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1 |Table
of Contents | Chapter 3
CHAPTER 2 - LEGAL FRAMEWORK
OVERVIEW
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 depreciation, depreciation recapture, 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 generally terminated in 1986). By establishing a legal
framework for § 1245 and § 1250 property, examiners will have a better
understanding of this issue and have a basis for determining property
classifications and cost allocations.
The Internal Revenue Code (IRC) has historically authorized depreciation
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 (IRC §
167 and the regulations thereunder). Several
different methods are described for calculating depreciation under IRC §§
167 and 168, including straight line, declining balance, sum-of-the-years
digits, and income forecast. The deduction has generally been calculated
with respect to the adjusted basis and useful life of (or recovery period
for) the property and by utilizing an appropriate depreciation method. At
one time, salvage value was also a factor in the computation. The shorter
the useful life (or recovery period), the larger the current tax deduction,
thus providing an incentive for tax purposes. Buildings and structural
components have substantially longer depreciable lives than personal
property. Therefore, it is desirable for taxpayers to maximize personal
property costs in order to accelerate depreciation deductions and, hence,
reduce tax liability. The remainder of this chapter provides a brief
historical perspective of the statutes, rulings and major court cases that
relate to depreciation and cost segregation studies.
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BULLETIN F
Many attempts have been made to provide bright-line tests for
classifying property by its useful life (or recovery period) due to the
frequent controversies that have arisen with the determination of economic
life. For example, IRS Publication Number 173 (also known as "Bulletin
F") was published 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:
1.
Composite Method: A depreciation chart
provided a composite rate for 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 inexpensive theaters.
2.
Component Method: Taxpayers could
elect to depreciate the building equipment separately from the structure
itself. A list provided lives for various types of structures, ranging from
50 years for apartments, hotels, and theaters, to 75 years for grain
elevators and warehouses. A separate list provided lives for over 100 items
of installed building equipment, ranging from 5 to 25 years, or the life of
the building.
Regulation § 1.167(a)-7(a) allows taxpayers to either depreciate
individual items on a separate basis or to combine assets into 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.
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COMPONENT DEPRECIATION
In 1959, the Tax Court recognized the right of taxpayers to calculate
depreciation using a component method for newly constructed property Shainberg vs. Commissioner, 33 T.C. 241
(1959)]. While the building shell was given a useful life of 40 years, the
plumbing, wiring, and elevators were assigned a life of 15 years, and the
paving, roof, and heating and air conditioning systems were given a useful
life of 10 years.
Revenue Procedure 62-21, 1962-2 C.B. 418, superceded
Bulletin F and provided safe harbor useful lives based on industry-specific
asset classes for taxpayers that met the reserve ratio test (a complex
provision). As long as the taxpayer could demonstrate that its retirement
policies were consistent with the selected class life, the Service would
not challenge the useful life. 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. Except to the extent the class
lives were incorporated into the Class Life Asset Depreciation Range System
(ADR), this revenue procedure was revoked for all years after 1970.
Revenue Ruling 66-111, 1966-1 C.B. 46 (subsequently modified by Revenue
Ruling 73-410, 1973-2 C.B. 53), addressed the use of component depreciation
for used real property, in light of the decision in Shainberg.
The ruling concluded that "When a used building is acquired for a lump
sum consideration, separate components are not bought; a unified structure
is purchased… Accordingly, an overall useful life for the building must be
determined on the basis of the building as a whole."
Revenue Ruling 68-4, 1968-1 C.B. 77, concluded that the asset guideline
classes outlined in Revenue Procedure 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."
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ASSET DEPRECIATION RANGE (ADR)
The elective ADR system was developed for tangible assets placed in
service after 1970, with the intent of minimizing controversies about
useful life, salvage value, and repairs. It also abolished the controversial
reserve ratio test. Under the ADR system as enacted by former IRC § 167(m)
and implemented by Revenue Procedure 72-10, 1972-1 C. B. 721, all tangible
assets were placed in one of the more than 100 asset guideline classes
(which generally corresponded to those set out in Rev. Proc. 62-21). The
classes of assets were based on the business and industry of the taxpayer.
In addition, each class of assets other than land improvements and
buildings was given a range of years (called "asset depreciation range")
that was about 20 percent above and below the class life. As long as
taxpayers did not deviate from this range in useful lives, the Service
would not challenge the useful life. An optional repair allowance method
was also permitted at the election of the taxpayer.
If the taxpayer did not elect the ADR system, Revenue Ruling 73-410,
1973-2 C.B. 53, clarified that a taxpayer may utilize the component method
of depreciating used property if a qualified appraiser "…properly
allocates the costs between non-depreciable land and depreciable building
components as of the date of purchase."
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ACCELERATED COST RECOVERY SYSTEM
(ACRS)
Issues involving salvage value and useful life continued to arise, as
well as controversy regarding the repair allowance, so Congress enacted IRC
§ 168 in 1981 (generally effective for property placed in service after
December 31, 1980). The Accelerated Cost Recovery System (ACRS) was intended
to provide a less complicated method for computing depreciation (known as
"cost recovery") by eliminating salvage value and specifying
recovery periods for various classes of assets. Depreciation deductions
were calculated based on the applicable depreciation methods, recovery
periods and placed-in-service conventions outlined in § 168. In contrast to
the elective ADR system, ACRS was mandatory and provided only five (later
six) recovery periods. ACRS also allowed for a faster write-off of assets than
had been allowed under previous rules (e.g., the 40-year life for real
property was reduced to either a 15, 18, or
19-year recovery period, as reflected by the 1985 amendments to ACRS).
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MODIFIED ACCELERATED
COST RECOVERY SYSTEM (MACRS)
Significant modifications, generally less favorable to taxpayers, were
made to ACRS by the Tax Reform Act of 1986 (effective for property placed
in service after December 31, 1986). Under the Modified Accelerated Cost
Recovery System (MACRS), the recovery period for buildings and structural
components increased dramatically. For example, the 15, 18, or 19-year
recovery periods for real property are now 39 years for nonresidential real
property (or 31.5 years for nonresidential real property placed in service
by the taxpayer before May 13, 1993) and to 27.5 years for residential
rental property, under the general depreciation system of § 168(a).
Equipment and machinery generally fall into the 3, 5, or 7-year recovery
periods. Land improvements generally have a 15-year recovery period under
the general depreciation system of § 168(a). The wide gap in MACRS recovery
periods provides a strong incentive for taxpayers to allocate or reallocate
costs of long- lived property to short-lived property, wherever possible.
Revenue Procedure 87-56, 1987-2 C. B. 674, provides the class lives and
recovery periods for most MACRS assets. These determinations are based on
the specific industry of a taxpayer and the specific activity for which the
assets are used. But see discussion of Duke Energy Natural Gas Corporation
v. Commissioner, 109 T.C. 416 (1997), rev’d, 172
F.3d 1255 (10th Cir. 1999), nonacq., 1999-2 C.B. xvi; Saginaw Bay Pipeline Co., et al v. United States,
124 F. Supp. 2d 465 (E.D. Mich. 2001), rev’d and rem’d, 2003 FED App. 0259P (6th Cir.) (No.01-2599); and
Clajon Gas Co. LP, et al v. Commissioner, 119
T.C. 197 (2002), rev’d, 2004 U.S. App. LEXIS 284 (8th Cir. Mo. Jan. 12, 2004),
on page 6.3-8. Appendix
Chapter 6.3 provides an overview of recovery period determinations.
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EXPENSING PROVISIONS
AND BONUS DEPRECIATION - IRC §§ 168, 179, AND 1400L
Another incentive for allocating costs to shorter-lived property is the
expensing provision of IRC § 179. The ceiling limitation for expensing
capital amounts invested in qualifying section 179 property (qualifying
tangible personal property acquired by purchase for use in the active
conduct of a trade or business) has steadily increased over time, from
$10,000 per year to over $25,000 ($100,000 per year for certain qualifying
property placed in service for taxable years beginning after December 31,
2002, and before January 1, 2006). By maximizing the costs allocable to
tangible personal property, the taxpayer can not only get an immediate
write-off under § 179, but also qualifies for a shorter recovery period
under § 168 for any remaining basis in the property. Also, the 30-percent
additional first year bonus depreciation allowance pursuant to § 168(k),
enacted by the Job Creation and Worker Assistance Act of 2002 (Public Law
107-147), provides even further incentive for taxpayers to segregate
property into shorter recovery periods. The Jobs and Growth Reconciliation
Tax Act of 2003 recently increased the bonus depreciation under § 168(k) to
50 percent for certain qualifying property acquired after May 5, 2003, and
placed in service before January 1, 2006. Section 1400L provides special
rules for qualifying property used by a business in the New York Liberty
Zone.
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WHAT IS TANGIBLE
PERSONAL PROPERTY?
While § 167 provides an allowance for depreciation for both tangible and
intangible property, § 168 (as written) only applies to tangible property.
Since neither § 167 nor § 168 provides a definition of tangible property,
one must look to § 48 and the regulations thereunder
(prior to the passage of Public Law 101-508) for definitions and examples
of tangible property (as well as for buildings and structural components).
This area will be discussed further in the following sections.
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INVESTMENT TAX CREDIT
- IRC § 48
In order to stimulate the economy, Congress enacted Code § 48 in 1962.
The ITC was designed to encourage the modernization and expansion of
productive facilities through the purchase of certain new or used assets
for use in a trade or business. Section 48 generally allowed a tax credit
for investment in tangible depreciable property placed in service during
the taxable year. The amount of the credit was the "applicable
percentage" of the investment in qualifying property placed in service
during the taxable year, depending on the useful life of the property and
whether it was new or used when acquired. The percentage was initially 7
percent but was later increased to 10 percent (Revenue Act of 1978). The
amount of the qualifying investment was limited and the ITC was subject to
recapture if the property was not held for its entire useful life. Over the
years, many other changes were made to the rules, including reductions in
the depreciable basis of property for which ITC was claimed, temporary
suspensions, termination, reinstatement, and, ultimately, the general
repeal of ITC in 1986. Most of these revisions were related to the
perceived economic needs of the country at the time they were enacted.
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TANGIBLE PERSONAL
PROPERTY
Eligible ITC property is defined in former IRC § 48(a)(1)
with reference to IRC § 38 (in fact, eligible property is often referred to
as "section 38 property"). It 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 property qualifying as tangible personal
property for purposes of ITC.
Treas. Reg. § 1.48-1(c) provides examples of qualifying property, and
states that
…'tangible personal property' means 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).
This same subsection states that "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 section 38. Furthermore, 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.
In addition, the regulations provide examples of non-qualifying
property. For example, "…buildings, swimming pools, paved parking
areas, wharves and docks, bridges, and fences are not 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.]
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BUILDINGS AND
STRUCTURAL COMPONENTS
Treas. Reg. § 1.48-1(e)(1) provides a detailed explanation of buildings
and their structural components for ITC purposes and has been the primary
source for guidance, both with respect to component depreciation and cost
segregation studies. The term "building" is described as
…any structure or edifice enclosing a space within its walls and usually
covered by a roof whereby the structure improves the land, and provides
shelter or housing for work, office, 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. Such term 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 the following:
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 section 1.48(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 include 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.
The term "structural components" is defined in § 1.48-1(e)(2)
of the Regulations as
…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 condition 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 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".
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SECTION 1245 AND
SECTION 1250 PROPERTY
The benefits of the ITC were somewhat offset by the provisions of IRC §§
1245 and 1250, also enacted in 1962. 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 very similar to that for ITC and make reference to the
regulations under § 48 and the definitions under § 38 property. These
interrelated Code sections and the regulations (38, 48, 1245 and 1250)
provide the pertinent authority for determining eligibility for ITC. They
also determine eligibility for the immediate write-offs under section 179,
the appropriate recovery periods for depreciation (§§ 167 and 168) and for
depreciation recapture upon a disposition.
The primary issue in cost segregation studies is the proper
classification of assets as either § 1245 or § 1250 property. Accordingly,
the ITC rules are critical in determining whether a taxpayer has classified
property into the appropriate asset class.
Section 1245(a)(3) provides that "section 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 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 of a primary concern for purposes of this discussion. It is important
to note that § 1245(a)(3) specifically excludes a
building or its structural components 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. As
previously discussed, those regulations (§ 1.48-1) provide definitions of
tangible personal property that qualifies as § 38 property for ITC.
Section 1250(c) defines "section 1250 property" as any real
property, other than section 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.
Land improvements (i.e., depreciable improvements made directly to or
added to land), as defined in Asset Class 00.3 of Rev. Proc. 87-56, may be
either § 1245 or § 1250 property and are depreciated over a 15-year
recovery period. Buildings and structural components are specifically
excluded from 15-year property. Examples of land improvements include
sidewalks, roads, canals, waterways, drainage facilities, sewers, wharves
and docks, bridges, fences, landscaping, shrubbery, and radio and
television towers. Note that some activity asset classes also include land
improvements such as asset class 57.1 of Rev. Proc. 87-56.
From a statutory standpoint, the primary test for determining whether an
asset is § 1245 property eligible for ITC is to determine whether or not it
is a structural component of a building. In other words, if an asset is not
a structural component of a building, then it can be considered to be §
1245 property. The structural component determination hinges on what
constitutes an inherently permanent structure and how permanently the asset
is attached to such a structure. Clearly, this is a factually intensive
determination and explains the lack of bright-line tests for segregating
property into § 1245 and § 1250 classifications.
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FUNCTIONAL USE TEST
The early administrative rulings on ITC focused on a "functional
use test" to determine whether an asset constituted § 1245 property.
Rather than examining the inherent permanency characteristics of the asset,
the test evaluated the purpose for which the asset was used. For example,
if the asset served a function normally attributable to a structural
component or permanent structure, it was not treated as tangible personal
property even if it could be moved. However, following several conflicting
court decisions which addressed the inherent permanency of particular
assets, the Service shifted its focus from the functional use test to an
evaluation of factors indicating inherent permanency.
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INHERENT PERMANENCY
TEST AND THE "WHITECO FACTORS"
Revenue Ruling 75-178, 1975-1 C.B. 9 outlined several criteria to
determine § 1245 property classification. These criteria included (1)
whether the asset is movable or removable; (2) how the asset is attached to
real property; (3) the design of the asset; and (4) whether the asset bears
a load.
The classic pronouncement addressing inherent permanency was Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664,
672-673 (1975). The Tax Court, based on an analysis of judicial precedent,
developed six questions designed to ascertain whether a particular asset
qualifies as tangible personal property. These questions, referred to as
the "Whiteco Factors," are:
1.
Can the property be moved and has it been moved?
2.
Is the property designed or constructed to remain
permanently in place?
3.
Are there circumstances that show that the property may
or will have to be moved?
4.
Is the property readily movable?
5.
How much damage will the property sustain when it is
removed?
6.
How is the property affixed to land?
It should also be noted, however, that moveability
is not the only determinative factor in measuring inherent permanency. In
L.L. Bean, Inc. v. Comm., T.C. Memo. 1997-175, aff'd,
145 F.3d 53 (1st Cir. 1998), it was determined that, even though the
structure could be moved, it was designed to remain permanently in place.
Thus, it was determined to be an inherently permanent structure.
Examiners should also consider the following points when addressing the Whiteco factors:
- The manner in which an item
is attached to a building or to the land,
- The weight and size of the
item,
- The time and costs required
to move the components,
- The number of personnel
required in planning and executing a move,
- The type and quantity of
equipment required for a move,
The history of the item or similar items being moved,
- The time, cost, manpower and
equipment required to reconfigure the existing space if the item is
removed,
- Any intentions regarding the
removal,
- Whether the item is designed
to be moved, and
- Whether the item is readily
usable in another location.
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REPEAL OF ITC AND
COMPONENT DEPRECIATION
Due to the significant tax benefits derived from ITC-eligible property,
the use of component depreciation proliferated during the 1970's and
created problems not unlike those faced today by taxpayers, practitioners,
and the Service regarding cost segregation studies. The problem became so
pronounced during the late 1970’s that Congress disallowed component
depreciation as a method of computing depreciation for buildings, simultaneously
with the enactment of ACRS in the Economic Recovery Tax Act of 1981 (ERTA)
[see IRC § 168(f)(1)]. In addition to the controversies surrounding the
determination of qualifying § 1245 property, the driving force behind this
action was the disadvantage suffered by smaller taxpayers that could not
afford to have expensive ITC studies performed.
In 1986, MACRS reiterated that the use of component depreciation was not
allowable. Section 168(i)(6)
provides that depreciation for any addition or improvement to property
shall be computed in the same manner as the depreciation for the underlying
property, as if the underlying property had been placed into service at the
same time. [Prior to 1981, an asset composed of separately replaceable
components could have been fragmented for depreciation purposes even though
the interdependent components were parts of an integrated whole.].
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HOSPITAL CORPORATION
OF AMERICA v.
COMMISSIONER ("HCA") (1997)
A recent landmark decision, Hospital Corporation of America v. Commissioner, 109
T.C. 21 (1997)("HCA"), provided the
legal support to use cost segregation studies for computing depreciation.
In effect, this decision has reinstated a form of component depreciation.
In HCA, the Service took the position that certain property items were
structural components of a building and that § 168(f)(1)
prohibited the use of a component depreciation method for computing
depreciation on buildings (including structural components). The Service
also argued that § 168(f)(1) effectively changed
the definition of tangible personal property for ACRS purposes (i.e., after
the enactment of ACRS in 1981) by excluding any item attached to the building
from being § 1245 property. Accordingly, the prohibition against component
depreciation precluded an item from being treated as § 1245 property if it
was attached to a building and had utility beyond its relationship to the
particular piece of property.
However, Judge Wells ruled that the property at issue was § 1245
property and rejected the Service’s argument that findings based on Treas.
Reg. § 1.48-1(e) were inapplicable following the enactment of ACRS in 1981.
Based on his review of the statutory and regulatory language, as well as
case law, Judge Wells concluded that the enactment of ACRS did not redefine
§ 1250 property to include property that had been § 1245 property for
purposes of ITC. Accordingly, the court determined that §168(f)(1), prohibiting component depreciation, applied only
to §1250 property.
The HCA ruling effectively reinstated a form of component depreciation
for certain building support systems, such as the electrical and plumbing
systems that directly serve tangible personal property. Therefore, cost
segregation methodologies previously used to allocate the cost of a
building between structural components and ITC property can now be used for
§ 1245 and § 1250 property.
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ACTION ON DECISION
The Service did not appeal HCA since it could not state that the court's
reasoning and decision were clearly erroneous. In an Action on Decision
(AOD CC-1999-008), the Service acquiesced to the validity of the method
approved by the court (i.e., pre-1981 ITC tests remained applicable for
determining tangible personal property under both ACRS and MACRS). However,
the Service non-acquiesced to the court’s findings as to which specific
assets qualified as tangible personal property. Two cases, LaPetite
Academy and Boddie-Noell, were specifically referenced in the AOD
with respect to the determination of structural components and tangible
personal property. In Boddie-Noell Enterprises,
Inc. v. United States,
36 Fed. Cl. 722 (1996), aff’d
without op., 132 F.2d 54 (Fed Cir. 1997), the court held that acoustical
tile ceilings, a portion of an electrical system and a plumbing system were
structural components under the regulations. In LaPetite
Academy, Inc. v. United States, 95-1 U.S.T.C. (CCH) 50,193 (W.D. Mo. 1995) aff'd without op., 72 F.2d 133 (8th Cir. 1995), wall
panels, kitchen plumbing, bathroom accessories and a portion of the
electrical system were held to be structural components under the regulations.
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CHIEF COUNSEL
GUIDANCE
Chief Counsel issued further guidance to the field in the form of an
advice memorandum dated May 28, 1999. It made the following observations
and recommendations for field agents examining cost segregation studies:
- The determination of whether
an asset is a structural component or tangible personal property is a
facts-and-circumstances assessment.
- The use of cost segregation
studies must be specifically applied by the taxpayer.
- Allocations must be based on
a "logical and objective measure" of the portion of the
equipment that constitutes § 1245 property.
- An accurate cost segregation
study may not be based on non-contemporaneous records, reconstructed
data, or taxpayer's estimates or assumptions that have no supporting
records.
- Cost segregation studies
should be closely scrutinized by the field.
- A change in depreciation
method is a change in method of accounting, requiring the consent of
the Secretary or his delegate.
[Note, however, that the recent 5th Circuit opinion in Brookshire Brothers Holding, Inc. &
Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003),
aff’g T.C. Memo. 2001-150, reh’g
denied (March 31, 2003), which was adverse to the Service, may impact cases
in that circuit. The court affirmed the Tax Court decision that the
regulations allow taxpayers to make temporal changes in their depreciation
schedules, as well as changes in the classification of property, without
the consent of the IRS. However, the 10th Circuit opinion in Kurzet v. Commissioner, 222 F.3d 830
(10th Cir. 2000), was favorable to the government on this issue. Clearly,
the issue is unsettled. However, Treas. Reg. § 1.446-1T(e)(2)(ii)(d)(2)(i), effective for taxable years ending on or after
December 30, 2003, provides that a change in the depreciation or
amortization method, period of recovery, or convention of a depreciable or
amortizable asset is a change in method of accounting. See Example 9 of Treas.
Reg. § 1.446-1T(e)(2)(iii), which specifically
relates to changes based on a cost segregation study. On January 28, 2004,
Chief Counsel Notice CC-2004-007 was issued, setting forth Chief Counsel’s
Change in Litigating Position on the application of § 446(e) to changes in
computing depreciation. Examiners are directed to contact either Bonny Dominguez or Phil Whitworth, Change in
Accounting Method Technical Advisors, for the most current information
(phone numbers 330-253-7339 or -7346, respectively). You can also refer to Appendix
Chapter 6.2 for additional information and details regarding Notice
CC-2004-007 (January 28, 2004).]
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LACK OF BRIGHT-LINE
TESTS FOR DISTINGUISHING § 1245 AND § 1250 PROPERTY
A myriad of court cases has addressed the classification of property for
ITC purposes. All of the cases are factually-intensive and quite often the
opinions of the courts conflict. In addition, though the Service has issued
numerous revenue rulings to address specific fact patterns, no bright-line
tests have evolved. Because of this problem, significant controversy still
exists regarding property classification for depreciation purposes.
It is beyond the scope of this chapter to review all the applicable
cases. However, Appendix
Chapter 6.4 provides a summary of the major court decisions and
pronouncements in this area. This chapter is organized by case name and by
construction division per the Construction Specification Institute (CSI)
Master Format Division. In addition, specific guidance for the casino, restaurant,
ahd retail industries is
provided in Appendix
Chapter 7.1, Appendix
Chapter 7.2, and Appendix
Chapter 7.3, respectively.
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SUMMARY AND
CONCLUSIONS
This chapter has provided a legal framework for distinguishing § 1245
property from
§ 1250 property and for determining appropriate recovery periods. It cannot
be overemphasized that the classification of assets is a factually
intensive determination. Based on HCA, the recent AOD, and the 1999 Chief
Counsel Advice Memorandum, the use of cost segregation studies is expected
to increase. Thus, examiners need to examine and evaluate a cost
segregation study in light of the applicable statutes and judicial
precedent established for a similar fact pattern.
In the next chapter, we will take a closer look at the methodologies
used to prepare cost segregation studies.
Chapter
1 | Table
of Contents | Chapter 3
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