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Note: Each chapter in this Audit Techniques
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Chapter 4 |
Table of Contents | Chapter 6.1
CHAPTER 5 - REVIEW AND EXAMINATION OF A COST SEGREGATION STUDY
INTRODUCTION
The preceding chapters described the legal framework for classifying assets ( Chapter 2), common methods
used to segregate costs ( Chapter
3), and elements of a quality cost segregation study and report (Chapter
4). This chapter provides suggested audit steps for reviewing and examining
a cost segregation study.
The appropriate audit steps depend on the nature and size of the segregation project
as well as on the overall quality of the study. Cost segregation is a factually
intensive determination that is based on complex tax law and engineering analysis.
While agents may be able to evaluate the adequacy of some cost segregation studies
(e.g., smaller projects), other studies may require specialists with expertise,
industry experience and specialized training.
The Engineering Program in LMSB is the principal source of technical expertise for
examining cost segregation studies. The Computer Audit Specialist (CAS) Program
in LMSB is also available to provide assistance when a study is based on statistical
sampling. Formal advice, using the referral process, should be solicited through
the LMSB web site (IRWEB/LMSB/Field Specialists/, and select Engineers or CAS) and
the Specialist Referral System (SRS). Informal advice is also available by contacting
your local specialist group.
The suggested audit steps are presented below in an outline format. In order to
have a better understanding of these steps, examiners may want to refer to Appendix
Chapter 6.6 for a brief overview
of the construction process. While some steps will not apply to all studies, each
step should be carefully considered before moving on to the next one.
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STEPS FOR REVIEWING A COST SEGREGATION STUDY AND REPORT
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Review A Copy Of The Cost Segregation Study & Report
If the taxpayer has claimed depreciation deductions based on a cost segregation
study, the examiner should review and evaluate the study and report.
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Request a copy of the Cost Segregation Study/Report.
Refer to the IDR Exhibits in Appendix
Chapter 6.7 for suggested language.
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Request a copy of the Letter of Engagement to determine the scope
of the study.
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Determine the Nature of the Fee Arrangement.
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Many firms charge a fee based primarily on the size of the project. Out-of-pocket
expenditures are generally added to this cost.
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Some firms use contingency fees where cost is based primarily on the tax benefits
received from a study. Contingency fee arrangements create the incentive to maximize
§ 1245 costs, usually through "aggressive" legal interpretations and/or by inappropriate
cost or estimation techniques. Accordingly, examiners should closely scrutinize
studies performed on contingency fees.
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Read the Entire Report.
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Evaluate the Study with respect to its depth, accuracy and methodology.
What methodology was used (see Chapter
3)? How does the study and report compare to the quality elements described
in Chapter 4?
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Determine the Cost Allocation Process and the Source of any Unit Costs.
How were costs allocated? Were actual costs or estimates used? How were unit costs
determined?
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Review the Property Units and the Types of Assets.
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Assets are generally classified into various units or groups of assets and are often
listed in both a "Summary" and "Detail" format.
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The "Property Unit Summary" is a summary of the unit (asset)
groupings by land, land improvements, 3-year, 5-year, 7-year, 10-year,
15-year, 20-year, 27.5-year and/or 39-year property.
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The "Property Unit Detail" is a detailed asset schedule
within each unit (asset) grouping that describes the assets and shows their costs.
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An example of a unit grouping is "Kitchen Equipment--Plumbing". Within this grouping,
the Property Unit Detail schedule might list the floor drain, grease trap, or sink.
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Abbreviated methodologies may not classify assets into property units. Nevertheless,
assets still must be identified, supported and documented in a cost segregation
report.
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Verify The Cost Basis And Reconcile Depreciation Records
Examiners should reconcile the basis of property in a study to basis in
the taxpayer's books and records.
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Request Detailed (Asset-by-Asset) Depreciation Schedules that tie
to the return. Determine how the study assets are shown on the depreciation schedules.
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Review Tax Depreciation Schedules to verify that tax basis reconciles
with the study; note any differences. Are fixtures, furnishings and equipment included
in the study? Are they on other cost recovery schedules? Have these costs been duplicated?
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Request Prior Year Tax Depreciation Schedules that correspond to
the study’s assets. Do these schedules reconcile to depreciation for prior year
returns? Property reclassified to a shorter recovery period must be depreciated
using the proper method pursuant to IRC § 168(b). For example, if straight-line
depreciation was used for other property placed in service for a given recovery
period during the same year that the reclassified assets were placed in service,
then IRC 168(b)(3) requires that the reclassified assets must also be depreciated
using the straight-line method. The election to use straight-line depreciation is
irrevocable pursuant to IRC § 168(b)(5).
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Request Contemporaneous Documentation to Substantiate and Verify the Basis of
Assets.
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Determine Whether Basis was Properly Allocated to land, non-depreciable
land improvements (general land grading, off-site street improvements) and/or other
property types aside from those considered by the study.
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Were any project costs allocated to land or land improvements? Many studies allocate
almost all costs to building and personal property, instead of allocating appropriate
amounts to land, land improvements, or other long-lived assets. In the case of acquired
property, it is often appropriate to assign a large portion of an acquisition price
to land, prior to allocating the remaining purchase price to other property.
- Conduct A Risk Analysis To Evaluate Audit Potential
and Determine Audit Scope.
- Review the Classification of Property Units and its reasonableness.
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Compare the Study’s Property Descriptions and Classifications To Revenue Procedure
87-56, 1987-2 C.B. 674. Are there any deviations that may indicate
a potential audit issue? Can you identify specific assets that might need to be
viewed during a tour of the projector facility?
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Request Additional Information (as needed) to determine audit potential.
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Issue IDR's to determine the classification of items not readily understood (refer
to Appendix Chapter 6.7 for
suggested language).
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Request contemporaneous records (permits, design studies, contractor payment records,
contracts, purchase orders, invoices) to verify the costs and descriptions of property
as well as to ascertain their functional use. This will facilitate the determination
of the proper asset classification pursuant to Revenue Procedure 87-56. For example,
machinery located in a chemical plant is 5-year property instead of 7-year property
if it meets the requirements of Asset Class 28.0 (refer to Appendix
Chapter 6.3 for information on asset classes).
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Request the "Capital Expenditure Request" to verify project costs and identify related
purchases (it may also help determine the intended use of the property).
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In some cases, it may be more appropriate for the preparer of the study to respond
to the document requests.
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Supporting documents may include computer files, hardcopy files, plans, etc. A Computer
Audit Specialist can assist in viewing computer files not ordinarily viewable on
IRS computers.
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Summarize Your Preliminary Findings.
Quantify the tax impact of potential audit issues, such as:
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The cost basis of items that are in question or dispute or are unsubstantiated.
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Assets that have been misclassified
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Double deductions for separately-acquired assets.
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The use of improper depreciation methods.
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The incorrect placed-in-service date.
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Large look-back computation (i.e., the study reflects a change in method of accounting,
with the return reflecting a deduction for depreciation not deducted in prior years)
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Determine the Need for Specialists (e.g., Engineers and/or Computer
Audit). Specialists may be required to assist in the examination of complex projects.
It is important that specialists be involved in the audit as early as possible.
Informal assistance may also be requested when needed.
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A study with significant tax impact generally requires the assistance of specialists.
These studies will typically have a large number of assets or complex assets.
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A study that allocates estimated costs between § 1245 and § 1250 property (particularly
electrical or plumbing component systems) typically requires the assistance of an
Engineer. Engineers can provide the expertise needed for the proper development
and resolution of the issue.
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Studies involving numerous assets or allocations may require the assistance of a
Computer Audit Specialist (CAS) to process the data and/or evaluate any statistical
sampling methods.
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Determine the Scope and Depth of Your Examination. Risk analysis
is a subjective process based on the experience, knowledge and judgment of the examiner.
Guidelines provided in the previous chapters will assist examiners in evaluating
the overall accuracy and adequacy of a study as well as in determining audit potential
and scope. Studies with little tax impact should be closed expeditiously. Studies
with significant tax impact should be considered for additional review and examination
and will generally require specialist assistance.
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Schedule an Interview with the Preparer. If possible, this should be completed before
or contemporaneous with the on-site inspection (see Step 5). The interview should
address the scope and assumptions of the study and any observations of the project
or facilities. Possible interview questions include:
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Were the properties inspected at the time of the study?
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Were photographs and/or video media taken and/or relied upon in classifying property?
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Were sampling techniques used?
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What cost estimating guides were used? Where are the guides located (for purposes
of verifying estimates)?
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What documentation was used to establish the cost basis and particular use of a
property item?
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How was the cost of each property item identified, segregated, and classified?
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Where are the workpapers?
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Inspect the Property
In general, the Service engineer (if assigned) is responsible for arranging
the on-site inspection, which provides the opportunity to view the assets in question.
Inspections also help identify underground utilities, off-site improvements and
general grading costs that may have been misclassified as § 1245 or § 1250 property.
Overall, the inspection provides information to assist in determining classifications
of § 1245 and § 1250 property.
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Prior to Scheduling the Tour, Complete your Review of the Study
in order to identify specific assets and concerns that require inspection.
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Prepare a List of Assets/Items that Warrant Inspection and provide
it to the taxpayer beforehand. Ask additional questions and/or view additional property
components during the tour as needed.
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Plan the Inspection to Minimize Time and Travel Costs. For cases
involving multiple properties of similar character, consider inspecting only a representative
number of properties or facilities.
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Take a Camera or Video Recorder (Camcorder) to record the condition
of the property. Confirm beforehand that photography will be allowed/permissible.
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Request that the Property Manager/Maintenance Engineer be Available
During the Tour. It is important that someone familiar with the physical attributes
and workings of the property be available to answer questions and provide access
to non-public areas.
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Request that the Preparer Attend the Tour if possible. He/she can
identify the physical attributes of specific assets and explain how they were classified.
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Request Access to Plans, Drawings and Contract Documents that are
located on-site.
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Prepare an IDR in duplicate so that any requested items received
during the inspection can be noted and an acknowledgement copy of the IDR can be
left with the taxpayer.
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View the Project Site and Note Features that impact the cost allocations
and property classifications. Consider the following points:
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Location - Record the address and locate it on a map for future reference. What
is the character of the neighborhood and how does the location impact land value?
Is there any other property for sale in the area? Note the real estate company name
and the address of the property for future reference.
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Topography - Observe the topography and determine whether the land was initially
hilly or low-lying. Did the project include the general grading of the land? Were
large amounts of fill required in order to build?
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Site Conditions - Determine whether the project included the subdividing or rezoning
of land. Did it require environmental or land use permits, or the construction of
access roads? Were off-site improvements (e.g., streets, sidewalks, sewers, storm
drains) constructed? Were any of these improvements dedicated to the local municipality?
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Condition of Property - Is the property new or old, worn or renovated? Were the
materials modern or old?
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Project Records – Where are the original project records (e.g., drawing, plans,
contracts, payment records) located? Ask for the names of employees who may have
particular knowledge of the construction. Request interviews with such individuals
as needed.
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Individual Assets - View each challenged asset to gain a thorough understanding
of the facts and circumstances that affect its classification and cost. Ask the
site manager how the facility is used and how individual assets
operate.
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Cost Data - Discuss the methodology that was used to determine the cost of assets.
Were standard cost guides used to estimate costs? Ask on-site maintenance and
facility operations personnel about local construction and repair costs
in order to verify the estimated costs in a study.
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Prepare Notes and Drawings for future reference.
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Obtain sufficient information to properly classify each challenged asset.
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When possible, obtain local cost data to verify estimates and cost allocations.
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Review And Verify The Classes Of Property
Review the study again to determine whether property classifications are correct.
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Are Assets Classified into their Proper Groups, such as?
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Land
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Non-Depreciable Land Improvements (i.e., all off-site construction and general land
grading expenses)
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Depreciable Land Improvements
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Buildings, Structural Components and Other § 1250 Property
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Office Furniture, Fixtures and Equipment
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Information Systems
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Building Systems (e.g., mechanical, electrical, plumbing)
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Process Systems (e.g., process piping)
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Non-Residential Real Property
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Other Miscellaneous Property
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Are Assets Assigned to the Proper Asset Class and Recovery Period?
- Example 1
Some studies may include a specific component of a building's electrical system
(e.g., plug outlet, switch, branch circuit) as being allocable to the piece of tangible
personal property that it supports (e.g., dishwasher, garbage disposal, etc.). Accordingly,
the component item is treated as § 1245 property (7-year MACRS). However, if that
same electrical component item can be used for other pieces of equipment, the Service
examiner may consider it to be part of the building’s general electrical system.
Accordingly, it would then be classified as part of the building as § 1250 property
(39-year MACRS).
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Perform A Cost Analysis
Once proper classifications and recovery periods have been determined, the next
step is to determine the costs allocable to individual assets. This determination
will depend on whether the asset is newly constructed or is a purchased or existing
facility. It is important to realize that cost determinations are very time consuming.
Therefore, it is recommended that examiners determine that significant discrepancies
exist, or are strongly suspected, before undertaking Steps 7A or 7B below.
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A. Cost Analysis Of Newly-Constructed Property
Actual cost records should be available from the preparer, taxpayer, general
contractor, and/or other third parties. Cost records should be requested for significant
property items only.
- Gather Background Information.
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Secure total project costs by requesting information related to the construction
project billings.
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Review construction drawings, blueprints and specifications.
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Blueprints and specifications identify property items, construction methods and
locations of items within the structure.
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Review the "as-built" drawings if available (generally available from the taxpayer,
architect, contractor, local building department, local fire department, or insurance
carrier). Review the most "up-to-date" drawings as well. These drawings are typically
found in the engineering or property manager’s office and can be accessed during
the inspection.
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Request the building and occupancy permits, which can assist in establishing the
placed in service date.
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Request photographs of the site showing the condition of the property before the
project began. This will help determine whether significant site preparation or
general grading costs were incurred.
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Request Contemporaneous Records to Substantiate the Cost Basis of Assets in
the Study.
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Contract documents specify how payments are made and typically require payment requests
to be broken down into individual items of property. The American Institute of Architects
(AIA) Form G-702 is used to process payments on nearly all construction projects.
This form requires contractors to break down their payment requests into amounts
for each individual building system or trade (e.g., site preparation, grading, concrete,
wood, electrical).
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Purchase orders and invoices are another source of cost data.
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Analyze the Total Project Costs.
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Review the Contractor’s Requests for Payment in AIA Forms G-702 and G-703.
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Review capitalized costs including change orders, indirect costs and out-of-pocket
costs. Test for completeness by looking for any missing elements (e.g., land shaping
costs may be in a separate contract).
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Review invoices for any pre-purchased installed equipment. On large construction
projects, the taxpayer may separately pre-purchase items that have a long delivery
time (e.g., large capacity electrical sub-stations or transformers). The examiner
should verify if any pre-purchased electrical equipment is included in the total
project cost.
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Reconcile Total Project Costs in the Taxpayer's Records with the Total Project
Costs in the Study.
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Request a copy of the taxpayer's general ledger data to support the fixed asset
amounts on the depreciation schedule. How does it compare it to the amounts shown
in the study?
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Typically, the property unit numbers or reference numbers found in a study do not
track the taxpayer's accounting entries. Find out what sources the preparer used
in preparing his/her study.
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Verify that the total project cost in the study reconciles to the total cost basis
of assets in the taxpayer's books and records. The revenue agent is in the best
position to do this since he/she is the most familiar with the taxpayer’s accounting
methods. The agent will also know where to look for other costs that should be in
the building account, but may have been expensed or otherwise entered improperly
into another account.
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Compare all data with the contemporaneous cost records.
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List any unsupported basis for potential disallowance.
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Reconcile Detailed Cost Breakdowns to individual property elements.
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Actual cost records should be used whenever possible.
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Review the taxpayer's internal "Job Cost Reports." Typically, a preparer relies
on these documents to derive the unit costs (assuming that the cost and description
of the assets in the Job Cost Reports are accurate).
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The study methodology should be disclosed in the Assumptions and Limiting Conditions
section of the report.
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A careful analysis of the Job Cost Reports may yield significant audit adjustments
because the taxpayer does not always properly classify items that are listed in
this report. For example, the Job Cost Report includes a code for Furniture and
Fixtures. Within this code are multiple records of vendors from whom the taxpayer
claimed to have purchased items, such as furniture and fixtures. The preparer included
the total cost as § 1245 property and listed it in the study as "FF&E." However,
upon requesting contracts for each of the vendors under this heading, the Service
examiner discovered that some of these assets were actually § 1250 property and,
therefore, concluded that these costs were erroneously included in "FF&E." Therefore,
it is important that the examiner review the vendor contracts in the Job Cost Reports,
especially those that detail the "Description of Work", to verify asset costs.
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Prepare a List of Items/Costs that are Not Properly Substantiated.
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Compute the Correct Costs (as necessary) for individual items or groups of property.
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Review the Cost Segregation Study/Report Again.
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Review the study for its style and order of presentation. The narrative typically
describes the order of the development of costs and the spreadsheets show the analysis
and sequence.
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Review the Study conclusions and recommendations.
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Review the Assumptions and Limiting Conditions.
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Verify that the assumptions and limiting conditions are consistent with the facts
developed from the inspection and the review of drawings and specifications.
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Analyze How the Detailed Cost Breakdown was Prepared.
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Review Direct Costs.
Typically, cost segregation studies will incorporate a mixture of §1245 and §1250
properties into unit-by-unit direct cost recommendations. A review of a study should
include identification of any of these disputable costs, and ensure that §1245 properties
are segregated from §1250 properties.
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Review Indirect Costs.
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Examiners need to ensure that any indirect costs are properly allocated to their
respective assets.
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Indirect costs generally relate to the land, certain land improvements, and/or the
building or other structures. Indirect costs generally do not relate to the placement
of machinery or furniture and fixtures. However, there are exceptions, such as for
the design of a manufacturing line. Refer to
Chapter 4, "Principal Elements of a Quality Cost Segregation Study and Report,"
for additional discussion of indirect costs.
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Studies often use large spreadsheets and sophisticated formulas to compute the allocation
of indirect costs (generally on a pro-rata basis). The examiner should verify any
formula by testing the allocations of indirect costs to ensure they do not exceed
the total indirect costs.
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Identify Potential Audit Issues.
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Site Preparation, General Grading and Land Shaping Costs Building and facility projects
often require general grading, site preparation and other costs to make the site
suitable for a proposed use. These costs, along with costs for stripping existing
forest and vegetation, grading and compaction to provide a level site, and construction
of site access roads, are generally non-depreciable costs allocable to the basis
of land. A study may exclude these costs as being outside the scope of its work.
In other instances, a study may argue that no costs are allocable to non-depreciable
items. Whether these types of costs are included in the study or not, the examiner
should determine all land shaping costs and allocate these costs to either non-depreciable
land, to the building, and/or to land improvements. Before-and-after photographs
may help with this determination. Also, the examiner should inspect the taxpayer's
books and records to determine how these items were treated for financial and tax
purposes.
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Section 1245 Property – Did the Study Utilize Cost Estimates or Actual Cost Records?
Review the § 1245 and § 1250 property listings and identify the most significant
items. The examiner should check the contractor payment records (e.g., AIA Form
G-702) to see if actual costs of these items were used in the study or whether these
item costs were based on some sort of allocation or estimate.
For example, if the Form G-702 shows $1.2 million for the "electrical" division
work and the study shows or allocates $1.8 million to specialized § 1245 electrical
equipment, then there may be a problem with the study’s cost determination. In this
case, the examiner should request additional information to determine the source
of the $1.8 million allocation. Note that this is only a "smell check," since additional
equipment or other property purchased by the taxpayer outside the construction contract
may significantly affect this type of comparison.
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Potential Problems with Residual Methods.
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When a residual approach has been used, the examiner must be especially careful
when reviewing § 1245 property costs. In essence, this method estimates the § 1245
property costs and then simply assigns the remaining portion of the total cost to
§ 1250 property. In general, the § 1250 residual cost is neither estimated nor checked
for reasonableness. All too often the result of this procedure is that the § 1245
property cost is too high and the § 1250 property cost is too low.
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Cost estimates can also be manipulated to produce unreasonably high estimates for
§ 1245 property. This is because there are a wide variety of cost data publications
that may be used, and some of these have relatively high estimates for costs.
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Most data sources have a higher cost for installing only one unit (e.g., a single
electrical outlet) as opposed to installing 10 or 100 units. "Quantity discounts"
and competitive bidding may significantly reduce the actual unit cost. Accordingly,
estimates for multiple units based on a single unit cost may be incorrect. The following
is an example of this problem.
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Assume that 500 of the 120-volt electrical outlets in a particular building have
been determined to qualify as § 1245 property. The R. S. Means DataBase, 2003 Edition,
page 464, line 4015, lists a total price of $34.50 per 120-volt duplex receptacle.
Based on this data, a study may estimate that the 500 outlets have a total installed
cost of $17,250 (500 x $34.50). However, this estimate should be reviewed or compared
with the contractor’s actual price in order to determine its validity. When the
contractor was awarded the contract, he/she submitted a schedule of cost for each
item of work, such as for plumbing, electrical, heating, and site work (Form G-702
and G-703). The examiner should review Forms G-702 and G-703 to determine the cost
that the contractor assigned to the electrical work. If the Form G-703 indicates
that $120,000 was assigned to electrical receptacles and there were 5530 receptacles
to install, then the actual unit cost to install each receptacle is only $ 21.18
per outlet. The total actual cost for the 500 outlets is therefore only $10,590
(500 x $21.18). This compares to the estimated cost of $17,250 [Note that both cost
estimates (based on either the R. S. Means data or on the contractor's actual costs)
would need to be increased by any applicable indirect costs].
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Potential Problems with "Rule of Thumb" Methods
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While the documentation of costs drawn from the use of a "rule of thumb" method
is typically sketchy and inadequate, the examiner should not categorically reject
a study involving the use of "rules of thumb." The documentation needs to be examined
and verified on its own merits to determine if cost recovery properties are properly
identified and placed into proper recovery periods.
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B. Cost Analysis Of Existing Property
For used or recently-acquired properties, the adjusted basis or purchase
price is allocated between § 1245 and § 1250 property. However, different considerations
and audit techniques will apply depending on the records available. In addition
to the steps for new construction, the following audit steps for existing properties
should be considered.
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Review the Acquisition Documents to determine the assets purchased.
Determine whether there was a written purchase price allocation agreed to by the
buyer and seller (you may need to contact the seller). If there was an allocation
between personal and real property, then the allocation is binding on the taxpayer
(and therefore a taxpayer’s subsequent cost segregation study is moot). Only the
Service can challenge a contract allocation. See Section 1060(a); Commissioner
v. Danielson, 378 F.2d 771 (3rd Cir. 1967), cert. denied, 389 U.S.
858 (1967); and North American Rayon Corp. v. Commissioner, 12
F.3d 583 (6th Cir. 1993).
If there was not a written price allocation, then the examiner should address the
study and go to the next step.
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Review the Escrow Documents and Payment Records to substantiate
the overall purchase price.
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Ensure that the Land has been Properly Valued.
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Land included in the purchase price is valued first. The value of land should be
determined at its "highest and best use." Properties tend to appreciate based on
the value of land.
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Land value should not be reduced for any pre-existing environmental contamination
because the prior owners are often held responsible for this and/or the property
is generally insured for this situation.
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Ensure that Older Properties are Adjusted for Depreciation.
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Assets and asset groupings must be carefully reviewed and scrutinized to determine
their physical and economic condition.
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Relatively new items should be valued as new (e.g., windows, building exterior,
emergency generator).
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Older items may be physically deteriorated or functionally or economically obsolete
and should be assigned a value commensurate with their condition or use. For example,
a building may have been pre-wired for telephones but, if it is a "non-digital"
system, it may have a low value.
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Ensure that Replacement Cost Values are Properly Adjusted for the
actual condition and remaining economic useful life of the assets.
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The value of used components must be reduced from new replacement value in proportion
to the observed economic obsolescence or physical depreciation as compared to similar
new assets. This principle is discussed in regard to the Helipot Building in
Lesser v. Commissioner, 42 T.C. 688 (1964), aff’d, 352 F.2d 789 (9th
Cir. 1965), acq., 1966-2 C.B. 5, cert. denied, 384 U.S. 927 (1966).
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Review the Contract Files for information regarding the original
construction and any subsequent repairs or modifications. This information should
be used when viewing the existing condition of the building to verify, if possible,
that the original contract work was performed.
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Review the Blueprints or Drawings. The existing structure should
be compared to the "as-built" drawings to help identify subsequent repairs and modifications.
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Consider Demolition Expenses.
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Assets scheduled to be demolished should have no basis or value assigned to them.
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Code Section 280B provides that the demolition cost of any structure is a capital
cost chargeable to the land. Any abandonment losses incurred in connection with
a demolition should also be considered for capitalization to the land [See Priv.
Ltr. Rul. 9131005 (Apr. 25, 1991)].
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In summary, the examiner should ensure that:
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The study methodology considers the value of all the assets in place at the time
of purchase or at the time the study is prepared, whichever is appropriate.
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The value of property items must take into account the physical wear and tear on
each property item and any economic or functional obsolescence.
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Review Sampling Techniques (If Necessary)
Preparers may utilize sampling techniques to minimize the time and costs associated
with performing an analysis on all the properties (refer to the discussion in Chapter
4, Cost Segregation Methodologies). Sampling may also be utilized with cost documents.
The use of sampling adds another level of difficulty in examining these studies.
The examiner should take the following steps in reviewing a taxpayer’s sampling
technique.
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Understand the Sampling Technique.
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In situations involving large numbers of substantially identical properties, a study
may utilize sampling or estimation techniques to select specific properties on which
a "full" cost segregation study is performed. This approach, often referred to as
"modeling", is typical for retail or food chain operations, where a "cookie-cutter"
type of structure is involved.
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The taxpayer may have a limited number of "prototype" structures, such as free-standing
units, locations in enclosed malls, locations in "strip" malls, full-service locations,
carryout units, leased properties. The population is stratified by prototype to
form groups of similar structures.
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Sampling within each prototype group is then performed with the results extrapolated
over the entire population within that prototype.
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Determine/Evaluate the degree of Similarity Between Properties Within a Group.
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The determination of the similarity between properties within a prototype group
is difficult and creates a potential area of dispute. The examiner should be aware
that while the appearance of a particular structure may be very similar to the prototype,
differences could exist.
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The rationale for stratifying properties is generally based on factors such as style
of the structure (e.g., location in strip/enclosed mall as opposed to a free standing
location), geographical location, total square footage, leased, or owned. A stratification
that is based on the total number of windows in a structure or on the total square
footage of the site is highly suspect and generally warrants further analysis.
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Geographic variations due to physical site characteristics, climate, building codes,
and union versus nonunion labor, may create a wide disparity in structure costs.
Therefore, stratification of otherwise similar properties across wide geographical
areas may not be an accurate approach. Accordingly, the methodology should be carefully
reviewed, as the "sampled" property may not be relevant to the other properties
within the strata or group.
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Engineers and Computer Audit Specialists should be involved to properly analyze
and evaluate the strata and groupings, as well as the sampling methodology.
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Review the Sampling Methodology.
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When conducted properly, statistical sampling is a reliable technique when the risk
(sampling error) of not examining 100 percent of the properties can be accurately
determined.
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The use of a modeling technique is a reliable technique, provided the standard models
or templates are properly analyzed and are similar to their respective groups (i.e.,
appropriate stratification into similar groups).
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Judgment sampling is another technique, but is highly subjective. Therefore, it
warrants greater scrutiny by the examiner.
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Potential Issues
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Improper sampling techniques (regardless of the methodology used) that do not reflect
a valid estimate.
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There is a relatively small number of units in the population (less than 100) and
a small sample size. However, small sample size can be overcome by the application
of a proper statistical sampling methodology and the utilization of the least advantageous
limit computed at a 95% one-sided confidence level.
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Simply stated, the least advantageous limit is computed as the point estimate plus
or minus the sampling error, where the result provides the least benefit to the
taxpayer.
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Missing records, substitution of missing items, missing documentation, and the use
of estimated costs.
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Some cases may not be appropriate for sampling (e.g., small number of dissimilar
properties).
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Inappropriate stratification of properties and faulty statistical sampling within
each stratum.
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Judgmental sampling is highly subjective and thus may be of limited value.
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Request the Assistance of Engineers and Computer Audit Specialists.
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If the taxpayer has utilized any form of sampling in a study, it
is imperative that a Computer Audit Specialist be consulted to review the sampling
method. An engineer can also assist in the review of strata and property groups
as well as with the cost allocations of property.
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The "Field Directive on the Use of Estimates from Probability Samples," issued by
the Director, Field Specialists, on March 14, 2002, provides basic statistical sampling
guidelines. This directive addresses the general use of statistical sampling by
taxpayers and is included in Appendix Chapter 6.5. Additional guidance on sampling
applicable to cost segregation studies may be forthcoming and will be added to this
guide when it becomes available.
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Sampling techniques may also be a useful tool for examiners when reviewing the adequacy
and accuracy of a cost segregation study. Consultation and/or referral to a statistical
sampling coordinator in the Computer Audit Specialist Program is highly recommended
in order to develop a reliable and supportable sample.
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The uniform capitalization (UNICAP) rules of § 263A require the capitalization of
all direct costs and certain indirect costs properly allocable to real property
and tangible personal property produced by the taxpayer. Self-constructed assets
and property built under contract are treated as property "produced" by the taxpayer.
Therefore, changes to the class life or basis of an asset may require a concurrent
adjustment of UNICAP costs.
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Furthermore, § 263A(f) requires the capitalization of certain interest expenses
incurred in connection with the production of property. The interest capitalization
rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property
and include inherently permanent structures in the definition of real property.
In summary, all real property and certain tangible personal property are subject
to the interest capitalization rules. Therefore, changes to real and tangible personal
property costs may impact the amount of capitalized interest.
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Taxpayers may attempt to exclude all § 1245 property from interest capitalization
by arguing that § 1245 property is tangible personal property that does not meet
the classification thresholds of Treas. Reg. § 1.263A-8(b)(1). However, § 1245 property
that is an inherently permanent structure is subject to interest capitalization
without any restrictions.
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Ideally, a taxpayer’s books and records should consider and comment on UNICAP treatment
when amounts are restated for prior tax years based on a cost segregation study.
Refer to Appendix Chapter 6.1 for a summary of the provisions of IRC § 263A. Specific
questions can be referred to the § 263A Technical Advisors.
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Consider Change In Accounting Method
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Research The Law, The Regulations And Appropriate Rulings
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Before reaching a final conclusion on the classification of a specific asset, the
examiner should have conducted all the necessary research and reviewed all the relevant
court cases, rulings and regulations that relate to ITC and the challenged asset.
While some assets may, at first glance, appear to be building-related, there may
be revenue rulings or court cases that have concluded that these assets are instead
tangible personal property (e.g., electrical wiring, HVAC, decorative millwork).
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Appendix Chapter 6.4 contains
a summary of pertinent court cases that relate to the classification of property
for ITC and depreciation purposes. The examiner should read and study these cases
for guidance. An examiner must also recognize that the determination of class life
for a particular asset is factually intensive and that the determination may vary
with a particular industry and/or with the specific use by the taxpayer.
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Industry-specific guidance is included in
Chapter 7.1 (Casinos),
Chapter 7.2 (Restaurants),
and Chapter 7.4 (Pharmaceutical
and Biotechnology). It is anticipated that specific guidance for additional industries
will be developed in the near future; additional guidance will be added to Appendix
Chapter 7 as it becomes available.
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Summarize The Findings And Discuss The Challenged Assets
With The Taxpayer
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If the preliminary conclusion is that the taxpayer has misclassified certain assets,
the examiner should meet with the taxpayer as soon as practical to discuss his/her
findings and the reasoning behind them. This discussion may clear up any misunderstandings
and disagreements as to the facts and perhaps will provide a setting for reaching
a resolution of the issue.
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Prepare The Final Report Or The Notice Of Proposed
Adjustments (if necessary)
At the conclusion of the examination, the examiner (agent and/or specialist)
should prepare and issue a final report. Consider making adjustments in a contra
account rather than adjusting the basis of each property item affected, especially
if indirect allocations are involved. Specialists should consider having the examining
agent calculate the cost recovery or amortization adjustments to ensure that all
pertinent factors are included in the computation. Adjustments to the construction
period interest may also be applicable.
SUMMARY AND CONCLUSIONS
Using the steps outlined in this chapter, the Service examiner can evaluate the
adequacy and accuracy of a study and determine the proper classification and cost
of property. The need for a specialist, such as an Engineer or Computer Audit Specialist,
should also be evaluated and determined as soon as possible. Hopefully, the guidance
in this ATG will facilitate the audit process and minimize burden on taxpayers,
practitioners, and examiners alike.
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Chapter 4 |
Table of Contents | Chapter 6.1
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