue procedure provides an automatic consent to revoke the partial dispositions election either by filing an amended return on or before the first year that the taxpayer uses the new safe harbor or by filing a time-limited automatic method change for the taxpayer’s first or second taxable year beginning after Dec. 31, 2013. Thus, calendar year taxpayers who have already filed their 2014 returns are only eligible to make the revocation as a method change on the 2015 return. The Section 481(a) adjustment required for the revocation must be taken into account entirely in the year of change.
If a taxpayer does not revoke partial disposition elections made prior to the year of change, the method change to the remodel-refresh safe harbor must be done on a cut-off basis and does not apply to any amounts incurred prior to the year of change. Additionally, no audit protection will be provided for those taxpayers who do not revoke their partial disposition elections.
Similar restrictions, with some differences in the procedural aspects, are provided for taxpayers who made partial dispositions of MACRS property under the temporary regulations and/or in taxable years prior to Jan. 1, 2012.
Requirement to use general asset accounts
To use the remodel-refresh safe harbor, taxpayers must make retroactive general asset account elections 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 has a qualifying disposition under Treas. Reg. Sec. 1.168(i)-1(e), which is generally a disposition of the entire building or leasehold interest.
The revenue procedure 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.
Method changes and documentation requirements
The revenue procedure 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. Certain eligibility requirements for filing automatic method changes are waived for the first or second taxable year beginning after Dec. 31, 2013, for these changes. This means 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 taxpayer using the remodel-refresh safe harbor must keep specific documentation related to the method in its work papers. An example of the type of documentation required is included in an appendix to the revenue procedures.
Implications and next steps
This is long-awaited guidance for retailers and restaurant operators. The safe harbor provides a simplified approach to analyzing complicated facts related to remodel and refresh projects for these taxpayers. The more than 50 pages of guidance may at first seem daunting to implement, especially with all the dispositions and general asset account rules. However, once implemented, the methodology is likely to become a routine analysis and documentation exercise in future years.
Businesses eligible to take advantage of the safe harbor method will want to work with their tax advisor to determine the next steps for implementing these procedures, as failure to properly take into account all the procedures may prevent a Section 481(a) adjustment for some or all of a taxpayer’s remodel-refresh costs on qualified buildings.
T +1 202 861 4140
T +1 202 521 1558
The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP.
Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.