Cost Segregation – Risks and Benefits

Overview

Recently, I devoted a blog post to the benefits of a farming or ranching operation from the utilization of a cost segregation study. https://lawprofessors.typepad.com/agriculturallaw/2019/03/cost-segregation-study-do-you-need-one-for-your-farm.html.  That post generated a great deal of nice comments and input and a request for another post looking at the risks of using a cost segregation study.  Indeed, in 2018, the IRS issued a Chief Counsel Advice (CCA) discussing when the preparers of cost segregation studies could be subjected to penalties.

Issues and risks associated with cost segregation studies – that’s the topic of today’s post.

Background

As pointed out in my prior post, cost segregation is the practice of taking a large asset (such as a building) and splitting its structural component parts into a group or groups of smaller assets that can be depreciated over shorter lives.  See Treas. Reg. §1.48-1(e)(2)(provides guidance on the definition of a “structural component”).  A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate).  In tax lingo, the studies often result in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period.  See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763.  But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property).  This technique will generate larger depreciation deductions in any particular tax year.  The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on a farm or ranch, and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets.  These changes make it more likely that a cost segregation study will provide additional tax benefits.   

Placed-in-Service

Because of the additional depreciation incentives included in the TCJA, the “placed-in-service” date of an asset is of primary importance.  When is an asset deemed to be placed in service for depreciation purposes?  The answer is when the asset is in a condition or state of readiness and availability for a specifically assigned function such as use in the taxpayer’s trade or business. See Treas. Reg. §1.167(a)-11(e)(1)(i); see also Treas. Regs. §§1.46-3(d)(1)(ii) and 1.46-3(d)(2); Von Kalinowski v. Comr., 45 F.3d 438 (9th Cir. 1994), rev’g. T.C. Memo. 1993-26.  In practice, the determination of when an asset is placed in service is highly fact-dependent.  In addition, the answer to the question can turn on the type of asset that is involved.  As applied to commercial buildings, for example, the IRS tends to use the date on a certificate of occupancy as a factor in determining the placed-in-service date of the building or a portion of the building.  But, in Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. 2015), the court held that the two buildings of a retail operation at issue in the case were placed in service in the year when they were ready and available to store equipment and contained racks, shelving and merchandise.  The court viewed it as immaterial that the certificates of occupancy for the buildings did not allow public access until the next year.  The placed-in-service date was important in Stine because the taxpayer sought to have the buildings placed in service in 2008 (rather than 2009) to be eligible to deduct Gulf Opportunity Zone bonus depreciation on the buildings.  The IRS issued a non-acquiescence in Stine.  A.O.D. 2017-02 (Apr. 10, 2017).  The IRS said that it will continue to litigate the placed-in-service issue on the basis of its position that a retail store isn’t placed in service until it is open for business.

IRS Audit Approach

The IRS has posted to its website a very detailed audit technique guide (ATG) concerning cost segregation studies.  See https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents.  The guide is useful in terms of the information it provides practitioners concerning its view on what constitutes a properly conducted cost segregation study.  In the ATG, IRS auditors are advised to closely scrutinize cost segregation studies that are conducted on a contingency fee basis.  The IRS believes that such fee structures incentivize the maximization of I.R.C. §1245 costs through “aggressive legal interpretations” or by inappropriate cost or estimation techniques.  As a result, firms performing cost segregation studies may be better off billing the work based on the size of the project plus out-of-pocket expenses.  Auditors are also advised to conduct in-depth reviews of cost segregation studies to determine the appropriateness of property depreciation classifications and determine if there are any land or non-depreciable land improvements that the study has classified as depreciable property.  This could be a particularly important issue for cost segregation studies involving farm and ranch taxpayers.

In the ATG, IRS examiners are to closely look at the classification of I.R.C. §1245 and I.R.C. §1250 property.  On this distinction, taxpayer records and documentation are critical.  IRS will look to see whether a building component designated as I.R.C. §1245 can actually be used for other pieces of equipment.  If it can, it will likely be classified as part of the building. The ATG also notes that IRS examiners can use sales tax records of the taxpayer as guidance on the proper allocation between I.R.C. §1245 and §1250 property.   Other key points on the I.R.C. §1245/I.R.C. §1250 distinction involve whether the cost segregation study used cost estimates or actual cost records or a residual approach to determine the actual cost of I.R.C. §1245 items.  What IRS is looking for is whether the cost of I.R.C. §1245 property has been set too high. 

Another specific area of examination involves when depreciable and non-depreciable property are acquired in combination for a lump sum.  The ATG points out to examiners that the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of the acquisition bears to the value of the entire property at that time.  See Treas. Reg. §1.167(a)-5.  Thus, examiners are to look at the fair market values of the properties at the time of acquisition.  The fair market value of the land is to be based on its highest and best use as vacant land even if it has improvements on it.  Thus, the ATG states that it is not correct for a cost segregation study to estimate land value by subtracting the estimated value of improvements from the lump sum acquisition price.  Doing so, according to the IRS, results in an overstatement of the basis of depreciable improvements. 

The ATG instructs examiners to reconcile total project costs (in terms of cost basis) in the taxpayer’s records with the total project costs in the cost segregation study.  Thus, the IRS can be expected to request a copy of the taxpayer’s general ledger data.  A key question will be whether costs that should have been in the taxpayer’s building account, for example, are showing up in another account or were expensed.  Likewise, the ATG states that examiners should see if costs associated with site preparation, grading and land contouring have been properly (in the IRS view) allocated to land basis rather than being allocated to the overall building cost. 

Preparer and Aiding and Abetting Penalties?

In 2018 the IRS issued a CCA taking the position that the preparers of cost segregation studies could be subjected to penalties.  CCA 201805001(Oct. 26, 2017).  The CCA involved a set of facts where an engineer/consultant prepared a cost segregation study without having any direct role in preparing tax returns.  The engineer/consultant simply provided the completed study to the taxpayer so that the taxpayer could use it in the preparation of the taxpayer’s returns.  The cost segregation study divided a 39-year property into component parts, many of which were assigned five-year MACRS lives.  On audit, the IRS disagreed with the structural building components being classified as five-year property.  Simply correcting the improper classification on the taxpayer’s returns was not enough.  The IRS took the position that I.R.C. §6701 could serve as the basis for penalties against the study’s preparer for aiding and abetting the understatement of tax liability.  The IRS position was that the engineer/consultant, by preparing the cost segregation study, was aiding or advising in the preparation of the taxpayer’s return.  That satisfied I.R.C. §6701(a)(1).  Accordingly, the engineer/consultant either knew or had reason to know that the study would be used “in a material matter relative to the IRC.”  That satisfied I.R.C. §6701(a)(2). In addition, the IRS argued that the engineer/consultant had actual knowledge that the cost segregation study would result in an “understatement of the tax liability of another person” under I.R.C. §6701(a)(3).  This last point is important.  If the preparer of a cost segregation study knows that the study inflates depreciation deductions that will result in an understated tax liability, liability is present given that the fist two elements of potential liability under I.R.C. §6701 are practically presumed present. 

The IRS determined that the engineer/consultant was liable for the $1,000 penalty for aiding and abetting the misstatement of individual tax forms.  Had a misstated corporate form been involved, the penalty would have been $10,000.  However, the IRS took the position that the $1,000 penalty should be imposed multiple times because the cost segregation study contributed to five returns misstating income as a result of the classification of 39-year property as five-year property.  Why the IRS didn’t take the position that six $1,000 penalties should be imposed was not clear.  Five-year MACRS property results in six-years of depreciation deductions (one-half year’s depreciation in each of year one year six under the one-half year convention).  The IRS cited In re Mitchell, 977 F.2d 1318 (9th Cir. 1992) to support its position that multiple penalties should be imposed.

Conclusion

The favorable depreciation rules contained in the TCJA certainly create incentives for the greater use of cost segregation studies.  In addition, care should be taken by the preparer(s) of a cost segregation study.  The recent CCA indicates that the IRS is looking to establish that a study author has actual knowledge (under the preponderance of the evidence standard) that the study would result in an understatement of tax liability.  See, e.g., Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991).  Actual knowledge must be shown.  If a cost segregation study is prepared in accordance with the general guidance of Hospital Corporation of America & Subsidiaries, penalties should be avoided.  But, ambiguities will very likely exist on the distinction between I.R.C. §1245 and I.R.C. §1250 property. 

As Sergeant Esterhaus would say, ”Let’s be careful out there.”