Cost Segregation Audit Techniques Guide - Chapter 2 - Legal Framework
Note: Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.
Chapter 2 – Legal Framework
- Early History of Depreciation
- Bulletin “F”
- Codification of Depreciation Changes
- Guideline Life System
- Asset Depreciation Range (ADR) System
- Accelerated Cost Recovery System (ACRS)
- Modified Accelerated Cost Recovery System (MACRS)
- § 1245 Property and § 1250 Property
- Investment Tax Credit – § 48
- Tests for Distinguishing § 1245 and § 1250 Property
- Inherently Permanent Test
- Hospital Corporation of America Case
- Electrical Distribution Systems
- Incentives for Cost Segregation and Cost Recovery
- Audit Guidance
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 asset classification, depreciation 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the discussion will focus on the rules and decisions impacting several interrelated Code sections (including ITC that was revoked in 1986).
The Internal Revenue Code (IRC) has historically authorized depreciation deductions 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 (§ 167 and the regulations thereunder). The deduction has generally been calculated with respect to the adjusted basis and useful life (or recovery period) of the property by utilizing an appropriate depreciation method. At one time, salvage value was also a factor in the computation. Buildings and structural components have substantially longer depreciable lives than tangible personal property. The shorter the useful life (or recovery period) of any given property will result in a larger annual tax deduction to the taxpayer. Therefore, it is desirable for taxpayers to maximize costs allocable to tangible personal property in order to accelerate depreciation deductions and reduce tax liability. This chapter provides a brief historical perspective of the statutes, regulations and major court cases that relate to cost segregation studies.
For about 20 years after the introduction of our present income tax system in 1913, taxpayers were generally given freedom to determine depreciation allowances. Both individuals and corporations could claim a reasonable allowance for depreciation of property arising out of its use or employment in the business or trade. The deductions claimed were not challenged unless it could be shown by clear and convincing evidence that they were unreasonable. Prior to 1934, a taxpayer had wide leeway as to the amount which could be written off each year against current income as an allowance for the cost of machinery, equipment and buildings. As long as the taxpayer’s policy was consistent and in accordance with sound accounting practice, the tax authorities raised little question, realizing that the cost could be written off only once. See Announcement 71-76, 1971-2 C.B. 503.
In 1934, the Treasury Regulations (Treas. Reg.) were amended to provide that the burden of proof would rest upon the taxpayer to sustain the depreciation deduction claimed. Taxpayers became responsible to furnish full and complete information with respect to the cost or other basis of the assets related to the claimed depreciation. The required information for each asset included the age, condition and remaining useful life, the portion of their cost or other basis, which had been recovered through depreciation allowances for prior taxable years, and any other information as the Commissioner may require in substantiation of the deduction claimed. Whatever plan or method of depreciation a taxpayer would choose to adopt, it “must be reasonable and must have due regard to operating conditions during the taxable period.” T.D. 4422, 1934-1 C.B. 58.
The earliest edition of Bulletin “F” was a pamphlet issued in 1920, which contained no schedule of suggested average lives but defined depreciation as follows: “Depreciation means the gradual reduction in the value of property due to physical deterioration, exhaustion, wear, and tear through use in trade or business.” Obsolescence was treated as a separate and supplemental factor in computing the depreciation allowance where the facts supported an additional amount. Bulletin “F” was first revised in 1931, at which time the first schedule of suggested lives was published as a separate pamphlet. The schedule provided useful lives for individual assets used by industry groups. In Bulletin “F”, the Internal Revenue Service (Service) explicitly frowned on the use of a composite rate of depreciation; rather, the Service advocated depreciation by items or by groups of items having practically identical physical characteristics and length of life. In conjunction with the burden shifting from the Service to the taxpayer regarding depreciation deductions, useful life became largely determined by reference to standardized lives prescribed in Bulletin “F” and a taxpayer had a heavy burden of proof to sustain any shorter life for an individual asset.
Bulletin “F" underwent a second revision 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 14 different types of 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 lesser quality theaters. These composite depreciation rates correspond to useful lives ranging from 28.5 years to 66.7 years.
- Component Method: Taxpayers could elect to depreciate building equipment separately from the structure. A list provided lives for various types of structures, ranging from 50 years for apartments, hotels and theaters, to 75 years for warehouses and grain elevators. A separate list provided lives for over 100 items of installed building equipment, ranging from 5 to 25 years, with certain installed building equipment listed as having the same life as the life of the building in which it was installed.
Bulletin “F” also allowed taxpayers to either depreciate individual items on a separate basis or to combine assets into composite, classified, or 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 1954, major changes were made to depreciation laws. Aside from the authorization of new methods of depreciation, § 167(d) was added which authorized written agreements between the Service and taxpayers specifically dealing with the useful life and rate of depreciation of any property.
In 1956, the ability to depreciate on an account basis (first allowed in Bulletin “F”) was codified in Treas. Reg. § 1.167(a)-7(a). The regulations moved away from the concept of physical life, focusing instead on the period of time the property was used in the trade or business of the taxpayer. See Treas. Reg. § 1.167(a)-1(a). Also, as part of a policy designed to reduce administrative controversies, the Service codified a policy that it would only re-determine estimated useful life when the change in the useful life is significant and there is a clear and convincing basis for the redetermination. See Treas. Reg. § 1.167(a)-1(b).
In Shainberg vs. Commissioner, 33 T.C. 241 (1959), the Service challenged the taxpayer’s method of depreciation of segregating buildings and the various items of equipment in the buildings into separate component groups. The Tax Court held that the taxpayer could calculate depreciation using a component grouping method as was their right under the regulations. In general, the courts have sustained the estimated useful lives assigned by taxpayers such as a 40-year life for the building structure, a 15-year life for the roofs, plumbing, wiring and elevators, and a 10-year life for the paving, ceilings, and heating and air conditioning systems.
Revenue Procedure (Rev. Proc.) 62-21, 1962-2 C.B. 418, superseded Bulletin “F”. Instead of thousands of asset classifications, assets were grouped into approximately 75 broad industrial classifications and by certain broad general asset classifications, with a “Guideline Life” established for each of these classes. The guideline lives were about 30-40 percent shorter than Bulletin “F” lives and about 15 percent shorter than the lives in actual use by taxpayers. Use of the guideline lives required taxpayers to meet a reserve ratio test (complex provision). The Rev. Proc. represented a fundamental change by treating assets as a class rather than as individual assets; even though assets within a class were heterogeneous with respect to ages, useful lives and physical characteristics. 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.” The Rev. Proc. listed 13 different types of buildings, with guideline lives ranging from 40 years for apartments, hotels, and theaters, to 60 years for warehouses and grain elevators. The Guideline Life system did not address repair and maintenance expenditures.
Revenue Ruling (Rev. Rul.) 66-111, 1966-1 C.B. 46, addressed the use of component depreciation for used real property and distinguished its facts from those in Shainberg. Rev. Rul. 66-111 decided that "when a used building is acquired for a lump sum consideration, separate components are not bought; a unified structure is purchased” such that the value of components (e.g., ceilings, floors, electrical systems, etc.) of a used building cannot be separated from the value of the building as a whole. Thus, the cost basis of used real property cannot be allocated into separate component accounts for determining a composite life in computing depreciation; rather, an overall useful life for the building must be determined based upon the building as a whole. The ruling was later modified by Rev. Rul. 73-410, 1973-2 C.B. 53, which held that the component method of computing depreciation may be utilized for used real property if: 1) the cost of acquisition is properly allocated to the various components based on their value; and 2) useful lives are assigned to the component accounts based on the condition of such components at the time of acquisition. See also Lesser v. Commissioner, 352 F.2d 789 (9th Cir. 1965).
Rev. Rul. 68-4, 1968-1 C.B. 77, concluded that “it is not proper to use the component method of computing depreciation by assigning the guideline class life from Rev. Proc. 62-21 to the structural shell of a building and assign different useful lives to the other integral parts or components of the building. Rev. Proc. 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."
Rev. Proc. 72-10, 1972-1 C. B. 721, superseded Rev. Proc. 62-21 and set forth the Class Life Asset Depreciation Range (ADR) system for tangible assets placed in service after 1970. The purpose of the ADR system was to minimize controversies about useful life, salvage value, and repair and maintenance expenditures. It also abolished the controversial reserve ratio test. Under the elective ADR system, all tangible assets were grouped into more than 100 asset guideline classes (generally corresponding to those set out in Rev. Proc. 62-21) based on the business and industry of the taxpayer. Each class of assets (other than land improvements and buildings) was given a class life as well as a range of years (called "asset depreciation range") that was approximately 20 percent above and below the class life. A taxpayer could select a depreciation period from this range and it would not be challenged by the Service. Thus, the ADR system disassociated an asset’s depreciation period from its useful life, but treated it as the useful life for all income tax purposes, even though the depreciation period could be significantly shorter than the actual useful life. However, buildings were generally excluded from the ADR system (except for a 3-year transitional period). The ADR system served as a comprehensive scheme for dealing with property, including repair and maintenance expenditures (via an optional repair allowance) and salvage value. The asset guideline set forth in Rev. Proc. 72-10 was superseded by Rev. Proc. 77-10, 1977-1 C.B. 548, and served as an update to the asset guideline classes and class lives.
In 1981, Congress enacted the Accelerated Cost Recovery System (ACRS) to simplify the depreciation rules and to stimulate the economy by allowing greater deductions over shorter periods. ACRS eliminated salvage value, minimized exceptions and elections, and moved away from the useful life concept. ACRS allowed depreciation deductions (this term is used for convenience; since ACRS is not based on estimated useful lives, cost recovery under it may not technically qualify as depreciation) for recovery property over a predetermined recovery period by applying a statutory percentage to its basis (cost). These statutory percentages were set forth in a series of tables. In contrast to the elective ADR system, ACRS was mandatory and provided only five (later six) recovery periods. ACRS allowed for a faster cost recovery of assets than had been allowed under previous rules (e.g., the 40-year life for real property was reduced to a 15, 18, or 19-year recovery period, depending on the placed-in-service date of the property). ACRS was generally applicable for property placed in service from 1981 through 1986.
ACRS prohibited component depreciation as a method of computing depreciation for buildings. ACRS required the depreciation deduction for any component of a building to be computed in the same manner as the deduction allowable for the building, beginning on the later of the date the component is placed in service or the building is placed in service. See former § 168(f)(1); Proposed Treas. Reg. §§ 1.168-2(e) and 1.168-6. The driving force behind this action was to eliminate controversies surrounding the determination of qualifying § 1245 property (as explained below).
In 1986, Congress enacted the Modified Accelerated Cost Recovery System (MACRS). Cost recovery was now based on the applicable depreciation method, the applicable recovery period, and the applicable convention, as outlined in § 168. MACRS provided two depreciation systems: the general depreciation system and the alternative depreciation system (applicable for property used outside the United States, tax-exempt use property, property for which an alternative depreciation system election has been made, and a couple of other finite categories not germane to this discussion). MACRS also required appropriate basis adjustments to compute subsequent year deductions and modified other ACRS provisions including property classifications. The recovery period for buildings and structural components increased dramatically. For example, the 15, 18, or 19-year recovery periods for real property became 39 years for nonresidential real property (31.5 years for nonresidential real property placed in service before May 13, 1993) and 27.5 years for residential rental property, under the general depreciation system. Both types of buildings have a 40-year recovery period under the alternative depreciation system. In Rev. Proc. 87-57, 1987-2 C.B. 687, the Service furnished optional tables to provide applicable deduction percentages under MACRS.
The classification of property under MACRS is important because it affects the applicable depreciation method, recovery period, and convention. Each item of property depreciated under MACRS is assigned to a property class, which establishes the item’s recovery period. The applicable recovery periods for MACRS are determined by statute or by reference to class lives. Class lives for MACRS are set forth in Rev. Proc. 87-56, 1987-2 C. B. 674. This Rev. Proc. establishes two broad categories of depreciable assets: 1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and 2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities. The same item of depreciable property can be described in both an asset category (asset classes 00.11 through 00.4) and an activity category (asset classes 01.1 through 80.0), in which case the item is classified in the asset category (unless it is specifically included in the activity category). See Norwest Corp. & Subs. v. Commissioner, 111 T.C. 105 (1998) (item described in both an asset and an activity category should be placed in the asset category). Chapter 4 - Principal Elements of A Quality Cost Segregation Study and Report provides an overview of asset classifications and recovery period determinations.
MACRS continued the prohibition against the use of the component method of depreciation. Although MACRS repealed ACRS § 168(f)(1), which related specifically to components of § 1250 class property, it enacted § 168(i)(6), which provides that improvements made to real property are depreciated using the same recovery period applicable to the underlying property as if the underlying property were placed in service at the same time the improvements were made. Regarding improvements, the statute makes reference to § 1245 property and § 1250 property. § 168(i)(12) provides that the terms “§ 1245 property” and “§ 1250 property” have the meanings given such terms by § 1245(a)(3) and § 1250(c), respectively.
In 1962, Congress enacted the provisions of §§ 1245 and 1250. 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 essential for determining eligibility for a number of other Code provisions (including §§ 167, 168, 179, and former § 48). One of the primary issues in cost segregation studies is the proper classification of assets as either § 1245 or § 1250 property. The main difference between §§ 1245 and 1250 is whether the provisions apply to the entire amount or an applicable percentage of the gain.
§ 1245(a)(3) provides that "§ 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 (not including a building or its structural components) that was 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 relevant to this discussion. It is important to note that a building or its structural components is specifically excluded 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. This regulation relates to former § 48 which was enacted in 1962 along with §§ 1245 and 1250. § 48 allowed an Investment Tax Credit (ITC) based on the "applicable percentage" of the investment in tangible depreciable property placed in service during the taxable year. The ITC (§ 48) was later repealed in 1986.
§ 1250(c) defines "§ 1250 property" as any real property, other than § 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.
Eligible ITC property is defined in former § 48(a) (1) with reference to § 38 (in fact, eligible property is often referred to as "§ 38 property"). Eligible property 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 classifying property as tangible personal property for purposes of ITC.
Treas. Reg. § 1.48-1(c) defines 'tangible personal property' as 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). Thus, buildings, swimming pools, paved parking areas, wharves and docks, bridges, and fences are not tangible personal property. 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 § 38. Further, 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.
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) defines a "building" as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, 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. It also 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: (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 [former] § 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 includes 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. Thus, the term “building” does not include such structures as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns and coal tipples.
Treas. Reg. § 1.48-1(e)(2) provides that "structural components" 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 conditioning 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 as 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."
There is no general bright-line test for segregating property into § 1245 property and § 1250 property classifications. Each situation is factually intensive and is dependent on the particular facts and circumstances involved.
From a regulatory standpoint, the primary test for determining whether an asset is § 1245 property eligible for ITC is to ascertain that it is not a building or other inherently permanent structure, including items which are structural components of such buildings or structures. In other words, if an asset is not a building or a structural component of a building, then it can be deemed to be § 1245 property. The determination of structural component hinges on what constitutes an inherently permanent structure, how permanently the asset is attached to such a structure and whether it relates to the operation or maintenance of the structure. See Treas. Reg. §§ 1.48-1(c)-(e).
Early administrative rulings by the Service on ITC focused on the use of a "functional” or “equivalency” test. This test is based on the determination that if the primary use of property is to provide for the functions normally served by inherently permanent structures or structural components thereof, then the property should be so classified. Several courts, however, rejected this approach.
In Rev. Rul. 75-178, 1975-1 C.B. 9, the Service reconsidered its position based on the contrary case law. It states, “The use of a functional or equivalency test (1) to classify property as inherently permanent where it is not itself physically attached to the land, or (2) to classify property as a structural component where it is not an integral part of (and therefore a permanent part of) a building, is no longer the criteria to be used to classify property. Rather, the problem of classification of property as ‘personal’ or ‘inherently permanent’ should be made on the basis of the manner of attachment to the land or the structure and how permanently the property is designed to remain in place.” Thus, the test to be used to determine whether an asset is tangible personal property is the inherently permanent test.
The seminal case involving the determination of whether an asset is inherently permanent is Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). The Tax Court noted that “tangible personal property” is not intended to be defined narrowly, nor to follow the rules of State law where fixation to the land is a basis for distinguishing personal property from other property. It further stated that assets accessory to the operation of a business, such as machinery, printing presses, office equipment, individual air-conditioning units, display racks and shelves, etc., generally constitute tangible personal property for purposes of § 48, even though such assets may be termed fixtures under local law. Based on an analysis of prior case law, the Tax Court put forth six questions designed to ascertain whether a particular asset qualifies as tangible personal property. These questions, also referred to as the "Whiteco factors," are:
- Is the property capable of being moved, and has it in fact been moved?
- Is the property designed or constructed to remain permanently in place?
- Are there circumstances, which tend to show the expected or intended lengths of affixation, i.e., are there circumstances, which show that the property may or will have to be moved?
- How substantial of a job is the removal of a property and how time-consuming is it? Is it “readily removable”?
- How much damage will the property sustain upon its removal?
- What is the manner of affixation of the property to the land?
It should be noted that movability is not determinative in measuring permanence. The court in Whiteco held that affixation to land does not per se exclude the property from the category of tangible personal property. Additionally, in L.L. Bean, Inc. v. Commissioner, T.C. Memo. 1997-175, aff'd, 145 F.3d 53 (1st Cir. 1998), the court held that the mere fact that a structure is theoretically capable of being moved does not conclusively establish that it is not inherently permanent.
Examiners should also consider the following additional factors when addressing permanency (some of which may overlap with the Whiteco factors):
- History of the item or similar items being moved;
- Manner in which an item is attached to a building or to the land;
- Weight and size of the item;
- Function and design of the item;
- Intent of the taxpayer in installing the item;
- Time, cost, manpower, and equipment required to move the components;
- Time, cost, manpower, and equipment required to reconfigure the existing space if the item is removed;
- Effect of the item’s removal on the building; and
- Extent the item can be reused after removal.
See Amerisouth XXXII, Ltd. V. Commissioner, T.C. Memo. 2012-67; Trentadue v. Commissioner, 128 T.C. 91 (2007); PDV America, Inc. and Subs. v. Commissioner, T.C. Memo. 2004-118; Hospital Corp. of America and Subs. v. Commissioner, 109 T.C. 21 (1997).
Please note that land improvements may or may not be inherently permanent. Asset Class 00.3 of Rev. Proc. 87-56 describes land improvements as depreciable improvements made directly to or added to land, whether such improvements are § 1245 property or § 1250 property. Examples of land improvements include sidewalks, roads, canals, waterways, drainage facilities, sewers, wharves and docks, bridges, fences, landscaping, shrubbery, and radio and television transmitting towers. Buildings and structural components are specifically excluded from the category of land improvements. Land improvements may also be included in some activity asset classes such as asset class 57.1 of Rev. Proc. 87-56.
In Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997) (“HCA”), the taxpayer classified as tangible personal property certain items relating to hospital facilities and claimed depreciation deductions using a 5–year recovery period. The Service took the position that a number of those items were structural components of the related buildings and that they must be depreciated over the same recovery period as the buildings to which they related. The Service also argued that using a different recovery period for the disputed property items than for the buildings to which they relate in effect results in component depreciation, which is a method that is no longer permitted under ACRS and MACRS ( § 168(f)(1) and § 168(i)(6), respectively). Thus, according to the Service, the tests developed under the ITC to differentiate between § 1245 property and § 1250 property were inapplicable to ACRS and MACRS.
The Tax Court held that at the time ACRS was enacted, Congress did not intend to redefine § 1250(c) to include property which was considered under long-standing precedent to constitute § 1245 property. Thus, the precedent that was developed to ascertain whether property constituted eligible § 38 property for purposes of ITC was equally applicable to ascertain whether property constituted § 1245 property for purposes of ACRS/MACRS. Conversely, to the extent that property did not qualify as eligible § 38 property for purposes of ITC, the property cannot constitute § 1245 property for purposes of ACRS/MACRS. The court further held that the prohibition contained in § 168 against the use of component depreciation applied only to § 1250 property.
In an Action on Decision (AOD-1999-008), the Service acquiesced to the decision in HCA to the extent that the term “tangible personal property” as defined under the ITC remained applicable under both ACRS and MACRS. The Service, however, did not agree with the court’s determinations as to whether the various assets at issue constituted tangible personal property.
Pursuant to HCA, cost segregation methodologies previously used to allocate the cost of a building between ITC property and structural components likewise can be used for segregating § 1245 property from § 1250 property. However, this does not necessarily mean that an asset is exclusively either § 1245 property or § 1250 property; certain assets can contain characteristics of both code sections. Regarding primary and secondary electrical distribution systems, the court in HCA concluded that the portion of the cost of the primary and secondary electrical distribution systems corresponding to the percentage of the electrical load carried to the hospitals' equipment constituted as § 1245 property, whereas the portion corresponding to building operations constituted as § 1250 property. As a result of the ruling in HCA, the Tax Court followed its precedent in Morrison, Inc. v. Commissioner, T.C. Memo. 1986-129, and Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980).
In Scott Paper, the court focused on the ultimate uses of power at the taxpayer's facility and distinguished the power used in the overall operation or maintenance such as lighting, heating, ventilation and air-conditioning of the building from the power used to operate the taxpayer's machinery. It held that items which occur in an unusual circumstance and do not relate to the operation or maintenance of a building should not be structural components despite being listed in Treas. Reg. § 1.48–1(e)(2). To the extent that the primary electric carried electrical loads to be used for the taxpayer’s production processes or other such qualifying uses, the investment credit was allowed for the primary electric improvements; to the extent that the primary electric related to the overall operation or maintenance of buildings, they were structural components of such buildings such that they did not qualify as tangible personal property for purposes of the ITC. This became known as the functional allocation approach. Hence, the court made an allocation of the facility’s primary electric between § 1245 property and § 1250 property.
In Morrison, the court followed the functional allocation approach from Scott Paper and held that the electrical distribution systems were not structural components to the extent of the load percentages that were carried to equipment (§ 1245 property). On appeal, 891 F.2d 857 (11th Cir. 1990), the Circuit Court affirmed the decision in the Tax Court. It also made three broad announcements with regard to the electrical distribution system issue. First, taxpayers can claim ITC on a percentage basis. Second, it adopted the Tax Court’s method of focusing on the ultimate use of electricity distributed with regard to the electrical system. Third, the Tax Court’s method is consistent with the ITC’s purpose to provide an incentive for businesses to make capital contributions. Subsequent to the Eleventh Circuit’s opinion in Morrison, the Service issued AOD-1991-019 in which it stated that the Service would not challenge the functional allocation approach set forth in Scott Paper to determine the eligibility of electrical systems of a building to qualify as § 38 property. For a more detailed explanation of the functional allocation approach, please see Chapter 8.1 - Electrical Distribution Systems.
Case law has extended the reasoning of Scott Paper to such items as electrical wiring, outlet receptacles, electrical connectors, telephone connection equipment, fire protection systems, water piping and lines, drain lines, gas lines, and plumbing and gas connectors. See Amerisouth, supra, HCA, supra; Morrison, supra; Texas Instruments, Inc. v. Commissioner, T.C. Memo 1992-306; Duaine v. Commissioner, T.C. Memo.1985–39. Please note, however, that the functional allocation approach is only applied to a building’s primary and secondary electrical distribution systems.
The tax code provides numerous incentives for taxpayers to perform cost segregation studies and allocate costs to § 1245 property. Aside from a shortened cost recovery period (since § 1245 property has shorter lives than § 1250 property), certain incentives generally apply to tangible personal property (§ 1245 property) and not real property (§ 1250 property). Some of these incentives include:
- § 168(k), Special Allowance for Certain Property (i.e., Bonus Depreciation)
- § 179, Election to Expense Certain Depreciable Business Assets
Other incentives included in the tax code, however, may reduce the need for a taxpayer to perform a cost segregation study because they give preferential treatment for certain qualifying § 1250 property. Some of these incentives include:
- § 168(e)(6), Qualified Leasehold Improvement Property
- § 168(e)(7), Qualified Restaurant Property
- § 168(e)(8), Qualified Retail Improvement Property
- § 1400L, Tax Benefits for New York Liberty Zone
- § 1400N, Tax Benefits for Gulf Opportunity Zone
Please note that the requirements and restrictions for utilizing all of the above incentives can be complex. In addition, the amount of the deduction allowed by the above incentives has changed over time such that one needs to pay special attention to the placed-in-service date of the property at issue. As such, you may wish to contact the Practice Network that has jurisdiction over the incentive to ensure that the applicable provisions are properly followed.
The Service issued a series of Field Directives intended to provide direction to effectively utilize resources in the classification and examination of a taxpayer who is recovering costs through depreciation of tangible property used in the operation of a business. The directives were issued for a variety of industries including casinos, restaurants, retail industries, biotech and pharmaceutical industries, and auto dealerships. The directives contained matrices and related definitions as tools to reduce unnecessary disputes and foster consistent audit treatment. The directives specified that if the taxpayer’s tax return position was consistent with the recommendations in the matrix, then Examiners should not make adjustments to categorization and lives. If the taxpayer reported assets differently, however, then adjustments should be considered. See Chapter 7 of this Guide for matrices applicable to various industries.
This chapter has provided a legal framework for cost segregation by providing a brief history of depreciation, discussing various asset classification and cost recovery models, defining relevant terms, examining the former investment tax credit (ITC), explaining tests for distinguishing § 1245 property from § 1250 property, showing how cost segregation principles transferred from the ITC to current cost recovery systems, clarifying how cost segregation applies to building systems, enumerating incentives for cost segregation, and conversing about audit tools.
It cannot be overemphasized that the classification of assets is a factually intensive determination. There are no bright-line tests for segregating property into § 1245 property and § 1250 property classifications. Based on the final tangible regulations released in September 2013, it is expected that the use of cost segregation studies by taxpayers will increase. Thus, Examiners need to examine and evaluate a cost segregation study in light of the applicable statutes, regulations and judicial precedent.