December marks the official start of the holiday season. And while many restaurants prepare to host office parties, unveil their seasonal menus, and distribute year-end bonuses to employees, it is also time for them to begin their year-end tax planning and assess other areas of their operations impacting their revenue and profits.
Tax Incentives, Credits, and other Planning Considerations
As 2015 draws to a close, Congress continues to work on a tax extender bill, which could prolong many expired provisions for two years.
However, at this point, taxpayers must make business decisions without knowing whether or not tax provisions that expired December 31, 2014 will be extended prior to year-end. A recap of some of these provisions is provided below along with our assessment of the potential tax ramifications should Congress fail to extend certain legislation.
Gone is the 2014 bonus depreciation provisions for qualified new property additions which allowed for immediate 50% depreciation on qualified asset purchases placed in service prior to January 1, 2015. These provisions also applied to certain qualified leasehold improvement property. Also gone are the enhanced Section 179 expensing provisions which provided for a current deduction of up to $500,000 on qualifying new or used property placed in service before January 1, 2015. This deduction will decrease to a maximum $25,000 annual deduction and is phased out once overall qualified asset purchases exceed $225,000. The failure by Congress to extend these two provisions would significantly increase the out-of-pocket cost for an operator with respect to 2015 build outs. Additionally, this could cause a problem for fiscal year pass-through entities with 2015 year-ends. Even though 2014 purchases would be subject to the higher limits, the pass-through of these items to a calendar year (2015) shareholder would be subject to the lower limits and result in a loss of deductions.
A 15-year depreciation life was allowed for certain qualified leasehold improvements, qualified restaurant property, and qualified retail improvements that were placed in service prior to January 1, 2015. Absent an extension of this provision, the depreciation life for non-residential real estate is 39 years.
The President’s bill looks to enhance and make permanent the Section 179 deduction with an increase to $1MM. A Republican extender bill would carry bonus depreciation through December 31, 2016. California does not conform to the provisions listed above and has different Section 179 thresholds.
Repair and Capitalization Regulations
In September 2013, the IRS released final “repair regulations.” These complicated regulations provide guidance on when taxpayers are required to capitalize certain costs and when they can currently deduct costs for acquiring, maintaining, repairing, and replacing certain property. These repair regulations apply to tax years beginning on or after January 1, 2014 but can be applied retroactively to the 2012 and 2013 tax years as well.
A significant taxpayer-friendly provision, requiring action before the end of this year is the safe harbor De minimis expensing rule. This rule allows a taxpayer with audited financials to deduct the cost of up to $5000 per invoice or per item of new property additions ($500 if the taxpayer does not have audited financials, $2500 effective for costs incurred during taxable years beginning on or after January 1, 2016 pursuant to recently issued IRS Notice 2015-82).
Recently issued Revenue Procedure 2015-56 provides a safe harbor election for restaurant companies with an applicable audited financial statement to currently deduct 75% of their qualified “refresh/remodel” costs. Operators should review this Revenue Procedure to determine its applicability to their restaurant. To take advantage of this safe harbor provision for the 2015 tax year, the taxpayer must have a “written accounting” policy for these costs in place prior to January 1, 2015. The policy must treat costs below the threshold as a current deduction and account for them in accordance with this policy. To benefit from this provision for 2014, the policy should have been in place before January 1, 2014.
For 2014 tax returns, the IRS provided two methods to comply with the new regulations in Revenue Procedure 2015-20. The Small Business exception method allows some businesses to change their accounting method to comply with these regulations without having to file a Form 3115 Change in Accounting Method request or a separate statement in their return. These businesses must have total assets of less than $10MM as of the first day of the tax year which conformity is requested or have average annual gross receipts of $10MM or less for the prior three years.
Businesses qualifying for this exception may apply the regulations prospectively beginning with their 2014 tax year. Therefore, no look back calculation or possible IRC section 481(a) adjustment is required. This method does NOT provide the business with prior year look back audit protection with respect to its compliance to the new regulations. It also does not give the business the ability to take advantage of additional deductions that might exist in prior years. CohnReznick has suggested that its clients include a statement with their 2014 return.
The second method requires the adoption of the final regulations as provided for in Rev. Proc. 2015-13 & 14, filing of IRS Form 3115, and computing a negative/positive IRC. Sec 481(a) adjustment, if applicable. This method is a retroactive application of many of the provisions. The filing of this form provides audit protection for previously expensed items which, under the new regulations, must be capitalized.
Under certain circumstances, businesses may be able to file a Form 3115 with their 2015 tax return to adopt the new regulations. Doing so would still provide audit protection but certain favorable provisions available in 2014 would not apply.
- R&D Tax Credit
The research and development (R&D) tax credit can provide up to a 20% credit for certain qualified expenses incurred for the development of new products, methodologies, procedures or technologies over a certain base amount. The credit expired at the end of 2014. Though the restaurant industry does not typically utilize this credit, there are circumstances where operators may be considered to have incurred qualifying expenditures (i.e. test kitchens, development of new yeast strains or other technology).
- Work Opportunity Tax Credit (WOTC)
The work opportunity tax credit provides a generous credit for the hiring of certain qualified individuals who began work prior to January 1, 2015. To date, this credit has not been extended. WOT- qualified individuals include employees receiving certain government benefits, supplemental social security income, or long-term family assistance, as well as veterans. Advanced certification is required to claim this credit and documentation is needed on or before the day the qualified employee begins work. The WOT is a rolling credit that can provide benefit in years following the year of hire. The Republican extender bill would continue this credit through December 31, 2016.
- FICA Tip Credit
The FICA tip credit is provided to operators based on employee tips that social security has been paid on. Although this credit is not set to expire, it is often overlooked by the restaurant industry.
As stated by Danny Meyer, who recently announced with the elimination of tipping at his full-service restaurants, the loss of the Federal FICA tip credit will cost him approximately $1MM in lost federal credits. We will see if other operators are willing to take a higher moral ground when faced with a similar increase in their income tax bill.
- Small Business Health Care Tax Credit
The Small Business Health Care Tax Credit continues to be available for employers that pay for their employees’ health insurance. This credit has limited applicability to most companies and is phased out if a business has more than 25 full-time equivalent employees.
- Enterprise Zone Credits
State enterprise zones, like federal empowerment zones, provide tax incentives at the state level to businesses that operate in certain qualified areas. Businesses should contact their tax professional to determine if they operate in one of these zones.
- Go-Biz/California Competes Credit
California repealed its Enterprise Zone credit program as of December 31, 2013 and replaced it with the new GO-Biz/ California Competes credit program. The new program is fairly similar to the old program but not as beneficial since it contains a major exclusion impacting the restaurant industry. Certain food services companies do not qualify for this new program unless they meet the small business exception.
The new California Competes tax credit, on the other hand, is an investment based credit available to all companies investing in California. A credit application is submitted by the company and then approved by a state board. Approval is based on the new employees to be hired as well as the investment in property, equipment, and wages to be paid in California.
If you operate your restaurant as an S corporation or LLC, it is important to review your tax basis prior to year-end. You need to ensure that your basis is sufficient to allow for the deduction of any operating losses or tax credits generated in 2015. S corporation basis rules are more restrictive than those for an LLC, so you should confirm that your CPA understands the intricacies of these rules.
Also, the imposition of the 3.8% Medicare Tax on Net Investment Income (NII applies to income from passive activities. You should review the tax characterization of your pass-through activities, if attempting to characterize them as non-passive, to determine if you are meeting the material participation rules.
For many restaurants, gift cards can be a significant part of the business. Understanding and complying with gift card escheat rules is important and each state has different rules regarding gift cards. In California, gift cards never expire so funds are not required to escheat to the state. But if you have operations in states where gift cards expire and escheat rules apply, you might consider setting up a separate gift card entity to minimize or eliminate turning over those funds to the state.
Also, California gift cards with a value under $10 are redeemable for cash if requested by the holder. Failure to comply with this law has subjected many California operators to class action suits from Los Angeles and San Diego law firms.
Affordable Care Act
Implementation of the Affordable Care Act (ACA) provisions were effective in 2015 for employers with 100 or more full time employees but delayed until 2016 for those with 50 or more full-time employees. Most companies have probably already analyzed the impact of these provisions. It is still unknown if the 30 hour per week threshold will be increased to 40 hours or if ACA might be repealed. You should confirm that your payroll processing company will deal with the information reporting requirements imposed by the ACA.
If your company provides Health Reimbursement Arrangements (HRA), the IRS has determined that these arrangements are employer payment plans and considered to be group plans subject to the ACA market reform provisions. Failure to comply with these provisions could subject your company to an excise tax pursuant to IRC Code Sec. 4980D. IRS Notice 2015-17 provides some relief from the excise tax if you are considered a “Qualified Small Employer”, but this exception expired after June 30, 2015.
In 2014, mandatory tips were no longer considered tips for purposes of IRS Form 8027 or Form 8846 FICA tip credit. Moving forward, these monies will need to be treated as wages to the server. As such, they will NOT be eligible for the FICA tip credit even if they are distributed to the server like a normal tip. For a tip not be considered a mandatory service charge, it must be made free from compulsion. Additionally, the customer must have unrestricted right to determine the amount, the payment should not be the subject of negotiation or dictated by employer policy, and the customer typically must have the right to determine who receives the payment.
It is also possible that, similar to California, your state may consider mandatory tips or service charges to be part of the sale of food and subject these amounts to sales tax. If this is the case, you may instead want to provide a suggested tip schedule on the bill and allow the customer to determine the actual tip thus avoiding this provision.
Some restaurants now charge customers “reservation” or “no show” fees. So, are these fees subject to sales tax? An informal letter from the California State Board of Equalization has stated that these fees are not subject to sales tax if the customer does not show up for their reservation. If a customer does use the reservation, the fee is considered to be a part of the transfer of a tangible product (the meal) and subject to sales tax.
California Labor Code Sec. 2810.3, effective in 2015, makes restaurants of certain sizes liable for wage and labor violations when using outside contract employees. Operators should review their outside labor contracts to determine if the agreement has an indemnification provision should they be sued by a contract employee.
EB- 5 Programs
When financing for an expansion exceeds an operator’s cash flow resources, the operator can use “friends and family”, traditional bank lending sources, private equity investments, or other sources to secure the resources it needs. The operator may also consider using an EB-5 program. The EB-5 program is similar to debt financing (i.e. you don’t have to give up ownership or control) but at potentially lower interest rates. EB-5 applicants must make either a $500K or $1MM investment and the restaurant operator must provide at least 10 full-time jobs for qualifying workers over a two period in a qualifying geographic area. There is a rigorous application process and additional transaction costs. However, for some operators this program has appeal.
Year-end Business Review
With taxes and other business costs generally increasing, it is more important than ever for an operator to review all aspects of their operations to assess their financial standing. The end of the year is an ideal time to do this. Some of the components of a year-end business review should include answering a number of key questions about your business such as:
- Price increases- When was the last time one was implemented? Was it across the board or only on specific menu items?
- Flash reports- Data overload can be crippling. However, identifying five or six key metrics (prime cost, average check, table turn) that you should monitor on an ongoing basis can help you identify areas of success as well as those with problems.
- Perfect Check- Have you trained your staff to aim for the” perfect check” (cocktail, appetizer, entrée, side, dinner drink, dessert, coffee)? Do you analyze the average check per server to identify those servers that may require additional training?
- Inventory control- How often do you review your restaurant’s inventory? Who has access to food and beverage? Are the controls in place for inventory ordering? Do you maintain a waste and spoilage report? Have you reviewed your supplier contracts to determine if prices can be negotiated? Does someone check supplier deliveries for weight and quantity?
- Service- Does someone monitor customer complaints and social media posts? Is guest feedback then communicated back to the staff?
- Menu engineering- Have you identified slow moving items and removed from the menu? Have you looked at portion control?
- Technology- Do you utilize staffing and reservation software to minimize your labor hours and maximize table optimization?
With competition coming from new concepts, increasing food and labor costs, and local and federal tax rates on the rise, an operator must do everything possible to maximize the bottom line. Many of the points covered here can provide significant savings without altering the culture of your restaurant. As you prepare to celebrate the holidays with you family, friends, and staff, year-end is the right time to address tax issues and other items that can significantly impact your restaurant in 2016 and beyond.