Taxpayers often own a property that they would like to trade for another, but they do not want to be taxed on the exchange. Fortunately, only three years after Congress enacted the first modern income tax law, Congress added a provision that allowed taxpayers to defer gain recognition on the exchange of properties.  These enormously complex §1031 rules can be distilled into one simple rule: Taxpayers can defer the recognition of gain (paying taxes) on the simultaneous or delayed exchange of one property for another.

This simple rule obscures the complexity of this law. To qualify for deferring gain recognition, the exchange must be of properties held for productive use in a trade or business or for investment. The property cannot be held for personal use. Further, stocks, bonds, inventory, and certain other properties do not qualify. The §1031 exchanged properties must be “like kind”, which means of the same nature or character even though they may differ in quality. Domestic and foreign properties are not like-kind. Though real estate is generally like kind to other real estate, even if one is improved and the other unimproved, personal property has an additional requirement to be of like class. Even when properties are like kind, there are additional hurdles before an exchange will qualify for gain deferral.

These additional hurdles include significant timing rules and rules related to taking cash out of the transaction. Originally, like kind exchanges had to be simultaneous. For example, a farmer might want to swap one pasture for one owned by an adjacent farmer. In the seminal Starker decision, the Ninth Circuit Court of Appeals expanded the concept to deferred exchanges. In a deferred exchange, a taxpayer can sell a property, deposit the proceeds with a qualified intermediary, and identify a replacement property within 45 days that is then acquired within 180 days. This concept was further enlarged to include a reverse like-kind exchange where the replacement property is acquired before the original property is sold, and a build-to-suit like kind exchange where the replacement property is improved and the improvements count as part of the replacement. Even with these substantially liberalized rules, taxpayers can still recognize gain in an exchange.

Recognizing gain on an exchange is called receiving boot. “Boot” is cash received in the exchange, which is taxed at normal capital gains rates. “Boot” also includes situations where the liabilities assumed by the buyer exceed those of the seller. If a taxpayer continually trades up, that is, acquires property worth more than the relinquished property, he or she can generally avoid boot.

§1031 like kind exchanges, though complicated, are an effective strategy to defer the recognition of gain from selling properties. They require that the taxpayer remain invested in like kind property, but otherwise permit flexibility in changing asset types, (e.g. residential real estate to commercial real estate).

Though cost segregation is a very popular tax savings strategy, some aspects are seldom encountered in practice. One rarely encountered situation is the proper reclassification of what looks like a building to tangible personal property. From a tax perspective, reclassifying an apparent building to short-life tangible personal property has substantial, immediate cash tax benefits. These opportunities are most commonly found at heavy manufacturing facilities and typically depend on a building-like structure functioning as large piece of machinery or equipment.

Most manufacturing industries are assigned a seven-year tax recovery period for their tangible personal property. For each million dollars of basis, reclassifying a structure from 39-year nonresidential real estate to seven-year tangible personal property results in additional first-year tax deductions of approximately $550,000 after taking into account 50% bonus depreciation and the much shorter recovery period. Assuming a 40% tax rate, this means first year cash savings of approximately $220,000. To understand how it is possible to reclassify an entire “building” to tangible personal property, an understanding of the former Investment Tax Credit is necessary.

The former Investment Tax Credit (“ITC”) was a tax credit for the construction or acquisition of most tangible personal property and certain other tangible property, not including buildings and their structural components, used as an integral part of certain industries, such as manufacturing. (The former ITC rules still govern MACRS property classifications to a large extent.) The meaning of the former ITC regulations and rules were very frequently litigated. Over the course of many years, the courts developed many tests to determine whether a structure was a building, other tangible property, or tangible personal property.

The two primary tests to identify a building were: 1) the appearance test and, 2) the function test. In practice, the courts primarily looked to the function test. This test looked to whether human activity in a structure was minimal or incidental to the functioning of the structure as part of the manufacturing process. For example, an automated, deep freeze storage warehouse may have minimal human activity relative to the primary function of freezing food products. In such cases, human activity may be limited to only routine maintenance. In the manufacturing context, the Tax Court expanded this logic to facilities such as heavy craneway structures in the Lukens case in 1987.

In Lukens, the Tax Court held that a steel foundry’s craneway structures were essentially an item of machinery or equipment. A craneway structure consists of elevated rails along which a crane moves. The cranes transport heavy materials through a production process. In Lukens, the craneways had roof coverings and siding that functioned as walls for the cranes. The structures had no offices, restrooms, heating or air conditioning for employee comfort. The structures were designed to support the cranes as well as the rudimentary roof. Another way of looking at Lukens is that the structure of the crane also, incidentally, supported the roof and siding and that the roof and siding were necessary to protect the cranes and only incidentally protected the workers. Since all human activity was incidental to the production process and the structures functioned as a giant piece of machinery, the Tax Court held that they were not buildings, but rather tangible personal property. This was so even though they looked like buildings with roofs and some walls.

The facts and circumstances for applying Lukens are very specific and may easily be misinterpreted. Certain types of structures, such as parking garages, are specifically defined as buildings though some taxpayers have unsuccessfully attempted to argue otherwise. If you or your clients have heavy manufacturing facilities or automated facilities with minimal worker accommodations, please contact us to discuss a cost segregation study to determine whether the entire facility qualifies as short-life property.

Full Lukens Case Document

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800.806.7626 or visit www.sourcehovtax.com.

In 2005, responding to customer requests for a flavorful gluten-free beer, this specialty brewery began experimenting with new formulations that would satisfy beer connoisseurs. Typically, gluten-free beers are generic white lagers that lack the exotic flavor and aroma of popular microbrewery beers. The challenge the company faced was creating a balance of gluten-free ingredients that worked together without creating a bitter brew. After continued experimentation, the company successfully developed a gluten-free beer that lived up to customer expectations.

SourceHOV|Tax began conducting R&D tax credit studies for the company in 2005 when the company’s revenues were $10 million. For nearly a decade, the company has benefitted from R&D credits averaging $65,000 annually. This $65,000 offset in taxes has allowed it to continue investing in the development of additional brews, and in 2013 it reached $70 million in sales. The company’s ability to grow at this pace is, in large part, driven by sales of its new products.

Over the last two years, the new temporary and proposed reliance tangible property capitalization regulations have brought to light previously overlooked tax compliance opportunities. One of the more well-publicized opportunities involves permitting taxpayers to write off the remaining adjusted basis of retired building structural components. This new opportunity has a significant exception: Taxpayers cannot take a loss on the demolition of an entire building.

Historically, taxpayers were permitted to take a loss on the demolition of a building as long as they did not intend to demolish it upon purchase. If a taxpayer intended to demolish a newly acquired building, the taxpayer had to capitalize any basis allocable to the building to a non-depreciable land account. This harsh result led to frequent litigation between the Service and taxpayers. After decades of disputes, Congress enacted Code section 280B in 1984 to settle this area of contention. This Code section requires taxpayers to capitalize to non-depreciable land accounts the remaining adjusted basis of a demolished building plus the costs of demolition. Code section 280B itself has no exceptions for when or how the building was acquired or why it was demolished.

For many years afterwards, section 280B remained on the books with little explanation. In 1994, the Tax Court held in De Cou v. Comm’r, 103 T.C. 80 that a taxpayer could take a loss on a building abandoned due to unforeseen and extraordinary obsolescence even though it was later demolished. This permitted some taxpayers to take a loss on a building. In 1995, the Service provided a safe harbor in Revenue Procedure 95-27 for section 280B: a refurbished building will not be considered demolished as long as both: 1) 75 percent or more of the existing external walls are retained as internal or external walls, and 2) 75 percent of more of the existing internal structural framework is retained in place. Without looking at other statutory provisions, this safe harbor allowed taxpayers to demolish significant portions of a building, recognize a loss, and not capitalize those portions’ adjusted bases and demolition costs to land.

Even though the section 280B safe harbor did not prevent taxpayers from writing off retired structural components, for many years the Service took the position that retired structural components could not be written off under the MACRS rule that prohibits the component depreciation of buildings. When Treasury released temporary regulations on the disposition of tangible assets, this long-standing policy was reversed. According to the temporary and proposed reliance regulations, with proper substantiation and making the proper elections, taxpayers can now write off the adjusted bases of retired building structural components unless section 280B applies.

Based on the safe harbor of Revenue Procedure 95-27, taxpayers can write off the adjusted bases and demolition costs of retired structural components as long as the two safe harbor requirements are met. Tax practitioners should consider this major limitation of the new disposition regulations when advising their clients of the tax consequences of substantially renovating a newly acquired building.

In a late session Tuesday, the California Senate passed proposal AP93 that effectively repeals the California enterprise zone credit and replaces it with significantly scaled back hiring credits. The proposal largely retains the current geographic boundaries eligible for the credits and includes a sales tax exemption for manufacturing and biotech research companies as well as $30 million in the budget for tax credits that can be negotiated on a case-by case basis with the state.

The amendments would extend the carry forward provision for existing enterprise zone hiring credits to 10 years from the current five years, and a sunset provision on other parts of the program would be extended from five years or less to seven years. Additionally, ex-criminals would be eligible for hiring credits.

A priority of Governor Jerry Brown, this legislation is now headed to the Assembly where its future is uncertain.

SourceHOV |Tax is a national provider of specialty tax credit consulting services. If this legislation will cause a significant reduction in your EZ credits, we can help you identify other tax saving strategies such as R&D tax credits to offset the shortfall. For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800-806-7626 or visit www.sourcehovtax.com.

Michael Warady CFP, National Director, Software R&D Consulting

Michael Warady CFP, National Director, Software R&D Consulting

The year 2010 saw the launch of the iPad, Facebook market share overtake Google, Twitter go commercial and Toy Story 3 finish the year as the top domestic grossing film.  While there are many events and highlights of 2010, there is one that many may have overlooked.

On September 27, 2010, the President signed into law the Small Business Jobs Act. Even today, business owners are learning more about the act and the benefits it provides.

The act included many areas of tax savings.  One such area is the highly publicized R&D tax credit.  The R&D tax credit is one of several general business credits.  The act allowed small businesses better flexibility to utilize general business credits to offset taxes.

Software and manufacturing companies, who often qualify for the R&D tax credit, now have a much greater ability to reap cash rewards from the R&D credit. The bill allows small businesses to offset not only regular tax, which was the standard rule, but also Alternative Minimum Tax.  Companies that had previously not been able to take advantage of the credit because of this limitation are now able to see the full benefit of the credit and are paying less tax.

The second advantage provided by the act was the expansion of the ability to “carry back” the 2010 credits into prior years.  Small businesses can now carry back their 2010 R&D credits to offset the prior five years of taxes paid versus the one-year carry back that is currently and historically been in place.

There are a couple of caveats.  First, it is only available for the credits generated in the 2010 tax year–but this is still good news!  Companies with a December 31 year-end still have at least until March 15, 2014 to claim 2010 tax credits.  These credits will first offset taxes paid in 2010, any remaining 2010 credit can be carried back and used of offset both regular and AMT taxes in 2005-2009. The second caveat is that it is only available for small businesses; companies whose average gross receipts for 2007–2009 are under $50 million.  Keeping the March 15, 2014 date in mind, companies have just less than a year to go back and reclaim cash.

So, if you haven’t revisited your 2010 tax return, now is the time.  I highly recommend taking a look at your tax liability for 2010.  If you did pay tax, there are strategies available that can create tax refunds for qualifying companies.  Even S-Corporations or other flow through entities may benefit.

Michael Warady, CFP, is the National Director of Software R&D Consulting.  He has been working with companies throughout the U.S. to educate business owners and C-level individuals on the benefits and value the Research & Development Tax Credit can bring to their businesses.  He has helped bring over $150 million back to the business community through the R&D Tax Credit strategy.  Please contact Michael at (847) 914-9270 or michael.warady@sourcehovtax.com to learn more about how SourceHOV|Tax can help create additional cash flow for your business.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

After a multi-year court battle over R&D tax credits claimed by Union Carbide Corporation, the Supreme Court recently denied Union Carbide’s request for certiorari.  This denial makes the Second Circuit’s affirmation of the Tax Court decision final.  The Tax Court determined that Union Carbide was not entitled to research credits for the entire amount spent for supplies.

In this case, Union Carbide conducted three research projects to improve manufacturing processes. The research was conducted on products that were already in the process of being manufactured and were ultimately sold. Union Carbide claimed research credits for the additional cost of supplies associated with the research in addition to the cost of supplies used in production.

On audit, the IRS challenged the applicability of the credit for production supplies that would have been used regardless of any research performed.

The Tax Court concluded that Union Carbide was entitled to research credits only for the additional supplies used to perform the research. Costs for supplies used for actual production were found not to be research under the tax code. According to the Tax Court, these costs were “raw materials used to make finished goods that would have been purchased regardless of whether UCC was engaged in qualified research,” and that at best, these costs are indirect research costs and therefore excluded from the definition of qualified research expenses.

On appeal, the Second Circuit agreed that the costs at issue were, at best, indirect research costs that were excluded from the definition of qualified research expenses.

The case went to the Supreme Court who on March 18, 2013, declined to review it, making the Second Circuit decision final.

This decision continues to show the importance of identifying and tracking supply costs when performing research associated with new or improved manufacturing processes,  Many of these supply costs are tracked in general “cost of goods sold” or “inventory” accounts and are not readily identifiable, making research credit claims associated with these costs more difficult to support and defend.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

Governor Hassan Signs R&D Tax Credit Bill

Bipartisan Bill Doubles Tax Credit, Makes Measure Permanent

CONCORD – Enacting a key provision of her innovation plan to help businesses grow and create jobs, on March 21, 2013, Governor Maggie Hassan signed into law bipartisan legislation doubling funding for the state’s research-and-development tax credit and extending it permanently.

“Expanding the R&D tax credit is a critical component of our innovation agenda,” Governor Hassan said. “By doubling funding for the R&D tax credit, we can help more businesses develop in New Hampshire the new products that can lead to growth and job creation. Making the credit permanent will also help businesses who might need the credit down the road to plan ahead.

“Increasing funding for the research-and-development tax credit also sends a message to entrepreneurs and businesses considering where to locate that the State of New Hampshire will continue to work with them to encourage innovation and invest in our economic future.

Governor Hassan was joined for the signing ceremony by prime sponsor Senator Bob Odell and other members of the legislature, representatives from the economic development community, and New Hampshire businesses that have used the R&D tax credit, including Val Zanachuck, president of Graphicast in Jaffrey, an innovative small business that develops graphite mold casting technology to produce precision metal parts for a variety of industries.

“This legislation is a shining example of the tradition of collaborative, bipartisan problem-solving that the people of New Hampshire expect from their leaders,” Governor Hassan said. “Members of both parties, from both the House and the Senate, came together, shared thoughts and ideas, addressed concerns, and passed by overwhelming margins a common-sense measure to help businesses. By working together, we are sending a strong signal that New Hampshire is a state that welcomes innovation.”

“As a manufacturer, we have to constantly upgrade our manufacturing methods and processes to maintain a competitive business,” Val Zanchuck said. “New product development and process improvements are our R&D. For us, this R&D does not take place in a laboratory, it takes place on the shop floor. The R&D tax credit helps provide resources that we reinvest to improve and accelerate these activities.”

In addition to expanding the R&D tax credit, the Governor’s “Innovate NH” jobs plan focuses on building the best workforce in the country by making higher education more affordable and on providing businesses with technical assistance to help them create jobs.

Governor Hassan’s fiscally responsible, balanced budget substantially restores cuts made to New Hampshire’s public universities and community colleges in exchange for freezing in-state tuition for the next two years. Her budget proposal also will help New Hampshire’s businesses grow and attract new companies with good jobs by supporting economic development efforts, funding business incubators, and providing businesses with support to help them enter new markets around the world.

While there is no current timetable for the adoption of International Financial Reporting Standards (IFRS) for U.S. companies, the looming conversion has long been a source of concern for companies using the Last In First Out (LIFO) method of accounting. Because IFRS does not recognize the LIFO method, full adoption of IFRS by the Securities and Exchange Commission would force companies off of LIFO for tax purposes, since the conformity rule requires companies using LIFO for tax purposes also use LIFO for financial statement reporting.

However, recent developments should provide LIFO taxpayers relief and cause less worry about the impact IFRS conversion may have on their business. In a recent memo addressed to The LIFO Coalition, Les Schneider, Tax Counsel to The LIFO Coalition, explains that it is increasingly unlikely that the SEC will fully adopt IFRS or disallow the LIFO method. It is very possible, under the form of convergence currently being contemplated by the SEC, that LIFO will remain an acceptable method in spite of the fact that it is not recognized by IFRS.

LIFO repeal has also been a threat on the legislative front, appearing in President Obama’s budget multiple years. While there is currently no pending legislation calling for the repeal of LIFO for tax purposes, an argument always used by legislators when discussing LIFO repeal is the impending IFRS convergence. With it being increasingly unlikely that a full IFRS adoption and disallowance of LIFO for financial statement purposes will take place, legislator’s LIFO repeal argument has certainly become less valid. Any future legislative efforts arguing the use of LIFO for tax purposes will certainly become more difficult.

LIFO is an established tax method that has been a part of U.S. tax law for over 80 years and is used by hundreds of thousands of companies that carry inventory across all types of industries.

Please contact me for additional information at chandry.jimenez@sourcecorptax.com.

Attempt to Subdivide Component Assets Identified by Cost Segregation Study Deemed “Immaterial”

A number of our clients have expressed concern about a recent tax court case where the court disallowed reclassification of assets identified by a cost segregation study. After careful review, we concluded that the decision is a narrow one and will likely not apply beyond the facts in this case. We believe that the decision will not readily apply to all purchase price allocations.

In Peco Foods, Inc. & Subsidiaries, Petitioner v. Commissioner of Internal Revenue, Respondent ( T.C. Memo 2012-18) the tax court upheld the decision of the Internal Revenue Service precluding Peco Foods from modifying purchase price allocations of two processing plants it purchased in 1995 and 1998. The court upheld the terms of the respective asset purchase agreements, which the buyer and seller had agreed to at the time of the purchases.

The purchase agreements contained provisions in both allocation schedules stating that “the parties would use these values for all purposes including tax and financial reporting,” making the contracts binding unless Peco could prove they were unenforceable. The court determined that Peco’s decision to allocate the purchase price among machinery, equipment, and furniture showed that it was aware of the specific component assets but chose not to allocate additional purchase price to those assets. Therefore the court determined that Peco intended the asset described as “Processing Plant Building” to be treated as a single asset.

The court also found that Peco believed the term “Processing Plant Building” was ambiguous only after it perceived a benefit could be realized by subdividing the building into component assets. Therefore, the court ruled that there was no ambiguity in the term.

Peco agreed to allocate the purchase price of the plant among three assets: Real Property: Land, Real Property: Improvements,” and “Machinery, Equipment, Furnitures and Fixtures.”

The court determined that the decision to allocate the purchase price separately among these various assets showed that Peco was aware of the existence of subcomponent assets but chose not to allocate additional purchase price to them. The court also determined that had Peco intended to allocate purchase price to subcomponent assets, it would have done so by allocating additional purchase price to the asset described as “Machinery, Equipment, Furnitures and Fixtures.”

In addition, the appraisal for the second plant was dated prior to the date on which Peco entered into the agreement, suggesting that Peco could have adopted a more detailed allocation schedule into the agreement but chose not to.

The second agreement contained a merger clause providing that the contract, accompanying exhibits, and closing documents “constitute the entire agreement between the Parties.” The court determined that this clause creates a presumption that the writing represents a “final and complete agreement of the parties.”

The court never reached the issue of cost segregation when it ruled that the agreements were not ambiguous and that whether the acquired assets may be subdivided into component assets was immaterial because Peco may not deviate from its characterization of those assets as stated in the original allocation schedules.

Because Peco Foods attached a statement to Form 8594 allocating specific amounts of the Purchase Price to Processing Plant Buildings and Real Property Improvements, they cast the allocations in stone. The tax court found that the agreements were enforceable, the terms were unambiguous, and all relevant assets were covered. Peco claimed that it could reallocate the useful lives of assets under Code Sec. 338(b)(5), the “residual method,” which applies when the parties do not agree in writing as to the allocation of any part of the consideration. However, since all assets were covered by the agreements, and the agreements were enforceable, the residual method did not apply.

Because the original documents went into the level of detail of identification they are bound to stay within those allocations. In our experience, agreements containing such specificity are rare. Therefore, we don’t expect any significant impact from this ruling nor do we anticipate an appeal.

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