Source: https://www.expertcostseg.com/irs-itg-audit-techniques-chapter-5/
Timestamp: 2019-05-23 07:47:45
Document Index: 516229866

Matched Legal Cases: ['§ 1245', '§ 168', '§ 168', '§ 168', '§ 1245', '§ 1245', '§ 1250', '§ 1245', '§ 1245', '§ 197', '§ 197', '§ 1245', '§ 1250', '§1245', '§1250', '§1245', '§1250', '§ 1245', '§ 1250', '§ 1245', '§ 1245', '§ 1245', '§ 1250', '§ 263', '§ 1', '§ 1', '§ 446']

IRS ITG Audit Techniques Chapter 5 - O'Connor Cost Segregation
IRS ITG Audit Techniques Chapter 5
Chapter 5 – Review and Examination of a Cost Segregation Study
The preceding chapters described the legal framework for classifying assets (Chapter 2), common methods used to segregate costs (Chapter 3), and elements of a quality cost segregation study and report (Chapter 4). This chapter provides suggested audit steps for reviewing and examining a cost segregation study.
Review A Copy Of The Cost Segregation Study & Report
If the taxpayer has claimed depreciation deductions based on a cost segregation study, the examiner should review and evaluate the study and report.
Some firms use contingency fees where cost is based primarily on the tax benefits received from a study. Contingency fee arrangements create the incentive to maximize § 1245 costs, usually through “aggressive” legal interpretations and/or by inappropriate cost or estimation techniques. Accordingly, examiners should closely scrutinize studies performed on contingency fees.
Assets are generally classified into various units or groups of assets and are often listed in both a “Summary” and “Detail” format.
The “Property Unit Summary” is a summary of the unit (asset) groupings by land, land improvements, 3-year, 5-year, 7-year, 10-year, 15-year, 20-year, 27.5-year and/or 39-year property.
The “Property Unit Detail” is a detailed asset schedule within each unit (asset) grouping that describes the assets and shows their costs.
An example of a unit grouping is “Kitchen Equipment–Plumbing”. Within this grouping, the Property Unit Detail schedule might list the floor drain, grease trap, or sink.
Examiners should reconcile the basis of property in a study to basis in the taxpayer’s books and records.
Request Prior Year Tax Depreciation Schedules that correspond to the study’s assets. Do these schedules reconcile to depreciation for prior year returns? Property reclassified to a shorter recovery period must be depreciated using the proper method pursuant to IRC § 168(b). For example, if straight-line depreciation was used for other property placed in service for a given recovery period during the same year that the reclassified assets were placed in service, then IRC 168(b)(3) requires that the reclassified assets must also be depreciated using the straight-line method. The election to use straight-line depreciation is irrevocable pursuant to IRC § 168(b)(5).
Compare the Study’s Property Descriptions and Classifications To Revenue Procedure 87-56, 1987-2 C.B. 674. Are there any deviations that may indicate a potential audit issue? Can you identify specific assets that might need to be viewed during a tour of the projector facility?
Use of “creative” nomenclature or inconsistent titles and descriptions to disguise the true character of a property asset. Does the study nomenclature reflect the construction records and blueprints?
Issue IDR’s to determine the classification of items not readily understood (refer to Appendix Chapter 6.7 for suggested language).
Request the “Capital Expenditure Request” to verify project costs and identify related purchases (it may also help determine the intended use of the property).
Quantify the tax impact of potential audit issues, such as:
Location – Record the address and locate it on a map for future reference. What is the character of the neighborhood and how does the location impact land value? Is there any other property for sale in the area? Note the real estate company name and the address of the property for future reference.
Topography – Observe the topography and determine whether the land was initially hilly or low-lying. Did the project include the general grading of the land? Were large amounts of fill required in order to build?
Site Conditions – Determine whether the project included the subdividing or rezoning of land. Did it require environmental or land use permits, or the construction of access roads? Were off-site improvements (e.g., streets, sidewalks, sewers, storm drains) constructed? Were any of these improvements dedicated to the local municipality?
Condition of Property – Is the property new or old, worn or renovated? Were the materials modern or old?
Individual Assets – View each challenged asset to gain a thorough understanding of the facts and circumstances that affect its classification and cost. Ask the site manager how the facility is used and how individual assets operate.
Cost Data – Discuss the methodology that was used to determine the cost of assets. Were standard cost guides used to estimate costs? Ask on-site maintenance and facility operations personnel about local construction and repair costs in order to verify the estimated costs in a study.
Review the study again to determine whether property classifications are correct.
Refer to Chapter 2, “Legal Framework” and to Appendix Chapter 6.4 for a summary of the pertinent law and judicial precedent with respect to the classification of property.
Recovery periods are either specifically assigned by statute (IRC § 168 and the Regulations thereunder) or are determined pursuant to Revenue Procedure 87-56, 1987-2 C.B. 674. Refer to Appendix Chapter 6.3, “Depreciation Overview,” for further information on recovery periods.
A common issue is the allocation of specific components or a portion of a building system to § 1245 property. The issue is often the result of poor documentation and/or improper legal support.
Some studies may include a specific component of a building’s electrical system (e.g., plug outlet, switch, branch circuit) as being allocable to the piece of tangible personal property that it supports (e.g., dishwasher, garbage disposal, etc.). Accordingly, the component item is treated as § 1245 property (7-year MACRS). However, if that same electrical component item can be used for other pieces of equipment, the Service examiner may consider it to be part of the building’s general electrical system. Accordingly, it would then be classified as part of the building as § 1250 property (39-year MACRS).
Some studies allocate a portion of the primary electrical feeder circuit that carries electricity to one specific item of equipment or machinery as § 1245 property. The use of a “standard” percentage of electrical costs is a common approach. However, in the Service’s view, these types of allocations should be based on usage or load studies designed to ascertain the percentage of electricity allocable to specific § 1245 property (as opposed to supporting the general function or maintenance of the building). Examiners can also check whether a company was reimbursed for the sales tax paid on electricity used in manufacturing; this information may provide insight as to the correct percentage. In summary, the examiner should conduct an in-depth analysis of the allocation and supporting documentation when a standard percentage is used.
Some taxpayers have filed claims based on a cost segregation study of leased property. Typically, leases were assigned to 39-year recovery property on the original returns. Subsequently, the taxpayer re-determines its allowable depreciation on the basis that the acquisition was for goodwill rather than for the lease. The benefit is a potential 15-year amortization of goodwill pursuant to IRC § 197 (if the acquisition otherwise qualifies under § 197). Examiners should closely scrutinize allocations of this type.
Once proper classifications and recovery periods have been determined, the next step is to determine the costs allocable to individual assets. This determination will depend on whether the asset is newly constructed or is a purchased or existing facility. It is important to realize that cost determinations are very time consuming. Therefore, it is recommended that examiners determine that significant discrepancies exist, or are strongly suspected, before undertaking Steps 7A or 7B below.
A. Cost Analysis Of Newly-Constructed Property
Actual cost records should be available from the preparer, taxpayer, general contractor, and/or other third parties. Cost records should be requested for significant property items only.
Review the “as-built” drawings if available (generally available from the taxpayer, architect, contractor, local building department, local fire department, or insurance carrier). Review the most “up-to-date” drawings as well. These drawings are typically found in the engineering or property manager’s office and can be accessed during the inspection.
Review the Contractor’s Requests for Payment in AIA Forms G-702 and G-703.
Reconcile Total Project Costs in the Taxpayer’s Records with the Total Project Costs in the Study.
Request a copy of the taxpayer’s general ledger data to support the fixed asset amounts on the depreciation schedule. How does it compare it to the amounts shown in the study?
Typically, the property unit numbers or reference numbers found in a study do not track the taxpayer’s accounting entries. Find out what sources the preparer used in preparing his/her study.
Verify that the total project cost in the study reconciles to the total cost basis of assets in the taxpayer’s books and records. The revenue agent is in the best position to do this since he/she is the most familiar with the taxpayer’s accounting methods. The agent will also know where to look for other costs that should be in the building account, but may have been expensed or otherwise entered improperly into another account.
Review the taxpayer’s internal “Job Cost Reports.” Typically, a preparer relies on these documents to derive the unit costs (assuming that the cost and description of the assets in the Job Cost Reports are accurate).
A careful analysis of the Job Cost Reports may yield significant audit adjustments because the taxpayer does not always properly classify items that are listed in this report. For example, the Job Cost Report includes a code for Furniture and Fixtures. Within this code are multiple records of vendors from whom the taxpayer claimed to have purchased items, such as furniture and fixtures. The preparer included the total cost as § 1245 property and listed it in the study as “FF&E.” However, upon requesting contracts for each of the vendors under this heading, the Service examiner discovered that some of these assets were actually § 1250 property and, therefore, concluded that these costs were erroneously included in “FF&E.” Therefore, it is important that the examiner review the vendor contracts in the Job Cost Reports, especially those that detail the “Description of Work”, to verify asset costs.
Typically, cost segregation studies will incorporate a mixture of §1245 and §1250 properties into unit-by-unit direct cost recommendations. A review of a study should include identification of any of these disputable costs, and ensure that §1245 properties are segregated from §1250 properties.
Indirect costs generally relate to the land, certain land improvements, and/or the building or other structures. Indirect costs generally do not relate to the placement of machinery or furniture and fixtures. However, there are exceptions, such as for the design of a manufacturing line. Refer to Chapter 4, “Principal Elements of a Quality Cost Segregation Study and Report,” for additional discussion of indirect costs.
Site Preparation, General Grading and Land Shaping Costs Building and facility projects often require general grading, site preparation and other costs to make the site suitable for a proposed use. These costs, along with costs for stripping existing forest and vegetation, grading and compaction to provide a level site, and construction of site access roads, are generally non-depreciable costs allocable to the basis of land. A study may exclude these costs as being outside the scope of its work. In other instances, a study may argue that no costs are allocable to non-depreciable items. Whether these types of costs are included in the study or not, the examiner should determine all land shaping costs and allocate these costs to either non-depreciable land, to the building, and/or to land improvements. Before-and-after photographs may help with this determination. Also, the examiner should inspect the taxpayer’s books and records to determine how these items were treated for financial and tax purposes.
Section 1245 Property – Did the Study Utilize Cost Estimates or Actual Cost Records?
Review the § 1245 and § 1250 property listings and identify the most significant items. The examiner should check the contractor payment records (e.g., AIA Form G-702) to see if actual costs of these items were used in the study or whether these item costs were based on some sort of allocation or estimate. For example, if the Form G-702 shows $1.2 million for the “electrical” division work and the study shows or allocates $1.8 million to specialized § 1245 electrical equipment, then there may be a problem with the study’s cost determination. In this case, the examiner should request additional information to determine the source of the $1.8 million allocation. Note that this is only a “smell check,” since additional equipment or other property purchased by the taxpayer outside the construction contract may significantly affect this type of comparison.
Most data sources have a higher cost for installing only one unit (e.g., a single electrical outlet) as opposed to installing 10 or 100 units. “Quantity discounts” and competitive bidding may significantly reduce the actual unit cost. Accordingly, estimates for multiple units based on a single unit cost may be incorrect. The following is an example of this problem.
Assume that 500 of the 120-volt electrical outlets in a particular building have been determined to qualify as § 1245 property. The R. S. Means DataBase, 2003 Edition, page 464, line 4015, lists a total price of $34.50 per 120-volt duplex receptacle. Based on this data, a study may estimate that the 500 outlets have a total installed cost of $17,250 (500 x $34.50). However, this estimate should be reviewed or compared with the contractor’s actual price in order to determine its validity. When the contractor was awarded the contract, he/she submitted a schedule of cost for each item of work, such as for plumbing, electrical, heating, and site work (Form G-702 and G-703). The examiner should review Forms G-702 and G-703 to determine the cost that the contractor assigned to the electrical work. If the Form G-703 indicates that $120,000 was assigned to electrical receptacles and there were 5530 receptacles to install, then the actual unit cost to install each receptacle is only $ 21.18 per outlet. The total actual cost for the 500 outlets is therefore only $10,590 (500 x $21.18). This compares to the estimated cost of $17,250 [Note that both cost estimates (based on either the R. S. Means data or on the contractor’s actual costs) would need to be increased by any applicable indirect costs].
While the documentation of costs drawn from the use of a “rule of thumb” method is typically sketchy and inadequate, the examiner should not categorically reject a study involving the use of “rules of thumb.” The documentation needs to be examined and verified on its own merits to determine if cost recovery properties are properly identified and placed into proper recovery periods.
B. Cost Analysis Of Existing Property
For used or recently-acquired properties, the adjusted basis or purchase price is allocated between § 1245 and § 1250 property. However, different considerations and audit techniques will apply depending on the records available. In addition to the steps for new construction, the following audit steps for existing properties should be considered.
Review the Acquisition Documents to determine the assets purchased. Determine whether there was a written purchase price allocation agreed to by the buyer and seller (you may need to contact the seller). If there was an allocation between personal and real property, then the allocation is binding on the taxpayer (and therefore a taxpayer’s subsequent cost segregation study is moot). Only the Service can challenge a contract allocation. See Section 1060(a); Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967), cert. denied, 389 U.S. 858 (1967); and North American Rayon Corp. v. Commissioner, 12 F.3d 583 (6th Cir. 1993). If there was not a written price allocation, then the examiner should address the study and go to the next step.
Land included in the purchase price is valued first. The value of land should be determined at its “highest and best use.” Properties tend to appreciate based on the value of land.
Older items may be physically deteriorated or functionally or economically obsolete and should be assigned a value commensurate with their condition or use. For example, a building may have been pre-wired for telephones but, if it is a “non-digital” system, it may have a low value.
The value of used components must be reduced from new replacement value in proportion to the observed economic obsolescence or physical depreciation as compared to similar new assets. This principle is discussed in regard to the Helipot Building in Lesser v. Commissioner, 42 T.C. 688 (1964), aff’d, 352 F.2d 789 (9th Cir. 1965), acq., 1966-2 C.B. 5, cert. denied, 384 U.S. 927 (1966).
Review the Blueprints or Drawings. The existing structure should be compared to the “as-built” drawings to help identify subsequent repairs and modifications.
Review Sampling Techniques (If Necessary)
Preparers may utilize sampling techniques to minimize the time and costs associated with performing an analysis on all the properties (refer to the discussion in Chapter 4, Cost Segregation Methodologies). Sampling may also be utilized with cost documents. The use of sampling adds another level of difficulty in examining these studies. The examiner should take the following steps in reviewing a taxpayer’s sampling technique.
In situations involving large numbers of substantially identical properties, a study may utilize sampling or estimation techniques to select specific properties on which a “full” cost segregation study is performed. This approach, often referred to as “modeling”, is typical for retail or food chain operations, where a “cookie-cutter” type of structure is involved.
The taxpayer may have a limited number of “prototype” structures, such as free-standing units, locations in enclosed malls, locations in “strip” malls, full-service locations, carryout units, leased properties. The population is stratified by prototype to form groups of similar structures.
Geographic variations due to physical site characteristics, climate, building codes, and union versus nonunion labor, may create a wide disparity in structure costs. Therefore, stratification of otherwise similar properties across wide geographical areas may not be an accurate approach. Accordingly, the methodology should be carefully reviewed, as the “sampled” property may not be relevant to the other properties within the strata or group.
The “Field Directive on the Use of Estimates from Probability Samples,” issued by the Director, Field Specialists, on March 14, 2002, provides basic statistical sampling guidelines. This directive addresses the general use of statistical sampling by taxpayers and is included in Appendix Chapter 6.5. Additional guidance on sampling applicable to cost segregation studies may be forthcoming and will be added to this guide when it becomes available.
Ideally, a taxpayer’s books and records should consider and comment on UNICAP treatment when amounts are restated for prior tax years based on a cost segregation study. Refer to Appendix Chapter 6.1 for a summary of the provisions of IRC § 263A. Specific questions can be referred to either of the Section 263A Technical Advisors, as follows:
Barbara J. Martin 708-503-7514.
Deborah Phillips 954-423-7624.
The issue of whether or not changes in depreciation methods, conventions, or recovery periods constitute accounting method changes is unsettled due to conflicting court opinions. However, Treas. Reg. § 1.446-1T(e)(2)(ii)(d)(2)(i) and Example 9 of Treas. Reg. § 1.446-1T(e)(2)(iii), effective for taxable years ending on or after December 30, 2003, provide that they do constitute changes in method of accounting. Please refer to Appendix Chapter 6.2 for the most current information, including a listing of revenue procedures for implementing accounting method changes and a discussion of Chief Counsel Notice CC-2004-007 (January 28, 2004), regarding Chief Counsel’s Change in Litigating Position on the application of § 446(e) to changes in computing depreciation.
The examiner should contact (via email) Philip J. Whitworth Change in Accounting Method Technical Advisor, when a change in accounting method issue is encountered. He may be reached at 330-253-7346.
Prepare The Final Report Or The Notice Of Proposed Adjustments (if necessary)
At the conclusion of the examination, the examiner (agent and/or specialist) should prepare and issue a final report. Consider making adjustments in a contra account rather than adjusting the basis of each property item affected, especially if indirect allocations are involved. Specialists should consider having the examining agent calculate the cost recovery or amortization adjustments to ensure that all pertinent factors are included in the computation. Adjustments to the construction period interest may also be applicable.