Tax Court decision could require capitalization of expansion costs.

• Author: Lamont, Greg
• Position: Specialty Restaurant Corp.

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...