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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.

From Federal Tax Updates Checkpoint Newsstand May 31, 2011

Businesses that trade in machinery or equipment for which they claimed bonus depreciation under Code Sec. 168(k) may qualify for another bonus depreciation deduction on the remaining depreciable basis if they swap for like-kind property that also is eligible under Code Sec. 168(k). In effect, the business gets two bonus depreciation deductions for its expenditure on the traded-in property. What’s more, this result is explicitly OK’d by the regs.

Background. Bonus first-year depreciation deductions are available for a property if: (1) it is property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less, computer software other than computer software covered by Code Sec. 197, qualified leasehold improvement property, or certain water utility property); (2) its original use commences with the taxpayer; and (3) it is timely bought and placed in service by the taxpayer.

The bonus first-year depreciation allowance is:

• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2007, and before Sept. 9, 2010;
• 100% of the cost of qualified property acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012 (before Jan. 1, 2013 for certain longer-lived and transportation property); and
• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2011 and before Jan. 1, 2013 (after Dec. 31, 2012 and before Jan. 1, 2014 for certain longer-lived and transportation property). (Code Sec. 168(k)(2), Code Sec. 168(k)(5))

Note that 50% bonus depreciation also applied for certain qualified property acquired after May 5, 2003 and before Jan. 1, 2005, and 30% bonus depreciation applied for certain qualified property acquired after Sept. 10, 2001, and before May 6, 2003.

MACRS property may be acquired (1) in exchange for MACRS property in a Code Sec. 1031 like-kind property exchange, or (2) to replace involuntarily converted MACRS property in a Code Sec. 1033 involuntary conversion. (Reg. § 1.168(i)-6(c)(1)) The replacement property is for depreciation purposes divided into the depreciable exchanged basis (i.e., remaining basis of the relinquished property carried over to the replacement property), and the depreciable excess basis (i.e., additional consideration to acquire the replacement property). Where the properties share the same recovery class and depreciation method, the depreciable exchanged basis is written off over what’s left of the relinquished property’s recovery period; and the depreciable excess basis is in effect treated as a separate property with a recovery period that begins anew. (Reg. § 1.168(i)-6(c)(3)(ii))

Double helping on bonus depreciation. When otherwise eligible MACRS property or computer software is acquired via a Code Sec. 1031 like-kind exchange or as a result of a Code Sec. 1033 involuntary conversion, both the carryover basis and the excess basis, if any, of the acquired property are eligible for bonus depreciation. (Reg. § 1.168(k)-1(f)(5)(iii)(A)) What’s more, it doesn’t matter if bonus depreciation was claimed on the old property. (Reg. § 1.168(k)-1(f)(5)(vi), Ex. 3)

RIA illustration: In January of 2010, ABX Corp. bought a new refrigerator truck (5-year MACRS property) for $100,000 and placed it in service that year. In 2011, ABX acquires another new, higher-capacity refrigerator truck in exchange for the truck bought in 2010 by trading in that truck and paying $50,000 cash. ABX uses the optional rate tables to compute depreciation and is subject to the half-year convention in 2010 and 2011.

For 2010, ABX claimed 50% bonus first-year depreciation for the truck bought and placed in service that year. As a result, its 2010 depreciation deduction for the truck was $50,000 of bonus depreciation (.50 × $100,000) plus $10,000 of regular first-year depreciation allowance (.20 recovery year one table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation]), for a total of $60,000.

For 2011, ABX claims an $8,000 depreciation deduction (.32 recovery year two table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation] × 6/12 [half-year convention applies]) for the relinquished truck.

ABX may claim a 100% bonus first-year depreciation deduction for the $32,000 remaining depreciable basis of the relinquished truck, i.e., the depreciable exchanged basis ($100,000 cost − $60,000 − $8,000). ABX also may claim a 100% bonus first-year depreciation deduction for the $50,000 in cash that it pays to acquire the upgraded refrigerator truck.

RIA observation: In essence, for bonus depreciation purposes, the regs treat a taxpayer like ABX as if it had sold the old truck for its remaining depreciable basis and then used the proceeds, along with additional cash, to purchase a new one.

RIA caution: This won’t work if the older-model truck was acquired in January of this year and the newer model in December. Under Reg. § 1.168(k)-1(f)(5)(iii)(B), bonus depreciation isn’t allowable for the exchanged (or involuntarily converted) MACRS property if the exchanged (or involuntarily converted property) is placed in service and disposed of in a like-kind exchange or involuntary conversion in the same tax year.

If you plan to expand your business, 2011 is a great time to invest in new equipment or building assets and benefit from newly expanded tax incentives. In his state of the union speech, President Obama highlighted the recently passed Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 signed into law December 17, 2010. As he said “Thanks to the tax cuts we passed, Americans’ paychecks are a little bigger today. Every business can write off the full cost of new investments they make this year.”

For businesses with projects that qualify for tax incentives such as cost segregation, the benefits for 2011 will be substantial. A taxpayer must meet specific requirements to utilize this tax deduction. Qualifying property generally includes: depreciable property with a recovery period of 20 years or less; water utility property; computer software; and qualified leasehold improvements. A cost segregation analysis is a method of identifying the maximum amount of qualifying property (property with a recovery period of 20 years or less) and separating those costs from the real property assets associated with a new building or expansion project.

Also, included in the tax relief act is a two-year extension of the 50 percent, first-year additional bonus depreciation allowance which applies to qualifying property acquired by a taxpayer from January 1, 2008 through December 31, 2012, and placed in service before January 1, 2013. The bonus depreciation rate increases from 50 percent to 100 percent in the case of qualifying property acquired after September 8, 2010, but before January 1, 2012, and placed in service before January 1, 2012.

To learn more about a no-cost estimate for a cost segregation analysis, please contact me at Bob.McPherson@sourcecorptax.com.

The Senate, by a vote of 61-38, passed H.R. 5297, the Small Business Lending Funding Act, as amended by the Senate. The tax title of this bill is called the Small Business Jobs Act of 2010. The bill is headed to the House of Representatives, which is expected to pass it without change, thereby clearing the measure for the President‘s signature.

The small business jobs bill includes a number of important tax provisions, including liberalized and expanded expensing for 2010 and 2011, revived bonus depreciation for 2010, five-year carryback of unused general business credits for eligible small businesses, removal of cell phones from the listed property category, and liberalized Code Sec. 6707A penalty rules.

As reported in the Wall Street Journal.

When I first began working in the area of cost segregation, people would ask, “What do you do for a living?” I would respond, “I explain to people what I do for a living, because no one has ever heard of it.” At the time only the large accounting firms provided this service.

Over the past decade, however, the cost segregation market has spread to small and medium sized investors and businesses. Despite the rapid growth of service providers nationwide, there are still underserved businesses and markets.

Building owners who acquired or built commercial buildings in prior years are often overlooked. There is a common misconception that only new construction qualifies for the benefit of cost segregation. However, anytime a building is built or changes hands, depreciation starts over, and a study can be performed. Cost segregation front-end loads that depreciation, so the owner recoups money faster.

When looking at buildings placed in service in prior years, the missed depreciation gets caught up on the tax return in the year of the study via a change in method of accounting (Form 3115) and a §481(a) adjustment.

For example, if you purchased a building in 2000 for $5 million and put it on the books as 39-year property, the straight-line depreciation would yield an annual deduction of $128,000. Through a cost segregation study, we reclassify 12% in 5-year and 8% in 15-year property. Because of the §481(a) adjustment, the additional current year deduction (above and beyond the depreciation already taken) would be $624,500, which would result in a current year cash flow increase of $218,575. The net present value over the entire tax life of the building is $149,110.

Due to the Tax Reform Act of 1986, we can conduct a cost segregation study for any commercial or rental building, constructed or acquired, since January 1, 1987. Ideal properties are those built or acquired in the last 15 years, but many good opportunities exist back to 1987.

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Focus On Opportunities:
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Everyday we see advertisements promoting how people can make money performing Cost Segregation studies.

However, the IRS provides stringent Cost Segregation guidelines (see IRS Cost Segregation Audit Techniques Guide).

A Quality Cost Segregation Study:
According to the IRS, a “quality” cost segregation study is a study that is both accurate and well documented. A quality study contains a number of characteristics, which are set forth below.

Principal Elements of a Quality Cost Segregation Study: 13 principal elements continue reading…