Is the Value of Cost Segregation Depreciating?

Editor: Anthony S. Bakale, CPA, M. Tax.

Depreciation

Recent decisions in the cases AmeriSouth XXXII, Ltd., T.C. Memo. 2012-67, and Peco Foods, Inc., T.C. Memo. 2012-18, have been announced as IRS victories that call into question the validity of cost-segregation studies and their value to taxpayers. But a closer analysis of each ruling suggests that any purported demise of cost-segregation studies may be premature.

In AmeriSouth, the IRS challenged the classification of component costs of AmeriSouth’s large apartment complex properties. AmeriSouth had used the services of a company purportedly specializing in asset classification and cost-segregation analysis for federal income tax purposes. Despite the cost-segregation study, the IRS argued that many of the types of component costs of the properties that the taxpayer treated as personal property or land improvements, in accordance with the conclusions of the cost-segregation study, should properly be classified as costs of structural components of the buildings to which they pertained.

The court generally held in favor of the IRS, finding that a significant portion of the component costs that were classified as personal property or land improvements in the cost-segregation study should be properly classified as residential rental real property. For “tax headline” purposes the ruling could be summed up as, “Cost-Segregation Study Does Not Withstand IRS Challenge.”

In Peco, the IRS challenged the taxpayer’s ability to classify assets for federal income tax purposes in accordance with the results of a cost-segregation study. The subject property was acquired by the taxpayer in two separate asset purchases, each constituting the purchase of a trade or business for federal income tax purposes. As such, the transactions were subject to Sec. 1060. In connection with the transactions, the parties to each transaction constructed and agreed to an allocation of the respective purchase prices among a list of identified assets.

Among the assets to which allocations of the respective purchase prices were made were the following building property assets: processing plant building, two holding sheds, and hatchery real property. Subsequently, the taxpayer obtained a cost-segregation analysis of the building property assets. The taxpayer used the asset classifications determined in the cost-segregation study for purposes of depreciating the component costs of the building property assets.

The IRS argued that the taxpayer had to classify the entire cost of the building property assets as a building, since the taxpayer had agreed to the specific allocation of a portion of the respective purchase prices to building property assets. The court held in favor of the IRS, finding that the specific allocation of purchase price to building property assets was controlling. For tax headline purposes the court’s decision could be summed up as, “Cost-Segregation Study Held Not Relevant in Determining Proper Classification of Assets.”

It is true that the decisions in these cases favored the IRS’s positions, and the associated headlines are not untrue. While it may initially seem that the usefulness of cost-segregation studies is significantly diminished by these decisions, a closer inspection of the facts and circumstances in each case should lead an astute tax practitioner to the opposite conclusion.

AmeriSouth

The AmeriSouth case involved a taxpayer that had disposed of the property that was the subject of the cost-segregation study prior to trial. With apparently little to gain or lose by expending a genuine effort to defend the asset classifications determined in the cost-segregation study, AmeriSouth did not do so. Its legal counsel was allowed to withdraw from representation, and AmeriSouth, left to defend itself, was unresponsive to the court. As such, the holdings of the court were made in a setting where the taxpayer offered no testimony, evidence, or argument at trial. It would seem impossible for the IRS not to prevail in its contested positions with such an advantage. Amazingly, the court found that some of the assets in question were not residential real estate, despite the taxpayer’s nonexistent defense.

Because the taxpayer offered no defense, the precedential relevance of the decision is questionable. The Tax Court’s decision is appealable to the Fifth Circuit, but it can be assumed that AmeriSouth will not appeal the decision. A taxpayer with a fact pattern identical to the one presented in AmeriSouth might be more successful merely because the taxpayer is willing to contest the IRS’s positions in court.

Selected holdings of the Tax Court’s memorandum opinion include the following:

Site preparation and earthwork is nondepreciable land cost: In qualifying its determination on this point, the court stated, “It’s certainly plausible that some of the pre-1970 site preparation relates to sidewalks, parking, and driveways and may therefore be depreciable, but AmeriSouth has presented no evidence on this point. In this context—or lack of context—we cannot uphold AmeriSouth’s allocation between the costs of land and site preparation” (AmeriSouth, slip op. at 22).

Comment: It would seem that an adequately supported allocation of costs of site preparation to such land improvements would likely be sustained, if defended.

Defining the building: The court held that the appropriate benchmark for determining whether a component relates to the operation or maintenance of the building takes into account the type of building that the component is part of. Thus, the analysis should be done considering a typical apartment building, not a mere “shell” building. The building definition conclusion would seem to preclude classifying as personal property many items common to apartment buildings that are customarily classified as personal property in cost-segregation studies (e.g., kitchen cabinetry, finish carpentry and millwork, appliances, specially dedicated electric or plumbing, decorative features, etc.). However, the court clarified that the appropriate determination nonetheless relies on the three prominent established factors, “whether an asset is: (1) accessory to a business, (2) permanent, or (3) ‘ornamentation.’”

In AmeriSouth, several such items were held to be structural components. Reflective of the manner in which the court arrived at its conclusion with respect to most of these items is its holding with respect to finish carpentry and millwork, as follows:

AmeriSouth’s millwork consists of cabinets and countertops. Their proper classification is strictly an issue of their permanence—AmeriSouth argues that they are all removable. But, as with finish carpentry, AmeriSouth did not present any evidence about the additional factors regarding their permanence that we need to consider. We therefore make the same finding as we do on finish carpentry: The millwork is a structural component. [AmeriSouth, slip op. at 58 (Emphasis added.)]

Comment: It would seem that classification of many items common to apartment buildings that are customarily classified as personal property in cost-segregation studies should continue to be classified as personal property where the taxpayer’s facts support that the items either: (1) lack “permanence”; (2) are necessary to and used directly with specific pieces of equipment; or (3) are principally “decorative.”

Special painting constitutes structural components of the building: The court held that the nature of the items painted controlled the classification of the paint. The court said, “AmeriSouth’s former attorneys asked at trial whether the classification of the paint should follow that of the items painted, and the Commissioner’s witness responded yes. We see no reason to coat that succinct view with any additional analysis—those items are structural components and, therefore, so is the paint” (AmeriSouth, slip op. at 60).

Comment: It would seem that this holding removes uncertainty regarding classifying painting costs as personal property where the items painted are personal property.

The usefulness of a cost-segregation study performed by a person competent in both the application of recognized cost-estimation principles and in the assessment of personal property vs. structural components, considering the nature of the building and the relevant authoritative tax guidance for the three prominent established factors, has increased as a result of the AmeriSouth decision. The case is a reminder that taxpayers should take care to engage a cost-segregation specialist whose work product addresses and satisfies the authoritative and computational support requirements for the asset classifications it contains. AmeriSouth highlights that anything less is essentially worthless for purposes of sustaining a taxpayer’s asset classifications in court.

Peco

The Peco case involved a taxpayer that participated in two asset purchase transactions constituting the acquisition of a trade or business pursuant to Sec. 1060. Sec. 1060(a) generally provides that where parties to an applicable asset acquisition agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, the agreement is binding on the parties. While the agreement in writing is binding on the parties to the asset purchase, it is not binding on the IRS. Practically, however, the IRS will find it difficult to significantly adjust a reasonable purchase price allocation agreed to in writing by two unrelated parties dealing at arm’s length and in good faith.

In light of the decision in Peco, it is clearly pointless to perform a cost-segregation study, for federal income tax purposes, to segregate the costs of components of purchased assets that have been identified as “building” in a purchase price allocation agreed to in writing by the buyer and seller.

Ideally, the informed tax practitioner will instead advise the acquiring taxpayer that if a cost-segregation study for the acquired assets would likely provide significant tax benefits, the study should be performed prior to the parties’ agreement as to the allocation of the purchase price and its asset classifications incorporated therein. Business transactions are often consummated under conditions less than ideal for allowing the performance of a thorough cost-segregation study prior to the execution of binding agreements. In such cases, the Peco decision provides valuable guidance for taxpayers to potentially frame the purchase price allocation in a manner that would allow sufficient flexibility to allow the buyer to classify assets according to the results of a cost-segregation study.

The court found that the allocation of purchase price to building property was controlling because the description of the property (i.e., processing plant building) was unambiguous as to whether the property was a building. The court analyzed the respective definitions of the term “building” and the term “plant.” Noting the distinction, the court opined,

In the light of these definitions, we believe that Peco and Green Acre would have simply referred to “Processing Plant” rather than “Processing Plant Building” had they intended to include within the term special mechanical systems and other assets that are not part of a building. By including the term “building” (i.e., a structure) to describe the assets acquired, we believe that Peco and Green Acre intended to allocate a portion of the purchase price to a structure and not to the assets contained therein. [Peco, slip op. at 19–20]

In similar situations, the allocation of a portion of an applicable asset acquisition purchase price to “plant” will be sufficient for both the buyer’s and the seller’s purposes. For example, for Sec. 1060 reporting purposes, the allocation of purchase price is less specific than this. For this purpose, included in Category V assets are all acquired fixed assets, whether personal property or real property. The purchase price allocated to all such acquired assets is aggregated, and the total is reported on Form 8594, Asset Acquisition Statement, as the purchase price allocated to Category V assets.

The Peco decision can educate taxpayers as to the improper way and the proper way to take advantage of the benefits of a cost-segregation study in the context of an asset purchase in the acquisition of a trade or business. When the parties agree to the allocation of purchase price to “plant” rather than “building,” the buyer is in a position to classify assets making up the “plant” according to a cost-segregation study of those assets, while the seller’s former tax treatment of the assets making up the “plant” is not necessarily compromised.

It is the nature of cost-segregation studies to investigate beneath the facade of a facility to analyze the appropriate asset classifications of the components making up the facility. It is fitting that analyzing beneath the surface of the recent holdings in AmeriSouth and Peco suggests that the usefulness and value of properly performed cost-segregation studies is enhanced rather than diminished.

EditorNotes

Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.