Small Business Auditing in Chicago

Chapter 1 -- INTRODUCTIONGoalWallpaperOverviewPURPOSE OF THE COST SEGREGATION AUDIT TECHNIQUES GUIDEDepreciation problems involving cost segregation studies cross LB&I industry lines and impact SB/SE taxpayers as well.   The absence of consistency in cost segregation studies and the absence of bright-line evaluations for identifying property bring about the issues of this problem.   The goal of this ATG is to offer the foundation to a better understanding of cost segregation studies and also to provide the examination steps that will ease the audit process and minimize burden on citizens, professionals and Service examiners alike.

Property allocations and reallocations are generally based on criteria set under the Investment Tax Credit (ITC) laws under § 48.   Because of this from numerous legislative acts, court decisions and Service rulings concerning land qualifying for ITC along with a deficiency of bright-line evaluations; complicated and frequently contradictory advice have affected the ease in determining § 1245 property from § 1250 property.   Relevant issues, like the capitalization of attention and manufacturing costs under IRC § 263A and changes in accounting method, contribute to the complexity of this matter.   For additional guidance on court rulings consult with Chapter 6.4 - Relevant Court Cases contained in this ATG.
The following example illustrates that the tax benefits of a cost segregation study.   In general, a more turnkey construction project comprises elements of tangible personal property (e.g., telephone system, computer system, process piping, storage tanks, etc.).   It is relatively easy to identify these items as § 1245 property and devote a portion of the complete project costs on them.   But a cost segregation study can also report certain building occupancy items (e.g., carpet, wall coverings, partitions, millwork, light fittings) as § 1245 property which would have likely been categorized or grouped under § 1250 property with no conclusion of a cost segregation study.   These items may or may not constitute just as qualifying § 1245 property based on the particular facts and circumstances where the project was created.

Cost segregation studies are most commonly prepared for the allocation or reallocation of construction costs to real property.   A building, called "§ 1250 home", is normally non-residential real property (39-year) or residential rental property (27.5-year) property eligible for property intrusion.   Equipment, furniture and fittings, known as "§ 1245 home", are real property.   Tangible personal property includes a shorter recovery interval (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance, incentive depreciation and § 179 deduction).   Thus, a faster depreciation write-off (and taxation benefit) can be obtained by allocating property prices to § 1245 property.


Technical and/or procedural cost segregation questions might be filed to the Deductible & Capital Expenditures Practice Network.
This ATG provides technical info, audit techniques and examples of suitable cost segregation studies to concentrate the efforts of examiners.   The use of cost segregation studies will probably continue to increase, and there are no criteria about the preparation of those studies.   These studies vary widely in terms of the methodology, instruction, depth, format, and knowledge of the study's preparer.   This lack of consistency, combined with the complexity of the legislation in this region, often results in an examination that may be controversial and burdensome for all parties.

 It had been upgraded by members of the Deductible & Capital Expenditures Practice Network (DCE PN) and is not intended as an official IRS pronouncement.  
In the last several decades, a growing number of taxpayers have submitted either authentic tax returns or claims for refund using depreciation deductions according to cost segregation studies.   The underlying incentive for preparing these studies for Federal income taxation purposes is the significant tax benefits based on using shorter recovery periods and accelerated depreciation procedures (including bonus depreciation and Internal Revenue Code (IRC) § 179 deduction) for calculating depreciation deductions.   The prevailing problems for Service examiners include getting an understanding of the justification employed to segregate property into its different parts, and the processes used to allocate the total project costs among those elements.
In a landmark decision, the Tax Court ruled that, to the extent real property is included in an acquisition or in overall costs, it ought to be handled as for depreciation purposes.   The court also decided that the rules for determining whether land qualifies as real property for purposes of ITC (beneath pre-1981 tax law) will also be applicable to discovering depreciation under present law.   
This Audit Techniques Guide (ATG) has been created to assist Internal Revenue Service (Service) Examiners in the inspection and evaluation of cost segregation studies.  The Principal goals would be to provide examiners with an understanding of:

The following example illustrates the sophistication of cost segregation difficulties.   Along with identifying particular project components that work as § 1245 property, cost segregation studies can treat parts of construction components as § 1245 property.   By way of example, some things of this building's electrical system encourage § 1245 property and § 1250 property.   The Study will normally recognize the costs of the division circuits feeding the § 1245 property and classify according to the retrieval period of the § 1245 property (i.e. 5 or even 7 year recovery).   It might also recognize that, for instance, 15 percent of a building's electrical supply system (EDS) directly affirms § 1245 property, for example technical kitchen equipment.   Based on that conclusion, the analysis will then treat 15 percent of the EDS cost as § 1245 property together with the identified § 1245 division circuits.    The allocation of building components to § 1245 property is often a contentious matter.

In order to calculate depreciation for Federal income tax purposes, taxpayers should use the proper method and appropriate recovery interval for every property or asset owned.   Real Estate, whether acquired or constructed, frequently is composed of numerous asset types with distinct recovery phases.   Thus, land is usually separated into individual parts or asset groups using the same recovery periods and placed-in-service dates to properly compute depreciation.   When the true cost of each individual part is available, this can be a rather simple procedure.   However, when only lump-sum costs are available, cost estimating methods may be needed to "segregate" or "devote" prices to individual components of property (e.g., property, land improvements, buildings, equipment, furniture and fixtures, etc.).   This sort of investigation is generally called a "cost segregation analysis," "cost segregation analysis," or "cost feasibility analysis."

Examiners reviewing cost segregation research need to establish the proper classification and correct expenses of property.   In certain instances (e.g., small projects) examiners might have the ability to evaluate a study without assistance.   But, other research may require experts with expertise, business expertise and specialized training (e.g., Engineers, Computer Audit Specialists and/or DCE PN Senior Revenue Agents).   Examiners should conduct a hazard analysis as early as possible to ascertain the depth of an examination and the need for additional aid.
Why cost segregation studies have been conducted for Federal income tax purposes;The way cost segregation studies are prepared;What to look for in the inspection and evaluation of these studies; also,If certain topics identified at the cost segregation study need further examination.