Cost Segregation ATG - Chapter 6.6 - Construction Process
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APPENDIX - CHAPTER 6.6 - Construction Process
- Stages In The Construction Process
- Other Project Delivery Methods
A cost segregation study is typically completed using information that was developed for the construction process. This information includes drawings, specifications, and supplier and contractor payment documents. To better understand how a cost segregation study is conducted, it is helpful to understand this process. The following discussion provides a general overview of this process, from the conceptual stage through the bidding, construction, payment, and completion stage of a project. Although there may be certain facts and circumstances in specific geographic locales that vary from what is presented here, the basic construction concepts are similar in all locales. For purposes of this discussion, it is assumed that a fee contractor, rather than an in-house labor force, performs the construction. For additional information and a glossary of construction terms, refer to the LB&I Construction Industry or the Construction Industry Audit Techniques Guide.
The Construction Process is composed of six distinct stages; each of these stages is discussed below in more detail.
All construction projects begin with planning and design, also referred to as "architectural programming." Numerous overlapping steps occur during this conceptual or design phase, prior to actual construction of the project.
An Architect is the primary designer of a building or project and controls the overall design, specifications, finished materials (e.g., brick, paint, carpet, wall covering, etc.), and other architectural features of the building. In addition, the Architect supervises the Engineers responsible for the structural, mechanical, electrical, lighting, plumbing and communications system design of the building. Engineers must always conform to the design requirements of the Architect. Each member of the design team must also be licensed with the proper state licensing authorities where the facility is located.
Planning & Architectural Programming
During the initial stages of the design process, the Architect(s) and Engineer(s) have a number of client meetings in order to determine the purpose and objective of the proposed construction. The primary activities, for which the project is being constructed, as well as the relationships between spaces, are reviewed. Consideration is also given to how well the completed project relates to adjacent buildings (if any) and its surroundings. The preliminary programming produces a list of solutions, alternatives, feasibility studies and costs estimates. After a review of the programming statement, schematic plans are prepared.
Schematic plans are the first plans of a facility and show the interrelationship between spaces and activities. All of the parties (Architects, Engineers and the client) review the schematic plans and make recommendations, as necessary. Any changes are then incorporated into the final schematic plans. Revised schematic plans are also known as "preliminary plans," and provide a graphic view of the project, the refined details of how the project will look, and the relationship of all spaces.
Once the preliminary planning phase is complete, the project then enters a stage involving the preparation of contract bid documents and working drawings.
The construction contractor(s) are normally selected through a competitive bidding process, but may also be selected via negotiation. In order to solicit construction bids, the builder must provide potential bidders with: a) Working drawings and plans for the proposed structure, as well as b) Project specifications. These are called the “construction documents” and offer a complete and detailed set of information in order to communicate all the required items within a building project.
All projects, whether they involve new construction or the expansion of an existing structure, require the preparation of contract documents. The contract working drawings and plans provide a pictorial representation of the construction work, and specify or lay out the designer’s intentions for the facility. The drawings illustrate, among other things, the appearance, layout, equipment, and amenities of the project. These drawings show the Architect’s plan/design for the building’s overall appearance, such as finish materials, floor plans, sizes and use of each building area. In contrast, Engineers design the building’s structural, mechanical, electrical, plumbing and communication systems.
The Architect also begins to gather project data to deal with problems or situations that are expected to arise during the construction process, such as local zoning requirements, local infrastructure, traffic, environmental and population impact, acoustic, energy, lighting, and aesthetic considerations. Various consulting Engineers may also be utilized to solve specific project problems.
The following are examples of the numerous drawing plans that may be involved in a construction project.
The architectural drawings (or “Plans) indicate the layout of the project, such as floor plans, elevations, sections, and details of the construction and architectural finishes. These plans are typically numbered sequentially with the prefix "A" for "architectural." The most common type of an architectural plan, is an overhead view of the spaces on a specific floor. These plans also indicate the length, width and various heights of the structure and floor elevations. Plans may show notes of specific construction information and may contain details on a specific portion of work.
Exterior elevations show the exterior and the exterior finishes, and are similar to photographs of the exterior. Architectural schedules on the plans indicate the door types, windows, hardware, plumbing, and light fixtures in each room.
In preparing the plans, the Architect utilizes graphic symbols, instead of words, to indicate various facility conditions. These symbols indicate the various types of material, sizes, and room finishes to be used. Symbols may be shown on the plans themselves or in the legends of the plans. [A list of general symbols is shown in the Appendix of Plan Reading and Material Takeoff, by Wayne J. DelPico, published by R. S. Means Company.]
A civil Engineer is responsible for the proper drainage of a site, as well as the design of land improvements, such as paving, curb and gutter design, retaining walls, and drainage culverts. Site plans prepared by the civil Engineer indicate the existing and proposed grades of the land and the specific location of the facility on the land.
The structural plans are prepared by structural Engineers and show the structural design of a building. These plans incorporate foundation planning with considerations for rain, snow, wind, earthquakes, and other natural phenomena. Structural Engineers design the facility for both "live" and "dead" loads of the building. Live loads consist of the people, furniture and other items that are not part of the building, but are supported by the building. Dead load is simply the weight of the building or structure itself.
Mechanical plans are prepared by a mechanical Engineer to show the design of the various mechanical systems in the building. These systems must be designed to incorporate the proper air conditioning, heating, and ventilation equipment, as well as adequate plumbing, to meet the needs for all of the building’s designated activities.
Like the structural Engineer, the mechanical Engineer must design the mechanical building systems to meet building "loads." For example, office work produces a certain level of heat load, whereas cooking in a commercial kitchen may produce greater heat loads. The energy use of the air conditioning, heating, pumps and other building equipment are monitored by the mechanical Engineer and are considered when specifying building equipment for an efficiently designed building system. Mechanical plans are numbered with the prefixes "P" for "plumbing" and "H" for "heating, ventilating and air conditioning."
Electrical plans are prepared by an electrical Engineer, and show the electrical distribution system for the efficient distribution of power in a building. The plan design includes the distribution of electrical power from the utility company and the distribution to power-specific equipment. Engineering design factors for the overall electrical "load" of a building must also be considered (e.g., proper sizing and arrangement of transformers, panel boards, circuits, wires, conduits and power to the various machines, equipment and activities in the building). Electrical Engineers may also handle the lighting design requirements of the building, as well as specialty areas such as a central security monitoring system, a computerized control system, and fire and smoke management systems. Electrical plans are numbered with the prefix "E" for "electrical."
There may be several other sets of plans that detail the layout of special communications systems. For instance, the fire and security systems, network computers system, telephone and communications systems, media and entertainment systems could be shown on a separate set of plans. All of these plans could be included with the bid documents or be a separate contract all together. If there is a specific issue that arises during your examination of a cost segregation study that concerns one of these communications systems, be sure to ask for them in addition to the other sets of plans of your subject building.
The second part of the contracts and bid documents stage is the preparation of project specifications, also known as "specs." Specs instruct the contractor on how to build the project, and consist of contract documents, the technical specifications of the materials and the quality of the materials to be installed, and the workmanship for installation of the materials. Given the amount of information that is required to be included, specs have to be organized in a coherent manner. The most widely accepted system for arranging construction specifications is the “CSI MasterFormat.” The CSI format, developed by the Construction Specification Institute, requires four categories of information: bidding requirements, contract forms, contract conditions, and technical specifications.
Bidding requirements describe the conditions of the bid to the owner, and encompass the Invitation to Bid, the Instructions to Bidders, the Information Available to Bidders, the Bid Forms and Attachments, and the Bid Security Forms. The type of contract between an owner and a contractor dictates the form of the bidding conditions.
Contract forms are divided into sections, including the Agreement, the Performance and Payment Bonds, and the Certificates.
The contract conditions include the General Conditions and Supplementary Conditions.
Technical specs are generally prepared for each specific project in the CSI MasterFormat (see below) and these include hundreds, perhaps thousands of individual items that will be installed in a project. The CSI MasterFormat have been modified (2004) to include many more divisions included for electrical and communication systems to accommodate current trades and systems now included in most buildings.
The Construction Specifications Institute (CSI) is a national organization dedicated to the standardization and improvement of construction specifications. The CSI MasterFormat is a master list of numbers and titles classified by construction work results to standardize and facilitate communication within the construction industry. The MasterFormat system is widely used in the construction industry by Architects, Engineers, Estimators, and Contractors to organize detailed construction cost information.
Currently, the IRS most commonly sees the following system in cost segregation studies,
The CSI Format consists of 16 "Divisions of the Work", which are:
- Division 1 - General Requirements
- Division 2 - Site Work
- Division 3 - Concrete
- Division 4 - Masonry
- Division 5 - Metals
- Division 6 - Wood & Plastics
- Division 7 - Thermal & Moisture
- Division 8 - Doors & Windows
- Division 9 - Finishes
- Division 10 - Specialties
- Division 11 - Equipment
- Division 12 - Furnishings
- Division 13 - Special Construction
- Division 14 - Conveying Systems
- Division 15 - Mechanical
- Division 16 - Electrical
Each CSI Division is further sub-divided into three additional parts called General, Products, and Execution (Installation).
- General - explains the scope or the limits of work for a particular CSI Division and makes a correlation between the technical specifications and the general and supplementary conditions of the contract. The administrative portion for any trade (e.g., shop drawings) would also be found in this section.
- Products - lists the materials to be used, by name and model number, and explains the quality of materials and the basis for any substitution.
- Execution - explains the method of material installation, techniques to be used, and workmanship quality.
In 2004, the MasterFormat expanded from 16 Divisions to 50 Divisions, reflecting innovations in the construction industry. The 16 Division CSI MasterFormat was modified to include many more divisions and provide greater detail for work results to accommodate current trades and systems now included in most buildings. An example of the modification from 2004 includes a division for communication systems separate from the electrical division. The new CSI MasterFormat numbers and titles are intentionally structured for anticipated growth and expansion in the future, and some are reserved for future expansion.
The New Divisions are:
PROCUREMENT AND CONTRACTING REQUIREMENTS GROUP:
- Division 00 — Procurement and Contracting Requirements
General Requirements Subgroup
- Division 01 — General Requirements
Facility Construction Subgroup
- Division 02 — Existing Conditions (natural conditions)
- Division 03 — Concrete (footing)
- Division 04 — Masonry (concrete block/brick)
- Division 05 — Metals (beams)
- Division 06 — Wood, Plastics, and Composites (framing)
- Division 07 — Thermal and Moisture Protection (insulation water barrier)
- Division 08 — Openings (doorways)
- Division 09 — Finishes
- Division 10 — Specialties
- Division 11 — Equipment
- Division 12 — Furnishings
- Division 13 — Special Construction
- Division 14 — Conveying Equipment
- Division 15 to 19 — RESERVED FOR FUTURE EXPANSION
Facility Services Subgroup:
- Division 20 — RESERVED FOR FUTURE EXPANSION
- Division 21 — Fire Suppression
- Division 22 — Plumbing
- Division 23 — Heating Ventilating and Air Conditioning
- Division 24 — RESERVED FOR FUTURE EXPANSION
- Division 25 — Integrated Automation
- Division 26 — Electrical
- Division 27 — Communications
- Division 28 — Electronic Safety and Security
- Division 29 — RESERVED FOR FUTURE EXPANSION
Site and Infrastructure Subgroup:
- Division 30 — RESERVED FOR FUTURE EXPANSION
- Division 31 — Earthwork
- Division 32 — Exterior Improvements
- Division 33 — Utilities
- Division 34 — Transportation
- Division 35 — Waterway and Marine
- Division 36 to 39 — RESERVED FOR FUTURE EXPANSION
Process Equipment Subgroup:
- Division 40 — Process Integration
- Division 41 — Material Processing and Handling Equipment
- Division 42 — Process Heating, Cooling, and Drying Equipment
- Division 43 — Process Gas and Liquid Handling, Purification and Storage Equipment
- Division 44 — Pollution Control Equipment
- Division 45 — Industry-Specific Manufacturing Equipment
- Division 46 — Water and Wastewater Equipment
- Division 47 — RESERVED FOR FUTURE EXPANSION
- Division 48 — Electrical Power Generation
- Division 49 — RESERVED FOR FUTURE EXPANSION
As Cost Segregation Professionals convert to this newer system, the IRS will see more studies incorporating the 50 Divisions. No matter which system is utilized in the cost segregation study, it is important to note that this is just one method of organizing the abundance of information (labor and materials) needed in a construction project. The examiner should always look at the underlying information to verify the accuracy of the cost segregation study.
The American Institute of Architects (AIA) is a nationally recognized professional organization of Architects. AIA has developed standardized contract documents for building design and construction that are universally accepted in the building design and construction industry. These AIA Contract Documents are organized by the following series:
A-Series – Owner/Contractor Agreements
B-Series – Owner/Architect Agreements
C-Series – Other Agreements
D-Series – Miscellaneous Documents
E-Series – Exhibits
F-Series – Reserved
G-Series – Contract Administration and Project Management Forms
AIA Document A201, General Conditions of the Contract for Construction
The general conditions establish the legal terms and conditions that will govern the construction of the project and address everything involved in the project from minor items to critical items. The general conditions include a number of provisions that determine the respective rights and responsibilities of the owner and contractor. AIA Document A201 is a standardized document that provides the legal basis and description of the following contract items:
- Administration of the Contract
- Construction by the Owner or by separate Contractors
- Changes in the Work
- Payments and Completion
- Protection of Persons and Property
- Insurance and Bonds
- Uncovering and Correction of Work
- Miscellaneous Provisions
- Termination and Suspension of the Contract
Document A201 provides legal definitions of the elements in the construction process, the items that will be provided by the contractor, and details how to prepare material submittals, shop drawings, and progress payment requests.
The third stage of the construction process is bidding. Once an owner determines that a project is feasible and that construction financing is available, the owner will solicit bids or proposals from general contractors and/or specialty contractors. Owners generally use trade publications and newspapers in order to invite contractors to bid on a construction job. A copy of "The Notice to Contractors" will be shown in the project’s specifications, providing contractors with the bidding procedures.
The following is the sequence of events to prepare a contract bid:
- The contractor obtains a copy of the plans and specifications from the owner in order to prepare a formal estimate of the construction cost or bid (experienced construction personnel prepare the bids).
- The contractor reviews the contract plans and specifications to determine how to build the project and to consider all the limitations or conditions the owner requires for the project.
- The contractor solicits bids from subcontractors, estimates their direct material and labor costs, and evaluates the ultimate profit potential of the contract. The amount of the bid covers the estimated costs and a profit for the construction project.
- The owner evaluates all of the submitted bids and then awards the contract.
- The contract document and specs contain the project start and completion dates, the progress billing procedures, the insurance requirements, and other pertinent information.
The preparation of a bid is the first step in the cost control system of a construction project. The agreed-upon bid price then becomes the budget by which the actual expenditures are measured and drawn against. The object of a cost control system is to provide the general contractor and/or owner with information regarding actual project costs versus the anticipated or budgeted costs. These cost comparisons become essential for internal control purposes.
Standard cost manuals, such as the "R. S. Means Building Construction Cost Data," are used by a general contractor to compute a bid. These guides contain a compilation of cost data for each phase of construction. There are also construction cost data guides for both union and non-union wage rates. If the IRS examiner needs to estimate construction costs as part of the analysis of a study, it is important to use the proper wage rates.
Subcontractors bid jobs in much the same way that a general contractor does. A subcontractor may also solicit bids from sub-subcontractors for specialty construction.
Working drawings and specifications provide information to allow general contractors to estimate the project’s construction costs. Along with using their own estimators, a contractor usually has the subcontractor’s and the material supplier’s information readily available. If necessary, a general contractor can perform the preliminary details and/or shop in order to estimate the proper costs to construct various parts of a building. The general contractor gathers all the information from his estimators and subcontractors and then adds in an amount for overhead and profit. This final cost estimate is used in the competitive bidding for the construction of a project.
The cost estimate of a building or project is broken down and organized by the construction divisions shown in the specifications. The cost estimate is further detailed by trade and by item. The general contractor may also have a bank of information in order to estimate labor and material costs. Otherwise, the contractor will rely on any of several cost estimating manuals (e.g., R. S. Means Building Construction Cost Data (highly detailed), Marshall Valuation Services, etc.).
While bidding is the most common method used to select a general contractor, negotiation may also be used, especially in a situation where an owner has worked with a contractor in the past and a relationship of trust has been established. In a negotiated situation, the profit of the contractor is often a percentage of the total construction cost and this percentage is agreed to with the owner.
The fourth stage of the construction process, called fieldwork, is the actual construction of the project. Fieldwork is broken down into building permits, subcontractors, scheduling subcontractors, shop drawings, project submissions, and change orders.
Before construction can begin, the appropriate municipality must issue a building permit. Specifications and blueprints must be provided to the municipality's building department, along with the application for a permit. The period of time for a permit to be approved can be lengthy, especially in the case of new construction. The general contractor or owner may also be required to submit results of soil testing, environmental impact studies, and any other necessary testing or studies. Sometimes, a public hearing is mandated if there is opposition to the project. In most cases, a permit is issued within a few months. The cost of the permit and any related studies may be the responsibility of either the owner or the general contractor.
Construction projects must also follow the standards of the applicable building code. A building inspector will be involved at various construction stages in order to verify that the project is being constructed according to municipal code.
Subcontractors range from a one-man operation to nationwide, publicly traded corporations, or divisions of larger corporations. Subcontractors are distinguished from general contractors by their limited scope of work, which usually involves specialized skills, knowledge, or ability. Subcontractors, which include plumbers, electricians, framers, and concrete workers, generally enter into contracts with the general contractor and may provide the raw materials used in their specialty areas. The general contractor, not the owner of the property, pays the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors’ work may either be completed in stages or continuously.
Scheduling of Subcontractors
The general contractor schedules the subcontractor's work so that the construction runs smoothly and is completed on schedule. The general contractor is also responsible for scheduling the subcontractor in such a way that one subcontractor does not hold up another. This order on subcontractor sequencing is known as the "critical path."
The following is an example of the sequence in scheduling subcontractors for a small project:
- Clear the land (which may include demolition of existing structures)
- Excavate the land (which may include digging holes and leveling)
- Pour the foundation
- Frame steel and/or concrete
- Rough framing
- Rough electrical
- Concrete flooring
- Heating and air conditioning
- Ductwork for heating and air conditioning
- Elevators and/or escalators
- Sprinklers and other safety equipment
- Install electrical fixtures
- Insulate and weather strip
- Frame windows and door sashes
- Install tile and marble
- Install suspended acoustical ceilings
- Install toilets, sinks and other plumbing fixtures
- Paint walls (inside and out)
Working drawings only include enough detail to show the general contractor the overall layout of the building. The individual specialty trades and suppliers use working drawings to produce shop drawings for items such as granite finishing, cabinets and countertops, structural steel, etc. Shop drawings detail the specific building components and are usually produced after the final design phase but before the beginning of the construction phase. Drawings are prepared in accordance with the instructions on Document A201. The Architect/Engineer will also check each shop drawing for precise measurements and for compliance with the intended building design.
Project submissions are an important part of the construction process. Each installed building item must receive the Architect’s approval to ensure that the item or product is in conformance with technical specifications. Project submissions illustrate each item's intended use, function, method of attachment or installation requirements, and placed-in-service date. When the project starts, the Architect and /or Engineer monitors the contractor’s progress and often approves the progress payments made to the contractors. The Architect/Engineer may also make modifications to the building plans as needed.
Change orders are the written contract revisions that increase or decrease the total contract price. Change order documents contain the change order number, change order date, a description of the change, and the amount of the change order. Contractors, based on the terms of the contract, may also issue orders.
The fifth stage of the construction process is the construction payments stage. When a contractor completes a prescribed amount of work, the owner pays the contractor for the completed work, and records the payments on their books (CIP or WIP accounts).
Specifications for Payment
The following AIA Documents are normally used in the contractor progress payment process:
AIA G701 – Change Order
AIA G702 – Application and Certificate for Payment
AIA G703 – Continuation Sheet
The specifications for contract payments are shown in Document A201, under the “General Conditions for Construction Contracts”, and contain AIA Forms G701 (utilized for change orders) and G702. Form G702 requires that the contractor break down the bid into various parts of work. The project designer (Architect or Engineer) critically reviews Form G702 schedule of values prepared by the contractor and either accepts or rejects them. The close scrutiny of this form is due to the future release of funds that will be used to pay for the progress (and ultimately the completion) of construction. This form also provides the first basis for the construction cost control on a project. The Architect and/or Engineer have a legal and fiduciary responsibility for the accuracy of the cost allocations. The Architect and the owner also want an adequate and timely distribution of funds to ensure smooth progress payments and to ensure that there will be the necessary funds to pay for the completion of the last portion of the project.
It is also to the contractor’s benefit that items of construction be broken into as many parts as possible. The more individual items of work the contractor can identify and complete, the more items of work will be entitled for billing and request of payment. Typical schedules of values on Form G702 may be 15 to 20 pages long and may contain hundreds, if not thousands, of individual cost items.
The contractor submits Form G702 to request payment on a regular basis. The contractor completes Form G702 by listing the total construction cost for each item of work completed to date. The amount previously paid for the work and the amount accomplished in the current billing period are subtracted from the total amount to arrive at the amount of money remaining, minus a retainage for the completion of the work.
It is extremely important for the IRS examiner to analyze the G702 and G703 documents. These documents are prepared by a third party (which provides an element of objectivity) and includes a detailed breakdown and analysis of the construction costs.
The Architect/Engineer may make modifications or change orders to the construction plans as needed. Change orders should be reviewed for any agreed changes to the payment schedule.
In some contracts, there is a schedule of unit costs or prices used in the construction of the building. CSI MasterFormat Division 01 in the 16 Division format or Division 00 in the new 50 Division format typically provides for unit prices to be revealed in the bidding documents. The IRS examiner should verify that there is a schedule of Unit Prices in the contract documents and request a copy.
Most Corporate Taxpayers must keep records of their payments in a sub ledger for construction-in-process (CIP) or work-in-process (WIP) type costs in order to be compliant with GAAP requirements. All payments made by a company are recorded on their general ledger (GL). The payment records are transferred and held to the appropriate sub ledger until the project is completed. When the building project is placed in service, the taxpayer moves or transfers the costs to their fixed asset or depreciation schedule and begins cost recovery for the project for both book and tax purposes. The IRS examiner should request all relevant costs in these accounts for the cost segregation project under examination.
The final phase of the construction process is known as the completion stage, and it readies the building for occupancy.
Record Drawings (previously called As-Built’s)
After a facility or project is completed, the Architect and contractor prepare a set of plans known as record drawings. These drawings represent exactly how the facility was constructed and they also incorporate all the changes to the original construction drawings. It is very important that the IRS examiner reviews these record drawings; these drawings represent the actual construction of the project.
Notice of Partial Completion
In some instances, the owner may desire to occupy a portion of the completed building. In that case, local building officials conduct an inspection to determine if that portion of the facility meets all building codes and is safe to be occupied. If approval is granted, a "Certificate/Notice of Partial Occupancy" is issued.
Notice of Substantial Completion
Local building officials issue this notice when 95 % of the construction is complete.
Notice of Completion/Certificate of Occupancy
A "Notice of Completion" is requested by the contractor/owner when the building is 100% complete. The project must pass a final inspection by local building officials in order for the "Notice of Completion" and the "Certificate of Occupancy" to be issued. These documents are recorded at the office of the local recorder and the property will be then appraised for property tax purposes.
Taxpayer Places the Asset in Service – Begins Depreciation
The costs for the project are recorded in the taxpayer’s CIP or WIP sub ledger, and held in this suspense account until the costs can be recovered. Once the project is placed in service, depreciation can begin. For the taxpayer’s recordation of the project, in their books and records, depreciation begins when the costs in the CIP are transferred into a fixed asset account or to a depreciation schedule. The IRS examiner should request these records from the taxpayer.
While design-bid-build is probably the most common delivery method used for construction projects today, there are other methods. The differences between the various project delivery methods mainly stem from how the parties organize their participation and responsibilities to complete the project. While the responsibilities of the parties may vary based on the specific project delivery method, the contract documents that guide construction and the contractor payment process are normally similar in all project delivery methods. The two methods an examiner is most likely to encounter, besides design-bid-build, are construction management and design-build.
Construction Management – This project delivery method is very similar to the design-bid-build method, but the management and construction oversight duties ordinarily performed by the general contractor are performed by a construction manager. The construction manager does not perform any of the actual construction work as a general contractor does, but only manages the construction.
Design-Build – This is a project delivery method in which the owner contracts with a single entity to perform both the design and the construction of the project. There are no separate Architect and Contractor as in design-bid-build.