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.
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.