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One of my running jokes is that the Internal Revenue Code is a white collar jobs program for college graduates who are not quite smart enough to become engineers. But what happens when engineers realize that some types of tax work can be more lucrative than doing whatever it is that engineers do? That's how we get cost segregation specialists.
Blaise Dusenberry, a senior technical reviewer in the Office of Chief Counsel, IRS, refers to one such as a "tax consultant/engineer". The TCE is designated in Chief Counsel Advice 201805001 as P. And P will be in a world of hurt if STR Dusenberry's advice is followed, but just for background I will tell you a little about the cost segregation industry.
Why Cost Segregation?
When a building is placed in service in a trade or business, the taxpayer will be able to recover its cost over a period of time. Typically, though a building is not just a building. You also buy the land, the cost of which you don't recover until you sell the property. That sucks.
But there is all sorts of stuff inside the building and surrounding it. Some of that stuff the taxpayer gets to write off a lot faster than the basic structure of the building and its key components. Could be 39 years for the building and maybe 15 or even 5 years for the other stuff - or now thanks to the Tax Cuts and Jobs Act - instantly for the other stuff.
Figuring out the stuff in the building that isn't the building and how much you would need to spend to replace the parking lot and the outside lighting is not something you can expect an accountant to do. That's why you have the tax consultant/engineers.
They are usually paired with a really good sales team that goes around terrifying accountants that they will lose their clients because they have been slow pokes in writing off the assets. They do these great spreadsheets that illustrate the benefits of a faster write-off.
If the cost segregation was missed on acquisition, it can be done as an accounting method change, which will create a whopping big deduction in the year it is put through.
The Magna Carta of the cost segregation industry is an excerpt from the IRS Cost Segregation Audit Techniques Guide - Principal Elements of A Qualify Cost Segregation Study and Report. There are thirteen elements of the quality study
- Preparation By An Individual With Expertise and Experience
- Detailed Description Of The Methodology
- Use of Appropriate Documentation
- Interviews Conducted With Appropriate Parties
- Use Of A Common Nomenclature
- Use Of A Standard Numbering System
- Explanation Of The Legal Analysis
- Determination Of Unit Costs And Engineering “Take-Offs”
- Organization Of Assets Into Lists Or Groups
- Reconciliation Of Total Allocated Costs To Total Actual Costs
- Explanation Of The Treatment Of Indirect Costs
- Identification And Listing Of § 1245 Property
- Consideration Of Related Aspects (e.g. I.R.C. § 263A, Change in Accounting Method And Sampling Techniques)
A quality report has nine elements
- Summary Letter
- Narrative Report
- Schedule of Assets
- Schedule of Direct and Indirect Costs
- Schedule of Property Units and Costs
- Engineering Procedures
- Statement of Assumptions and Limiting Conditions
- Certification
- Exhibits
The salesmen imply that if you don't have the quality study and report then you just have to write the whole thing off over 39 years, but I don't think that is actually the case. The Cohan rule is, in my mind, clearly applicable here, but if you are dealing with big dollars the study is probably worthwhile. My back of the envelope is that you definitely want one on a project over $2 million or so, but somebody has told me that it might be as low as $500,000 on a medical building.
What Is Quality?
There are two types of quality. One is the technical quality, which will make the report stand up on audit. The other is how much the thing is saving you by pushing as much as conceivably possible into the five year category. The second factor can create a race to the bottom in terms of the first factor. That is the tension poor P ran into and at least in the eyes of the auditor P got a little carried away.
Penalties
Code Section 6701 allows for the imposition of a penalty of $1,000 ($10,000 in the case of a corporation) on any person
who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document, who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and who knows that such portion (if so used) would result in an understatement of the liability for tax of another person,
The CCA indicates that the penalty can be applied to P.
Since a cost segregation study might cost five to ten thousand dollars, a thousand dollar penalty is kind of painful, but not the end of the world. Only it's worse. That report did not cause P's client to file one wrong tax return. There were five, since the deprecation deduction was wrong on each of five returns. (It occurs to me that it actually should have been six and maybe that is what it will be. The five year write off is spread over six returns with a partial year in the first and sixth years.) And if the client was a corporation it would be $10,000 times five (or maybe six). That is nasty.
What the advice does not address directly, although it alludes to it, is whether P is responsible for multiple individual returns in the case of partnerships. Think about it if P's client was a partnership with twenty partners and P ends up being penalized on each K-1. Ouch!
Watch Out
The Tax Cuts and Jobs Act should increase the demand for cost segregation studies. The immediate write-off of a significant percentage of the acquisition cost will make for a significant benefit. This CCA is an indication that the IRS may have a project going on aggressive cost segregation consultants similar to what happened with appraisers who were overvaluing conservation easements. You may want to be a little cautious if the savings claims seem excessive. Remember Reilly's Eleventh Law of Tax Planning - Pigs get fed. Hogs get slaughtered.
Other Coverage
Ed Zollars had a summary in Current Federal Tax Developments.
