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Food Industry Overview - Significant Law and Important Issues

LMSB-04-0207-018

"This document is not an official pronouncement of the law or the position of the Service and cannot be used, or cited, or relied upon as such."

9. Significant Law and Important Issues

A.    Coordinated Issues

Issue

Brief Summary of Issue

Package Design Costs

Food and beverage companies incur significant costs in developing package designs for their products.  Package design costs are costs incurred to develop the shape, size, graphics, etc. on a product package.  The Internal Revenue Service has issued guidance in the form of a coordinated issue paper and several Revenue Procedures (Revenue Procedures 90-63, 97-35, 97-37, 98-39) and Revenue Ruling 89-23 stating that these costs are capital in nature and depending upon the election a taxpayer makes, are recoverable over four or five years.

The issue was litigated (RJR Nabisco, Inc., et al., v. Commissioner. T.C. Memo. 1998-252). The taxpayer convinced the court that package design costs are merely a form of advertising (point of purchase advertising), and as such are currently deductible.  The Internal Revenue Service argued that although there are some advertising characteristics present, the fact that there is a long term benefit dictates that these costs are capital in nature and therefore must be capitalized.

Note: This issue has been recommended for de-coordination.  The reason for the de-coordination is based on the December 22, 2003 release of the final regulations on capitalization of intangibles (Treas. Reg. § 1.263(a)-4).  The final regulations provide that an amount paid to create a package design, computer software or an income stream from the performance of services under a contract is not treated as an amount that creates a separate and distinct intangible asset. 

Charitable Contributions of Food Inventory

IRC Section 170(e)(3) allows an enhanced deduction for qualifying contributions of food inventory.  Basically this deduction is equal to the basis of the property contributed plus one half of the appreciation, not to exceed twice the basis.  This amount would be treated as a contribution and cost of goods sold would be reduced by the basis of the property contributed. 

The Congressional intent of this code section is to encourage charitable contributions of excess inventory.  Some of the problems encountered during examinations are as follows:

-Taxpayer took enhanced deduction but did not reduce cost of goods sold by the basis of the property.

-Contribution made to an organization that is not a qualifying organization.

-Fair market value (this is the area where most disputes between the taxpayer and the revenue agent occur).

Settlement guidelines have been developed.

Investment Credit on Refrigerated Structures

Although investment tax credit no longer exists, the definition of Section 38 property is used to help make determinations about the characterization of property as either Section 1245 or Section 1250 property.  This coordinated issue paper discusses whether or not investment tax credit is allowed for refrigerated structures.  The coordinated issue paper is a summary of relevant Revenue Rulings and Letter Rulings discussing various fact patterns.

Settlement guidelines have been developed.

B.  Emerging or Other Significant Issues

Issue

Brief Summary of Issue

Depreciable Life of a Restaurant’s Smallwares Asset Account and Treatment of Replacements

When a full service restaurant opens a location, they will purchase $40,000 to $70,000 worth of smallwares (glassware, china, silverware, linen and small kitchen tools).  An issue had been identified relating to the recovery period of these assets and how to treat the replacement costs of these items.  This issue was considered under the new Industry Issue Resolution (IIR) program.  On January 7, 2002, the Service issued guidance (Rev. Proc. 2002-12) on a safe harbor method of accounting for the cost of smallwares.   The IRS will now allow for the cost of certain smallwares as current year deductible expenses.  For more information see:    http://www.irs.gov/pub/irs-drop/rp-02-12.pdf

Gift Cards/Certificates Deferral of Income

The Food & Beverage TA has observed inconsistent tax accounting treatment for gift cards/certificates involving both revenue and expense recognition.  This is a Tier II issue and an IDD will be issued in 2007.

Losses Incurred When a Restaurant is Closed

Is a taxpayer entitled to deduct the difference between the adjusted basis of the property and its appraised value when a location is closed but not disposed of?  In the restaurant industry approximately 80 percent of all new restaurants go out of business within 2-3 years.  Conversely, franchised restaurants and national chain restaurants have an 80-90 percent success rate.  Some taxpayers are taking the position that when the building is owned, they are entitled to a loss in the form of added depreciation equal to the difference between the adjusted basis and the appraised value of the building, when a decision is made to close an unprofitable location.  Members of the National Restaurant Association have been working with the Food TA to determine what the correct tax position is, given this fact pattern.   The Food TA has taken the position that a loss on the Section 1250 property is not allowed until an actual disposition (sale or abandonment) has occurred.  The mere closing of the store is not an actual disposition. 

Treatment of Upfront Payments to Restaurant Owners From Suppliers under Supplier Agreements

It is common in the restaurant industry for suppliers to enter into supplier arrangements with restaurants; typically these arrangements extend beyond the taxable year.  For example, suppose that Supplier A enters into an agreement with a restaurant chain to supply soft drink concentrate.  The contract states that the supplier will advance $5,000,000 to the restaurant chain immediately and in return the restaurant chain agrees to purchase all of its soft drinks from Supplier A for the next five years.  Technical Advice Memorandum 9719005 discusses the treatment of upfront payments received under supplier agreements and states that upfront payments are income upon receipt.  Many taxpayers will recognize this income ratably over the life of the contract.      

Some taxpayers are treating the upfront payments as loans.  The IRS does not agree with that treatment.

Several court cases discuss the issue including:

  • Westpac Pac. Food v. Commissioner, 2006 U.S. App. Lexis 15160 (9th Cir., June 21, 2006)
  • Karns Prime & Fancy Foods Ltd. v. Commissioner, T.C. Memo 2005-233 Colombo v. Commissioner, T.C. Memo 1975-162
  • Erickson Post Acquisition, Inc. v. Commissioner, T.C. Memo 2003-218

Contact the Technical Advisor if you have questions in this area.                     

C.  Recent or Pending Legislation

Effective Date

Title

Summary and Impact of Legislation

2006 & 2007

H.R. 990 &

S. 37  Good Samaritan Hunger Relief Tax Incentive Act

The Pension Protection Act of 2006 expands the enhanced deduction available for food contributions now contained in section 170(e)(3) to all taxpayers (currently enhanced deduction only applies to C Corps).  The provisions expire on 12-31-2007

Pending

H.R. 2 Minimum Wage/Small Business Tax Package

The American Jobs Creation Act of 2004 established that restaurants could depreciate qualified restaurant building improvement costs over 15 years through the end of 2005. The Tax Relief and Health Care Act of 2006 extended the existing improvement provision for costs incurred through the end of 2007. The Minimum Wage/Small Business Tax Relief bill (H.R. 2) that passed the Senate on February 1, 2007 contains two provisions which would extend the improvement piece through March 31, 2008 and add new construction depreciation from the date of enactment through March 31, 2008 as well.

Pending

S. 419; H.R. 920 Restaurant Depreciation

Recently, bill were introduced to enact a permanent 15-year depreciation schedule for restaurant building improvements and new construction.

Pending

H.R. 2 Minimum Wage/Small Business Tax Package

As part of the Tax Relief and Health Care Act of 2006, WOTC and the Welfare-to-Work tax credit were each extended through 2006, and then combined through 2007. In addition, the bill extended the paperwork filing deadline from 21 days to 28 days. The Minimum Wage/Small Business Tax Relief bill (H.R. 2) that passed the Senate on February 1, 2007 contains a five year extension of WOTC through 2012.

D.  Specific Industry Related Tax Law

Effective Date

Code Section

Summary and Impact of Law

Current

Section 170(e)(3)

Allows C Corporations an enhanced deduction for qualified contributions of food inventory to qualified organizations.

10/22/04 to 12-31-07

168(e)(3)(E)

15 year deprecation for “qualified leasehold improvement property” and “qualified restaurant property.” 

1-1-05

199(c)(4)(B)

Congress generally excluded the restaurant industry from the scope of § 199, Domestic Production Deduction, by including this phrase as an excluded activity:  “The sale of food or beverages prepared by the taxpayer at a retail establishment.” 

E.  Important Revenue Rulings or Revenue Procedures

Effective Date

Title and Number

Summary and Impact of Ruling and Procedure

Retroactive

Revenue Ruling 92-80

States that INDOPCO does not affect the deductibility of advertising.  The ruling further states that advertising must be capitalized in the unusual circumstances where it is directed towards obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or with institutional or goodwill advertising.

1983

Revenue Ruling    85-8

Ruling discusses the amount of a taxpayer’s charitable contribution deduction under various circumstances.  Supersedes Revenue Ruling 83-29.

Retroactive

Revenue Ruling    98-39

Ruling discusses year end accruals relating to outstanding liability a manufacturer has under cooperative advertising arrangements with retailers, specifically the ruling states that the fact of liability is established when a retailer conducts qualified advertising vs. when a claim for reimbursement is received from the retailer.  Revenue Ruling 98-39 was the desirable method of announcing that the Service has changed its position on the issues addressed in TAM’s, 9320001, 9343006, 9204003 and 9416004.

2002

Revenue Procedure 2002-12

On January 7, 2002, the Service issued guidance (Rev. Proc. 2002-12) on a safe harbor method of accounting for the cost of smallwares.   The IRS will now allow for the cost of certain smallwares as current year deductible expenses.

2003

Revenue Ruling  2003-112

This provides guidance on whether an individual meets the family membership requirements permitting certification for the WOTC and WTW tax credits.  Many taxpayers are filing claims using the revenue ruling as justification.  The service position is that the only amounts claimed that have state certificates are allowable.  See IRS Announcement 2006-49:  http://www.irs.gov/irb/2006-29_IRB/ar12.html

2004

Revenue Procedure 2004-34

This revenue procedure allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of certain advance payments to the extent the advance payments are not recognized in revenues (or, in certain cases, are not earned) in the taxable year of receipt.

See full Rev. Proc. at:http://www.irs.gov/irb/2004-22_IRB/ar16.html

F.  Important Court Cases

Date Opinion Issued

Name of Court Case and Citation

Summary of Importance of Court Case

1995

Lucky Stores, Inc. and Subs v. Commissioner 105 T.C. 480 (1995)

Adverse decision relating to the valuation of bread contributed to charitable organization.  No appeal was taken due to the factual nature of the case.  Many taxpayers will cite this as authority for their valuation of contributed inventory.  Unless the fact pattern is similar to the facts in the case, the decision will not be relevant.

1998

RJR Nabisco, Inc., et al., v. Commissioner, T.C. Memo 1998-252

Adverse decision relating to package design costs.  Decision states that package design costs are a form of advertising and as such are currently deductible.  Action on Decision issued recommending nonacquiescence.

1990

Jefferson Pilot Corp. v. Comm.  98 T.C. 435 (1992), affd. 995 F2d 530 (4th Cir. 1993)

The court determined that a license is a franchise as defined in IRC Section 1253(b)(1).  The Courts looked to the legislative history of IRC Section 1253 and found that it does not limit the application of IRC Section 1253 to private commercial franchises.  This has resulted in taxpayers filing Forms 3115 to change their method of accounting for the cost of liquor licenses.  Previously the Service’s position was that a liquor license had an indeterminate life and therefore costs were not recoverable through depreciation or amortization.  As a result of this decision, taxpayers can amortize the cost of their liquor license. See also

Tele-Communications Inc. (TCI) v. Comm. 95 T.C. 495 (1990)

Affd. 12F 3d 1005 (10th Cir. 1993)

1990

Fox Photo, T.C. Memo 1900-348

This decision allowed a small structure to be treated as 5-year property for depreciation purposes.

2001

WestPac Pacific Foods, et. Al. V. Commissioner, T.C. Memo 2001-175

The Tax Court has held that a partnership that distributed goods to related grocery chains wasn’t entitled to defer recognition of upfront cash payments as income from various manufacturers beyond the year of receipt.

Caution see appeal below

2005

Karns Prime & Fancy Foods Ltd. v. Commissioner, T.C. Memo 2005-233

The Tax Court held that the $1.5 million from the retailer’s principal supplier under a supply agreement was income, not a loan, because the company was under no unconditional obligation to repay and because it had some guarantee that it could keep a portion of the funds.

2006

Westpac Pac. Food v. Commissioner, 2006 U.S. App. Lexis 15160 (9th Cir., June 21, 2006).

The 9th Circuit, reversing the Tax Court, held that cash advances a wholesaler made to a retailer for volume commitments were not income when received because the advances were similar to a loan, which is not an "accession to wealth." The 9th Circuit found the advances were made solely in consideration of Westpac’s purchase commitment, and thus, were advances given in lieu of periodic volume discounts.  Note: To the extent a taxpayer is outside the 9th Circuit Court of Appeal’s jurisdiction, the Tax Court’s Westpac decision, supporting the IRS position, remains the law.

G.  Technical Advice Memorandums - Field Service Advices

PLRs AND TAMs ARE ADDRESSED ONLY TO THE TAXPAYERS WHO  REQUESTED THEM.  FSAs ARE NOT BINDING ON EXAMINATION OR  APPEALS, NOR ARE THEY FINAL DETERMINATIONS.  FURTHERMORE,  SECTION 6110(k)(3) PROVIDES THAT PLRs, TAMs, AND FSAs MAY NOT  BE USED OR CITED AS PRECEDENT.

 

Number

Description

November 26, 2001

FSA 200147035

Concludes that graphic and/or package design costs are distinguishable from business advertising costs either because the benefits associated with advertising costs do not extend beyond the tax year or because these costs are recurring in nature.  Similarly, we must acknowledge the treatment or short-term promotional designs as advertising rather than package design.  Therefore, graphic and package design costs should generally be capitalized.

June 12, 1995

LTR 9522001

Discussion on whether food products development activities may qualify for research credit.

May 4, 1998

LTR-9834003

Concludes that promotional funds advanced to food brokers from manufacturers are income to the broker under certain circumstances.

May 12, 1998

LTR 9719005

Payments a purchaser receives from manufacturers in exchange for entering into supplier agreements are income upon receipt v. being reported over the life of the contract.

 

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Page Last Reviewed or Updated: 05-Mar-2014