Restaurateurs need to understand how the expansion of new locations can cause major cash problems and loss of tax benefits

Although 8 out of every 10 restaurants fail, those restaurants that exceed normally open a second location. The reasons for opening a second location include:
1.The restaurateur has previously successfully grown a restaurant chain. Many of the restaurateurs who I have worked with have successfully been able to obtain as much as 10 times EBITDA for their restaurant chain. For example, Fleming’s Prime Steakhouse was sold to Outback who is now known as Bloom in Brands and Eddie V’s Seafood Bistros sold to the Darden restaurant chain.
2.Other restaurateurs find out how many successful restaurateurs were able to sell their restaurant chain for.
3.Other restaurateurs want to increase their income and they believe that they can make more money investing in themselves then in the stock market.

The problem is that most Restaurant CPAs do not understand that taxation of restaurants is much different than other industry taxation!

The CPA who specializes in helping restaurateurs is alert to a cash flow problem that will occur when the LLCs that own the new locations have different LLC partners with different ownership percentages than the previous LLCs.

Why is this problem?

When a restaurant chain is owned 100% by one S corporation and the new restaurants are the same identical restaurant brand, 100% of the startup or what are called preopening costs are deductible as the expenses are incurred.

But when the restaurant concept is different or more likely when the ownership is different in each restaurant with the same concept, the IRS would argue that the startup or preopening costs need to be spread over 180 months.

Why is this problem?

It is a problem because most restaurant chains that expand, get the money to expand from taxable income from the current restaurants but only get pennies on the dollar in tax benefits when the start up or preopening costs are written off over 180 months.

Here is an example:

ABC restaurant chain has a successful restaurant located at Scottsdale Fashion Square. The restaurant is owned by ABC Fashion Square 1, LLC. The restaurant distributes cash to members of $400,000. The members are taxed on the profits of the LLC that happen to be $340,000 for 2013. If these members are in the 45% tax bracket due to the new tax act, the members will have to pay $153,000 in income taxes in April 2014. However in December 2013, ABC Paradise Valley 2, LLC. Opens after startup costs of $180,000. If because of significantly different ownership in #2 then #1, the tax CPA prepares the tax returns for #2 with $180,000 startup costs as an asset, the members will only get tax deductions of just $10,000, not $180,000.

Should ABC restaurant chain open a 3rd location with significantly different membership ownership percentages as #1 and #2 on January 2, 2014 with startup or preopening costs of $180,000, the members will have spent $360,000 out of the $400,000 they received from #1 on #2 and #3 start up or preopening costs and then have to liquidate other investments to pay the income tax $153,000 by April 15, 2014.

Cash inflows from #1 distribution $400,000
Cash outflows on #2 and #3 start up and preopening costs- $360,000
Tax savings on #2 of 45% of $18,000=+$8,100
Cash remaining to pay $153,000 income tax on taxable income of #1=$48,100
Tax to be paid on 4-15-14=-$153,000
Negative cash flow due to expansion and start up/preopening rules= -$104,900

Internal revenue code Sec. 195 does give some small businesses a very small amount of relief.

However, although taxpayers may currently deduct up to $5,000 in start-up costs, the $5,000 limitation is reduced dollar for dollar (but not below zero) by the amount of the taxpayer’s start-up costs that exceed $50,000. As you can see most restaurateurs have to spend much more than $50,000 in startup or preopening costs. The bad news is that the remainder of the taxpayer’s start-up costs are amortizable over 180 months (15 years) beginning with the month in which the taxpayer begins an active trade or business [IRC Sec. 195(b)(1)].

What do start up or preopening costs include?

Expenses included before the opening date of the restaurants including:
A.Recruitment of employees, of new employees, expenses and relocation expenses for current employees or new employees from competitors
D.Site location, market and feasibility studies,
E.Pre-opening advertising and promotion expenses, standby commitment fees, etc.

Marketing expenses and the costs of training employees are deductible under IRC Sec. 162 if the taxpayer is already engaged in a trade or business. But if such expenses are incurred before business begins, the Section 195 start-up expense rules apply. However, IRC Sec. 195 does not apply to interest and taxes that are deductible under IRC Secs. 195163 and 164 without regard to whether the taxpayer is engaged in an active trade or business [IRC Sec. 195(c)(1)].

For example: ABC restaurants, Inc. owns 100% of ABC #1 and #2. ABC restaurants have the same menu, the same physical plant and systems. #2 startup/preopening expenses can be written off immediately. #2 startup/preopening costs do not have to be written off over the 180 months.

When is the startup period over?

Generally, the taxpayer must be in a position to begin earning revenue from the trade or business for the start-up period to end.

Let us use an example:
XYZ’s ownership:

#1, LLC John Doe 100%
#2, LLC. John Doe’s corporation: Doe Enterprises, Inc. 65%
Jack and Jill Fell 20%
#3 Philips construction company, Inc. 15%

XYZ #2 should probably not expense the startup costs when opened but write off the startup costs over 180 months.

Since the start-up period relates to a particular trade or business, a business that has multiple trade or business activities may also have multiple start-up periods. As a result, a business that has been in existence for many years may be subject to IRC Sec. 195 for start-up expenses associated with a new business activity. Although regulations defining a separate line of business have not been issued, the IRS has ruled that establishing a similar business in a separate legal entity can result in the creation of a new trade or business (Ltr. Rul. 8423005).

The Briarcliff Candy Corp is a good case to review to understand when startup/preopening costs should be written off.

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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