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Cost Segregation Audit Techniques Guide - Chapter 5 - Review and Examination of a Cost Segregation Study

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Chapter 4 | Table of Contents | Chapter 6.1

Chapter 5 - REVIEW AND EXAMINATION OF A COST SEGREGATION STUDY

INTRODUCTION

The preceding chapters described the legal framework for classifying assets (Chapter 2), common methodologies  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 and report.

The appropriate audit steps depend on the nature and size of the cost segregation project as well as on the overall quality of the study.  Cost segregation is a factually intensive determination that is based on complex tax law and engineering analysis. While Examiners may be able to evaluate the adequacy of some cost segregation studies, other studies may require specialists with expertise, industry or construction experience and specialized training.

The Engineering Program in the Large Businss and International (LB&I) business unit of the IRS is the principal source of technical expertise for examining cost segregation studies.  The Computer Audit Specialist (CAS) Program in LB&I is also available to provide assistance when a study is based on statistical sampling.  Formal advice, using the referral process, should be solicited through the LB&I website and the Specialist Referral System (SRS).  Informal advice through consultation is also available by contacting your engineering or computer audit specialist group.  The Senior Revenue Agents in the Deductible and Capital Expenditures Practice Network (DCE PN) are also available to assist Examiners with this issue.  Refer to the DCE PN website for up-to-date information and guidance on this issue or to submit an inquiry.  Here is a link to the DCE PN website: [https://organization.ds.irsnet.gov/sites/lbi_ipg_program/DCE/default.aspx]

Cost segregation studies and fixed asset reviews typically utilize documents and cost information prepared for purposes of the construction process; Special Topics Chapter 6.6 – Construction Process, provides a brief overview of the construction process.  Cost segregation studies can be examined using a step-by-step approach.  The suggested audit steps below may not apply to all cost segregation studies, however, each step should be carefully considered and determined to be applicable or not before moving on to the next one.

STEPS FOR EXAMINING A COST SEGREGATION STUDY AND REPORT

Risk Analysis

Risk analysis is the process that compares the potential benefits to be derived from examining a specific area on a tax return with the resources needed to complete the examination.

1. Review A Copy Of The Cost Segregation Study Report for Initial Risk Analysis Purposes

Every Cost Segregation Study should have a report that summarizes the results of the cost segregation study.  The report should provide:

  • Background regarding the subject property
  • An explanation of the methodology used by the preparer
  • Details regarding the assets classified in the study
  • The applicable class lives and recovery periods of the assets
  • The rationale and authority for the property classifications made in the Study.

Refer to Chapter 4 for a discussion of the principle elements of a quality cost segregation study and report.

In reviewing a Cost Segregation Study Report for risk analysis purposes, one must read the report to obtain a general understanding of the study methodology and the property classifications made therein.  The following steps are suggested when reviewing a cost segregation report for risk analysis purposes:

  • Request a copy of the Cost Segregation Study Report.  Refer to the IDR Exhibits in Special Topics Chapter 6.7 – Information Document Requests for suggested language.
  • Read the Entire Report with Emphasis on the Property Classifications.
  • Review the Property Units and the Types of Assets.
    • Assets are generally classified by cost segregation studies into various units or groups of assets and are often listed in both a "Summary" and a "Detail" format.
      • A “Unit (or Asset) Group” is a group of individual assets that together form a larger assembly that is considered to be and treated as a single asset.
      • The “Property Unit Summary” is a list summarizing the Unit Groups by asset class or recovery period (i.e. land, 3, 5, 7, 10, 15, 20, 27.5 and/or 39-year property.)
      • The “Property Unit Detail” is a listing of the individual assets that comprise each Unit Group.  This list describes the individual assets and indicates the cost basis of the asset as determined in the study.
      • An example of a Unit Group is “Kitchen Equipment - Plumbing” (which is made up of a group of individual assets).  For this Unit Group, the Property Unit Detail would list the individual assets (for example floor drain, grease trap, sanitary piping, sink, water supply piping, etc.) that make up the “Kitchen Equipment – Plumbing” Unit Group and provide the cost basis of each of the individual assets as determined in the cost segregation study.
    • Abbreviated methodologies may not classify assets into Unit Groups, Property Unit Summary or Property Unit Detail.  Nevertheless, assets should be identified, supported and documented in a cost segregation report.

2. Verify The Cost Basis And Reconcile Depreciation Records

Cost Segregation Studies are used to classify taxpayer assets into shorter recovery periods to accelerate the depreciation deductions for the assets.  The study results should be easily reconcilable to the taxpayer’s depreciation or fixed asset schedules.

Examiners should reconcile the cost basis of property in a study to the cost basis contained in the taxpayer's books and records.

  • Request Detailed (Asset-by-Asset) Depreciation Schedules that tie to the tax return.  Determine how the study assets are shown on the depreciation schedules.
  • Review Tax Depreciation Schedules to verify that tax basis reconciles with the study and note any differences.  Are fixtures, furnishings and equipment included in the study?  Are they located on other depreciation or fixed asset schedules? Have these costs been duplicated?
  • 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 Internal Revenue Code § 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 § 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 § 168(b)(5).

3. Conduct A Risk Analysis To Evaluate Audit Potential

Conduct a risk analysis to evaluate the audit potential and determine audit scope.

  • Review the descriptions in the Property Unit Detail schedule to determine the type of property in each unit (or group).
  • Review the individual assets in each Property Unit Detail schedule.  Is each asset classified properly? (The asset matrices included in Chapter 7 can be of great assistance in this review.)
  • Compare the Study’s Property Descriptions and Classifications To Revenue Procedure 87-56, 1987-2 C.B. 674.  Is the property included in the proper Asset Class?  Are there any deviations that may indicate a potential audit issue?  Identify specific assets that might need to be viewed during a tour of the facility.
  • Common situations suggesting audit potential include:

    • Mixed asset types in the same unit (or group). (i.e., assets with different recovery periods).
    • Building structural components or leasehold improvements classified with improper shorter-lived § 1245 recovery periods.
    • Minimal or no dollar amounts assigned to land, non-depreciable land improvements, building, or other longer-lived assets.
    • Use of “creative” nomenclature, inconsistent titles and/or descriptions to disguise the true character of an asset.  All asset descriptions should be clear and understandable.  Does the nomenclature used for assets in the study agree with the nomenclature used in the construction records and documents? 
  • Request Additional Information (as needed) to determine audit potential.  In some cases, it may be more appropriate and efficient for the preparer of the study to respond to the document requests.  Supporting documents may include computer files, hardcopy files, plans, etc.  A CAS can assist in viewing computer files not ordinarily viewable on IRS computers.
    • Issue IDRs to determine the classification of items not readily understood or that are described in the report using an ambiguous description.  Refer to Special Topics Chapter 6.7 – Information Document Requests for suggested language.
    • Request contemporaneous records (permits, design studies, contractor payment records, AIA payment documents such as G702 and G703, contracts, purchase orders, invoices) to verify the costs and descriptions of property as well as to ascertain their functional use.  This will facilitate the determination of the proper asset classification pursuant to Revenue Procedure 87-56.  For example, machinery located in a chemical plant is 5-year property instead of 7-year property if it meets the requirements of Asset Class 28.0 (refer to Special Topics Chapter 6.3 – Depreciation Overview for information on asset classes).
    • Request project information, such as the Capital Expenditure Request (CER) or Authorization for Expenditure (AFE), to verify project costs and identify related purchases.  This information may also help determine the intended use of the property.
  • Summarize Your Preliminary Findings.

    Determine the tax impact of potential audit issues, such as:

    • Assets with a cost basis that is questionable, disputed or unsubstantiated.
    • Assets that have been misclassified and given an improper recovery period.
    • Double deductions for separately acquired assets.
    • The use of improper depreciation methods.
    • Incorrect placed-in-service dates.
    • Large look-back computations (i.e., the study reflects a change in method of accounting, with the return reflecting a deduction for depreciation not deducted in prior years).
  • Determine the Need for Specialists (e.g., Engineers and/or Computer Audit).  Specialists may be required to assist in the examination of complex projects.  It is important that specialists be involved in the audit as early as possible.  Informal assistance may also be requested when needed.
    • A study with significant tax impact generally requires the assistance of specialists.  These studies will typically have a large number of assets, or complex assets.
    • A study that allocates estimated costs between § 1245 and § 1250 property (particularly electrical or plumbing component systems) typically requires the assistance of an Engineer who is experienced in construction and construction estimating.  Engineers can provide the expertise needed for the proper development and resolution of the issue.
    • Studies involving numerous assets or allocations may require the assistance of a CAS to process the data and/or evaluate any statistical sampling methods.
  • Determine the Scope and Depth of Your Examination.  Risk analysis is a subjective process based on the experience, knowledge and judgment of the examiner.  Guidelines provided in the previous chapters will assist Examiners in evaluating the overall accuracy and adequacy of a study as well as in determining audit potential and scope.  Studies with little tax impact should be closed expeditiously.  Studies with significant tax impact may require specialist assistance and should be considered for additional review and examination.

Examination

The examination of the cost segregation issue should proceed if the Risk Analysis identifies audit potential due to the asset classifications in the study, and required materiality thresholds of the specific examination are met.

4. Review the Cost Segregation Study Report for Examination Purposes 

  • Request a copy of the Cost Segregation Study Report, if not previously done for the Risk Analysis.  Refer to the IDR Exhibits in Special Topics Chapter 6.7 – Information Document Requests for suggested language.
  • Request a copy of the Letter of Engagement to determine the scope of the study.
  • Determine the Nature of the Fee Arrangement.
    • Many firms charge a fee based primarily on the size of the project.  Out-of-pocket expenditures are generally added to this cost.
    • 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.  Refer to Circular 230.
  • Evaluate the Study with respect to its depth, accuracy and methodology and consider the following questions:  What methodology was used (see Chapter 3 – Cost Segregation Approaches)?  How does the study and report compare to the quality elements described in Chapter 4 – Principal Elements of a Quality Cost Segregation Study and Report?
  • Determine the Cost Allocation Process used in the Study and the Source of any Unit Costs.  The following questions may assist in determining the Cost Allocation Process:  How were costs allocated?  Were actual costs or estimates used?  How were unit costs determined?
  • Request Contemporaneous Documentation to Substantiate and Verify the Cost Basis of Assets. 
  • Determine Whether Cost Basis was Properly Allocated to land, non-depreciable land improvements (clearing, grubbing, general land grading) and/or other property types aside from those considered by the study.
    • Consider if any project costs were allocated to land or land improvements. Many studies allocate almost all costs to building and personal property, instead of allocating appropriate amounts to land, land improvements or other long-lived assets.  In the case of acquired property, it is often appropriate to assign a large portion of an acquisition price to land prior to allocating the remaining purchase price to other property.  See “Allocating Purchase Price of Acquired Property” later in this chapter.

5. Interview The Cost Segregation Study Preparer

An interview with the preparer of the cost segregation study is an efficient way to obtain detail regarding the methodology used for the study as well as answers on the classification of questionable assets and the reasoning behind those classifications.

  • Schedule an Interview with the Preparer.  If possible, this should be completed before or contemporaneous with the on-site inspection.  The interview should address the scope and assumptions of the study and any observations of the project or facilities.  Possible interview questions include:
    • Were the properties inspected at the time of the study?
    • Were photographs and/or video media taken and/or relied upon in classifying property?
    • Were sampling techniques used?
    • What cost estimating guides were used?  Where are the guides located (for purposes of verifying estimates)?
    • What documentation was used to establish the cost basis and particular use of a property item?
    • How was the cost of each property item identified, segregated and classified?
    • Where are the supporting workpapers located?

6. Inspect the Property

In some instances, the only way to resolve a question regarding the proper classification of an asset is to actually inspect the asset as installed in the taxpayer’s facility.  An inspection can provide information to the examiner on the purpose and use of an asset as well as details of the installation and construction of the asset.

In general, the Service Engineer (if assigned) is responsible for arranging the on-site inspection, which provides the opportunity to view the assets in question. Inspections also help identify underground utilities, off-site improvements and general grading costs that may have been misclassified as § 1245 or § 1250 property.  Overall, the inspection provides information to assist in determining classifications of § 1245 and § 1250 property.

  • Prior to Scheduling the Tour, Complete your Review of the Study in order to identify specific assets and concerns that require inspection.
  • Prepare a List of Assets/Items that Warrant Inspection and provide it to the taxpayer beforehand.  Ask additional questions and/or view additional property components during the tour as needed.
  • Plan the Inspection to Minimize Time and Travel Costs. For cases involving multiple properties of similar character, consider inspecting only a representative number of properties or facilities. 
  • Take a Camera or Video Recorder (Camcorder) to record the condition of the property.  Confirm beforehand that photography will be allowed/permissible.
  • Request that the Property Manager/Maintenance Engineer be Available During the Tour. It is important that someone familiar with the physical attributes and workings of the property be available to answer questions and provide access to non-public areas.
  • Request that the Preparer Attend the Tour.  The preparer should be able to identify the physical attributes of specific assets and explain how they were classified.
  • Request Access to Plans, Drawings and Contract Documents that are located on-site.
  • Prepare an IDR in duplicate so that any requested items received during the inspection can be noted and an acknowledgement copy of the IDR can be left with the taxpayer.
  • View the Project Site and Document Features that impact the cost allocations and property classifications.  Consider the following points:
    • 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?
    • Project Records – Where are the original project records (e.g., drawing, plans, contracts, payment records) located?  Ask for the names of the employees who may have particular knowledge of the construction.  Request interviews with such individuals as needed.
    • 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 the study.
  • Prepare Notes and Drawings for future reference.
    • Obtain sufficient information to properly classify each challenged asset.
    • When possible, obtain local cost data to verify estimates and cost allocations.

7. Review And Verify The Asset Classes and Recovery Periods Of Property

A major goal of a Cost Segregation Study examination is to verify the proper classifications and recovery periods of the assets included in the study.

Review the study again to determine whether the property classifications assigned to the assets in the study are correct.  This review is done in greater detail than the initial review performed for risk analysis purposes.  The goal is to verify the proper recovery period of all assets and to identify possible land or non-depreciable land improvements classified as depreciable property in the study.  As in the initial risk analysis review, the property matrices in Chapter 7 can be of great assistance in this detailed review.

  • Are Assets Classified into Proper Groups according to Asset Class or Recovery Period?  Consider the following assets:
    • Land
    • Non-Depreciable Land Improvements (i.e., non-recurring land preparation costs such as general land shaping and grading)
    • Depreciable Land Improvements
    • Buildings, Structural Components and Other § 1250 Property
    • Office Furniture, Fixtures and Equipment
    • Information Systems
    • Building Systems (e.g., mechanical, electrical, plumbing)
    • Process Systems (e.g., process piping)
    • Non-Residential Real Property
    • Other Miscellaneous Property
  • Are Assets Assigned to the Proper Asset Class and Recovery Period?
    • The classification of assets as either § 1245 or § 1250 property is a factually intensive determination with no bright line tests.
    • Common Audit Issues

      A common issue is the allocation of specific components or portions of a building system to § 1245 property.  The issue often arises as a result of poor documentation and/or improper legal support.

      • Example 1
        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 (e.g., 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).
      • Example 2
        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.  Refer to Chapter 8.1 for a discussion of the proper methodology for the functional allocation of an electrical distribution system.
      • Example 3
        Some taxpayers have filed claims based on cost segregation studies of leased property.  Typically, leases were assigned to 39-year recovery property on the originally filed tax 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 § 197 (if the acquisition otherwise qualifies under § 197).  Examiners should closely scrutinize allocations of this type.

8. Research The Law, The Regulations And Appropriate Rulings

Before reaching a final conclusion on the classification of a specific asset, the examiner should have conducted all the necessary research and reviewed all the relevant court cases, rulings and regulations that relate to asset classification and the challenged asset.  While some assets may, at first glance, appear to be building-related, there may be revenue rulings or court cases that have concluded that these assets are instead tangible personal property (e.g., electrical wiring, HVAC, decorative millwork).

Special Topics Chapter 6.4 – Relevant Court Cases contains a summary of pertinent court cases that relate to the classification of property for depreciation purposes.  The examiner should read and study these cases for guidance.  An examiner must also recognize that the determination of class life for a particular asset is factually intensive and that the determination may vary with a particular industry and/or with the specific use by the taxpayer.

Industry-specific guidance is included in Chapter 7.1 (Casinos), Chapter 7.2 (Restaurants), Chapter 7.3 (Retail), Chapter 7.4 (Biotechnology and Pharmaceutical), Chapter 7.5 (Auto Dealerships), and Chapter 7.6 (Auto Manufacturing).  It is anticipated that specific guidance for additional industries will be developed in the future, and will be added to Industry Specific Guidance Chapter 7 as it becomes available.

9. Cost Analysis

Once the proper classifications and recovery periods for the assets have been established, the next step, if required, is to perform a Cost Analysis.  In a Cost Analysis, the examiner considers how the study allocated the project construction costs to the individual assets, evaluates whether the allocation was performed properly, and determines whether the cost basis of the assets as shown in the study is correct.

The methodology used for the Cost Analysis depends on whether the assets are part of a newly constructed facility or are part of an existing facility that was acquired by the taxpayer.  The difference in Cost Analysis methodologies between these two situations is due to the different methods used to perform studies for these properties.  Actual construction cost information is nearly always available for Newly-Constructed properties; however, it is rarely available for acquired properties.  Property appraisal approaches and construction cost estimating techniques are often used to determine the construction costs for acquired properties.

It is important to realize that in order to properly perform a Cost Analysis, knowledge of construction and construction estimating is required and will most often involve the assistance of a Service Engineer.  It is also important to realize that performing a Cost Analysis is very time consuming; therefore, they should only be completed if there are significant questions regarding the proper basis amounts assigned to the assets on the study.

If a cost analysis is required, see Step 12 below.

10. Summarize The Findings And Discuss The Challenged Assets With The Taxpayer

If the preliminary conclusion is that the taxpayer has misclassified certain assets, the examiner should meet with the taxpayer as soon as practical to discuss his/her findings and the reasoning behind them.  This discussion may clear up any misunderstandings and disagreements as to the facts and perhaps will provide a setting for reaching a resolution of the issue.

11. Prepare The Final Report Or The Notice Of Proposed Adjustments (if necessary)

At the conclusion of the examination, the Examiner (Revenue 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 Examiner calculate the depreciation or amortization adjustments to ensure that all pertinent factors are included in the computation.  Adjustments to the construction period interest may also be applicable.

Other Considerations

Depending on the methodology used for the cost segregation study, the type of indirect costs that were part of the construction, and whether the study is changing the classification of existing assets, the following steps should be considered as part of the examination.

12. Perform A Cost Analysis

  1. Cost Analysis of Newly-Constructed Property
    Actual cost records should be available for Newly-Constructed Properties.  This information can most likely be obtained from the cost segregation study preparer, the taxpayer, the project Architect, the project construction manager or the general contractor.  Cost records should be requested for significant property items only.  Significant in this situation is defined based on the materiality amounts of the specific examination.
    • Gather Background Information.
      • Secure total project costs by requesting information related to the construction project billings.
      • Review construction drawings and specifications. 
        • Construction drawings and specifications identify property items, construction methods and locations of items within the structure.
        • Review the record drawings (often called “as-built” drawings) if they are available.  Record drawings are prepared at the end of the construction project and incorporate all changes to the original building design made during construction so they represent a record of what was actually constructed.  These drawings are generally available from the taxpayer, the project Architect, the project general contractor or the construction manager.  Other possible sources include the local building department, local fire department or the taxpayer’s insurance carrier.  Review the most “up-to-date” drawings as well.  These drawings include the latest revisions made by the Architect and Engineers and are typically found in the taxpayer’s facilities engineering or maintenance departments or the property manager’s office depending on the type of facility.
      • Request copies of the building permit and certificate of occupancy (C of O), which can assist in establishing the construction start date and the placed in service date.
      • Request photographs of the site showing the condition of the property before the project began.  This will help determine whether significant site preparation or general grading costs were incurred.
    • Request Contemporaneous Records to Substantiate the Cost Basis of Assets in the Study.
      • Contract documents specify how payments are made and typically require payment requests to be broken down into individual items of property. Refer to Special Topics Chapter 6.6 on the Construction Process for a discussion of how payments to contractors and suppliers are made and documented in a typical building construction project.
      • For purchases made outside the construction contract (i.e. furniture or equipment) or for indirect costs (i.e. Architectural/Engineering fees, plan review fees, etc.), purchase orders and invoices are a good source of cost data.
    • Analyze the Total Project Costs.
      • Review the General Contractor’s and major Subcontractor Requests for Payment (i.e. AIA G702 and G703).  Particular attention should be made to the final pay applications, as these should be more indicative of the final total construction cost.
      • Review any construction costs that may not be shown on the pay applications, including change orders, indirect costs and out-of-pocket costs.  Test for completeness by looking for any missing elements (e.g., land shaping costs may be in a separate contract).
      • Review invoices for any pre-purchased or owner-furnished equipment.  On large construction projects, the taxpayer may separately pre-purchase items that have a long delivery time (e.g., large capacity electrical sub-stations or transformers) or may directly purchase large equipment items such as air handling units in order to avoid the contractor markup.  The contractor may also install owner-furnished equipment.  The examiner should verify if any pre-purchased owner-furnished equipment is included in the total project cost and that the cost of such equipment is treated appropriately.
    • 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 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 the 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 Examiner is in the best position to do this since he/she is the most familiar with the taxpayer’s accounting methods.  The Examiner 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.
      • Compare all data with the contemporaneous cost records.
      • List any unsupported basis for potential disallowance.
    • Reconcile Detailed Cost Breakdowns to individual property elements.
      • Actual cost records should be used whenever possible.
      • 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). 
        • The study methodology should be disclosed in the Assumptions and Limiting Conditions section of the report.
        • A careful analysis of the Job Cost Reports may yield significant audit adjustments.  The following is an example illustrating how the taxpayer does not always properly classify items that are listed in this report.
        • 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”, in order to verify asset costs.
    • Prepare a List of Items/Costs that are Not Properly Substantiated.
    • Compute the Correct Costs (as necessary) for individual items or groups of property.
    • Review the Cost Segregation Study Report Again.
      • Review the study for its style and order of presentation.  The narrative typically describes the order of the development of costs and the spreadsheets show the analysis and sequence. 
      • Review the study’s conclusions, recommendations, assumptions and limiting conditions.
      • Verify that the assumptions and limiting conditions are consistent with the facts developed from the inspection and the review of the drawings and specifications.
    • Analyze How the Detailed Cost Breakdown was Prepared.
      • Review Direct Costs.
        • Confirm that the direct costs are properly classified as either § 1250 or § 1245 property, and identify any questionable items for further review.
      • Review Indirect Costs.
        • Ensure that indirect costs are properly allocated to their respective assets.
        • 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 – Principle Elements of a Qualified Cost Segregation Study and Report, for additional discussion of indirect costs.
        • Studies often use large spreadsheets and sophisticated formulas to compute the allocation of indirect costs (generally on a pro-rata basis).  The examiner should verify any formula by testing the allocations of indirect costs to ensure they do not exceed the total indirect costs.
    • Identify Potential Audit Issues.
      • 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 (called clearing and grubbing) in addition to grading and compaction to provide a level site, are generally non-depreciable costs allocable to the basis of the land.  A study may exclude these costs as being outside the scope of its work.  In other instances, a study may argue that none of these costs are allocable to non-depreciable land improvements.  Whether these types of costs are included in the study or not, the examiner should determine all land preparation costs included in the project, analyze them and allocate them to non-depreciable land improvements, building, and/or depreciable 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 both financial and tax purposes.
      • § 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 quick check since additional equipment or other property purchased by the taxpayer outside the construction contract may significantly affect this type of comparison.
      • Potential Problems with Residual Methods.
        • When a residual approach has been used, the examiner must be especially careful when reviewing § 1245 property costs.  In essence, this method estimates the § 1245 property costs and then simply assigns the remaining portion of the total cost to § 1250 property.  In general, the § 1250 residual cost is neither estimated nor checked for reasonableness.  All too often the result of this procedure is that the § 1245 property cost is too high and the § 1250 property cost is too low.
        • Cost estimates can also be manipulated to produce unreasonably high estimates for § 1245 property.  This is because there are a wide variety of cost data publications that may be used, and some of these have relatively high estimates for costs.
        • 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.  Economies of scale, "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 (duplex receptacle) 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 taxpayer awarded the contract, the contractor submitted a schedule of cost for each item of work, such as for plumbing, electrical, heating, and site work (Forms 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 $ 21.70 per outlet.  The total actual cost for the 500 outlets is therefore only $10,850 (500 x $21.70). The total actual cost compared to the estimated cost ($17,250) may result in a significant difference.  Note that 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.
      • Potential Problems with “Rule of Thumb” Methods
        • 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 "rule of thumb."   The documentation needs to be examined and verified on its own merits to determine if cost recovery properties are accurately identified and placed into proper recovery periods.
  2. Cost Analysis of Existing or Acquired Property

    Allocating Purchase Price of Acquired Property

    Cost segregation is applied both to determine the classification of property and to allocate the cost basis of property.  This section focuses on cost segregation studies involved in allocating cost basis when acquiring a group of assets.  Such allocations generally must rely on determining the fair market values of the acquired assets.

    In this audit technique guide, new property and particularly new building construction projects receive much attention in the chapters addressing cost segregation studies and reports.  However, cost segregation is not limited to Newly-Constructed property.  Cost segregation also applies to the acquisition of a group of assets often acquired for a lump sum, such as real estate or a trade or business.  Approaches for segregating newly constructed property rely on contemporaneously billed and itemized costs, published costs of new property, or other estimated costs new.  In order to determine the fair market values of the acquired assets, appraisal practices and procedures must be relied on to allocate/segregate a lump sum basis.

    In the case of an acquisition including a combination of depreciable and non-depreciable property for a lump sum (e.g., buildings and land), the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time; Treas. Reg. § 1.167(a)–5, apportionment of basis.  The relevant inquiry is the fair market values of the properties at the time of acquisition.  Whether an opinion of value is provided in a report styled as a cost segregation study or an appraisal report, any opinion of value should be developed and reported by appropriate standards of the professional appraisal practice.

    Examiners should consider seeking the expertise of IRS Engineers and Appraisers when examining value and allocation issues.

    Real Estate Allocations

    In allocating, a lump sum price paid for real estate, appropriate appraisal practices and procedures must be applied to determine the fair market values of the non-depreciable land and each of the depreciable assets (buildings, land improvements and personal property).  The cost segregation study should explain the standard of value that is applied.  When performing a risk analysis of a cost segregation study, Examiners should also consider whether value opinions were provided by a competent and qualified appraiser.

    The fair market value of land should be based on the highest and best use of the land as though vacant, even if the land has improvements.  The land value may equal the value of the total real estate even if the real estate has substantial improvements, when such improvements do not contribute value to the property. Whereas land has value, improvements contribute value.  The value of the total real estate, less the value of the land, results in the value of the improvements. Accordingly, it is inappropriate to estimate the value of the land by subtracting the estimated value of the improvements from the lump real estate price.  Basis assigned to land in this residual fashion may result in understating the appropriate basis in the land and overstating the appropriate basis in the depreciable improvements.  Examiners should also be wary if a cost segregation study relies solely on local assessed values rather than appropriately determining fair market values.

    § 1060 Allocations

    § 1060 prescribes special allocation rules for determining a transferee’s (buyer’s) basis and a transferor’s (seller’s) gain or loss in an applicable asset acquisition. An applicable asset acquisition is any transfer of assets (either directly or indirectly) that constitutes a trade or business and with respect to which the purchaser’s basis in such assets is determined wholly by reference to the consideration paid for them. See §1060(c).

    A group of assets constitutes a trade or business if i) the use of the assets would constitute an active trade or business under § 355 or, ii) its character is such that goodwill or going concern value could under any circumstances attach to such group of assets. See Treas. Reg. § 1.1060-1(b)(2).

    The Omnibus Budget Reconciliation Act of 1990 amended § 1060(a) to provide that where the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, that agreement is “binding” on the transferee and the transferor unless the Commissioner determines that the allocation (or fair market value) is not appropriate.  See § 1060(a)(2).  The House Report accompanying the amendment to § 1060(a) explained that:

    … a written agreement regarding the allocation of consideration to, or the fair market value of, any of the assets in an applicable asset acquisition will be binding on both parties for tax purposes, unless the parties are able to refute the allocation or valuation under the standards set forth in the Danielson case.  The parties are bound only with respect to the allocations or valuations actually provided in the agreement. * * *

    The committee does not intend to restrict in any way the ability of the Internal Revenue Service to challenge the taxpayers’ allocation to any asset or to challenge the taxpayers’ determination of the fair market value of any asset by any appropriate method, particularly where there is a lack of adverse tax interests between the parties. See H. Rept. 101-881, at 351 (1990).

    In Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967), the Court of Appeals ruled that a taxpayer can challenge the tax consequences of a written agreement “as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”  The Court of Appeals for the Eleventh Circuit has expressly adopted the Danielson rule.  See Plante v. Commissioner, 168 F.3d 1279, 1280-1281 (11th Cir. 1999); Bradley v. United States, 730 F.2d 718, 720 (11th Cir. 1984); and North American Rayon Corp. v. Commissioner, 12 F.3d 583, 589 (6th Cir. 1993).

    In Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-18, aff’d 522 Fed. Appx. 840 (11th Cir. 2013), the taxpayer purchased two poultry processing plants in applicable asset acquisitions under § 1060.  As part of the acquisitions, Peco Foods entered into written agreements with the seller allocating the purchase price among the acquired assets.  In addition, Peco Foods hired an outside consulting firm to perform a cost segregation study on the acquired plants, and subsequently filed a Form 3115 with its tax return to change its accounting method and reclassify certain property from nonresidential real property to tangible property.  The IRS disputed these changes, arguing that the taxpayer could not modify the purchase price allocations and subdivide them into component assets in a manner at odds with the allocation schedules.  The Tax Court held that Peco Foods was bound by the clear and unambiguous terms of the original allocation schedules and could not deviate from its characterization of those assets.  Thus, the taxpayer was not allowed to change its method of accounting for the acquired assets pursuant to its cost segregation study.  It is unclear whether the holding in Peco Foods would apply to acquisitions other than applicable asset acquisitions under § 1060.

    Where the parties to an applicable asset acquisition do not agree in writing to the allocation of consideration of the assets, § 338(b)(5) applies.  In general, sellers and purchasers must allocate the consideration under the residual method as described in Treas. Reg. §§ 1.338-6 and 1.338-7 to determine the transferee’s basis in, and the transferor’s gain or loss from, each of the assets transferred. See Treas. Reg. § 1.1060-1(a).

    In addition to the steps previously discussed for Newly-Constructed property, 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 written purchase price allocation is binding on the taxpayer and cannot be changed by a taxpayer’s subsequent cost segregation study.  Only the Service can challenge a contract allocation.  See § 1060(a); Danielson, supra.  If there was not a written price allocation, then the examiner should address the study and go to the next step.  See Peco Foods, supra.
    • Review the Escrow Documents and Payment Records to substantiate the overall purchase price.
    • Ensure that the Land has been Properly Valued.
      • Request a copy of the appraisal that provides the opinion of the fair market value of the property.  The appraisal should indicate the value of the land and improvements separately.  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.
      • Land value should not be reduced for any pre-existing environmental contamination because the prior owners are often held responsible for this and/or the property is generally insured for this situation. 
    • Ensure that Older Properties are Adjusted for Depreciation.
      • Assets and asset groupings must be carefully reviewed and scrutinized to determine their physical and economic condition.
      • Relatively new items should be valued as new (e.g., windows, building exterior, emergency generator).
      • 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.
    • Ensure that Replacement Cost Values are Properly Adjusted for the actual condition and remaining economic useful life of the assets.
      • The value of used components must be reduced from the replacement cost new 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 Contract Files for information regarding the original construction and any subsequent repairs or modifications.  This information should be used when viewing the existing condition of the building to verify, if possible, that the original contract work was performed. 
      • Review the Construction Drawings.  The existing structure should be compared to the record drawings (commonly called “as-built” drawings) to help identify subsequent repairs and modifications.  In many instances for an acquired property, full construction drawings are not available or are minimal.
    • Consider Demolition Expenses.
      • Assets scheduled to be demolished should have no basis or value assigned to them.
      • § 280B provides that the demolition cost of any structure is a capital cost chargeable to the land.  Any abandonment losses incurred in connection with a demolition should also be considered for capitalization to the land.  See TAM 9131005 (Apr. 25, 1991).

    In summary, the examiner should ensure that:

    1. The study methodology for the proper allocation of the purchase price between the non-depreciable land and depreciable building and personal property must be based upon their values as of the date of purchase.
    2. The value of property items must take into account the physical wear and tear of each property item and any economic or functional obsolescence.

13. Review Sampling Techniques (If Necessary)

Taxpayers 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 when examining these studies.  The examiner should take the following steps in reviewing a taxpayer’s sampling technique.

  • Request the Assistance of Engineers and Computer Audit Specialists.
    • If the taxpayer has utilized any form of sampling in a study, it is imperative that a CAS be consulted to review the sampling method.  The CAS will use Rev. Proc. 2011-42 as guidance in evaluating the adequacy of the statistical sampling program.  If needed, the CAS will request that a statistical sampling coordinator be assigned to specifically review the sampling procedures used by the taxpayer.  An Engineer can also assist in the review of strata and property groups, and the cost allocations of property.
    • Sampling techniques may also be a useful tool for Examiners when reviewing the adequacy and accuracy of a cost segregation study. Consultation and/or referral to a statistical sampling coordinator in the CAS Program is highly recommended in order to develop a reliable and supportable sample.
  • Understand the 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 strip/enclosed malls, full-service locations, carryout units, leased properties.  The population is stratified by prototype to form groups of similar structures.
    • Sampling within each prototype group is then performed with the results projected to the entire population within that prototype.  The projection of sampling results is limited to items and years included in the original population.  The results cannot be extrapolated to years outside this population.  The application of “extrapolation with a haircut” to items or years not included in the sampled population is not allowed for cost segregation studies.
    • Adjustments made by an examiner to the cost allocation performed on a sampled item are projected to the overall population to determine the overall adjustment.  Based on which strata the adjusted sample resides in, the adjustment to the overall population may be significantly more than the adjustment made to the sampled item.  This should be considered when performing a risk analysis on cost segregation studies that use statistical sampling.
  • Determine/Evaluate the degree of Similarity Between Properties Within a Group.
    • The determination of the similarity between properties within a prototype group is difficult and creates a potential area of dispute.  The examiner should be aware that while the appearance of a particular structure may be very similar to the prototype, differences could exist.
    • The rationale for stratifying properties is generally based on factors such as the style of the structure (e.g., location in strip/enclosed mall as opposed to a free standing location), geographical location, and total square footage, leased, or owned.  A stratification that is based on relatively unimportant factors or irrelevant similarities, such as the total number of windows in a structure or the total square footage of the site, is highly suspect and generally warrants further analysis.
    • 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.
    • CAS and Engineers should be involved to properly analyze and evaluate the strata and groupings, as well as the sampling methodology.
  • Review the Sampling Methodology.
    • When conducted properly, statistical sampling is a reliable technique when the risk (sampling error) of not examining 100 percent of the properties can be accurately determined.
    • The use of a modeling technique is a reliable technique, provided the standard models or templates are properly analyzed and are similar to their respective groups (i.e., appropriate stratification into similar groups).
    • Judgment sampling is another technique, but this technique does not rely on statistical methodology and is highly subjective.  Therefore, it warrants greater scrutiny by the examiner. 
  • Potential Issues
    • Improper sampling techniques (regardless of the methodology used) that do not reflect a valid estimate.
    • A relatively small number of units in the population (less than 100) can yield a small sample size.  However, small sample size can be overcome by the application of a proper statistical sampling methodology and the utilization of the least advantageous limit computed at a 95% one-sided confidence level.
      • Simply stated, the least advantageous limit is computed as the point estimate plus or minus the sampling error, where the result provides the least benefit to the taxpayer.
      • Many taxpayers simply use the point estimate without regard to the sampling error, thereby ignoring the risk of error inherently associated with sampling techniques.
    • Missing records, substitution of missing items, missing documentation, and the use of estimated costs.
    • Properties that may not be appropriate for sampling (e.g., small number of dissimilar properties).
    • Inappropriate stratification of properties and faulty statistical sampling within each stratum.
    • Use of Judgment sampling, which is highly subjective and thus may be of limited value.

14. Consider § 263A

The uniform capitalization (UNICAP) rules of § 263A require the capitalization of all direct costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer.  Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer.  Therefore, changes to the class life or basis of an asset may require a concurrent adjustment of UNICAP costs.

Furthermore, § 263A(f) requires the capitalization of certain interest expenses incurred in connection with the production of property.  The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property.  In summary, all real property and certain tangible personal property are subject to the interest capitalization rules.  Therefore, changes to real and tangible personal property costs may impact the amount of capitalized interest.

Taxpayers may attempt to exclude all § 245 property from interest capitalization by arguing that § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A-8(b)(1).  However, § 1245 property that is an inherently permanent structure is subject to interest capitalization without any restrictions.  In general, the standard for determining whether an item of property is inherently permanent for purposes of § 263A and § 199 is broader than the standard for cost recovery (depreciation).  For more discussion and analysis used to determine whether an item is inherently permanent under various Code provisions, see Appendix Chapter 6.5, “Inherently Permanent” Standard Under Various Code Sections.

Ideally, a taxpayer’s books and records should consider and comment on the treatment of UNICAP when amounts are restated for prior tax years based on a cost segregation study.  Refer to Special Topics Chapter 6.1 – Uniform Capitalization for a summary of the major provisions of § 263A. Specific questions regarding § 263A can be referred to the Inventory & 263A Practice Network: [https://organization.ds.irsnet.gov/sites/lbi_ipg_program/CostAccounting/Default.aspx]

15. Consider Change In Accounting Method

In general, it is the position of the Service that a change in depreciation method, recovery period or convention for depreciable property resulting from the reclassification of property is a change in accounting method.  Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file Form 3115, Application for Change in Accounting Method) and the adjustment to income is made pursuant to § 481(a).  Accordingly, claims for adjustment based on a cost segregation study performed after the original return was filed should not be allowed (unless a Form 3115 has been filed).

Some of the more common issues encountered in this area include:

  • Use of incorrect revenue procedure for implementing change in accounting method (i.e., use of automatic change procedures instead of non-automatic change procedures);
  • Terms of revenue procedure not properly applied;
  • Change is not made to a proper method;
  • Form 3115 is not filed;
  • Taxpayers want to add items to the original Form 3115, as filed;
  • Lack of records to substantiate the § 481(a) adjustment;
  • Informal claims filed in lieu of Form 3115;
  • Informal claims filed prior to preparation of cost segregation study;
  • Lack of detail to determine basis and recovery periods.

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. § 1.446-1 (e)(2)(ii)(d)(2)(i) and Example 9 of Treas. Reg. § 1.446-1 (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 Special Topics Chapter 6.2 for a more detailed discussion of Changes in Accounting Method.  Specific questions regarding changes in accounting methods can be referred to the Methods of Accounting and Timing Practice Network [https://organization.ds.irsnet.gov/sites/lbi_ipg_program/AccountingMethods/Default.aspx].

SUMMARY AND CONCLUSIONS

Using the steps outlined in this chapter, the Service examiner can evaluate the adequacy and accuracy of a cost segregation study and determine the proper classification and cost of property.  The need for a specialist, such as a CAS or an Engineer, should also be evaluated and determined as soon as possible.  The guidance in this ATG is designed to facilitate the audit process and minimize burden on taxpayers, practitioners and Examiners alike.

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Page Last Reviewed or Updated: 03-Nov-2016