Global Tax Insights
Why Cost Segregation Providers Should Watch OutSeptember 15, 2014
Two Tax Court cases that have caused cost segregation providers to make sure their “i(s)” are dotted and “t (s)” are crossed.
Over the past few years, we have seen several new developments in the practice of cost segregation. In an effort to reduce the amount paid in federal and state income taxes, companies can take advantage of a cost segregation study. This is the process by which the costs of longer lived depreciable assets are separated from the cost of shorter lived assets.
How it Works
Cost segregation follows that the capitalized and depreciated cost of real property like an apartment complex (depreciated over 27.5 years) or a factory building (depreciated over 39 years) should not include certain shorter lived assets whether they are located inside or outside of the facility. Once identified, these assets can then be depreciated using shorter useful lives which result in quicker depreciation deductions.
The tax court cases discussed below illustrate the need to engage a competent cost segregation expert when considering undergoing a study.
About twenty years ago, Peco Foods was determined to expand its poultry processing business, leading to their purchase of two poultry plants in Mississippi. Peco Foods decided on a purchase agreement and allocation but were disappointed with the depreciation expense offered based on the allocations from the purchase agreements. The company was later audited by the IRS and they revealed that under Sec. 1060 of the IRC, the original written allocation at the time of the purchase permanently determines the depreciation and classifications of assets.
The case eventually was heard by the Tax Court who agreed with the IRS. The Tax Court’s decision stresses the importance of preparing a purchase agreement that includes proper language regarding purchase price allocations.Assuming the taxpayer neglected to have a study done prior to the purchase, the language used in the purchase price allocation documents should support post-acquisition cost segregation. If one were desired by the purchaser, the Tax Court stated, Peco Foods could not retroactively adjust purchase price allocations that were agreed to, in writing, at the time it purchased the assets of the two poultry processing plants.Hence, the company was bound to the original agreement from the time of purchase.
AmeriSouth owned an apartment complex and instituted a cost-segregation study. The company then tried to depreciate over 1,000 building components over 5 or 15 year spans. The tax court decided that AmeriSouth had to depreciate these structural components over the life of the buildings.
In the case of AmeriSouth, the Tax Court did not to follow its own previous definition of what qualifies for cost segregation. Specifically,the court stated a structural component of a building is “any asset required for the operation of 'that' building” and should be capitalized and depreciated as part of the building. This definition is considerably different than the one used by the court in its previous, landmark decision, in the Hospital Corporation of America case. In that case, the court defined a structural component of a building as any asset required for the operation of a generic building. This definition is much narrower than the definition used in the AmeriSouth case.
Here’s an example to help illustrate why this is important.Let’s assume three taxpayers build three identical buildings. The buildings are on the same street (next door to each other, actually), in the same city and are built in compliance with the same building codes. One would hope that, if built to code, the buildings would include all components for the operation of a “generic” building in that city. If the owners retrofitted these generic buildings according to the needs of their three different businesses, most, if not all, of the asset additions would not be required for the operation of a “generic” building. These additions would qualify for shorter depreciation lives than the lives of the buildings.
If the definition used for a structural component of a building in the AmeriSouth case were applied many of the asset additions would be “required” for the operation of each individual building and therefore would have to be capitalized and depreciated over the lives of the buildings.
The decision in the AmeriSouth case HAS NOT (at the time of this writing) been used as precedent in subsequent cases.
Note:Both of these cases maintained the legitimacy of cost segregation despite their outcomes. With many taxpayers depending on the tax savings they receive from cost segregation studies to run or expand their business, it is important for the tax court to put clear and understandable rules in place.
In any case, cost segregation can still be a great benefit for companies if they don't abuse it! For more information, contact any member of our Tax Services Group.