Major Developments in Cost Segregation

Because of two important cases, 2012 and 2013 proved to be critical years for the practice of cost segregation, which involves breaking down one asset into many smaller components with varying useful lives. The benefits of cost segregation are immediately obvious in the area of depreciation. If a taxpayer takes a large asset (e.g., an apartment building) and breaks it down for depreciation purposes into groups of smaller assets (e.g., the appliances are treated separately from the shell building), many of those smaller assets can be depreciated using shorter useful lives. This results in a substantially reduced tax liability in the near term if the practice is used to its maximum effect.

The use of cost segregation has proved to be so lucrative since the Tax Court decided the Hospital Corp. of America1 case that many financial planning firms have come to specialize in the practice. These firms have created divisions tasked with creating cost-segregation studies that break down a large asset into separate components for depreciation purposes.

Two recent Tax Court cases have limited the use of cost segregation, however. The first case is Peco Foods2—a case that was recently affirmed on appeal. This case demonstrates the importance of drafting a purchase agreement with purchase price allocations that will support post-acquisition cost segregation. Peco Foods shows that a cost-segregation study’s benefits are eliminated when a purchase agreement has wording that contradicts that study.

The second case is AmeriSouth.3 In this case, the taxpayer used a cost-segregation study to break down a single apartment complex into more than 1,000 assets, classifying everything from plumbing to molding as shorter-life depreciable assets. The IRS challenged this treatment, and the Tax Court mostly sided with the IRS. The case introduced a stricter definition of what components count as structural components.

While the 1997 case Hospital Corp. of America greatly increased the benefit of cost-segregation studies, AmeriSouth and Peco Foods from 2012 and 2013, respectively, tend to restrict it. It should be noted, however, that both cases uphold the overall concept of cost segregation. As the general concept of cost segregation undoubtedly still applies, this article discusses the rules that must be followed to use the principle of cost segregation in any form.

Peco Foods

In the 1990s, Peco Foods was intent on expanding its primary business of poultry processing. Using its subsidiary businesses, Peco Foods acquired two poultry plants in Mississippi: one in Sebastopol and the other in Canton. The purchase agreement for the Sebastopol plant allocated the $27.15 million purchase price for the plant over 26 assets, including one asset denoted as a “processing plant building.” In the acquisition of the Canton plant, the $10.5 million purchase price was allocated to only three assets classified into the three categories: (1) land, (2) improvements, and (3) machinery, equipment, furniture, and fixtures. In both acquisitions, Peco Foods agreed with the seller to an allocation of the total purchase price to certain assets “for all purposes (including financial accounting and tax purposes).”4

However, Peco Foods was unsatisfied with the depreciation expense available based on the allocations from the purchase agreements because most of the value was tied up in buildings with long useful lives. To meet its goals of greater cost recovery, the taxpayer sought the help of two third parties to perform cost-segregation studies on the plants.

The taxpayer’s objective was to perform a lookback study on the properties previously purchased to claim depreciation not previously deducted. These catch-up deductions, which can be used on the current tax return without amending previous returns, require an automatic change in accounting method obtained by filing Form 3115, Application for Change in Accounting Method, with the taxpayer’s current-year tax return.

Before the cost-segregation study and Form 3115 filing, Peco Foods had only 29 assets on its books from both acquisitions. After the study, there were well over 1,000 separately identifiable assets from the two plant purchases. As a great majority of the new assets had shorter useful lives than buildings, the upfront savings based on the additional depreciation were significant. Overall, the studies entitled Peco Foods to an additional $5,258,754 in depreciation from 1998 to 2002, which also resulted in immediate tax savings. (Of course, this is only a timing difference, as the overall depreciation would be the same under both methods.)

In 2008, the IRS issued a notice of deficiency stating that the taxpayer owed deficiencies of $120,751, $678,978, and $727,323 for the years 1997, 1998, and 2001, respectively, based primarily on the determination that Peco Foods was not due the additional depreciation it had claimed on the basis of its cost-segregation studies. The taxpayer petitioned the Tax Court in response to the notice of deficiency.

The IRS relied on two primary arguments in defense of its position: Sec. 1060(a) and the Danielson5 rule. In 1990, Congress amended Sec. 1060(a) to strengthen the binding nature of purchase agreements.6 As amended, the section states that:

If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Simply put, if a taxpayer allocates the purchase price in an applicable asset acquisition, Sec. 1060(a) in its current form requires the taxpayer to use these original allocations agreed to at the time of purchase unless the IRS finds that the allocations are inappropriate. In this case, that would mean the taxpayer would be forced to maintain the original 29 assets that were identified at the time of purchase instead of the numerous components determined in the cost-segregation studies.

As the Tax Court noted, the legislative history for the Sec. 1060(a) amendment states that “[t]he committee does not intend to restrict in any way the ability of the IRS to challenge the taxpayers’ allocation to any asset or to challenge the taxpayers’ determination of the fair market value of any asset by any appropriate method.”7

Secondly, the IRS pointed to the precedent of the Danielson case. Danielson stands for the proposition that a taxpayer can challenge the tax consequences of a written agreement as construed by the IRS “only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” Although Danielson was decided by the Third Circuit, it was adopted by the Eleventh Circuit—which is where the appeal of the Peco Foods case would be heard. The IRS argued that Danielson precluded the taxpayer from modifying the allocation schedules from its purchase agreements.

The IRS’s general argument was simple: Under Sec. 1060 and the Danielson rule, the original written allocation at the time of purchase determined the depreciable lives and classifications of the assets purchased and could not be modified.

The taxpayer had two responses to the IRS’s arguments. First, the taxpayer argued that Sec. 1060 does not prohibit a taxpayer from changing an asset’s class from Sec. 1250 property (e.g., a building) to Sec. 1245 property (i.e., personal property subject to a shorter useful life). Instead, Sec. 1060 only requires that the purchase price in an applicable asset acquisition be allocated under the principles of Sec. 338. The cost-segregation studies the taxpayer commissioned primarily shifted portions of buildings (Sec. 1250 property) to individual internal components (Sec. 1245 property). Thus, the revision of allocation schedules was allowable under Sec. 1060.

Second, Peco Foods argued that purchase agreements were unenforceable and thus the Danielson rule did not bar the company from modifying the allocations. It argued the agreements were unenforceable because the terms “Processing Plant Building” in the Sebastopol agreement and the term “Real Property Improvements” in the Canton agreement were ambiguous. According to Peco Foods, the terms, in the context of the respective agreement, did not reflect the parties’ intent to include within the terms specialized mechanical systems and other assets that qualified as Sec. 1245 property. Simply put, the use of these terms made the original agreements ambiguous to the degree that they could be considered unenforceable.

The Tax Court’s Decision

The Tax Court first found that Peco Foods had misinterpreted Sec. 1060. The court explained that, although generally the allocation of the purchase price in an applicable asset acquisition would be governed by Sec. 338(b)(5), a written agreement that includes an allocation of the purchase price supersedes the allocation under Sec. 338(b)(5). Therefore, if the written agreements were enforceable, the taxpayer could not modify the allocation schedules from the purchase agreements.

With regard to the Danielson rule, the Tax Court said the allocations from the purchase agreements were binding on the taxpayer unless (1) the IRS determined that they were not appropriate or (2) the agreement was unenforceable under traditional contract formation defenses. Because the IRS did not dispute the propriety of the original allocation schedules, the court determined that it only needed to decide the enforceability of each agreement.

The Tax Court therefore focused on whether the terms used in the purchase price allocation schedules were ambiguous. Under Mississippi law (which applied to the Sebastopol agreement because the plant was located in that state), an ambiguous term is “one capable of more than one meaning when viewed objectively by a reasonably intelligent person who has examined the context of the entire integrated agreement and who is cognizant of customs, practices, usages and terminology as generally understood in the particular trade or business.”8 Applying this definition, the Tax Court found that the original classifications were not ambiguous.

In its review of the Sebastopol agreement, the Tax Court found that the use of the word “building” in the allocation was significant. Peco Foods argued on multiple occasions that the term “processing plant building” was used ambiguously in the purchase agreement, and that it intended to classify the “processing plant building” with more specificity. The Tax Court did not find the taxpayer’s argument compelling because the word “building” is explicit and it clearly implies Sec. 1250 property. The taxpayer itself classified both the shell and the internal components as a building in the purchase agreement. According to the Tax Court, calling the entire processing plant (and all of its internal components) a “building” was a clear method of delineating a 39-year useful life for the property. However, the Tax Court did opine that a different result might have been achieved had the asset been described as a “processing plant.” Per the Tax Court, omission of the word “building” would have proved some intention by the buyer and seller that part of the purchase price be allocated to the assets within the shell of the building.

In its review of the Canton plant agreement, the Tax Court similarly analyzed the terms used in the allocation schedules. However, it applied Alabama law to this agreement because of a choice-of-law clause in the agreement. The court found that under Alabama law, it should discern the intent of the contracting parties from the contract as a whole and it should give the terms in a contract their “ordinary, plain, and natural meaning” unless the contract establishes that the terms were intended to be used in a special or technical sense.

The court concluded that the term “Real Property: Improvements” was unambiguous in the light of the Canton agreement as a whole. The court pointed out that Peco Foods and the seller of the Canton plant agreed to allocate the purchase price among three assets, namely, “Real Property: Land,” “Real Property: Improvements,” and “Machinery, Equipment, Furnitures [sic] and Fixtures.” The court stated that the decision to allocate the purchase price separately among these various assets showed that Peco Foods was aware of the existence of subcomponent assets but chose not to allocate additional purchase price to them. Therefore, the use of the term “Real Property: Improvements” was not ambiguous.

The Tax Court discerned that the original agreements were not ambiguous for another key reason: A clause included in both agreements stated that the allocations applied “for all purposes (including financial accounting and tax purposes).” In the eyes of the Tax Court, this clause effectively barred any change that would modify the taxes because the original agreement specifically noted that its figures must be used for tax purposes. Under this approach, a purchase agreement must bind both the transferee and transferor to ensure a consistent tax treatment for all parties.

Based on the above reasoning, the Tax Court determined that the IRS had not erred in its decision to prevent the taxpayer from modifying its original purchase allocation. Therefore, the court ruled in the IRS’s favor on all counts. The Eleventh Circuit upheld the Tax Court’s decision on appeal.

Peco Foods Tax Planning

Peco Foods is not an example of one side winning or losing a case based on specific facts. More accurately, the taxpayer’s loss was caused primarily by the flaws in the purchase agreements for the plants. The first and most egregious error was including the contract clause providing that the original allocations applied “for all purposes (including financial accounting and tax purposes).”

Fortunately, such a misstep can generally be avoided by not using such an explicit clause in a buyout contract. Without that legal millstone hanging around the taxpayer’s neck, the outcome of the case might well have been different.

The second major issue the taxpayer encountered was its use of explicit depreciation terminology such as “building.” While this issue might well have been moot because of the clause in the taxpayer’s agreement providing for the allocations to apply for all purposes, the court’s reasoning is clear and may help in future cases. A term such as “processing plant building” is not ambiguous. As this term is not open to debate by reasonable persons (i.e., it clearly classifies the entire item as a building), the taxpayer has no right to modify the allocation at a later date. Had the taxpayer chosen the phrase “processing plant” without the word “building,” this specific issue might have been avoided.

Once again, while Peco Foods buried its chances with flawed language, the simplest method of sidestepping that mistake is avoiding potentially damaging classifications such as “building.” If a taxpayer classifies an asset in a purchase agreement ambiguously (or simply avoids unhelpful words such as “building”), this issue will likely not arise.

Finally, it should be noted that the Tax Court did not take issue with either of the two third-party cost-segregation studies on their face. It was not because the taxpayer split 29 assets into well over 1,000; it was that it did so while under the restrictions of Sec. 1060 and the precedent of Danielson. The lesson of Peco Foods is that it is best to conduct a cost-segregation study before drafting a purchase agreement. In any case, cost-segregation experts should be involved early in any asset purchase. A real estate attorney experienced in cost-segregation law should be involved in negotiating an asset purchase and in drafting the final purchase agreement.

In Peco Foods, the Tax Court held that by signing an agreement that allocated the purchase price to specific assets, including real property, the taxpayer was barred from later reclassifying real property as personal property after conducting a cost-segregation study. Peco Foods raises a problem where real property is involved in a purchase of assets. Proper tax planning is required to determine how to best allocate the purchase price to the assets for tax purposes before signing any agreement.

Simply put, a tax expert in cost-segregation studies should be consulted before any purchase. This expert’s help can enable a company to identify and separate “personal property” cost such as fixtures and equipment from “real property” cost. In some cases, components of an acquisition might be separated into those that are necessary to operate the business and those required to operate an actual asset. For example, in Peco Foods, the purchase agreement could have identified the food-processing machines as separate assets from the plant facility. In addition, a real estate attorney should draft the sales agreement based on the report of the cost-segregation expert. This careful tax planning is required in asset acquisitions because of these recent developments in the area of cost segregation.

The AmeriSouth Case

Perhaps the biggest move the taxpayer made in the AmeriSouth case was its lack of action. Shortly after the legal proceedings began, the taxpayer stopped participating and its attorneys soon withdrew from the case. The Tax Court could have dismissed the case; however, the court completed the proceedings without the taxpayer’s presence and rendered a decision on the merits of the case, deeming any factual matters AmeriSouth did not contest to be conceded.

AmeriSouth owned an apartment complex and commissioned a cost-segregation study. It then attempted to depreciate more than 1,000 building components over five- or 15-year spans, instead of the 27.5 years applicable to rental real estate under the modified accelerated cost recovery system (MACRS). The Tax Court held that most of those components were structural components—integral to the buildings’ operation and maintenance as apartment buildings—and therefore they had to be depreciated over the life of the buildings.

The Tax Court in AmeriSouth defined structural components differently than in prior cases. Previous precedent held that a component is structural if it is essential to the operation of a generic shell building. However, the AmeriSouth case stated that an asset is a structural component when it is essential to the operation and maintenance of a specific piece of real estate. For example, under older case law, a water line to a hotel would qualify for cost segregation as it does not relate to the generic shell building. However, under AmeriSouth, the water line would be classified as essential to the operation or maintenance of the hotel and would be depreciated as part of the building.

It remains to be seen if the AmeriSouth definition of structural components will be accepted by other courts. So far, the Court of Federal Claims appears to have accepted it, albeit in a case involving like-kind exchanges rather than cost segregation.9 If this new definition of structural components is accepted, the amount of assets depreciated over shorter useful lives based on cost-segregation practices will be significantly reduced. Overall, though, the Tax Court did accept the concept of cost segregation.

Conclusion

These two recent cases provide valuable lessons on good cost-segregation practices. Peco Foods indicates that in an asset acquisition it is in the buyer’s best interest to carefully consider cost segregation (and possibly undertake a full cost-segregation study) before completing a purchase agreement between the buyer and seller. When drafting a purchase agreement, close attention needs to be paid to the descriptions and definitions used in the agreement.

In the long run, AmeriSouth may not be a significant limitation to cost segregation if other courts hold to older precedent and continue to define a component as structural if it is essential to the operation of a generic shell building. However, if courts adopt the AmeriSouth definition that a component is structural when it is essential to the operation or maintenance of a specific piece of real estate, then the total amount of depreciation deductible through the process of cost segregation may be significantly reduced. For tax planning purposes, taxpayers should carefully document assets that are not essential to the operation or maintenance of a specific piece of real estate in case the appeals courts adopt the AmeriSouth definition of a structural component for cost-segregation purposes.

Overall, however, one thing is clear: While there is some uncertainty in the area of cost segregation based on how AmeriSouth may be applied in the future, it should be noted that both the Peco Foods and AmeriSouth cases upheld the concept of cost segregation.

Footnotes

¹ Hospital Corp. of Am., 109 T.C. 21 (1997).

² Peco Foods, Inc., T.C. Memo. 2012-18., aff’d, No. 12-12169 (11th Cir. 2013).

³ AmeriSouth XXXII, Ltd., T.C. Memo. 2012-67.

⁴ Peco Foods, Inc., T.C. Memo. 2012-18 at *3.

⁵ Danielson, 378 F.2d 771 (3d Cir. 1967).

⁶ The Omnibus Budget Reconciliation Act of 1990, P.L. 101-508, §11323(a).

⁷ H.R. Rep’t No. 101-881, 101st Cong., 2d Sess., at 351 (1990).

⁸ Peco Foods, T.C. Memo. 2012-18 at *18, quoting Walk-In Med. Ctrs., Inc. v. Brever Capital Corp., 818 F.2d 260, 263 (2d Cir. 1987).

⁹ Deseret Management Corp., No. 09-273T (Fed. Cl. 8/22/13).