The Audit Technique GuideThe IRS has an audit technique guide or ATG that outlines the steps that are required to ensure a cost segregation study is performed correctly. The primary goals of the ATG are to provide examiners with an understanding of:
- Why cost segregation studies are performed for federal income tax purposes.
- How cost segregation studies are prepared.
- What to look for in the review and examination of these studies.
- When certain issues identified in a cost segregation study need further investigation.
The court cases outlined below were studies that have been thrown out because the proper due diligence wasn't followed, which set up a disallowance and tax preparer penalties.
Cost Segregation Done the Wrong Way
Case #1 - AmeriSouth XXXII, Ltd. v. Commissioner
In the case of AmeriSouth XXXII, Ltd. v. Commissioner, the U.S. Tax Court filed a memorandum opinion on March 12, 2012, denying AmeriSouth XXXII Ltd. over $1,000,000 of accelerated depreciation previously reclassified using a cost segregation study. This memorandum is significant and those in the accounting industry must undoubtedly take notice and exercise greater caution in how they hire qualified engineering firms to provide engineered tax studies for their clients.
Ultimately, they need assure, through their due diligence, that the selected engineering cost segregation partner can justify the results and is prepared to support the reclassifications in the event of an audit. Secondly, accountants also have a greater responsibility to advise their clients regarding firms that may inevitably place them at risk due to their methodology, experience or ability to defend their reports.
The facts of the memorandum are as follows:
- AmeriSouth, a limited partnership, bought an apartment complex in 2003 for $10.25 million. AmeriSouth commissioned a cost-segregation study and then attempted to depreciate more than 1,000 building components over five or 15-year spans, instead of the 27.5 years applicable to rental real estate under MACRS. Using its cost-segregation method, AmeriSouth deducted $3,029,029 for depreciation in the years 2003–2005.
- The IRS audited the partnership under the Tax Equity and Fiscal Responsibility Act and disagreed with AmeriSouth’s treatment of the components; it denied $1,079,751 in deductions for those years. The case ended up in Tax Court, where the IRS also argued that AmeriSouth was attempting to depreciate some assets it did not own.
- Around the same time as the case was tried, AmeriSouth sold the apartment complex and subsequently stopped responding to communications from the court, the IRS, and even its attorneys. The court allowed the attorneys to withdraw from the case. When AmeriSouth failed to file a post-trial brief, the court could have dismissed the case entirely, but instead, it decided the case, deeming any factual matters not contested to be conceded by AmeriSouth.
- The court looked in depth at the components in each of the 12 categories AmeriSouth had identified for faster depreciation: • site preparation and earthwork • water distribution system • sanitary-sewer system • gas line • site electrical work • special HVAC • special plumbing • special electric • finish carpentry • millwork • interior windows and mirrors • special painting
- Based on its examination of the facts, the court sided with the IRS, in all but a handful of instances, holding that most components were structural, integral to the buildings’ operation and maintenance, and therefore depreciable over the life of the building.
This case was unique because the property in question was being sold around the time the case was tried and AmeriSouth reportedly stopped responding to all communications simultaneously. With the withdrawal of their attorneys from the case, AmeriSouth did not have the expertise or evidence to uphold its provided study.
If AmeriSouth had allowed itself to be adequately represented, sufficient evidence could have been provided to refute the judge’s position on many of these disallowances. Experts in the engineering tax community familiar with the Hospital Corporation of America v. Internal Revenue Code would have been able to successfully challenge many of the court’s final disallowances of the reclassified components within the study.
Unfortunately, several items in the report were clearly aggressive, and the report included assets not even owned by the property owner, such as site improvements owned by the public government. This tactic opened the floodgates to the court potentially disallowing the entire report.
Ultimately the Court’s decision was beneficial for the engineering tax industry. Indeed, the articles after the memorandum have fueled great concern for the reliability of cost segregation studies.
Fortunately, the legitimacy has not changed, and these tax strategies are still one of the most viable tax treatments for real estate investors when done correctly. The memorandum, however, demonstrates the necessity for the CPA community to have a Request for Proposal (RFP) system in place to select qualified engineering partners to provide specialty tax services to their firm’s clients.
The RFP system for engineering tax services should include in its request:
- Verification of corporation engineering licenses
- Verification of employed professional engineers
- Verification of insurance coverages, including Errors & Omissions coverage for gross negligence
- Verification of licensed CPAs and/or licensed attorneys for protection from IRS tax controversy
- Verification the engineering firm has successfully defended reports against IRS audits.
- Minimum of 10 references from CPA firms nationally that verify satisfied peer results.
Case #2 -Peco Foods Inc. and Subsidiaries v. Commissioner
This second example Tax Court case provides an object lesson on the importance of CPAs taking extreme care in selecting specialty tax partners when their clients are purchasing the assets of a business that includes real estate. When a company acquires part or all of the assets of an existing trade or business, the purchaser’s tax basis is determined by the amount paid for the assets. Both parties in the transaction generally must agree to an allocation of the purchase price among the assets purchased. In the case Peco Foods Inc. and Subsidiaries v. Commissioner, the Tax Court ruled that a taxpayer who purchased the assets of a business could not retroactively change a purchase price allocation agreed to in connection with the asset acquisition. The court held that even a properly completed cost segregation study could not be used to reclassify assets from real property to personal property after the purchaser and transferor had an enforceable asset allocation agreement in place.
Although the taxpayer in the Peco Foods case was prevented from using a cost segregation study, taxpayers may be able to draft a purchase agreement that permits the taxpayer to perform a fixed-asset review or cost segregation study after the purchase transaction has been completed.
Experts Speak About Cost Segregation Service Provider Selection
“We as a firm go through a very thorough due diligence process when selecting outside consultants who provide specialty tax services for our clients. I anticipate that we as an industry will see more of these court cases until the CPA community as a whole does a better job of managing the RFP process for selecting specialty tax firm. We have a very regimented process for selecting such firms that are approved for our partners to refer to our clients. Realizing that this is an unregulated industry and there are many new firms claiming expertise, we interviewed more than a dozen firms before making a final selection. We were able to verify their engineering licenses, their employment of professional engineers, their insurance coverages as well as get peer references. We have been thrilled with the relationship, and we are glad we as a firm went through such a rigorous RFP process prior to selecting a firm we felt comfortable referring to our clients.”
“It is vital that CPA firms be aware that there are great differences in the quality of specialty tax firms and that an RFP process which is managed top-down by each firm is critical to assure the quality of service and mitigate future risk.”
At this time, we can only theorize as to the effect this current IRS memo will have on future inquiries. However, it would be reasonable to hope that those who are signing returns and advising clients investigate outside resources that provide such reports. If the IRS decides to intensify its evaluations of cost segregation reports, CPAs would be prudent to expect outside firms to note a going concern, provide audit defense, comply with Circular 230 regulations and offer detailed reports using architectural supported like plans and as-builts to substantiate claims.
Taking these two example cases together, this pair of contentious IRS cases should instill a greater sense of vigilance among CPAs when researching a suitable specialty tax partner.
The consequences of performing adequate due diligence in such cases can make an enormous difference in the final determination of allowable property classification and depreciation.
No matter if you're a CPA, commercial real estate owner or investor, at Engineer Tax Services you find a verified and trusted partner to provide the Cost Segregation services backed by experts in this specialty tax field.