Selections Newsletter - Winter 2016

December 2016


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Table of Contents

R&D for IPAs: Tax Breaks for Brewpubs
Variable Interest Entities – Guidance on ASU 2015‑02
Nine Questions Brewery Owners Should Ask Their CPAs
Proposed Regulations May Limit Discounts on Family Transfers – Guidance on IRS Section 2704
2016 Year in Review: Tax Planning for Restaurants

R&D for IPAs: Tax Breaks for Brewpubs

By Dirk Ahlbeck, Chris Bard, Chai Hoang

Over the past few years, it has become clear that craft beer is trending in the fast casual scene. While most fast casuals are stocking and selling, brewing their own beer is just around the corner. Owning and operating a brewery can be an expensive business, from the cost of maintenance and ingredients for brewing the beer, to employee compensation and everything in between. But a successful brewpub is well worth the cost: Not only are breweries significant for the restaurant industry, they are also stimulants for the agricultural and tourism industries, so many stand to benefit from their continued prosperity.

What can fast casuals brewing their own beer do to help keep their costs in check and the lights on? One often-overlooked option is taking advantage of the broad array of state, local and federal incentives available to businesses of all sizes for their investments to develop new or improved products and processes. For instance, many business owners may not realize that they needn’t be a high-tech business to qualify for state and federal R&D tax credits. In fact, a wide swath of activities are eligible for these credits, not just groundbreaking discoveries, but also activities to incrementally improve products and processes. Even failed attempts can qualify. In fact, they’re even more likely to qualify.

Picture this: A local watering hole just opened in Far Rockaway, N.Y., and is already loved by New Yorkers old and young. This establishment brews and sells a large craft beer selection on site in addition to quick and tasty bites, allowing customers to enjoy both in-house and at home. The employees are continuously attempting to develop new hopping techniques and fermentation processes and have recently explored the idea of opening a separate bottling facility. As a registered distributor, this restaurant would be entitled to several tax credits and incentives.

At the federal level, helpful resources like the U.S. Small Business Administration (SBA) encourage innovation and healthy businesses. Through the SBA, several incentives for small businesses are funded, including one that is particularly relevant to brewers, the Small Business Innovative Research Grant Program (SBIR). This program helps to fund R&D through contracts and grants, awarding nearly $2.5 billion annually.

Brewers would also be remiss if they didn’t consider the opportunities that came with the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015. As a part of the PATH Act, many small businesses have a new opportunity to reduce their taxes, namely by offsetting their Alternative Minimum Tax (AMT) with R&D tax credits. In addition, some startup businesses can elect to take up to $250,000 in credits against their portion of payroll taxes (FICA) annually for up to five years. This allows companies to monetize credits where they previously could not due to a lack of federal income tax liability.

Several state and local incentives are available to the brewpub, as well. As a new business in the state, the brewery should consider the START-UP NY program, which offers companies tax incentives for up to 10 years. Tax credits for this program encompass many taxes, including license and maintenance fees, sales and use tax, real estate/real property transfer tax and personal income taxes for New York state, New York City and Yonkers. For some, this program means no taxes at all. In addition, New York State offers exemptions that eliminate sales taxes on purchases of production machinery and equipment, property used for R&D purposes or fuels/utilities used in manufacturing and R&D.

Also available is the alcoholic beverage production credit, which is applicable for tax years beginning on or after Jan. 1, 2016. This credit is equal to 14 cents per gallon for the first 500,000 gallons of beer, cider, wine or liquor produced in New York state in a tax year, plus 4.5 cents per gallon for each additional gallon over 500,000 (up to 15 million additional gallons for beer, cider and wine, and up to 300,000 additional gallons for liquor) produced in New York state in the same tax year.

New York is hardly the only state to make major investments to attract startups and small businesses— states and municipalities nationwide offer a variety of tax credits and incentives to complement those provided at the federal level. Given their ready availability, these incentives should be a critical part of the planning process for anyone thinking about opening a new brewpub, expanding into a new market or adding a brewing component to their existing restaurant. Businesses are encouraged to consult their tax advisor and reach out to their local SBA office or state and local economic development agencies to determine which incentives will yield the greatest benefit.
Dirk Ahlbeck is a tax partner in BDO’s Restaurant practice. He can be reached at [email protected].

Chris Bard is the practice leader for BDO’s Specialized Tax Services Research and Development practice. He can be reached at [email protected].

Chai Hoang is a manager in BDO’s Specialized Tax Services Research and Development practice. She can be reached at [email protected]

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Variable Interest Entities – Guidance on ASU 2015‑02

By Giselle El Biri

The variable interest entity (VIE) rules continue to be a hot topic for restaurants. Many times, a restaurant may set up separate legal entities for various purposes, such as a real estate entity that owns the restaurant facility or a separate entity to operate a commissary. These organizational structures are typically driven by a potential positive tax outcome. However, under the VIE rules, the separate entities may be required to consolidate. These rules address situations in which an entity is structured in such a way that normal voting interest consolidation concepts may be ineffective in determining which party has a controlling financial interest. In other words, there are times when a controlling financial interest is achieved through an arrangement that may not depend on the voting rights of equity holders. 

Once a company has determined that none of the scope exceptions are applicable, analyzing whether an entity must be consolidated under the VIE guidance typically involves answering the following three questions: 

1. Does the company hold a variable interest in the entity?
2. Is the entity a VIE?
3. Is the company the primary beneficiary of the VIE? 

Early last year, the FASB issued ASU 2015-02, Amendments to the Consolidation Analysis, revising the VIE guidance, impacting each of the above questions. Over the course of two blog posts, we will explore each of these questions in more detail to illustrate how your restaurant business may be affected.

Does the company hold a variable interest in the entity? 

Some arrangements may obviously constitute variable interests, such as if the reporting entity holds an equity or debt interest in the entity, or if there are any guarantees exposing the reporting entity to risk of loss.  However, other situations may not be as obvious.  For example, licensing or royalty arrangements or management fee contracts may also be considered variable interests.

ASU 2015-02 specifically addresses management and similar fees, providing three criteria to assess in determining whether these types of arrangements have a variable interest:
a) The fees represent compensation for services provided and are commensurate with the level of effort required to provide those services.
b) The decision maker or service provider does not hold other interests in the VIE that individually or collectively would absorb a significant amount of expected losses or residual returns.
c) The service arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services negotiated at arm’s length.

If all three criteria are met, then the fee is not a variable interest.  If not, the fee must be included when determining whether the company receiving the fee is the primary beneficiary or not.

Is the entity a VIE? 

Under the VIE guidance, an entity is a variable interest entity if either of the following are true: 1) The entity’s total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support; or 2) As a group, the holders of the equity at risk lack the power to direct the activities of the entity that most significantly impact its economic performance; the obligation to absorb the expected losses of the entity ; and the right to receive the expected residual returns of the entity.

The equity investors as a group also lack power if both:
  1. The voting rights of some equity investors are not proportional to their obligations to absorb the expected losses of the entity or their right to receive the expected residual returns; and
  2. Substantially all of the entity’s activities involve or are conducted on behalf of an investor that has disproportionately few voting rights.

ASU 2015-02 clarified this guidance by providing additional factors to consider when determining whether the equity investors as a group lack power.  Those factors are different depending on whether the entity in question is a limited partnership or not.

Limited partnerships and similar legal entities (LPs)

The provisions of ASU 2015-02 eliminate the presumption that the general partner consolidates an LP.  There is now a two-step process in determining whether the partners of the LP, as a group, have the power to direct its activities.  This test includes analyzing whether there are substantive kick-out rights or significant participating rights.  For example, are the limited partners involved in the daily operations of the company? Is it “majority rules” if the limited partners agree to kick out the general partner?  In addition, in certain instances, liquidation rights may be considered the same as kick-out rights.  If the entity lacks both of these conditions, then the LP is a variable interest entity, and the company must consider the next question—whether it is the primary beneficiary of the LP—by analyzing its power to direct the LP’s activities and economic performance.

Entities other than LPs

Entities other than LPs, such as corporations, are analyzed similarly to LPs.  Do the equity holders collectively have rights to effectively direct activities that most significantly impact economic performance?  Does a single equity holder bear all of the risk or hold kick-out or participating rights over the decision maker?  If the answer to both these questions is no, then the entity is a VIE.

Is the company the primary beneficiary of the VIE?

The primary beneficiary is the entity that has both the power to direct the activities of the VIE that are most significant, and the obligation to absorb losses or the right to receive benefits that could be significant to the VIE.  When assessing whether a company is the primary beneficiary of a VIE, it must also consider the variable interests its related parties hold.

ASU 2015-02 also addresses how to include interests related parties hold when performing the primary beneficiary analysis.  Under this provision, how the reporting entity includes an interest a related party holds is based on whether the two entities are under common control or not. 

If the entities are not under common control, then the indirect interests the related party holds are included on a proportionate basis.  For example, if a company holds a 40 percent interest in another entity, and that second entity holds a 20 percent interest in the VIE, then the company holds an 8 percent indirect interest in the VIE. Conversely, indirect interests held through related parties that are under common control with the decision maker are considered the equivalent of direct interests in their entirety.  In this example, the company would hold the full 20 percent interest in the VIE that its equity method investee holds.

In addition, ASU 2015-02 indicates that if no single entity within a related party group holds both the power and economics related to the VIE, then a related party tie-breaker test should be performed to identify the primary beneficiary. In this instance, the party most closely associated with the VIE will consolidate it.

The effective date of ASU 2015-02 for public entities is for fiscal years beginning after Dec. 15, 2015, while it is effective for fiscal years beginning after Dec. 15, 2016, for all other entities.  Early adoption is permitted. Upon adoption, all existing variable interest relationships must be reassessed, and any changes to consolidation must be applied on either a modified retrospective basis, through a cumulative-effect adjustment or retrospectively to all periods presented. 

Giselle El Biri is an audit director in BDO’s Restaurant Practice. She can be reached at [email protected]

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Nine Questions Brewery Owners Should Ask Their CPAs

By Dirk Ahlbeck

Do you own a brewery and have a question that you think may be outside of your CPA’s scope of knowledge? Do yourself a favor and just ask! From research and development (R&D) to trademarking advice, your CPA can provide insights into some tricky financial scenarios and help your business improve cash flow while finding savings.

1. Why does inventory matter when I compute my beer ingredient costs, or Cost of Goods Sold (COGS)? What comprises COGS? 
There are a variety of reasons inventory matters when computing beer costs, particularly for your financial reporting. If your inventory is incorrect, it can affect the accuracy of your costs. For example, if you count inventory once per month, your monthly purchases or products used may not be factored in, misrepresenting actual inventory levels and, therefore, cost of sales. At the end of the month, brewers must make an adjustment to the actual physical inventory, which will affect COGS in the income statement. An alternative would be to keep a perpetual inventory system that records the sale or purchase of inventory with immediate reporting of the amount of inventory in stock, and accurately reflect the level of goods on hand.

COGS consists of all costs required to produce your product, including ingredients (malt, barley and hops), freight-in and freight-out for self-distributors, packaging (including keg leasing), excise taxes, labor and supplies. 

2. How can I help offset the cost of my brewery equipment while enhancing the space my brewery occupies?
It’s important to understand which tax laws—federal, state and local—are favorable to your business, in addition to applicable IRS codes. Are you eligible for Section 179, a part of the IRS tax code that allows a business to deduct the full purchase price of financed equipment and off-the-shelf software? Also, have you considered de minimis safe harbor election? Businesses can apply a de minimis safe harbor to amounts paid to acquire equipment in some circumstances.

Other options include bonus depreciation, an additional depreciation allowance, which is currently 50 percent of the cost in addition to regular depreciation and can be taken regardless of income or loss.  You can also carry major losses forward to future years to take advantage of deductions over a longer period of time. Your CPA should be able to assist you with understanding what makes the most sense for your business from a tax planning perspective.

3. How do I generate current cash from past investments?
Breweries, like any other business, are eligible for a variety of tax credits and incentives that could help put cash back in their pockets. Chief among these incentives is the federal research and development (R&D) tax credit, which breweries can apply to myriad activities, including developing new or improved wastewater management techniques, ingredient mixing methodologies and experimenting with product mixtures to create new aromas or flavors, among others.

In addition to the R&D credit, brewers may capitalize on the domestic production activities deduction (DPAD), allowing a deduction from net income based on qualified production activities, and the Federal Insurance Contributions Act (FICA) tip credit. The FICA tip credit allows brewery owners to get a credit for part of the taxes paid on their employees’ gratuity when it exceeds the federal and state minimum wage thresholds. The aim of this tip credit is to incentivize employers to report tipping as accurately as possible, resulting in more revenue from the tax credit once returns are filed. Additionally, on a local level, breweries can take advantage of manufacturing as well as sales and use tax incentives specific to the area in which they are producing craft beers.

Confirm with your CPA the credits (if any) for which you may qualify. Typically, beneficial credits exist for both small and large breweries, and every business should be able to apply some credit computation annually.

4. What is the best structure to save on taxes in the long run and set me up for success in the future?
You have several options for structuring your business for maximum tax benefit. The first is the management company structure, in which owners set up a separate C or S corporation to manage payroll and similar management activities. This structure is ideal for companies operating LLCs with owners subject to self-employment tax.

Another option is a holding company structure, which is simpler and less expensive in terms of accounting and tax costs. This is ideal for having several single-member LLCs and offers deductions for startups and pre-opening expenses.

5. Should I incorporate my brewery as an LLC as opposed to an S Corp or C Corp?
LLCs offer a degree of flexibility that may make them highly attractive to brewery owners. For example, they allow for an unlimited number of members (including non-U.S. residents and citizens), flexibility of distributions, an unlimited number of subsidiaries as well as less paperwork and ease in setting up. However, LLCs do entail some drawbacks, such as more restrictions surrounding transfers of units, the possibility of dissolution if a member leaves the LLC, and differing operating rules from state to state.

Your CPA can help you identify whether an LLC makes sense for your business and, perhaps more importantly, can help you establish an operating agreement and other formalities (that are not mandated by the LLC structure) to help protect your business.

6. How can I expense the cost of the building housing my brewery faster than I am using it?
You have a couple of different options available to you, both of which your CPA can discuss. First, you could purchase the building and perform a cost segregation study, which may allow you to shorten the depreciation time on the asset from the 39 years the IRS typically assigns to non-residential property.
You could also pursue a fixed asset review, which allows you to identify where you have the opportunity to reclassify assets for swifter depreciation.

7. How can I compare my financial numbers to other brewpubs and breweries?
It can be difficult to make an apples-to-apples comparison between yourself and a competitor, as a number of different metrics can be used to measure success. Your CPA can help you split your revenue streams into separate profit centers to help you get a better picture of how your business is performing. You’ll need to understand what portion of your revenues are derived from first- and third-party distribution, retail and restaurant operations. As you’re assessing each unit’s performance, you should use consistent baseline metrics to ensure you can accurately compare results (e.g., you should measure the amount of revenue derived from beer sales across each profit line in the same units—per gallon, per barrel, etc.).

From there, you can begin to look at how your performance stacks up against the competition. This will allow you to understand how your retail sales, for instance, may compare to that of a microbrewery without brewpub operations, or your restaurant operations to a gastropub that doesn’t brew its own beer.

8. What pitfalls might I encounter as I create federal, state and city excise tax returns?
The most important point to keep in mind when filing excise tax returns are that each jurisdiction has different filing requirements. For example, some jurisdictions may require paper filings rather than digital, which could impact your overall timeline. In addition, some filing areas may be more burdensome and time consuming than others. For example, if you’re filing in Illinois, its RL-26-R requires that you report every resale customer and how much you sold, as well as that customer’s state and account number. Failing to collect all of this information from the start can cause delays in reporting and missed deadlines. An experienced CPA can help you get all of your ducks in a row well in advance, helping to ensure compliance and avoid penalties.

9. Is trademarking my name and brand worth the expense, even if my brewery is small?
Yes! Doing so will make you distinguishable from other craft brewers, especially if you cover your brewery name, logo and core brands. While you will want to consult with a qualified legal expert to develop your trademark, your CPA can help you identify opportunities to write off expenses related to the trademark depending on the circumstances, making this a valuable conversation in which to include your CPA.

Dirk Ahlbeck is a tax partner in BDO’s Restaurant practice. He can be reached at [email protected].

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Proposed Regulations May Limit Discounts on Family Transfers – Guidance on IRS Section 2704

By Dr. Tami Bolder

Time may be running out for restaurant owners to take discounts on transfers to family members. On Aug. 2, 2016, the Department of the Treasury issued proposed regulations under IRC Section 2704 in response to perceived abuses in the use of valuation discounts. Currently, owners transferring non-controlling interests in privately held companies are able to consider discounts for lack of control and discounts for lack of marketability. Discounts for lack of control relate to the inability of non-controlling interest holders to impact the strategic direction of the entity. Discounts for lack of marketability account for the lack of a ready market to sell privately held interests.

The provisions of the IRS 2704 proposed regulations that may have the most impact on restaurant owners seeking to transfer wealth to family members include:

Transfers Within Three Years of Death

Under Section 2704(a) of the proposed regulations, if a transfer resulting in a restriction or elimination of a liquidation right occurs within three years of the transferor’s death, the transfer is treated as if it occurred at death. The effect of this three-year rule is that the transferred interest would be included in the transferor’s gross estate at liquidation value.

Applicable Restrictions

Applicable restrictions will not be considered when valuing interests transferred to family members under Section 2704-2 of the proposed regulations unless certain requirements are met. Section 2704-2 defines an applicable restriction as “a restriction that limits the ability to liquidate the entity if the limitation lapses or the liquidation right may be removed by the transferor or the transferor’s family.”  Applicable restrictions include restrictions on withdrawal rights and other restrictions on liquidation rights imposed under the terms of the entity’s governing documents and under local laws. Exceptions include:
  • Commercially reasonable restrictions on liquidation rights considered compulsory by an unrelated person providing capital to the entity.
  • Restrictions imposed by federal or state law (but only under certain conditions).
  • Each holder of an interest must hold a “put right,” which allows them to receive cash or property (not including notes unless certain conditions are met) at “Minimum Value” (defined as the interest’s share of the net value of the entity on the date of liquidation or redemption) within six months of the notice of the intent to withdraw.

Disregarded Restrictions

Under Section 2704-3 of the proposed regulations, when valuing transferred interests to a family member where the transferor’s family controlled the entity (meaning holding at least 50 percent of either the capital or profits interests) immediately before the transfer, applicable restrictions limiting the ability to liquidate the transferred interest will not be considered in the value of the transferred interest. Section 2704-3 states that, “disregarded restrictions includes one that (a) limits the ability of the holder of the interest to liquidate the interest; (b) limits the liquidation proceeds to an amount that is less than a minimum value; (c) defers the payment of the liquidation proceeds for more than six months; or (d) permits the payment of the liquidation proceeds in any manner other than in cash or other property, other than certain notes.”

While transferring ownership to a nonfamily member may seem like a viable option to avoid the control provision, the proposed regulations stipulate that interests transferred to non-family members are to be disregarded unless certain stringent requirements (including a holding period of at least three years prior to the transfer) are met as outlined in Section 2704-3.

If an applicable restriction is disregarded, the inability to liquidate and, thus, a discount for lack of marketability, is not considered in valuing the transferred interest, resulting in a higher value.

The IRS has a public hearing scheduled for Dec. 1, 2016, to discuss the proposed regulations.  If the regulations become final on or shortly after Dec. 1, 2016, the effective date would be 30 days after being finalized. Given this timing, the limits on taking valuation discounts for owners transferring wealth to family members may be in place shortly after the end of the year. Restaurant owners considering transferring an interest to a family member may want to act as soon as possible before the law changes.

Dr. Tami Bolder is a senior manager in BDO Consulting’s Valuation and Business Analytics practice. She can be reached at [email protected]

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2016 Year in Review: Tax Planning for Restaurants

By Phil Hofmann and Julie Komnick

As 2016 comes to an end, taxpayers need to be proactive in year-end tax planning. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), was signed into law in December 2015 and made many changes that are effective with 2016 tax returns. Restaurants, in particular, should be aware of the following items in this Act:

Certain accelerated filing deadlines: For the 2016 tax year, the due dates for filing W-2 and W-3 Forms, as well as certain 1099-MISC Forms, are now due by Jan. 31, 2017. Additionally, penalties have increased for late information return filings.

Changes to due dates for C-corp and partnership tax returns: Starting with 2016 tax returns, the due date has been moved back a month to the 15th day of the fourth month for the calendar year, with a five-month extension available. 2016 calendar partnership tax returns are due a month earlier, on March 15, 2017, with a six-month extension available.

Code Sec. 179 expensing: The PATH Act permanently set Code Section 179 expensing of qualified property at $500,000 with a $2 million investment limit prior to phaseout. These amounts are indexed annually for inflation. The 2016 amounts are $500,000 and $2.01 million. The $250,000 cap on qualified real property is no longer in effect, starting with 2016 tax returns. Keep in mind that the property does not have to be new to qualify for Sec. 179. Air conditioning and heating units are now eligible for expensing starting in 2016.

Bonus Depreciation: A 50 percent bonus depreciation is available for 2016 tax returns. A new category of property, “qualified improvement property” (QIP), applies in 2016 and permits the 50 percent bonus on certain 39-year property, among other things. QIP removes the third-party lease requirement and the three-year building age rule. Also, an election is permitted for corporations to forgo bonus depreciation and, instead, increase the amount of unused alternative minimum tax credits.

Research Credit: The PATH Act made the research credit permanent and more useful to small businesses. Recently, the IRS final regulations were issued with additional potential opportunities.

Work Opportunity Tax Credit: This credit was modified starting in 2016 to include hires of qualified, long-term individuals unemployed for 27 or more weeks.

Repair Regulations: Ensure the policies are being followed if you have filed accounting method changes, such as making annual elections as required and reviewing the de minimis capitalization thresholds for compliance. Taxpayers taking advantage of the de minimis thresholds should have a written capitalization policy in effect. Effective in 2016, the de minimis safe harbor limit was increased to $2,500 for taxpayers without an applicable financial statement. It remains at $5,000 for those with applicable financial statements. As a reminder, an applicable financial statement is defined as a certified audited financial statement.

Remodel-Refresh Safe Harbor: Restaurants should consider filing an accounting method change to treat 75 percent of qualified remodel-refresh costs as currently deductible repair expenses. Once an accounting method change is filed, future remodels in the same trade or business would be subject to the safe harbor provisions. An applicable financial statement is required to use the safe harbor method.

Shorter Recovery periods for certain property: The 15-year life for qualified leasehold improvements (QLIP), qualified restaurant buildings and improvements (QRP), and qualified retail improvements (QRIP) is now permanent.

FICA Tip Tax Credit: This is a credit against federal tax for payroll taxes employers pay on certain reported tips. Make sure you claim the credit if your operation has tipped employees.

Food Inventory Charitable Contributions: Several changes for 2016 were made to Sec. 170(e)(3), which allows an enhanced deduction for food contributions. A taxpayer-friendly change was made in the determination of the fair market value of food contributions. Restaurants should consider setting up a program to use this tax benefit.

Empowerment Zone Credit: This is a credit against federal tax for salary paid to employees who both live and work in designated zones. Be sure to check for new locations to determine if they are within a designated zone.

Tenant Improvement Allowances: Money received from a landlord can be excluded from taxable income in certain instances under Sec. 110. Be sure to follow the requirements in the code and regulations, including having the proper lease language.

Phil Hofmann is a tax senior director in BDO’s Restaurant Practice. He can be reached at [email protected].

Julie Komnick is a tax senior manager in BDO’s Restaurant Practice. She can be reached at [email protected]

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For more information on BDO USA’s service offerings to the restaurant industry, please contact:
Adam Berebitsky
Tax Partner and Co-Leader of the Restaurant Practice
   Dustin Minton
Assurance Partner and Co-Leader of the Restaurant Practice

Dana Zukofsky