CHAPTER 4 - PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION STUDY AND REPORT
Chapter 4 Table of Contents
As discussed in the last chapter, there are no standards for cost segregation studies. Thus, examiners will encounter a wide variety of studies and reports, as well as documentation. For example, some studies will be very brief. Other studies may be quite voluminous and complex. Regardless of the length of a study or the methodology used, a cost segregation study and report should always:
WHAT IS A "QUALITY" COST SEGREGATION STUDY?
A "quality" cost segregation study is a study that is both accurate and well-documented with regard to the three points above. Quality studies greatly expedite the Service’s review, thereby minimizing audit burden on all parties. A quality study contains a number of characteristics, which are set forth below.
PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION STUDY
The 13 principal elements of a quality study are:
1. Preparation By An Individual With Expertise And Experience The preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. Unfortunately, there are no prescribed qualifications for cost segregation preparers. However, a preparer’s credentials and level of expertise may have a bearing on the overall accuracy and quality of a study.
In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria. A quality study identifies the preparer and always references his/her credentials, experience and expertise in the cost segregation area.
2. Detailed Description Of The Methodology Chapter 3 discusses the most common methodologies used in preparing cost segregation studies. However, an actual study may be based upon a variation or combination of methods and, in fact, may not even identify by name the method used.
A quality study always describes the methodology that was used and details the steps that were taken to classify assets and determine costs.
3. Use Of Appropriate Documentation A quality study uses contemporaneous documentation to classify assets and determine costs. Documentation supporting a quality study will vary, depending on whether a property is new or used or whether original construction documents are available. The documentation in a quality study for both new and used properties is detailed below.
4. Interviews Conducted With Appropriate Parties Interviews with contractors and subcontractors, as well as with taxpayers and property managers, are quite valuable in ascertaining the specific use of a property and the construction process involved. A quality study documents all interviews conducted with appropriate parties, thus adding credibility to the depth and accuracy of its study. However, the examiner should recognize that subcontractor work details can be difficult to obtain since taxpayers generally have had no direct contact with them. In addition, general contractors may also be reluctant to share certain information because of confidentiality (e.g., profit margins).
5. Use Of A Common Nomenclature The use of creative or misleading nomenclature to describe property items, rather than common and clearly understood terms, detracts from the quality of a study. "Creative" descriptions may be used to disguise the true nature or character of an asset (e.g., a building sewage or water piping system referred to as "process piping"; an emergency exit sign termed "decorative placard").
A quality study always uses terminology consistent with the blueprints and other project documents (e.g., contract specifications, pay requests, etc.). The use of common and clearly understood terms facilitates Service review and avoids the confusion caused by misleading terms.
6. Use Of A Standard Numbering System The use of a standard numbering system, such as the Construction Specification Institute (CSI) Master Format Division, is helpful but not mandatory. A quality study numbers assets consistent with the contract bid documents and pay requests. This numbering system facilitates classifying property for computing depreciation and thus expedites the Service’s exam.
The CSI format categorizes costs by specific building systems or components, such as concrete, carpentry, metals, woods and plastics, mechanical, electrical, and lighting. Other typical groupings of assets may include land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment, etc. Refer to Appendix Chapter 6.6, which provides a more detailed discussion of standard numbering systems.
7. Explanation Of The Legal Analysis A quality study contains a thorough legal analysis, including relevant citations, to support its § 1245 property classifications. While the treatment of some items may be fairly clear based on consistent judicial decisions, there are many instances in which court decisions may appear to be contradictory or to which the Service has not acquiesced. These apparent contradictions generally reflect the intensely factual basis that underlies the proper classification of property. As might be expected, the proper classification of property is the source of much audit controversy.
The legal discussion in a quality study recognizes these contradictions and attempts to reconcile them to the specific facts and circumstances of the property at issue. An accurate analysis of the statutes and judicial precedent adds to the overall quality of a study and facilitates the Service’s review.
8. Determination Of Unit Costs And Engineering "Take-Offs" Once property items or assets have been identified and assigned to property classes (e.g., building and personal property), their respective costs must be determined. In order to determine a cost for each unit or class of property in a project or component system, total project costs (or total component system costs) must generally be broken down. This breakdown process is commonly known as engineering "take-offs".
In a quality study, engineering "take-offs" are carefully documented to show derived unit costs, and individual property units are clearly identified or highlighted on the "as-built" blueprints. For new construction, the cost of property items in an engineering take-off can generally be obtained from actual cost records. However, when actual costs are not available, costs must be estimated.
Cost estimates can vary widely depending on which estimating guide is used and whether costs are for "high" or "low" quality construction. In a quality study, cost estimates are always reconciled to an acquisition price, a total project cost, or to a component system cost to ensure the accuracy of an allocation. The proper use of an estimation technique is another frequent source of audit controversy. A quality study minimizes this controversy by clearly explaining and documenting the methodology used to assign costs to each asset.
9. Organization Of Assets Into Lists Or Groups Typically, a study lists assets by recovery period (e.g., land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment). A quality study’s asset listings tie to a taxpayer's fixed asset ledger, which also facilitates the Service’s review.
10. Reconciliation Of Total Allocated Costs To Total Actual Costs It is important that the same estimating technique be used on all of the items that reconcile to a purchase price, a project cost, or to a particular component cost. If different methods or cost guides are used on different property items (e.g., one method for tangible personal property and a different method for the building), cost distortions arise. A quality study always reconciles total allocated costs to total actual costs in order to ensure the accuracy of its allocations.
A quality study also considers and lists separately-acquired § 1245 property to prevent possible duplication. For example, if the total project cost includes furniture, fixtures and equipment (FFE), then it is appropriate to allocate costs to those items. However, if FFE is acquired separately and not included in the total project cost, then it is not appropriate to assign costs to FFE.
11. Explanation Of The Treatment of Indirect Costs A quality study lists all the costs associated with a particular project, including both direct and indirect costs, and explains the treatment of any indirect costs. Direct costs are the labor and material costs for specific items or assets. Indirect costs, also referred to as "allocables," are intangible costs that are incident to the construction of a facility. Indirect costs must be allocated proportionately to the basis of the specific assets to which they relate.
Indirect costs also include expenditures that should not be allocated to the entire project but rather assigned to the property class to which they relate. Costs to survey and subdivide land, grade the land to prepare a building pad, and construct offsite improvements are generally allocable only to land. On the other hand, costs for building permits, general conditions, and contractor overhead and profit are typically allocated to assets on a pro-rata basis.
Generally, indirect costs do not relate to the placement of business machinery, or furniture and fixtures since these assets are typically purchased and installed under separate contracts. However, indirect costs that specifically relate to components of personal property may be assigned to § 1245 property. For example, costs for special consultants (e.g., for computer wiring and process engineering) or costs to design the computer system may be assigned directly to that system. In addition, it may be reasonable to allocate certain indirect costs, such as liability insurance, bonds, and overhead/profit, where it can be shown that the total amount of the indirect costs is based upon the pro rata cost of each class of property.
The treatment of indirect costs is another area of frequent controversy. A quality study explains the purpose of each indirect cost, describes its allocation, and explains any deviations from commonly accepted practice.
12. Identification And Listing Of Section 1245 Property A quality study lists § 1245 property (including amounts) and shows any § 1250 property reclassified to § 1245 property.
13. Consideration Of Related Aspects (i.e., IRC § 263A, Change in Accounting Method and Sampling Techniques)
A quality study addresses related aspects, such as IRC § 263A, change in accounting method, and sampling techniques.
The uniform capitalization (UNICAP) rules of § 263A(a) require the capitalization of all direct costs and certain indirect costs 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. Furthermore, § 263A(f) requires the capitalization of certain interest expense incurred in connection with the production of property.
Although the courts have not uniformly agreed, it is the position of the Service that a change in depreciation method, recovery period, or convention for depreciable property constitutes a change in accounting method. Therefore, the use of a cost segregation study to reclassify property and/or reallocate costs requires the consent of the Commissioner. Please refer to Appendix Chapter 6.2 for more information regarding the current status of this issue.
Studies may utilize sampling techniques when taxpayers have a large number of substantially similar properties, such as retail or food stores. Studies may use such techniques as statistical sampling, modeling, or judgmental sampling.
When conducted properly, statistical sampling can be a reliable technique. However, improper sampling techniques may result in a final answer that does not accurately reflect a valid estimate. Factors addressed in a quality study’s sampling technique include the definition of the population being sampled, the size of the population, a description of any stratification techniques, and the consideration of sampling error.
A modeling approach may also be used to segregate property costs. This approach uses created models to approximate the different types of units involved. If the models are properly analyzed, then this method may be reasonably accurate when applied to the entire population. However, as discussed in Chapter 3, the delineation of strata may be difficult and is often an area of controversy. Furthermore, issues may arise as to whether the sampling method is statistically valid.
Some studies may rely solely on a judgmental sampling technique, which carries a higher level of risk due to the elements of subjectivity involved. A judgment sample is typically selected on the basis of perceived similarities and is not statistically valid. However, under certain, limited circumstances, the use of a judgment sample may be appropriate. In such a case, the underlying basis for the selection of particular units in a judgment sample must be rational and supported by adequate data.
A quality study addresses these related audit issues and comments on the treatment of these items for tax purposes, especially where the amounts are restated for prior tax years.
PRINCIPAL ELEMENTS OF A QUALITY COST SEGREGATION REPORT
A cost segregation report reflects a study’s methodology and conclusions. The amount of detail included in a report varies considerably since there is no standard or prescribed format. The following elements are found in a quality report.
SUMMARY AND CONCLUSIONS
This chapter described the principal elements of a "quality" cost segregation study and report. The degree to which a cost segregation study/report conforms to these elements will likely dictate the scope and depth of an examination. As is clear in Chapter 5, "Review And Examination Of A Cost Segregation Study," a quality study and report will expedite the exam process and, ultimately, minimize audit burden on taxpayers, practitioners and examiners alike.
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