A regular part of business operations in the chain segment of the restaurant industry is the periodic review and evaluation of individual units, units within a given geographic market, and, the overall performance of particular concepts. When a unit, market, or concept fails to meet company expectations for return on investment or performance criteria, the company may decide to permanently close a unit, withdraw from a market, or abandon a particular concept as no longer economically viable within a company’s operations. Rather than continue to drain cash flow, the units are closed, even though the underlying capital assets may not be sold for some time in the future.
Under generally accepted accounting principles a company typically recognizes a loss for the difference between the book basis of the closed units and their fair market value at the time of closure. However, many taxpayers overlook the potential entitlement to a corresponding tax loss deduction at the time the restaurant unit is permanently withdrawn from the operation, mistakenly believing that a tax loss deduction is not available until the loss is realized upon the actual disposal of the restaurant by sale, exchange, or otherwise. Support abounds, however, for deducting the differential between the tax book basis and the fair market value of the closed restaurant unit at the time it is permanently withdrawn from operations.
Generally, a sale or other disposition is necessary to establish a loss in value of capital assets. However, regulations under Sec. 167 of the Internal Revenue Code recognize entitlement to a tax loss deduction arising from the permanent withdrawal of depreciable property from use in the trade or business. The deduction reflects the tax accounting principle that unless the undepreciated expense of a retired asset is allowed at the time the asset is retired from use, the expense of the asset has not been properly allocated to the period over which it generated income.
At retirement, the “cost” of the asset used in business operations, measured by the excess of its adjusted tax basis over remaining fair market value, has already been expended and this cost may be recognized as an expense. The deduction of the difference between the adjusted tax basis and the fair market value simply allows a deduction to the extent of the expenditure or loss sustained. The loss may be recognized even though the taxpayer attempts to recover salvage value by subsequent sale or lease.
The key is to establish that the restaurant has been permanently withdrawn from use in operations.
The permanency of the closure is often inherent in the process that most companies undertake when analyzing whether to close any given restaurant. The process is detailed and involved and closure is typically considered only as a last resort after all other feasible options to revive or salvage a unit have been considered, tested, and explored. The decision to close generally reflects management’s conclusion that it would be financially imprudent to continue the unit in operations and that there is no reasonable prospect for profitable returns.
The finality of the closure decision is reinforced by the physical closing process: work staff is dismissed, food, liquor, and small wares inventory is returned or transferred to another location, doors are closed, utilities are disconnected, signage and all other identity and customer goodwill at the site is removed or dissipated, listing agreements to sell the property are signed, and, the unit is aggressively marketed for sale. In most cases, there is no question that when a unit is withdrawn from company operations the decision to do so is a final and irreversible one.
The successful restaurateur strives to differentiate his restaurant from others. Hundreds of thousands of dollars are often spent to distinguish one restaurant from another’s theme and operational motif. When a specific restaurant closes, that value, the value of the ongoing concern, is lost. It will not be recovered upon a subsequent sale. Proper tax accounting dictates that this loss in value is allocated to the time period over which the asset generated income and the loss be recognized at the time the unit is retired from use.
When the foregoing points are effectively presented with the proper legal support IRS has been receptive to such arguments and sanctioned the loss deduction at the time of the closure of the restaurant unit.