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Tax Court decision could require capitalization of expansion costs.

A 1992 Tax Court decision, Specialty Restaurant Corp., TC Memo 1992-221, poses a trap for unwary retailers in connection with store opening costs and, potentially, other expansion costs.

Specialty Restaurant Corp. (SRC) was a holding company with over 100 subsidiaries, the majority of which operated single restaurant establishments. Restaurants were operated in separate corporate entities to limit legal liability and comply with state liquor law regulations. During 1982 and 1983 eight new restaurants were opened, all as separate newly formed subsidiaries. SRC paid all costs and expenses, both capital and ordinary, incurred prior to the opening of each restaurant. Costs classified as ordinary included preopening rent, interest, salary and wages for construction personnel, travel to the site during the course of construction, and training for new employees. SRC deducted these expenses on its consolidated return in the year incurred.

On examination, the IRS disallowed SRC's deduction of these costs, stating that they represented "preopening" expenses that must be capitalized. The Service stated that the expenses were those of the respective subsidiaries, separate and distinct legal entities, rather than of SRC. Despite the fact that SRC filed a consolidated return with the subsidiaries, it was held that SRC'S payment of expenses were capital contributions and that each legal entity must apply tax accounting principles separately.

A corporation may deduct currently only ordinary and necessary expenses paid or incurred during a tax year in carrying on a trade or business. The IRS argued, and the court agreed, that since the restaurants were not open when the expenses were incurred, the costs could not be currently deducted by the subsidiaries (even though most would have been deductible by an ongoing operating business).

To make matters worse, the Service and the court delivered one final blow to the SRC group. Sec. 195 provides that "start-up expenses" may be treated as deferred expenses and amortized ratably over a period of 60 months, if the taxpayer makes a valid election to do so with its tax return for the tax year in which the business operation commences. Because SRC's subsidiaries failed to make the election, Sec. 195 did not apply. As a result, the costs were capitalizable and would effectively be recovered only for tax purposes on a sale of the restaurants.

Retailers with expansion plans must be aware of the rules relating to start-up expenditures and plan accordingly. Specialty Restaurant highlights a dual trap: the tax risk of using separate corporate entities and the problem of failing to timely elect the mitigating benefits of Sec. 195. When opening new stores, retailers should seriously consider the use of an existing operating entity, rather than forming a new corporation, since expenditures in connection with the expansion of an existing retail business may be currently deducted. The subsequent transfer of a newly established operation to a new subsidiary, to limit liability, for state tax planning or other business reasons, remains possible through proper planning.

To avoid the second pitfall highlighted by the Specialty Restaurant case, retailers should consider making a Sec. 195 election whenever there is doubt as to whether they have begun a "new" business activity. The following should generally not be considered new-geographical expansion; new store formats or trade names; store-within-a-store concepts; wholesaling similar merchandise; related licensing; and new services such as store credit cards or extended service contracts.

The IRS has never promulgated regulations interpreting Sec. 195, but did issue an announcement in 1981 setting forth the required contents of the election. Taxpayers must attach a statement to their timely filed return that includes a description and the amount of expenditures involved, the date incurred, the month in which the new business operations began and the number of months (not less than 60) in the amortization period. By making a Sec. 195 election, a retailer can ensure that start-up expenses will be deductible, albeit over an extended period of time.

Some commentators have raised the possibility of making a "protective" Sec. 195 election, while claiming a current deduction. A protective election would involve some sort of disclosure on the tax return stating that the taxpayer does not believe it has incurred any start-up expenditures, but is electing to amortize any such costs that the Service may subsequently. determine to be capitalizable on examination. The validity of such a protective election is uncertain, since there is no statutory authority for such a conditional election.

In the past, the IRS has not aggressively enforced the rules relating to start-up expenditures. However, having now added the Specialty Restaurant decision to its arsenal, it can be expected to seek more situations in which to apply the rules. The issues relating to start-up expenses are not likely to be limited to new stores. Retailers also need to consider these rules in planning the creation of a warehousing or distribution function, a separate centralized buying or real estate function, or the establishment of a mail order operation.
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Title Annotation:Specialty Restaurant Corp.
Author:Lamont, Greg
Publication:The Tax Adviser
Date:Apr 1, 1993
Words:816
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