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:: Cost Segregation Audit Techniques Guide - Chapter 2 - Legal
Framework
CHAPTER 2 - LEGAL
FRAMEWORK
In order to
better understand the tax
controversy surrounding the use
of cost segregation studies, it
is important to review the
relevant legal history and the
motivations of taxpayers to
allocate costs to personal
property. The legislative and
judicial history of
depreciation, depreciation
recapture, and Investment Tax
Credit (ITC) are closely
related. Accordingly, much of
the discussion will focus on the
rules and decisions impacting
several interrelated Code
sections (including ITC that was
generally terminated in 1986).
By establishing a legal
framework for § 1245 and § 1250
property, examiners will have a
better understanding of this
issue and have a basis for
determining property
classifications and cost
allocations.
The Internal
Revenue Code (IRC) has
historically authorized
depreciation as an allowance for
the exhaustion, wear and tear,
and obsolescence of property
used in a trade or business or
for the production of income
(IRC § 167 and the regulations
thereunder). Several different
methods are described for
calculating depreciation under
IRC §§ 167 and 168, including
straight line, declining
balance, sum-of-the-years
digits, and income forecast. The
deduction has generally been
calculated with respect to the
adjusted basis and useful life
of (or recovery period for) the
property and by utilizing an
appropriate depreciation method.
At one time, salvage value was
also a factor in the
computation. The shorter the
useful life (or recovery
period), the larger the current
tax deduction, thus providing an
incentive for tax purposes.
Buildings and structural
components have substantially
longer depreciable lives than
personal property. Therefore, it
is desirable for taxpayers to
maximize personal property costs
in order to accelerate
depreciation deductions and,
hence, reduce tax liability. The
remainder of this chapter
provides a brief historical
perspective of the statutes,
rulings and major court cases
that relate to depreciation and
cost segregation studies.
Many attempts
have been made to provide
bright-line tests for
classifying property by its
useful life (or recovery period)
due to the frequent
controversies that have arisen
with the determination of
economic life. For example, IRS
Publication Number 173 (also
known as "Bulletin F") was
published in 1942 and provided a
useful life guide for various
types of property based on the
nature of a taxpayer's business
or industry. Bulletin F
identified over 5,000 assets
used in 57 different industries
and activities and described two
procedures for computing
depreciation for buildings:
-
Composite
Method: A
depreciation chart
provided a composite
rate for buildings,
including all installed
building equipment. The
recommended rates ranged
from 1.5% per year for
good quality warehouses
and grain elevators to
3.5% per year for
inexpensive theaters.
-
Component
Method:
Taxpayers could elect to
depreciate the building
equipment separately
from the structure
itself. A list provided
lives for various types
of structures, ranging
from 50 years for
apartments, hotels, and
theaters, to 75 years
for grain elevators and
warehouses. A separate
list provided lives for
over 100 items of
installed building
equipment, ranging from
5 to 25 years, or the
life of the building.
Regulation §
1.167(a)-7(a) allows taxpayers
to either depreciate individual
items on a separate basis or to
combine assets into group
accounts and depreciate the
group account as a single asset.
Historically, some taxpayers
have interpreted this to mean
that assets can be segregated
into components and depreciated
separately.
In 1959, the
Tax Court recognized the right
of taxpayers to calculate
depreciation using a component
method for newly constructed
property Shainberg vs.
Commissioner, 33 T.C.
241 (1959)]. While the building
shell was given a useful life of
40 years, the plumbing, wiring,
and elevators were assigned a
life of 15 years, and the
paving, roof, and heating and
air conditioning systems were
given a useful life of 10 years.
Revenue
Procedure 62-21, 1962-2 C.B.
418, superceded Bulletin F and
provided safe harbor useful
lives based on industry-specific
asset classes for taxpayers that
met the reserve ratio test (a
complex provision). As long as
the taxpayer could demonstrate
that its retirement policies
were consistent with the
selected class life, the Service
would not challenge the useful
life. The asset class for
buildings included "…the
structural shell of the building
and all integral parts
thereof…", as well as equipment
which services normal heating,
plumbing, air conditioning, fire
prevention and power
requirements, and equipment such
as elevators and escalators.
Except to the extent the class
lives were incorporated into the
Class Life Asset Depreciation
Range System (ADR), this revenue
procedure was revoked for all
years after 1970.
Revenue Ruling
66-111, 1966-1 C.B. 46
(subsequently modified by
Revenue Ruling 73-410, 1973-2
C.B. 53), addressed the use of
component depreciation for used
real property, in light of the
decision in Shainberg. The
ruling concluded that "When a
used building is acquired for a
lump sum consideration, separate
components are not bought; a
unified structure is purchased…
Accordingly, an overall useful
life for the building must be
determined on the basis of the
building as a whole."
Revenue Ruling
68-4, 1968-1 C.B. 77, concluded
that the asset guideline classes
outlined in Revenue Procedure
62-21 "…may only be used where
all the assets of the guideline
class (building shell and its
components) are included in the
same guideline class for which
one overall composite life is
used for computing
depreciation."
The elective
ADR system was developed for
tangible assets placed in
service after 1970, with the
intent of minimizing
controversies about useful life,
salvage value, and repairs. It
also abolished the controversial
reserve ratio test. Under the
ADR system as enacted by former
IRC § 167(m) and implemented by
Revenue Procedure 72-10, 1972-1
C. B. 721, all tangible assets
were placed in one of the more
than 100 asset guideline classes
(which generally corresponded to
those set out in Rev. Proc.
62-21). The classes of assets
were based on the business and
industry of the taxpayer. In
addition, each class of assets
other than land improvements and
buildings was given a range of
years (called "asset
depreciation range") that was
about 20 percent above and below
the class life. As long as
taxpayers did not deviate from
this range in useful lives, the
Service would not challenge the
useful life. An optional repair
allowance method was also
permitted at the election of the
taxpayer.
If the taxpayer
did not elect the ADR system,
Revenue Ruling 73-410, 1973-2
C.B. 53, clarified that a
taxpayer may utilize the
component method of depreciating
used property if a qualified
appraiser "…properly allocates
the costs between
non-depreciable land and
depreciable building components
as of the date of purchase."
Issues
involving salvage value and
useful life continued to arise,
as well as controversy regarding
the repair allowance, so
Congress enacted IRC § 168 in
1981 (generally effective for
property placed in service after
December 31, 1980). The
Accelerated Cost Recovery System
(ACRS) was intended to provide a
less complicated method for
computing depreciation (known as
"cost recovery") by eliminating
salvage value and specifying
recovery periods for various
classes of assets. Depreciation
deductions were calculated based
on the applicable depreciation
methods, recovery periods and
placed-in-service conventions
outlined in § 168. In contrast
to the elective ADR system, ACRS
was mandatory and provided only
five (later six) recovery
periods. ACRS also allowed for a
faster write-off of assets than
had been allowed under previous
rules (e.g., the 40-year life
for real property was reduced to
either a 15, 18, or 19-year
recovery period, as reflected by
the 1985 amendments to ACRS).
Significant
modifications, generally less
favorable to taxpayers, were
made to ACRS by the Tax Reform
Act of 1986 (effective for
property placed in service after
December 31, 1986). Under the
Modified Accelerated Cost
Recovery System (MACRS), the
recovery period for buildings
and structural components
increased dramatically. For
example, the 15, 18, or 19-year
recovery periods for real
property are now 39 years for
nonresidential real property (or
31.5 years for nonresidential
real property placed in service
by the taxpayer before May 13,
1993) and to 27.5 years for
residential rental property,
under the general depreciation
system of § 168(a). Equipment
and machinery generally fall
into the 3, 5, or 7-year
recovery periods. Land
improvements generally have a
15-year recovery period under
the general depreciation system
of § 168(a). The wide gap in
MACRS recovery periods provides
a strong incentive for taxpayers
to allocate or reallocate costs
of long- lived property to
short-lived property, wherever
possible.
Revenue
Procedure 87-56, 1987-2 C. B.
674, provides the class lives
and recovery periods for most
MACRS assets. These
determinations are based on the
specific industry of a taxpayer
and the specific activity for
which the assets are used. But
see discussion of Duke Energy
Natural Gas Corporation v.
Commissioner, 109 T.C. 416
(1997), rev’d, 172 F.3d 1255
(10th Cir. 1999), nonacq.,
1999-2 C.B. xvi; Saginaw Bay
Pipeline Co., et al v. United
States, 124 F. Supp. 2d 465
(E.D. Mich. 2001), rev’d and
rem’d, 2003 FED App. 0259P (6th
Cir.) (No.01-2599); and Clajon
Gas Co. LP, et al v.
Commissioner, 119 T.C. 197
(2002), rev’d, 2004 U.S. App.
LEXIS 284 (8th Cir. Mo. Jan. 12,
2004), and Revenue Ruling
2003-81, 2003-2 C.B. 126, on
page 6.3-10.
Appendix Chapter 6.3
provides an overview of recovery
period determinations.
Another
incentive for allocating costs
to shorter-lived property is the
expensing provision of IRC §
179. The ceiling limitation for
expensing capital amounts
invested in qualifying section
179 property (qualifying
tangible personal property
acquired by purchase for use in
the active conduct of a trade or
business) has steadily increased
over time, from $10,000 to over
$25,000 per year ($100,000 per
year, adjusted annually for
inflation, for certain
qualifying property placed in
service for taxable years
beginning after December 31,
2002, and before January 1,
2008). By maximizing the costs
allocable to tangible personal
property, the taxpayer can not
only get an immediate write-off
under § 179, but also qualifies
for a shorter recovery period
under § 168 for any remaining
basis in the property. Also, the
30-percent additional first year
bonus depreciation allowance
pursuant to § 168(k), enacted by
the Job Creation and Worker
Assistance Act of 2002 (Public
Law 107-147), provides even
further incentive for taxpayers
to segregate property into
shorter recovery periods. The
Jobs and Growth Reconciliation
Tax Act of 2003 recently
increased the bonus depreciation
under § 168(k) to 50 percent for
certain qualifying property
acquired after May 5, 2003, and
placed in service before January
1, 2005 (January 1, 2006, for
certain property with a longer
production period). Code section
1400L provides special rules for
qualifying property used by a
business in the New York Liberty
Zone. Also, Code section 1400N,
as inacted by the Gulf
Opportunity Zone Act of 2005,
extends some of the rules to
property acquisitions after
August 28, 2005, and before
December 31, 2007, (December 31,
2008, for residential rental and
nonresidential real property),
for use in areas impacted by
Hurricanes Katrina, Rita, and
Wilma.
While § 167
provides an allowance for
depreciation for both tangible
and intangible property, § 168
(as written) only applies to
tangible property. Since neither
§ 167 nor § 168 provides a
definition of tangible property,
one must look to § 48 and the
regulations thereunder (prior to
the passage of Public Law
101-508) for definitions and
examples of tangible property
(as well as for buildings and
structural components). This
area will be discussed further
in the following sections.
In order to
stimulate the economy, Congress
enacted Code § 48 in 1962. The
ITC was designed to encourage
the modernization and expansion
of productive facilities through
the purchase of certain new or
used assets for use in a trade
or business. Section 48
generally allowed a tax credit
for investment in tangible
depreciable property placed in
service during the taxable year.
The amount of the credit was the
"applicable percentage" of the
investment in qualifying
property placed in service
during the taxable year,
depending on the useful life of
the property and whether it was
new or used when acquired. The
percentage was initially 7
percent but was later increased
to 10 percent (Revenue Act of
1978). The amount of the
qualifying investment was
limited and the ITC was subject
to recapture if the property was
not held for its entire useful
life. Over the years, many other
changes were made to the rules,
including reductions in the
depreciable basis of property
for which ITC was claimed,
temporary suspensions,
termination, reinstatement, and,
ultimately, the general repeal
of ITC in 1986. Most of these
revisions were related to the
perceived economic needs of the
country at the time they were
enacted.
Eligible ITC
property is defined in former
IRC § 48(a)(1) with reference to
IRC § 38 (in fact, eligible
property is often referred to as
"section 38 property"). It
included tangible personal
property (other than heating or
air conditioning units) and
other tangible property
(primarily machinery and
equipment) that was closely
integrated into the taxpayer's
trade or business. Land,
buildings, structural components
contained in or attached to
buildings, and other inherently
permanent structures, generally
were not eligible for ITC. Local
law was not controlling with
regard to property qualifying as
tangible personal property for
purposes of ITC.
Treas. Reg. §
1.48-1(c) provides examples of
qualifying property, and states
that
…'tangible
personal property' means any
tangible property except
land and improvements
thereto, such as buildings
or other inherently
permanent structures
(including items which are
structural components of
such buildings or
structures).
This
same subsection states that
"tangible personal property"
includes
…all property (other than
structural components) which
is contained in or attached
to a building. Thus, such
property as production
machinery, printing presses,
transportation and office
equipment, refrigerators,
grocery counters, testing
equipment, display racks and
shelves, and neon and other
signs, which is contained in
or attached to a building
constitutes tangible
personal property for
purposes of the credit
allowed by section 38.
Furthermore, all property
that is in the nature of
machinery (other than
structural components of the
building or other inherently
permanent structure) shall
be considered tangible
personal property even
though located outside a
building. Thus, for example,
a gasoline pump, hydraulic
car lift, or automatic
vending machine, although
annexed to the ground, shall
be considered tangible
personal property.
In
addition, the regulations
provide examples of
non-qualifying property. For
example, "…buildings, swimming
pools, paved parking areas,
wharves and docks, bridges, and
fences are not tangible personal
property."
The
Senate Report accompanying the
enactment of the Revenue Act of
1978 provided additional insight
into Congressional intent by
providing further examples of
qualifying and non-qualifying
property.
…[T]he committee wishes to
clarify present law by
stating that tangible
personal property already
eligible for the investment
tax credit includes special
lighting (including lighting
to illuminate the exterior
of a building or store, but
not lighting to illuminate
parking areas), false
balconies and other exterior
ornamentation that have no
more than an incidental
relationship to the
operation or maintenance of
a building, and identity
symbols that identify or
relate to a particular
retail establishment or
restaurant such as special
materials attached to the
exterior or interior of a
building or store and signs
(other than billboards).
Similarly, floor coverings
which are not an integral
part of the floor itself
such as floor tile generally
installed in a manner to be
readily removed (that is it
is not cemented, mudded, or
otherwise permanently
affixed to the building
floor but, instead, has
adhesives applied which are
designed to ease its
removal), carpeting, wall
panel inserts such as those
designed to contain
condiments or to serve as a
framing for picture of the
products of a retail
establishment, beverage
bars, ornamental fixtures
(such as coats-of-arms),
artifacts (if depreciable),
booths for seating, movable
and removable partitions,
and large and small pictures
of scenery, persons, and the
like which are attached to
walls or suspended from the
ceiling, are considered
tangible personal property
and not structural
components. Consequently,
under existing law, this
property is already eligible
for the ITC.
[S. Rep. No. 1263, 95th Cong.,
2d Sess. 117 (1978), reprinted
in 1978-2 C.B. Vol. 1 315,415.]
Treas. Reg. § 1.48-1(e)(1)
provides a detailed explanation
of buildings and their
structural components for ITC
purposes and has been the
primary source for guidance,
both with respect to component
depreciation and cost
segregation studies. The term
"building" is described as
…any structure or edifice
enclosing a space within its
walls and usually covered by
a roof whereby the structure
improves the land, and
provides shelter or housing
for work, office, display,
or sales space. The term
includes, for example,
structures such as apartment
houses, factory and office
buildings, warehouses,
barns, garages, railway or
bus stations, and stores.
Such term includes any such
structure constructed by, or
for, a lessee even if such
structure must be removed,
or ownership of such
structure reverts to the
lessor, at the termination
of the lease.
Specifically excluded from the
definition of the term
"building" are the following:
i. a structure which is
essentially an item of
machinery or equipment, or
ii. a structure which houses
property used as an integral
part of an activity
specified in section
1.48(a)(1)(B)(i) if the use
of the structure is so
closely related to the use
of such property that the
structure clearly can be
expected to be replaced when
the property it initially
houses is replaced. Factors
which indicate that a
structure is closely related
to the use of the property
it houses include the fact
that the structure is
specifically designated to
provide for the stress and
other demands of such
property and the fact that
the structure could not be
economically used for other
purposes.
The
term "structural components" is
defined in § 1.48-1(e)(2) of the
Regulations as
…includes such parts of a
building as walls,
partitions, floors, and
ceilings, as well as any
permanent coverings therefor
such as paneling or tiling;
windows and doors; all
components (whether in, on,
or adjacent to the building)
of a central air condition
or heating system, including
motors, compressors, pipes
and ducts; plumbing and
plumbing fixtures, such as
sinks and bathtubs; electric
wiring and lighting
fixtures; chimneys; stairs,
escalators, and elevators,
including all components
thereof; sprinkler systems;
fire escapes; and other
components relating to the
operation or maintenance of
a building.
However, the term
"structural components" does
not include machinery the
sole justification for the
installation of which is the
fact that such machinery is
required to meet temperature
or humidity requirements
which are essential for the
operation of other machinery
or the processing of
materials or foodstuffs.
Machinery may meet the "sole
justification" test provided
by the preceding sentence
even though it incidentally
provides for the comfort of
employees, or serves, to an
insubstantial degree, areas
where such temperature or
humidity requirements are
not essential. For example,
an air conditioning and
humidification system
installed in a textile plant
in order to maintain the
temperature or humidity
within a narrow optimum
range which is critical in
processing particular types
of yarn or cloth is not
included within the term
"structural components".
The
benefits of the ITC were
somewhat offset by the
provisions of IRC §§ 1245 and
1250, also enacted in 1962.
These Code sections result in
the conversion of capital gain
to ordinary income on the
disposition of a property, to
the extent its basis has been
reduced by an accelerated
depreciation method. The
definitions of property for
purposes of §§ 1245 and 1250 are
very similar to that for ITC and
make reference to the
regulations under § 48 and the
definitions under § 38 property.
These interrelated Code sections
and the regulations (38, 48,
1245 and 1250) provide the
pertinent authority for
determining eligibility for ITC.
They also determine eligibility
for the immediate write-offs
under section 179, the
appropriate recovery periods for
depreciation (§§ 167 and 168)
and for depreciation recapture
upon a disposition.
The
primary issue in cost
segregation studies is the
proper classification of assets
as either § 1245 or § 1250
property. Accordingly, the ITC
rules are critical in
determining whether a taxpayer
has classified property into the
appropriate asset class.
Section 1245(a)(3) provides that
"section 1245 property" is any
property which is or has been
subject to depreciation under §
167 and which is either personal
property or other tangible
property used as an integral
part of certain activities. Such
activities include
manufacturing, production or
extraction; furnishing
transportation, communication,
electrical energy, gas, water,
or sewage disposal services.
Certain other "special use"
property also qualifies as §
1245 property, but is not of a
primary concern for purposes of
this discussion. It is important
to note that § 1245(a)(3)
specifically excludes a building
or its structural components
from the definition of § 1245
property.
Treas. Reg. § 1.1245-3 defines
"personal property," "other
tangible property," "building,"
and "structural component" by
reference to Treas. Reg. §
1.48-1. As previously discussed,
those regulations (§ 1.48-1)
provide definitions of tangible
personal property that qualifies
as § 38 property for ITC.
Section 1250(c) defines "section
1250 property" as any real
property, other than section
1245 property, which is or has
been subject to an allowance for
depreciation. In other words, §
1250 property encompasses all
depreciable property that is not
§ 1245 property.
Land
improvements (i.e., depreciable
improvements made directly to or
added to land), as defined in
Asset Class 00.3 of Rev. Proc.
87-56, may be either § 1245 or §
1250 property and are
depreciated over a 15-year
recovery period. Buildings and
structural components are
specifically excluded from
15-year property. Examples of
land improvements include
sidewalks, roads, canals,
waterways, drainage facilities,
sewers, wharves and docks,
bridges, fences, landscaping,
shrubbery, and radio and
television towers. Note that
some activity asset classes also
include land improvements such
as asset class 57.1 of Rev.
Proc. 87-56.
From
a statutory standpoint, the
primary test for determining
whether an asset is § 1245
property eligible for ITC is to
determine whether or not it is a
structural component of a
building. In other words, if an
asset is not a structural
component of a building, then it
can be considered to be § 1245
property. The structural
component determination hinges
on what constitutes an
inherently permanent structure
and how permanently the asset is
attached to such a structure.
Clearly, this is a factually
intensive determination and
explains the lack of bright-line
tests for segregating property
into § 1245 and § 1250
classifications.
The
early administrative rulings on
ITC focused on a "functional use
test" to determine whether an
asset constituted § 1245
property. Rather than examining
the inherent permanency
characteristics of the asset,
the test evaluated the purpose
for which the asset was used.
For example, if the asset served
a function normally attributable
to a structural component or
permanent structure, it was not
treated as tangible personal
property even if it could be
moved. However, following
several conflicting court
decisions which addressed the
inherent permanency of
particular assets, the Service
shifted its focus from the
functional use test to an
evaluation of factors indicating
inherent permanency.
Revenue Ruling 75-178, 1975-1
C.B. 9 outlined several criteria
to determine § 1245 property
classification. These criteria
included (1) whether the asset
is movable or removable; (2) how
the asset is attached to real
property; (3) the design of the
asset; and (4) whether the asset
bears a load.
The
classic pronouncement addressing
inherent permanency was Whiteco
Industries, Inc. v.
Commissioner, 65 T.C. 664,
672-673 (1975). The Tax Court,
based on an analysis of judicial
precedent, developed six
questions designed to ascertain
whether a particular asset
qualifies as tangible personal
property. These questions,
referred to as the "Whiteco
Factors," are:
-
Can the
property be moved and
has it been moved?
-
Is the
property designed or
constructed to remain
permanently in place?
-
Are
there circumstances that
show that the property
may or will have to be
moved?
-
Is the
property readily
movable?
-
How
much damage will the
property sustain when it
is removed?
-
How is
the property affixed to
land?
It should also
be noted, however, that
moveability is not the only
determinative factor in
measuring inherent permanency.
In L.L. Bean, Inc. v. Comm.,
T.C. Memo. 1997-175, aff'd, 145
F.3d 53 (1st Cir. 1998), it was
determined that, even though the
structure could be moved, it was
designed to remain permanently
in place. Thus, it was
determined to be an inherently
permanent structure.
Examiners
should also consider the
following points when addressing
the Whiteco factors:
-
The
manner in which an item
is attached to a
building or to the land,
-
The
weight and size of the
item,
-
The
time and costs required
to move the components,
-
The
number of personnel
required in planning and
executing a move,
-
The
type and quantity of
equipment required for a
move,
The history of the item
or similar items being
moved,
-
The
time, cost, manpower and
equipment required to
reconfigure the existing
space if the item is
removed,
-
Any
intentions regarding the
removal,
-
Whether
the item is designed to
be moved, and
-
Whether
the item is readily
usable in another
location.
Due to the
significant tax benefits derived
from ITC-eligible property, the
use of component depreciation
proliferated during the 1970's
and created problems not unlike
those faced today by taxpayers,
practitioners, and the Service
regarding cost segregation
studies. The problem became so
pronounced during the late
1970’s that Congress disallowed
component depreciation as a
method of computing depreciation
for buildings, simultaneously
with the enactment of ACRS in
the Economic Recovery Tax Act of
1981 (ERTA) [see IRC §
168(f)(1)]. In addition to the
controversies surrounding the
determination of qualifying §
1245 property, the driving force
behind this action was the
disadvantage suffered by smaller
taxpayers that could not afford
to have expensive ITC studies
performed.
In 1986, MACRS
reiterated that the use of
component depreciation was not
allowable. Section 168(i)(6)
provides that depreciation for
any addition or improvement to
property shall be computed in
the same manner as the
depreciation for the underlying
property, as if the underlying
property had been placed into
service at the same time. [Prior
to 1981, an asset composed of
separately replaceable
components could have been
fragmented for depreciation
purposes even though the
interdependent components were
parts of an integrated whole.].
A recent
landmark decision, Hospital
Corporation of America v.
Commissioner, 109 T.C. 21
(1997)("HCA"), provided the
legal support to use cost
segregation studies for
computing depreciation. In
effect, this decision has
reinstated a form of component
depreciation.
In HCA, the
Service took the position that
certain property items were
structural components of a
building and that § 168(f)(1)
prohibited the use of a
component depreciation method
for computing depreciation on
buildings (including structural
components). The Service also
argued that § 168(f)(1)
effectively changed the
definition of tangible personal
property for ACRS purposes
(i.e., after the enactment of
ACRS in 1981) by excluding any
item attached to the building
from being § 1245 property.
Accordingly, the prohibition
against component depreciation
precluded an item from being
treated as § 1245 property if it
was attached to a building and
had utility beyond its
relationship to the particular
piece of property.
However, Judge
Wells ruled that the property at
issue was § 1245 property and
rejected the Service’s argument
that findings based on Treas.
Reg. § 1.48-1(e) were
inapplicable following the
enactment of ACRS in 1981. Based
on his review of the statutory
and regulatory language, as well
as case law, Judge Wells
concluded that the enactment of
ACRS did not redefine § 1250
property to include property
that had been § 1245 property
for purposes of ITC.
Accordingly, the court
determined that §168(f)(1),
prohibiting component
depreciation, applied only to
§1250 property.
The HCA ruling
effectively reinstated a form of
component depreciation for
certain building support
systems, such as the electrical
and plumbing systems that
directly serve tangible personal
property. Therefore, cost
segregation methodologies
previously used to allocate the
cost of a building between
structural components and ITC
property can now be used for §
1245 and § 1250 property.
The Service did
not appeal HCA since it could
not state that the court's
reasoning and decision were
clearly erroneous. In an Action
on Decision (AOD CC-1999-008),
the Service acquiesced to the
validity of the method approved
by the court (i.e., pre-1981 ITC
tests remained applicable for
determining tangible personal
property under both ACRS and
MACRS). However, the Service
non-acquiesced to the court’s
findings as to which specific
assets qualified as tangible
personal property. Two cases,
LaPetite Academy and
Boddie-Noell, were specifically
referenced in the AOD with
respect to the determination of
structural components and
tangible personal property. In
Boddie-Noell Enterprises, Inc.
v. United States, 36 Fed. Cl.
722 (1996), aff’d without op.,
132 F.2d 54 (Fed Cir. 1997), the
court held that acoustical tile
ceilings, a portion of an
electrical system and a plumbing
system were structural
components under the
regulations. In LaPetite
Academy, Inc. v. United States,
95-1 U.S.T.C. (CCH) 50,193 (W.D.
Mo. 1995) aff'd without op., 72
F.2d 133 (8th Cir. 1995), wall
panels, kitchen plumbing,
bathroom accessories and a
portion of the electrical system
were held to be structural
components under the
regulations.
Chief Counsel
issued further guidance to the
field in the form of an advice
memorandum dated May 28, 1999.
It made the following
observations and recommendations
for field agents examining cost
segregation studies:
-
The
determination of whether
an asset is a structural
component or tangible
personal property is a
facts-and-circumstances
assessment.
-
The use
of cost segregation
studies must be
specifically applied by
the taxpayer.
-
Allocations must be
based on a "logical and
objective measure" of
the portion of the
equipment that
constitutes § 1245
property.
-
An
accurate cost
segregation study may
not be based on
non-contemporaneous
records, reconstructed
data, or taxpayer's
estimates or assumptions
that have no supporting
records.
-
Cost
segregation studies
should be closely
scrutinized by the
field.
-
A
change in depreciation
method is a change in
method of accounting,
requiring the consent of
the Secretary or his
delegate.
[Note,
however, that the recent
5th Circuit opinion in
Brookshire
Brothers Holding, Inc. &
Subsidiaries v.
Commissioner,
320 F.3d 507 (5th Cir.
2003), aff’g T.C. Memo.
2001-150, reh’g denied
(March 31, 2003), which
was adverse to the
Service, may impact
cases in that circuit.
The court affirmed the
Tax Court decision that
the regulations allow
taxpayers to make
temporal changes in
their depreciation
schedules, as well as
changes in the
classification of
property, without the
consent of the IRS.
However, the 10th
Circuit opinion in
Kurzet v.
Commissioner,
222 F.3d 830 (10th Cir.
2000), was favorable to
the government on this
issue. Clearly, the
issue is unsettled.
However, Treas. Reg. §
1.446-1T(e)(2)(ii)(d)(2)(i),
effective for taxable
years ending on or after
December 30, 2003,
provides that a change
in the depreciation or
amortization method,
period of recovery, or
convention of a
depreciable or
amortizable asset is a
change in method of
accounting. See Example
9 of Treas. Reg. §
1.446-1T(e)(2)(iii),
which specifically
relates to changes based
on a cost segregation
study. On January 28,
2004, Chief Counsel
Notice CC-2004-007 was
issued, setting forth
Chief Counsel’s Change
in Litigating Position
on the application of §
446(e) to changes in
computing depreciation.
Examiners are directed
to contact Phil
Whitworth, Change in
Accounting Method
Technical Advisor, for
the most current
information (phone
numbers 330-253-7346 or
via e-mail
Philip Whitworth).
You can also refer to
Appendix Chapter 6.2
for additional
information and details
regarding Notice
CC-2004-007 (January 28,
2004).]
A myriad of
court cases has addressed the
classification of property for
ITC purposes. All of the cases
are factually-intensive and
quite often the opinions of the
courts conflict. In addition,
though the Service has issued
numerous revenue rulings to
address specific fact patterns,
no bright-line tests have
evolved. Because of this
problem, significant controversy
still exists regarding property
classification for depreciation
purposes.
It is beyond
the scope of this chapter to
review all the applicable cases.
However,
Appendix Chapter 6.4
provides a summary of the major
court decisions and
pronouncements in this area.
This chapter is organized by
case name and by construction
division per the Construction
Specification Institute (CSI)
Master Format Division. In
addition, specific guidance for
the casino, restaurant, ahd
retail industries is provided in
Appendix Chapter 7.1,
Appendix Chapter 7.2,
Appendix Chapter 7.3, and
Appendix Chapter 7.4,
respectively.
This chapter
has provided a legal framework
for distinguishing § 1245
property from
§ 1250 property and for
determining appropriate recovery
periods. It cannot be
overemphasized that the
classification of assets is a
factually intensive
determination. Based on HCA, the
recent AOD, and the 1999 Chief
Counsel Advice Memorandum, the
use of cost segregation studies
is expected to increase. Thus,
examiners need to examine and
evaluate a cost segregation
study in light of the applicable
statutes and judicial precedent
established for a similar fact
pattern.
In the next
chapter, we will take a closer
look at the methodologies used
to prepare cost segregation
studies.
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