Source: https://www.irs.gov/irm/part4/irm_04-043-001-cont04.html
Timestamp: 2017-04-25 00:51:59
Document Index: 442591919

Matched Legal Cases: ['§ 467', '§ 467', '§ 467', '§ 467', '§ 467', '§ 467', '§ 1']

Internal Revenue Manual - 4.43.1 Retail Industry (Cont. 4)
Section 1. Retail Industry (Cont. 4)
4.43.1 Retail Industry (Cont. 4)
4.43.1.9
Tangible Assets and Depreciation
4.43.1.10
4.43.1.11
4.43.1.9 Tangible Assets and Depreciation
4.43.1.9.6 Retail Topics and Issues
4.43.1.9.6.14 (07-23-2009)Cost Segregation Studies
A cost segregation study allocates the total cost or value of property into appropriate classes of property in order to compute
depreciation. These studies make detailed inventories of individual assets, in order to distinguish items of IRC 1245 property
from items of IRC 1250 property. A cost segregation study may be conducted on new construction, on a property acquisition, or on property already owned using
a change in accounting method, which is also known as a look-back study. Some retailers have hired firms to conduct cost segregation studies. Retailers use cost segregation studies to shorten depreciable
lives of improvements to property, whether leased or owned. The principal focus has been on reclassifying assets from buildings
(IRC 1250 property) to personal property (IRC 1245 property). For tax purposes, a building includes all of its structural
components. The cost of these components is not recovered separately from the building. Rather, these costs are recovered
using the life and depreciation method appropriate for the building as a whole. Upon a reclassification, such costs are no
longer treated as structural components of a building, but as property belonging to the retailer’s general activity class.
The number of individual items in a cost segregation study can be substantial. As noted earlier, the distinction between IRC
1245 property and IRC 1250 property is not always clear, which can result in significant differences of opinion. Despite these
challenges, cost segregation studies should be closely scrutinized by examiners. In assessing audit risk for a cost segregation study, an examiner should make the following audit considerations: Is the study based on contemporaneous records, reconstructed records, or estimates and assumptions that have no supporting
records? Did the study use actual costs or estimated costs? Did the study use modeling or statistical sampling? Modeling separates properties by common store footprints. For example,
free-standing stores are separated from mall stores; leased stores are separated from owned stores. Under modeling, the study
takes a sampling of stores within each group and applies the sample results to the population.
An IRS Cost Segregation Audit Techniques Guide was developed in 2004 and should be reviewed by the examiner. It can be found
on the IRS web site. It is an excellent resource guide and topics include: Legal framework Cost segregation methodologies Principal elements of a quality cost segregation study Review and examination of a cost segregation study Uniform capitalization Change in accounting method Depreciation overview Relevant court cases Statistical sampling
Construction process Information document requests Industry specific guidance including the LMSB RFPH Retail Industry Director Directive (IDD).
The IDD was issued in 2004 concentrating on 54 property classifications. It is not an official pronouncement of the law or
position of the IRS. The IDD effectively utilizes resources in the classification and examination of a retailer.
4.43.1.9.6.14.1 (07-23-2009)Documentation for Cost Segregation studies General Documents include: Asset and depreciation schedules
Cost Segregation Documents include: Letters of Engagement Executive Summary Cost Segregation Report All computational workpapers
4.43.1.9.7 (07-23-2009)Audit Techniques
General Audit Techniques include the following: Reconcile amount per return to working trial balance Scrutinize the basis of assets to ensure proper recordation Determine the retailer’s policy with respect to capitalization threshold Review the retailer’s retirement policy of assets and dispositions Review annual report to identify store openings, expansions and major remodels Analyze Schedule M adjustments for depreciation differences Review Asset & Depreciation Ledger for assets with basis reduction or negative tax basis Determine if any inducement was made for a new store or to encourage the retailer to remain at the location Determine, from the developer’s perspective, whether its intent was to compensate the retailer for certain assets or expenses
Analyze remodel expenditures for proper asset classification or expense Determine if a remodel included an expansion Determine the purpose of any remodel. Is there a betterment of the property? Make an engineering referral or consult an engineer for assistance Review Treas. Reg. 1.263(a)-4
Cost Segregation Auditing Techniques include the following: Read and evaluate cost segregation documents Verify cost basis and reconcile depreciation records Conduct a risk analysis to evaluate audit potential Interview the preparer Inspect the property Review and verify the classes of property Perform a cost analysis Consider sampling techniques Review any Forms 3115 related to depreciation or repair expense Apply law, regulations, and other appropriate guidance to facts 4.43.1.10 (07-23-2009)Intangible Assets
This section provides general background information about intangible assets and amortization items reported by retailers
and the general accounting practices for such items. Intangible assets are generally characterized by a lack of physical existence and a high degree of uncertainty concerning
Usually, these assets result from the operation of legal or contractual rights and include trademarks, patents, non-compete
agreements, employment contracts, and goodwill. They may be self-created or they may be purchased. The cost of an intangible
asset is generally recovered through amortization.
4.43.1.10.1 (07-23-2009)Potential Compliance Risks
Is the valuation of acquired intangibles in an asset acquisition proper?
Is the retailer properly classifying intangible assets? Is the intangible asset self-created or purchased? Is the amortization period and method computed properly? Did the retailer take a partial loss deduction for intangible assets?
4.43.1.10.2 (07-23-2009)General Tax Principles
IRC 167 allows as a deduction for depreciation a reasonable allowance for the exhaustion, wear and tear, and obsolescence
of property, both tangible and intangible, used in a trade or business. Under Treas. Reg. 1.167(a)-3, two requirements must be met in order to depreciate an intangible asset: The asset must have a limited useful life
The life can be estimated with reasonable accuracy.
IRC 197 allows an amortization deduction with respect to the capitalized costs of certain intangible property that is acquired
by a taxpayer and that is held by the taxpayer in connection with the conduct of a trade or business. The deduction is allowed
on a straight-line basis over a 15-year period. If IRC 197 applies, the taxpayer may not use IRC 167 to depreciate the intangible
IRC 197 does not apply to intangible property that is created by the taxpayer if the intangible property is not created in
connection with a transaction (or series of related transactions) that involves the acquisition of a trade or business or
a substantial portion of a trade or business. IRS Publication 535 provides an overview of IRC 197 intangibles. Treas. Reg. 1.263(a)-4 generally requires a taxpayer to capitalize an amount paid to create or acquire an intangible or to
create or enhance a separate and distinct intangible asset. On January 5, 2004, the Department of the Treasury and the IRS issued final regulations on the capitalization of intangibles.
Treas. Reg. 1.263(a)-4 prescribes rules for the capitalization of amounts paid or incurred to acquire or create (or to facilitate
the acquisition or creation of) certain intangibles.
Treas. Reg. 1.263(a)-5 requires a taxpayer to capitalize an amount paid to facilitate the following transactions (without
regard to whether the transaction is comprised of a single step or a series of steps carried out as part of a single plan
and without regard to whether gain or loss is recognized in the transaction): an acquisition of assets that constitute a trade or business (the taxpayer can be the acquirer or the target);
an acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the transaction, the taxpayer
and the business entity are related within the meaning of IRC 267(b) or IRC 707(b);
an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest
in the taxpayer, whether by redemption or otherwise);
a restructuring, recapitalization, or reorganization of the capital structure of a business entity (including reorganizations
described in IRC 368 and distributions of stock by the taxpayer as described in IRC 355;
a transfer described in IRC 351 or IRC 721 (whether the taxpayer is the transferor or transferee);
a formation or organization of a disregarded entity;
an acquisition of capital;
a stock issuance;
a borrowing; and
writing an option.
4.43.1.10.3 (07-23-2009)Key Considerations
The purpose of an allowance for depreciation or amortization is to protect the integrity of periodic income measurement by
allocating costs to the period in which they arose. Tax law relies on the concept of fair market value to allocate the purchase price of a business to the various assets in an
asset acquisition. As a practical matter, the fair market value of an asset is never an absolute amount. Rather, there is
likely to be a range of possible values. An examiner should consider whether the taxpayer has reported an amount or amounts
outside the range of reasonableness. Goodwill is defined in Treas. Reg. 1.197-2(b)(1). Amortization is the commonly accepted way of referring to depreciation of intangible property. The Internal Revenue Code and
the regulations, however, use the term depreciation, except in the context of IRC 197. The term "section 197 intangible" is a term of art with a specified but limited meaning.
4.43.1.10.4 (07-23-2009)Industry Practices
Retailers frequently incur expenditures for intangible assets in the normal course of their business operations. Intangible assets originate for most retailers from the acquisition of other retailers’ businesses. The fair market value
of intangible assets acquired in an acquisition is usually supported by an appraisal made by an independent valuation company.
The most common intangible assets acquired in an acquisition include: Goodwill Trademarks and trade names Private label design and development Proprietary software
Favorable portion of operating leases Customer and/or credit card lists
4.43.1.10.5 (07-23-2009)Financial Reporting
Financial Accounting Standards Board (FASB) 142 breaks intangibles into two broad classes: Intangible assets with finite lives subject to amortization usually on a straight-line method based on useful life. Intangible assets with indefinite lives not subject to amortization, but subject to an impairment test.
Costs of internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, that have
indeterminate lives, or that are inherent in a continuing business are expensed.
4.43.1.10.6 (07-23-2009)Retail Topics and Issues
Following are several retail industry applications for intangibles. 4.43.1.10.6.1 (07-23-2009)Examples of IRC 197 Intangibles
IRC 197 intangibles include: Goodwill Going concern value Workforce in place Business books and records, operating systems, or any other information base Any patent, copyright, formula, process, design, pattern, know-how, format, or other similar item Customer-based intangibles Supplier-based intangibles License, permit, or other right granted by a governmental unit or agency Covenant not to compete entered into in connection with the acquisition of all or a substantial interest in a trade or business
Franchise, trademark, or trade name, including renewals of such interests
4.43.1.10.6.1.1 (07-23-2009)Goodwill
Goodwill is the value of a trade or business based on the expected continued patronage due to its name, reputation, or any
other factor. When a retailer acquires an existing business, the retailer must allocate the purchase price to each asset acquired in an
amount equal to the asset's fair market value to determine the basis of the acquired assets. When an existing business is sold, the selling price usually exceeds the total fair market value of the tangible assets owned
by the business. The purchase price not allocated to tangible assets is assigned to intangible assets, such as goodwill. Goodwill has been defined as "the expectancy of continued patronage..."
, and "the expectancy that the old customers will resort to the old place." Goodwill is acquired by a purchaser of a going
concern where the transfer enables the purchaser to step into the shoes of the seller. Prior to enactment of IRC 197, goodwill
was nondepreciable as a rule of law because of the difficulties inherent in the computation of both its life and its value.
4.43.1.10.6.1.2 (07-23-2009)Going Concern Value
Under IRC 197, going concern value is the additional element of value of a trade or business that attaches to property by
reason of its existence as an integral part of an ongoing business activity.
Going concern value includes value based on the ability of a business to continue to function and generate income even if
there is a change in ownership (but does not include any other IRC intangible). Going concern value also includes the value based on the immediate use or availability of an acquired trade or business, such
as the use of earnings during any period in which the business would not otherwise be available or operational.
4.43.1.10.6.1.3 (07-23-2009)Workforce in Place
Workforce in place includes the composition of a workforce (for example, its experience, education, or training), the terms
and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of their attributes.
The amount paid or incurred for workforce in place includes, for example, any portion of the purchase price of an acquired
trade or business attributable to the existence of a highly-skilled workforce, an existing employment contract (or contracts),
or a relationship with employees or consultants (including, but not limited to, any key employee contract or relationship).
Workforce in place does not include any covenant not to compete or other similar arrangement. 4.43.1.10.6.1.4 (07-23-2009)Information Base
IRC 197 intangibles include any information base, including a customer-related information base. An information base includes business books and records, operating systems, and any other information base (regardless of
the method of recording the information). A customer-related information base is any information base that includes lists or other information with respect to current
or prospective customers. The amount paid or incurred for information base includes, for example, any portion of the purchase price of an acquired trade
or business attributable to the intangible value of technical manuals, training manuals or programs, data files, and accounting
or inventory control systems.
Other examples include the cost of acquiring customer lists, subscription lists, insurance expirations, patient or client
files, or lists of newspaper, magazine, radio, or television advertisers.
4.43.1.10.6.1.5 (07-23-2009)Know-how
Know-how for purposes of IRC 197 intangibles includes any patent, copyright, formula, process, design, pattern, know-how,
format, package design, computer software (as defined at Treas. Reg. 1.197-2 (c)(4)(iv)), or interest in a film, sound recording,
video tape, book, or other similar property.
4.43.1.10.6.1.6 (07-23-2009)Customer-based Intangible
A customer-based intangible is any composition of market, market share, or other value resulting from the future provision
of goods or services pursuant to contractual or other relationships in the ordinary course of business with customers. Customer-based intangibles include any portion of the purchase price of an acquired trade or business attributable to the
existence of: A customer base A circulation base An undeveloped market or market growth Insurance in force The existence of a qualification to supply goods or services to a particular customer
A mortgage servicing contract (as described at Treas. Reg. 1.197-2(c)(11) An investment management contract Any other relationship with customers involving the future provision of goods or services
4.43.1.10.6.1.7 (07-23-2009)Supplier-based Intangible
A supplier-based intangible is the value resulting from the future acquisition, pursuant to contractual or other relationships
with suppliers in the ordinary course of business, of goods or services that will be sold or used by the retailer Supplier-based intangibles include, for example, any portion of the purchase price of an acquired trade or business attributable
to The existence of a favorable relationship with persons providing distribution services (such as favorable shelf or display
space at a retail outlet) The existence of a favorable credit rating The existence of favorable supply contracts
The amount paid or incurred for supplier-based intangibles does not include any amount required to be paid for the goods or
services themselves pursuant to the terms of the agreement or other relationship.
4.43.1.10.6.1.8 (07-23-2009)License, Permit, or Other Rights
IRC 197 intangibles include any license, permit, or other right granted by a governmental unit (including, for purposes of
IRC 197, an agency or instrumentality thereof) even if the right is granted for an indefinite period or is reasonably expected
to be renewed for an indefinite period. These rights include, for example, a liquor license, a taxicab medallion (or license), an airport landing or take-off right
(sometimes referred to as a slot), a regulated airline route, or a television or radio broadcasting license. The issuance or renewal of a license, permit, or other right granted by a governmental unit is considered an acquisition of
the license, permit, or other right.
4.43.1.10.6.1.9 (07-23-2009)Covenant Not To Compete
IRC 197 intangibles include any covenant not to compete, or agreement having substantially the same effect, entered into in
connection with the direct or indirect acquisition of an interest in a trade or business or a substantial portion thereof.
An agreement requiring the performance of services for the acquiring retailer or the provision of property or its use to the
acquiring retailer does not have substantially the same effect as a covenant not to compete to the extent that the amount
paid under the agreement represents reasonable compensation for the services actually rendered or for the property or use
of the property actually provided. A covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant
not to compete) is not to be considered to have been disposed of or to have become worthless until the disposition or worthlessness
of all interests in the trade or business or substantial portion thereof that was directly or indirectly acquired in connection
with such covenant (or other arrangement).
4.43.1.10.6.1.10 (07-23-2009)Franchise, Trademark, or Trade Name
Trademarks and trade names represent the inherent value of the acquired retailer's name and/or its store (house) brands. IRC 197 intangibles include any franchise, trademark or trade name. The term franchise has the meaning given in IRC 1253(b)(1) and includes any agreement that provides one of the parties to
the agreement with the right to distribute, sell, or provide goods, services, or facilities, within a specified area. The term trademark includes any word, name, symbol, or device, or any combination thereof, adopted and used to identify goods
or services and distinguish them from those provided by others. The term trade name includes any name used to identify or designate a particular trade or business or the name or title used
by a person or organization engaged in a trade or business. A license, permit, or other right granted by a governmental unit is a franchise if it otherwise meets the definition of a
A trademark or trade name includes any trademark or trade name arising under statute or applicable common law and any similar
right granted by contract. The renewal of a franchise, trademark, or trade name is treated as an acquisition of the franchise, trademark, or trade name.
For financial reporting, franchise, trademark or trade name costs must be amortized over a period not to exceed 40 years.
4.43.1.10.6.2 (07-23-2009)Exceptions to IRC 197
IRC 197 intangibles do not include the following assets, rights or costs: Any interest in a corporation, partnership, trust, or estate
Any interest under an existing futures contract, foreign currency contract, notional principal contract, interest rate swap,
or similar financial contract Any interest in land
Computer software that is readily available to the general public, is subject to a nonexclusive license, and has not been
substantially modified. Any fees for professional services and any transaction costs incurred by parties to a transaction in which all or any portion
of the gain or loss is not recognized under part III of subchapter C of the IRC. IRC 197 intangibles do not include any of the following assets not acquired in connection with the acquisition of a trade
or business or a substantial part of a trade or business: An interest in a film, sound recording, video tape, book, or similar property A right to receive tangible property or services under a contract or from a governmental agency An interest in a patent, patent application, or copyright Certain rights that have a fixed duration or amount as provided in the regulations
Any right to service indebtedness secured by residential real property
An interest in computer software
IRC 197 intangibles do not include an interest under either of the following: An existing lease or sublease of tangible property A debt that was in existence when the interest was acquired
4.43.1.10.6.3 (07-23-2009)Disposition Under IRC 197 – General Rule The term "amortizable section 197 intangible"
generally means any section 197 intangible acquired after August 10, 1993 (or after July 25, 1991, if a valid retroactive
election under Treas. Reg. 1.197-1T has been made), and held in connection with the conduct of a trade or business or an for-profit
activity. A self-created intangible is not an amortizable IRC 197 intangible.
An amortizable IRC 197 intangible is treated as depreciable property used in the retailer’s trade or business. If an amortizable IRC 197 intangible is held for more than one year and used in the retailer’s trade or business, any gain
on disposition, up to the amount of allowable amortization, is ordinary income (IRC 1245 gain). Any remaining gain, or any
loss, is an IRC 1231 gain or loss. If an amortizableIRC 197 intangible is held one year or less, any gain or loss on disposition is an ordinary gain or loss.
4.43.1.10.6.4 (07-23-2009)Disposition under IRC 197 – Loss Disallowance Rules A retailer cannot deduct any loss on the disposition or worthlessness of an IRC 197 intangible that was acquired in the same
transaction (or series of related transactions) as other IRC 197 intangibles that are still owned by the retailer.
Instead, the retailer must increase the adjusted basis of each remaining amortizable IRC 197 intangible by a proportionate
share of the nondeductible loss. The increase in adjusted basis for each retained intangible is determined by multiplying the nondeductible loss on the disposition
of the intangible by the following fraction: The numerator is the adjusted basis of the retained intangible on the date of the disposition. The denominator is the total adjusted bases of all the retained intangibles on the date of the disposition. 4.43.1.10.6.5 (07-23-2009)Amounts Paid to Acquire or Create Intangibles
Acquired intangible assets and benefits as defined in Treas. Reg. 1.263(a)-4 require capitalization if acquired from another
party in a purchase or similar transaction and include: An ownership interest in a corporation, partnership, trust, estate, limited liability company, or other entity Financial instruments (e.g., debt instruments, notional principal contracts, options, etc.) Prepaid expenses: amounts prepaid for services or benefits to be received in the future
Amounts paid to obtain certain memberships and privileges, such as lifetime staff privileges at a hospital. However, amounts
paid for product certification (such as ISO 9000 costs) are not required to be capitalized. Amounts paid to obtain or renew certain rights from a governmental agency, such as a trademark, copyright, license, franchise,
permit, etc. Amounts paid to another party to induce that party to enter into, renew, or renegotiate an agreement that produces certain
rights Amounts paid to terminate certain contracts that allow the retailer to reacquire a valuable right that it did not possess
just prior to the termination
Amounts paid to acquire, produce, or improve real property owned by another, where the retailer expects to thereby receive
significant future benefits Amounts paid to defend or perfect title to intangible property
Created intangibles require capitalization. The determination of whether an amount is paid to create an intangible is based
on facts and circumstances. Distinctions between labels used to describe the intangible and the labels used by the taxpayer
and other parties to the transaction are disregarded. Transaction costs require capitalization. Transaction costs facilitate the acquisition, creation, and enhancement of intangible
assets, subject to the de minimis rule and the simplifying rule for employee compensation and overhead. Also, costs that facilitate
the retailer's restructuring or reorganization of a business entity or that facilitate a transaction involving the acquisition
of capital, including a stock issuance, borrowing, or recapitalization, require capitalization. The costs discussed in the preceding paragraphs of this sub-section apply to amounts paid or incurred on or after December
31, 2003. 4.43.1.10.6.6 (07-23-2009)Allocation of Purchase Price
In an acquisition, the determination of the fair market values of the intangibles may be problematic. The retailer will want to value land and 39-year property as low as possible and allocate some of the purchase price to goodwill
or going concern, if beneficial, or perhaps even to inventory. See IRM 4.43.1.5.6.9 regarding the inventory step-up issue.
Purchased intangibles will appear on the balance sheet and the amortization schedule. Form 8594, Asset Acquisition Statement, should be attached to the tax return to report the purchase/sale of a group of assets
if goodwill or going concern could attach to such assets and if the purchaser’s basis in the assets is determined only by
the amount paid for the assets.
4.43.1.10.6.7 (07-23-2009)Package Design Costs
The package design costs coordinated issue paper was de-coordinated on September 28, 2007 as a result of Treas. Reg. 1.263(a)-4.
Package design means the specific graphic arrangement or design of shapes, colors, words, pictures, lettering, and other elements
on a given product package, or the design of a container with respect to its shape or function. Activity related to sales
promotions, ingredient listings, trademarks and trade names is not package design in nature. Because it is often on the basis of the package alone that a buying decision is made, large amounts of time and money are
expended to develop effective packaging. Historically, manufacturers incurred most package design costs. The incidence of
retailers incurring package design costs has increased, however, with the growing popularity of private label brands or house
brands (products manufactured by others but sold exclusively by a particular retailer under its own label). Although a retailer's primary private brand may carry the name of the company, the same retailer may also carry other private
brands which are not as obvious because they carry no identifying information to link them to the retailer. Examiners should
be alert to identifying all private brands when determining packaging costs. Package design costs are related to the development of an initial concept, artistic representations, photography, preparation
of prototypes, market testing, and final revisions. Costs related to designs which were suggested but rejected may be applied
to subsequent designs and become part of their costs. For some products, such as aspirin, standard containers provided by
the manufacturer are used and retailers incur only label design costs. In the past, all costs associated with creating a package
design were deducted by retailers as current expenses. Recognizing that most packaging has a useful life in excess of one year, the IRS had taken the position that package design
costs should be capitalized with an indefinite, non-amortizable life. Elections were available, however, allowing amortization
over a specified period. See Rev. Proc. 97-35 and Rev. Proc. 98-39.
The final regulations regarding capitalization of intangibles (Treas. Reg. 1.263(a)-4) 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. 4.43.1.10.6.8 (07-23-2009)Private Label Design and Development
Retailers will often expend significant amounts to develop, acquire, and defend a private label. From the retailer's perspective,
the private label represents an important economic benefit by identifying goods specific to the retailer. Many retailers develop
private label (store/house) brands to reduce competitive pricing pressure, build customer loyalty, and generate higher margins.
The value of this intangible asset is typically determined by the cost to replace the design and production elements of the
private label brand. If the retailer has a large number of items which will carry the private label, a brandmark, or master label look, may be
developed. This would include a specific color scheme, name logo, and background graphics. All private product labels then
would be a variation of this brandmark. For example, a can of private label corn and a can of private label peas would have
the same master label, varying only by the picture of the product on the front of the can. The retailer might contract with
an outside consultant to develop the brandmark, but use in-house personnel to apply that look to each individual product.
For financial purposes, the amortization period is similar to the amortization period for trademarks and trade names. 4.43.1.10.6.9 (07-23-2009)Favorable Portion of Operating Leases
The valuation of a lease acquired in an acquisition may produce a favorable lease or an unfavorable lease. A favorable lease represents the value of an operating lease where the rent is below the market rate as of the acquisition
date. The basis of this intangible asset is usually determined by taking the difference between the present value of the market
rate and the lease agreement rate. The basis determination will include renewal periods if renewal is probable. An unfavorable lease represents the value of an operating lease where the rent is above the market rate as of the acquisition
date. An unfavorable lease will result in a deferred credit that is amortized over the life of the lease.
4.43.1.10.6.10 (07-23-2009)Website Development Costs
Generally, any website costs that are not software are classified as website content. This includes literary content, graphics,
sound, and video. Advertising content is deducted currently. All other content is capitalized if it has a useful life extending beyond the current
4.43.1.10.6.11 (07-23-2009)Internet Domain Names Domain names are generally regarded as intangible personal property. The nominal annual domain name registration fees are
generally deductible. However, if a retailer acquires a domain name, then capitalization should be considered under Treas. Reg. 1.263(a)-4(b). The
retailer is paying for a property interest that meets the definition of a purchased intangible. Some retailers may acquire multiple domain names at premiums to protect the reputation of their business which may be considered
4.43.1.10.6.12 (07-23-2009)Computer Software
Although computer software has tangible and intangible characteristics, it generally constitutes intangible property for Federal
income tax purposes. For purposes of IRC 197, computer software is defined as any program that is designed to cause a computer to perform a desired
function. Software includes computer programs of all classes such as operating systems, compilers, translators, assembly routines,
utility programs, and application programs. Software may be developed, purchased, or leased.
Computer software generally is treated as an IRC 197 intangible; however, certain off-the-shelf and certain separately acquired
software are not considered to be an IRC 197 intangible. Off-the-shelf software: Is readily available for purchase by the general public Is subject to a non-exclusive license Is not substantially modified IRC 167(f) provides rules for computing the depreciation deduction for property specifically excluded from IRC 197. Under
this provision, excluded purchased computer software is depreciated on a straight-line basis over a 36-month useful life.
Risk is what differentiates purchased software from internally-developed software.
Under IRC 197, computer software acquired in an acquisition is amortizable over 15 years. For leased software, rental payments are deductible as a business expense over the lease term in the same manner as any other
rental payments under Treas. Reg. 1.162-11. Audit Considerations: Are the computer software costs included, without being separately stated, in the cost of computer hardware (bundled software)?
When computer software is bundled with computer hardware, without being separately stated, the cost of the bundled software
is capitalized and depreciated as part of the computer hardware. Is computer software internally developed or purchased? This distinction is important in analyzing the federal tax consequences
of computer software costs. In some situations, software costs closely resemble research and experimental expenditures and,
consequently, may be expensed in the same manner as research and experimental expenditures. 4.43.1.10.6.13 (07-23-2009)Documentation Documentation can include the following: Sale and purchase agreements
Allocation of Purchase Price agreement Independent third-party appraisals
4.43.1.10.7 (07-23-2009)Audit Techniques
Audit Techniques can include the following: Reconcile amounts per return to working trial balance Reconcile differences between book and tax amortization to Schedule M
Analyze change in G/L account balances Review current year dispositions
Secure analysis of items amortized; verify basis and lives
Determine if the intangible is acquired or self created
Determine if the intangible qualifies for amortization
Verify that a determinable useful life for the intangibles exists
Verify amortization computations
Determine if retailer expensed intangibles for book purposes Determine if any abandonment losses for intangibles are present Consult an engineer for fair market value issues 4.43.1.11 (07-23-2009)Leases
This section provides general background information about lease transactions reported by retailers and the general accounting
practices for such leases. The retail industry is an asset-intensive business often financed by operating leases. More frequently than other industries
that make use of operating leases, retailers make leasehold improvements on top of the leased property. Retailers commonly
obtain concessions from landlords to defray all or part of their leasehold improvement costs. Retailers are typically the tenant in lease arrangements, but may also be the landlord. For example, a retailer may sublease
a former store or certain departments within a current store. As a result, leases, while not unique to the retail industry,
can be a significant area impacting business operations and income. 4.43.1.11.1 (07-23-2009)Potential Compliance Risks Whether the deduction for rent expense is improperly accelerated or insufficient rental income is reported. Whether income recognition of tenant construction allowances is improperly deferred by recognition through basis reduction.
Whether a sale-leaseback transaction represents a genuine sale or a financing transaction.
4.43.1.11.2 (07-23-2009)General Tax Principles IRC 162(a)(3) provides a current deduction for rentals or other payments required to be made as a condition to the continued
use or possession of property used in a trade or business to which the taxpayer has not taken title.
Rent is generally reported by both landlord and tenant and allocated to the periods of time specified in the lease. Unless the rental agreement is a section 467 rental agreement (see IRM 4.43.1.11.6.2), rent is deducted when paid for cash
basis taxpayers or for accrual basis taxpayers when the all-events test is met and economic performance occurs for the rental
liability. Unless the rental agreement is a section 467 rental agreement (see IRM 4.43.1.11.6.2), advance rentals are required to be
capitalized and deducted over the lease term. Unless the rental agreement is a section 467 rental agreement (see IRM 4.43.1.11.6.2), income received is generally taxable
in the year in which it is received for cash basis taxpayers and when payable for accrual taxpayers. The taxpayer with a depreciable interest in leasehold improvements must generally depreciate the improvements, if nonresidential
real property, over 39 years. Gain or loss from the sale of property is recognized
4.43.1.11.3 (07-23-2009)Key Considerations
The timing of rent payments may not coincide exactly with accounting periods. A liability account is required to reflect the
amount of unpaid rent at the end of the accounting period. Proper accounting for leases depends on whether substantially all of the risks and benefits of ownership of property have
been transferred from the lessor to the lessee. The determining factor in the tax treatment of construction allowances and improvements is the tax ownership of the leasehold
The benefits and burdens of ownership test establishes tax ownership by evaluating several factors. The benefits and burdens of ownership test establishes tax ownership by evaluating several factors. Whether a lease is a true
lease is based on all the facts and circumstances. The factors considered include: Whether legal title passes How the parties treat the transaction
Whether the contract creates present obligations on the seller to execute and deliver a deed and on the buyer to make payments
Whether the right of possession is vested
Who bears the risk of loss or damage to the property
Who receives the profits from the operation and sale of the property
Who carries insurance with respect to the property
Who is responsible for replacing the property
Who has the benefits of any remainder interests in the property
4.43.1.11.4 (07-23-2009)Industry Practices
Many retailers lease substantially all of their stores and warehouses. Operating leases are commonly used in the retail industry. Lease agreements typically include the following terms and conditions: Initial lease term of 10 to 20 years and renewal options,
Rent escalation (step rent) clauses, or Percentage (contingent) rent obligation. Anchor or major retailers often receive incentives to open a store in a new development.
Retailers commonly receive tenant (construction) allowances to defray the cost of improvements made to leased stores.
Construction allowances rarely exceed the retailer’s cost of construction.
Historically, grocery chains prefer to own real estate in centers in which they are the major tenant or anchor.
4.43.1.11.5 (07-23-2009)Financial Reporting
Annual rent expense is an average of rent over the lease term taking into account: Rent abatement (rent holidays), and
Fixed or known rent increases (rent escalation clauses).
Rent expense is generally recognized on a straight-line basis, over the lease term, beginning on the date the retailer takes
possession of the leased property and including any option periods considered in the determination of that lease term. The difference between the amounts charged to rent expense and rent paid is recorded as a deferred liability. Leasehold improvements are: Recorded at their gross cost, including items funded with landlord construction allowances.
Depreciated on the straight-line method over the shorter of their useful lives or related lease terms. Landlord incentives used to build out leased space are: Recorded as a deferred liability.
Amortized as a reduction of rent expense over the initial lease term.
Percentage rent is generally based upon store sales exceeding a stipulated amount and is recognized as incurred. For additional information about leases refer to: Statements of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases
The Financial Accounting Standards Board (FASB) Staff Position No. 13-1, Accounting for Rental Costs Incurred during a construction
period (Statement of Financial Position 13-1).
4.43.1.11.6 (07-23-2009)Retail Topics and Issues
A lease transfers the right to use and occupy real estate in exchange for the payment of rent. The classification of lease
transactions as well as the recognition of income and deductions associated with lease transactions is often different for
tax and financial reporting purposes.
4.43.1.11.6.1 (07-23-2009)Rent Escalation Clauses
Fixed rent for long-term leases is rare because landlords typically require the base rent to keep pace with the rate of inflation.
Thus, lease terms exceeding several years usually contain a rent escalation clause. The base rent can be adjusted by a dollar
amount, a fixed percentage, or a fixed index such as the Consumer Price Index (CPI). The CPI is commonly used to escalate
rent for leases of retail space.
4.43.1.11.6.2 (07-23-2009)Section 467 Rental Agreements (Potential for Rent Leveling) IRC 467 and the Income Tax Regulations under § 467 provide rules for rental agreements involving the use of tangible personal
property that provide increasing or deferred rent or, for agreements entered into after May 18, 1999, decreasing or prepaid
rent, and that require payments of $250,000 or more (§ 467 rental agreements). The accounting methods required by § 467 have
three primary purposes: to provide consistent reporting of rent by landlords and tenants,
to adjust rents in appropriate circumstances to take into account the time value of money, and
to prevent tax avoidance. To achieve these objectives, the regulations under § 467 provide for one of three different accounting methods, depending
on the circumstances: allocation of rent in accordance with the rental agreement (most common method),
the proportional rental method, which adjusts rents for the time value of money, and
the constant rental method (rent leveling), which prevents tax avoidance. The constant rental method (rent leveling) applies
only if an agreement is a disqualified leaseback or long-term agreement. If the term of a rental agreement is in excess of
75 percent of the statutory recovery period of the leased property (19 years for land), the rental agreement qualifies as
a long-term agreement. A rental agreement is a leaseback if the lessee (or a related person) had any interest in the property
(other than a de minimis interest) at any time during the two-year period ending on the date the agreement was entered into.
A long-term agreement or leaseback is disqualified only if the Commissioner determines that a principal purpose for providing
increasing or decreasing rent is the avoidance of Federal income tax.
For most leases of retail space, the landlord and tenant will not be subject to constant rental accrual (rent leveling) because
either there is no tax avoidance purpose for the increasing or decreasing rents or the agreement meets one of the exceptions
in the regulations under § 467. Exceptions to the constant rental accrual method (rent leveling) include the following: The uneven rent test – The uneven rent test is met if the rent allocated to each calendar year does not vary from the average
rent allocated to all calendar years by more than 10 percent (15 percent for real property); and
The increase or decrease in rent is wholly attributable to one of the contingent rent provisions set forth in the regulations
under § 467 (for example, price indexes, percentage of sales, or a requirement to pay third-party costs) and/or one of rent
holiday provisions in the regulations. To meet the constant rental accrual (rent leveling) exception, the rent holiday must
be a consecutive period that is either three months or less and at the beginning of the lease term, or it must be of reasonable
duration based on commercial practice in the locality where use of the property occurs and not exceed the lesser of 24 months
or 10 percent of the lease term. A rent holiday is a period where no rent or reduced rent is charged. The period is usually
short term in nature and granted for the period of store construction. Typically, a free rent period allows the tenant to
use money that would otherwise be used to pay rent for payment of construction costs. Generally, rent free periods of 12
months or less, dependent upon local customary practices, are reasonable. A longer rent-free period is acceptable in certain
Under FASB 13, a taxpayer is required to level rent expenses by amortizing the total of all rental payments over the life
of the lease Example 1: Application of FASB 13 Retailer enters into a 15-year lease, which requires base rent of $10 per square foot during the first
five years, $12 per square foot for the second five years, and $14 per square foot during the third five years. Under FASB
13, $12 per square foot (the leveled amount) is deducted throughout the life of the lease.
Example 2: Differences of Reporting for Tax and Financial Retailer enters into a 10-year lease and landlord provides a first year rent
holiday. The rent payment schedule calls for annual rent of $125,000 for the second through fifth year of the lease and $200,000
for remaining five years of the lease. Year
The primary audit consideration is whether the taxpayer overstated its current deduction for rent expense by including accrued
(step) rents associated with future tax years. The examiner should consider the following audit techniques to address the issue of step rents: Review liabilities for accrued rents or rents payable accounts.
Review Schedule M for adjustment to remove stepped up rent from the tax return.
Test selected leases to determine if the excess (amortized) rents were excluded from the tax return deduction.
4.43.1.11.6.3 (07-23-2009)Percentage Rent
Percentage rent provisions are common in shopping center leases because of the speculative nature of retail sales. For the
landlord, this provision provides an opportunity to share in the future economic success of the retailer’s business, often
in exchange for a lower base fixed minimum rent. For the retailer, this provision provides an opportunity to establish an
overall cost and budget for operating its business at the location. In particular, it allows a retailer to align the payment
of rent with actual cash flow. Percentage rent provisions in retail leases usually provide that the percentage rent is in addition to the fixed base minimum
rent. Percentage rent is calculated as a percentage of the tenant's annual sales in excess of a fixed dollar amount made in
or from the premises. The fixed dollar amount is often referred to as the breakpoint. Defining what constitutes a sale for
purposes of calculating percentage rent, and determining what may be excluded or deducted, often is the subject of negotiation
between landlord and tenant.
The primary audit consideration is whether the taxpayer estimates sales volume and accrues a liability for percentage rent
throughout the taxable year. The examiner should consider the following audit techniques to address the issue of estimating percentage rents: Ask how percentage rent is recorded.
Analyze lease abstracts and/or accrued percentage rent payables accounts.
Examine leases to determine when the liability for percentage rent becomes fixed, if estimates are recorded.
Use the percentage rent agreement to determine if all sales are reported.
Obtain copies of reports sent to the landlord and reconcile those sales figures with sales reported as income.
Obtain copies of any landlord audits and reconcile those sales figures with sales reported as income.
Some of these techniques may be impractical with a large retailer, but useful in the audit of a small retailer with only a
few stores.
4.43.1.11.6.4 (07-23-2009)Anchor Store Inducements
A shopping center needs one or more major or anchor retail tenants to acquire sufficient patronage to make the entire shopping
center a success.
Anchor stores often command significant inducements as a condition to locating in a shopping center. A developer’s inducement
may be in the form of cash, transfer of ownership of the building, and/or transfer of ownership of the land on which the store
is built. Anchor stores usually agree to operate a store for a period of 15 years in exchange for receipt of an inducement.
A developer’s payment of cash is typically less than the cost of IRC 1250 improvements incurred by a retailer. IRC 118 provides a means for any anchor tenant to exclude intangible inducements from gross income.
The primary audit consideration is whether the taxpayer properly reduced the bases of the assets acquired with the proceeds
under IRC 362(c)(2).
The examiner should consider the following audit techniques to address the basis reduction issue: Review annual report for new store openings and major remodels.
Review asset & depreciation ledger for assets with basis reduction or negative tax basis.
Review Schedule M adjustments for depreciation differences.
Apply the Industry Director’s Directive to facts and circumstances. Determine if the inducement was made for a new store or to encourage the retailer to remain at the location.
Determine, from the developer’s perspective, whether its intent was to compensate the retailer for certain assets or expenses.
4.43.1.11.6.5 (07-23-2009)Tenant Construction or Improvement Allowances
Retailers usually anticipate remodeling leased space in some way and installing their own trade fixtures. As lessees, retailers
are responsible for the build-out or finishing work of leased space they will occupy. Tenant improvement costs often represent
a significant percentage of the total value of a retail lease. Negotiation of a construction allowance is a major part of
many lease transactions. The purpose of a construction allowance is to offset the construction costs to the leased space.
Allowances are normally based upon the square footage of the building and rarely exceed the tenant’s construction costs.
The primary audit consideration is whether the taxpayer receives an accession to wealth from the receipt of a construction
allowance. The determining factor in the tax treatment of construction allowances and improvements is the tax ownership of the leasehold
improvements. Tax ownership is distinct from legal ownership. If the tenant owns the improvements, the allowance is treated as income to the tenant and the tenant must depreciate the costs
of the improvements over a 39-year period and the landlord applies the rules of Treas. Reg. § 1.263(a)-4(d)(6) to account
for the allowance paid. If the landlord owns the improvements, then the allowance (assuming it is all applied to costs of the real estate improvements)
is not treated as income to the tenant and the landlord depreciates the cost of the improvements over a 39-year period. The benefits and burdens of ownership test establishes tax ownership by evaluating several factors first adopted in Grodt & McKay Realty v. Commissioner, 77 T.C. 1221 (1981). See IRM 4.43.1.11.3(5)
For short-term retail leases, IRC 110 provides a safe harbor for retail tenants receiving qualified lessee construction allowances.
A retailer tenant’s gross income does not include allowances used to construct improvements of qualified long-term real property.
Qualified long-term real property is: Nonresidential real property that is part of, or otherwise present at, the retail space for which the short-term lease applies.
A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less (as determined
pursuant to IRC 168(i)(3)). Retail space is nonresidential real property that is leased, occupied, or otherwise used by the
lessee in its trade or business of selling tangible personal property or services to the general public. The term retail space
includes not only the space where the retail sales are made, but also space where activities supporting the retail activity
are performed (such as an administrative office, a storage area, and employee lounge). A taxpayer is selling to the general
public if the products or services for sale are made available to the general public, even if the product or service is targeted
to certain customers or clients.
Nonresidential real property as the retail space reverts to the lessor at the termination of the lease
The examiner should consider the following audit techniques to address the issue of gross income from the receipt of construction
allowances: Review annual report for new store openings and major remodels.
Determine that the lease agreement for the retail space expressly provides that the construction allowance is for the purpose
of constructing or improving qualified long-term real property for use in the lessee's trade or business at the retail space.
An ancillary agreement between the lessor and the lessee providing for a construction allowance, executed contemporaneously
with the lease or during the term of the lease, is considered a provision of the lease agreement for this purpose provided
the agreement is executed before payment of the construction allowance.
Examine contracts to determine ownership of leasehold improvements.
Apply the benefits and burdens test to determine tax ownership of the leasehold improvements. Allowances only apply to realty improvements. If the retailer conducted a cost segregation study, which reallocated costs
from IRC 1250 to IRC 1245 property, determine if the study considered the receipt of construction allowances in the computation
of any IRC 481(a) adjustment. 4.43.1.11.6.6 (07-23-2009)Sale and Leaseback
A sale and leaseback describes a transaction in which the owner of property sells it to another party and immediately leases
that property back from the buyer. Thus, the seller of the property becomes the seller-lessee, and the buyer of the property
becomes the buyer-lessor. A sale-leaseback may include all or part of the property sold and may be for all or part of the
property’s remaining useful life.
In the context of the retail industry, the retailer, which owned the property, becomes the tenant and continues to control
and use the property, paying rent. A retailer may consider this arrangement when it wants a new store, distribution center,
headquarters, or other building built to its own unique specifications and does not want to tie up capital in real property.
A typical lease under a sale-leaseback arrangement is long-term, usually 15 to 20 years with renewal options. The lease is
usually a triple net lease, i.e., the lessee is responsible for all real estate taxes, building insurance, and maintenance
on the property, in addition to rent.
FASB 98 describes the conditions needed for the transaction to be considered a true sale and leaseback under GAAP.
The primary audit consideration is whether the transaction represents a true sale or a financing. A secondary audit consideration
is whether the transaction, if determined to be a sale, reflects the fair market value of the property.
The examiner should consider the following audit techniques to address the issue of sale and leasebacks: Review the sale and purchase agreement and determine if the lessor retains significant and genuine attributes of a traditional
owner, including benefits and burdens of ownership. The examiner also should consider whether the landlord/purchaser is either
a related party or a tax indifferent party.
The incidence of taxation depends upon the substance of a transaction. The transaction must be viewed as a whole, and each
step, from commencement to consummation, is relevant. If the examiner determines that the transaction lacks economic substance, s/he should determine whether the transaction should
be reclassified as one of the following: A like-kind exchange (real property for a leasehold interest of 30 years or more)
A financing arrangement
A sham transaction to shift income and deductions
If the examiner determines that a true sale occurred, the examiner should: Review the independent professional appraisal to determine if the sale price reflects the fair market value of the property.
A loss may result from an unreasonable selling price. A loss may represent, in part, a real economic loss and a deferred loss
such as a prepayment of rent.
Determine the character (capital or ordinary) of the gain or loss.
Review the lease agreement to determine if the rate of rent is reasonable under the facts and circumstances. Rental payments
on the leaseback may be set higher than the prevailing market to compensate the seller-lessee for a selling price that is
set below fair market value. The examiner should consider the character of the gain or loss if a true sale occurred.
The examiner should consider whether, before the sale, the retailer capitalized all construction period costs, (e.g., costs
subject to IRC 263A).
4.43.1.11.6.7 (07-23-2009)Common Area Maintenance (CAM) Charges In addition to base rent, most leases provide for the recovery of a landlord’s operating expenses through one or more recovery
mechanisms. Shopping center owners recover their operating expenses through a mechanism called the common area maintenance
charge or CAM. Examples of common CAM charges include mall security, parking lot and hallway maintenance. CAM charges are
usually allocated on a pro rata basis among the shopping center tenants.
Common CAM clauses in retail leases: Require retailers to pay estimated CAM charges each month in advance. Require landlords to provide a written statement itemizing actual CAM costs at the end of the year.
Afford retailers the right to audit the landlord’s books and records to verify the expenses were incurred and the amounts
4.43.1.11.7 (07-23-2009)Audit Techniques
When examining this area, the examiner should establish what evidence exists to document the arrangement between the retailer
and its landlord or tenant. The examiner should consider reviewing the following general audit techniques to identify potential issues and obtaining the
following documentation to substantiate the propriety of the retailer’s lease transactions.
4.43.1.11.7.1 (07-23-2009)Issue Identification
Review public information, including the following: Annual reports
Form 10-K News releases The retailer's website for new store openings and major remodels
Review tax return information, including the following: Other current liabilities for accrued rents, deferred rent credits, and rents payable accounts
Schedule M to identify book/tax differences, such as step rents to remove stepped up rent from the tax return, depreciation
Review books and records, including asset and depreciation ledger for assets with basis reduction or negative tax basis.
4.43.1.11.7.2 (07-23-2009)Issue Development
Obtain and review written documentation, including the following: Letter of intent to lease Lease agreement Rent payment schedule Lease abstract Construction, operation, and reciprocal easement agreement Supplement agreements, which are also known as side agreements, allocable share agreements and separate agreements Work letter Certificate of occupancy
The examiner should refer to the specific retail topics and issues for additional audit techniques.
4.43.1.11.8 (07-23-2009)Other Information
A real estate lease is an agreement that gives a lessee the right to use and occupy real estate owned by the lessor in exchange
for the payment of rent. A lease is usually for a stated period of time and includes a specific periodic cost. The lease of
retail space generally consists of base rent and percentage rent.
4.43.1.11.8.1 (07-23-2009)Nature of Rent
Base (Standard) Rent The base rent is the amount a tenant contracts to pay for the use and occupancy of the property.
The monthly rental rate is usually quoted in terms of actual dollars and in dollars per square foot.
Percentage (Contingent) Rent The percentage rent is an amount in addition to the base rent.
Percentage rent is future rent payments based on factors that do not exist or cannot be measured at the inception of the lease.
Retail leases often include a clause calling for percentage rent. Percentage rent is generally measured on annual sales in excess of a stipulated amount (specified minimum level). Certain categories of sales may be excluded, such as sales to employees, sales taxes collected, and delivery charges. Retailers usually pay a fixed amount each month plus an additional amount based on a percentage of sales.
Percentage rent is not a fixed liability until the end of the measurement period.
High-priced low-volume retailers normally pay relatively higher percentages than low profit high volume businesses.
Example: On September 1, 2008, a retailer opens a new store. The percentage rent agreement calls for 5 percent of annual sales in
excess of $1M. The retailer files its tax return on a fiscal year ending in January, but the lease year runs from September
1, 2008 to August 31, 2009. The taxpayer estimates that annual sales for this store will be $2.5M. The estimated percentage
rent would be $75,000. Actual sales from September 1, 2008 through January total $1.8M. If percentage rent is accrued evenly
over time, the retailer would claim a deduction of $31,250 ($75,000 x 5 months/12months). If percentage rent is accrued based
on sales, the retailer would claim a deduction of $54,000 ($75,000 x $1.8M/$2.5M).