Pre-opening expenses for a new restaurant can be a trap for the unwary because they’re generally required to be capitalized as intangible assets for tax purposes and amortized over 15 years starting in the month the restaurant opens instead of fully deductible in the year incurred. However, if you add a location, your pre-opening expenses could be deductible for tax purposes in the year incurred if they are considered costs in expanding an existing business.
This article will illustrate how you can get your pre-opening expenses considered deductible ordinary and necessary business expenses instead of capitalized as intangible assets and amortized over 15 years. We will refer to a series of court cases and IRS private letter rulings because there is no Internal Revenue Code (IRC) section or IRS treasury regulation (the two most authoritative sources for tax law) that clearly explains when pre-opening expenses can be deducted when incurred. If you haven’t done so already, we recommend reading our article about the treatment of pre-opening costs for book and tax purposes before continuing with this article.
Keep in mind that we’re referring to intangible pre-opening expenses such as salaries and wages for training employees, advertising, and licenses, not tangible fixed assets or intangible contributions (construction labor) to developing fixed assets such as equipment, build-out, furniture, etc., which should be capitalized and depreciated over the useful life of the asset under section 263A of the IRC. As outlined in Before the Doors Open: Pre-Opening Costs for Restaurants, most pre-opening expenses fall under the classification of Section 195 start-up costs, which must be amortized over 180 months (about 15 years) for tax purposes instead of being deducted in the year incurred.
Why capitalize pre-opening expenses?
The rationale behind capitalizing pre-opening expenses is that they have a benefit for a term that exceeds a year; therefore, the costs are not ordinary but capital in nature and cannot be deducted under section 162 of the IRC in the year incurred. This principle was the standard until a critical 1970 US Supreme Court case, Commissioner vs. Lincoln Savings & Loan Association.
The Supreme Court, in the case of Commissioner v. Lincoln Savings & Loan Association, held that “The presence of an ensuing benefit that may have some future aspect is not controlling; many expenses concededly deductible have a prospective effect beyond the taxable year. What is important and controlling, we feel, is that the [premium] payment serves to create or enhance for [the taxpayer] what is essentially a separate and distinct additional asset.”
The case noted that creating a separate and distinct asset may be a sufficient condition for classification as a capital expenditure, such as an intangible asset, but not necessarily a prerequisite to such classification.
Is a new restaurant considered a separate and distinct asset?
Commissioner vs. Briarcliff Candy Corporation
Now that we know that having a separate and distinct asset is a sufficient condition for having to capitalize pre-opening expenses as an intangible asset, we must visit the case of Commissioner vs. Briarcliff Candy Corporation a few years later to determine whether opening a new restaurant is considered a separate and distinct asset.
Briarcliff Candy Corporation was a candy manufacturer and retailer for over 20 years. More than 80% of its sales were through its retail stores in highly populated urban centers in the northeast, and the rest were through wholesale customers. In the 1950s, there was an exodus of Northeast urban populations to the suburbs, and by 1962, Briarcliff’s sales and net income had suffered.
To address the problem, Briarcliff rolled out a program of soliciting independently operated retail outlets in 1962 to set up departments to distribute their candy. The retail outlets would set aside space in their store to exclusively sell their candy. The outlet would equip the space with a refrigerated display and storage counter at their expense and use their best effort to sell the candy to their customers. The refrigerator, counter, and candy were purchased from Briarcliff. Briarcliff spent about $212k promoting the franchising program and $120k operating it. The $212k promotional expenses included salaries, travel, advertising, postage, consulting fees, and other costs to get the word out and sell the contracts. The same year, it generated $400k in revenue from selling candy to the outlets. The program continued to grow steadily over the next six years, and by 1968, the company had 1,468 retail outlets selling its candy. Briarcliff deducted the $212k promotional expenses and $120k operational expenses on its 1962 tax return.
The IRS disallowed the deduction of the promotional expenses and claimed they should be capitalized because they were an investment in a capital asset, not ordinary and necessary expenses for expanding an existing business. In 1972, the tax court agreed.
Briarcliff appealed to the 2nd Circuit US Court of Appeals in 1973 and argued that, regardless of adding a division and entering into franchise contracts, it was doing no more than stimulating its sales department by making Briarcliff’s candy available in the suburbs to a class of customers who had moved there from the cities where they had been purchasers of its candy. It was selling the same products it had sold for decades.
The IRS argued that Briarcliff’s expenditures gave rise to a separate and distinct asset, a distribution system for its products involving securing agency contracts.
The 2nd Circuit US Court of Appeals held that the tax court’s decision was wrong. It concluded that the costs did not enhance or create a separate and distinct additional asset. Although the company established a separate division to obtain the contracts, added additional personnel, and advertised in drugstore trade journals, it was merely attempting to sell the same products it had always sold. Moreover, the contracts were not capital assets, and the benefits they provided for Briarcliff, although lasting over a year, were not a new and distinct asset. Briarcliff was merely trying to compensate for its decline in sales in response to the population shift of its customers to the suburbs.
So, when has a separate and distinct asset been created? Is adding a location to your restaurant group a separate and distinct asset?
IRS Letter Ruling 8423005
Determining whether a separate and distinct asset has been created requires reviewing years of case law and comparing them to the situation’s circumstances. Luckily, the IRS has already done the work for us.
On February 8, 1984, the IRS issued private letter ruling (PLR) 8423005. PLR 8423005 answers the following question:
“Are expenditures incurred in relocating managers, and interviewing, hiring, and training a workforce in connection with the establishment of new restaurants deductible under section 162 of the Internal Revenue Code, or capital expenditures under section 263, when the taxpayer has similar existing restaurants in other geographical locations which operate under the same trade name?”
The IRS generated the PLR for a 28-unit restaurant group, of which 26 locations are owned directly by the holding company, and 2 locations are owned by separate corporate subsidiaries to satisfy local ownership requirements to obtain liquor licenses. The restaurant group is under audit, and the IRS agents have requested clarification from the IRS about whether the costs incurred with opening new restaurants are deductible in the year incurred or capitalized as intangible assets. All restaurants have the same concept and trade names. Each location incurred its pre-opening expenses from a separate bank account.
The PLR clarifies that the pre-opening expenses for the 26 locations (directly owned by the holding company) are not considered Sec. 195 start-up costs that need capitalization and can be fully deducted as expansion costs in the year incurred. Pre-opening expenses are only considered Sec. 195 start-up costs in an established business when the established business’s new activities are distinguishable from those currently conducted by the business. The 26 stores were not a new activity unrelated to its prior business, and no separate asset is created when an existing business merely expands an identical business in a new geographical location.
However, the pre-opening expenses for the two locations opened in separate corporate subsidiaries must be capitalized as sec 195 start-up costs. The subsidiaries are considered separate and distinct corporations that cannot be ignored for tax purposes even though they’re wholly owned.
So, it’s clear that opening a new restaurant in a separate corporate entity is a deciding factor when a separate and distinct asset has been created. The PLR has repeatedly confirmed that separate and distinct corporations are not disregarded for tax purposes, even if they’re wholly owned. It appears that LLCs do not fall under the same consideration because they are disregarded for federal tax purposes if a parent company wholly owns them. Therefore, if you open a new location in a separate LLC (instead of a separate corporation), you can still consider the pre-opening expenses as an expansion of an existing business.
Although PLRs are frequently used as a reference for taxpayers, they can’t be used as a primary or secondary source when making a case against the IRS unless the PLR is issued directly to them. Therefore, we must look further into case law to support our conclusion.
Specialty Restaurant Corp., et al. v. Commissioner
In April 1992, the US Tax Court filed a Tax Case Memorandum (TCM) outlining the findings of Specialty Restaurant Corporation vs. Commissioner. This tax court case clarifies how to deal with expansion costs more precisely.
Between 1979, 1982, and 1983, Specialty Restaurant Corp. incurred $518k of pre-opening expenses for new restaurant locations through newly formed wholly owned subsidiaries. Subsidiaries were formed before each restaurant’s existence and used for distinct reasons, including insulation from creditors, lease requirements, and compliance with State liquor law regulations. The parent company, Specialty Restaurant Corp, paid for the pre-opening expenses and fixed assets before the new restaurant’s opening date. The pre-opening expenses include rent, interest, salaries, wages for construction personnel, travel to the site during construction, and training for new employees to be used at the new location.
The portion of expenses attributable to fixed assets was capitalized and depreciated when placed in service, but the pre-opening expenses were fully deducted in the year incurred. The IRS disallowed the deductions for pre-opening expenses and claimed that they should be capitalized under section 263A or section 195 start-up costs and depreciated over their useful lives or amortized over 15 years, respectively. The IRS claimed that the expenses were those of the respective subsidiaries, separate and distinct legal entities, not Specialty Restaurant Corp.
Specialty Restaurant Corporation petitioned that it was engaged in an established, functioning business when it incurred the expenses—the business of opening and managing theme restaurants in both subsidiary and divisional form. No separate lines of business or operations could be distinguished from its existing methods and facilities. Specialty also handled its operating subsidiaries’ accounting, finance, purchasing, management, advertising, training, and consulting services. They claimed that the deducted expenses were for carrying on that business, i.e., rents, interest, salaries, travel to and from the site, and training of new employees.
Specialty Restaurant Corp had a pretty typical restaurant group structure. The subsidiaries would pool funds into a concentrator checking account at Bank of America, which would cover operating and pre-opening expenses for all locations. The holding company would receive a management fee from each location based on sales to cover corporate costs such as director’s salaries. The directors of Specialty Restaurant Corp served as the directors of the subsidiaries. The holding company filed a consolidated return, including all its subsidiaries’ activity.
The IRS argued that it is inappropriate to disregard corporate lines and that until a business has begun to function as a going concern and has performed activities for which it was organized, the trade or business requirement does not allow taxpayer deductions for pre-opening expenses. They claimed that the costs were not ordinary and necessary nor incurred by Specialty; they are pre-opening expenses of the subsidiaries to establish their respective restaurants and thus represent capital contributions to the subsidiaries by Specialty. Furthermore, creating the subsidiaries provided distinct advantages, including limited liability and compliance with State liquor laws. The IRS concluded that choosing to do business as a separate corporation based on its advantages requires the acceptance of tax disadvantages.
The US tax court upheld the IRS’ determination that Specialty Restaurants Corporation’s pre-opening expenses incurred on behalf of its wholly owned subsidiaries were intangible assets that must be amortized over 15 years beginning on each restaurant’s opening month.
This supports the same conclusion as IRS Letter Ruling 8423005 mentioned above.
More Support for Deductible Expansion Costs
In PLR 9331001, issued in 1993, the IRS confirmed pre-opening expenses for expanding a retail boutique chain are deductible in the year incurred because the concepts were nearly identical and created under the same legal entity. However, it’s important to note that the boutiques were a division of a manufacturing and distribution business. Therefore, the first boutique store was not considered the expansion of an existing business but a separate and distinct asset for which pre-opening expenses had to be capitalized as intangible assets. Every boutique that opened after that was considered an expansion of the existing boutique business.
On June 21, 1996, the IRS issued Technical Advice Memorandum 9645002, which also confirmed that the pre-opening expenses for retail stores as part of an expansion program are deductible in the year incurred. The retail stores were operationally indistinguishable from one another, and it appears that all stores were being opened under the same subsidiary, which supports the previous court cases and PLRs.
How Can I Deduct Pre-opening Expenses?
Now that we have laid down the law.
How can you incur your pre-opening expenses and deduct them as ordinary and necessary business expenses in the year incurred?
For you to be able to deduct your pre-opening expenses for new restaurant locations, those locations can’t be considered separate and distinct assets. Opening your new location in a separate corporation will be treated as a separate and distinct asset, even if it’s wholly owned by an entity that is merely expanding its operation. Opening your new location as a separate entity with different ownership will also be treated as a separate and distinct asset, even if it’s an expansion of the same concept. Therefore, you must open your new location under your existing legal entity or in an LLC under your existing legal entity so that the pre-opening expenses for your new location can be deducted in the year incurred. Otherwise, those expenses must be capitalized as intangible assets and amortized over 15 years.
As you can see, your legal structure can have significant tax consequences; therefore, working with an accountant and attorney who can collaborate and understand the peculiarities and implications of restaurant expansion and growth is essential. If you want to learn more about working with The Fork CPAs, please don’t hesitate to contact us.
