A Recipe for Quality as Set Forth by the Chefs at the IRS
Some days tax practice is an art, and some days it’s a science. And every now and then, you get that rare day when it’s as easy as following a recipe. If you want to know if a cost segregation study that you and your client are planning meets the IRS standard for one of these studies, the Service’s “Cost Segregation Audit Technique Guide” spells out a list of 13 elements that contribute to a “Quality Cost Segregation Study.” A “quality” study is accurate and well-documented with respect to:
- Classification of assets,
- Explanation of rationale, and
- Substantiation of asset basis.
In order to be considered a quality study, a cost segregation study should contain each of these principal elements:
- Preparation by an Individual with Expertise and Experience. Typically, you want someone with a construction background, like a construction engineer, to conduct the study. In addition, someone with experience in cost estimation and allocation should also participate. The study should identify the preparer and describe the person’s relevant credentials, experience and expertise.
- Detailed Description of the Methodology. The study must describe the methodology used and detail the steps taken to classify assets and determine costs.
- Use of Appropriate Documentation. Contemporaneous documentation is critical to support classification of assets and determination of costs. Types of documentation may vary based on whether property is new or used and also on availability of original construction documents.
- Interviews with Appropriate Parties. Contractors, subcontractors, taxpayers and property managers all have something to contribute when it comes to understanding the construction process and the use of the property. These interviews should be conducted and, in accordance with the bullet above, documented.
- Use of a Common Nomenclature. This element flows out of the first bullet-point. Individuals with a construction background understand that terms used to describe the property should be consistent with blueprints and other project documents.
- Use of a Standard Numbering System. It’s important to number assets consistent with contract bid documents and pay requests.
- Explanation of Legal Analysis. A quality study should contain thorough analysis of relevant law, including relevant citations, to support section 1245 property classifications.
- Determination of Unit Costs and Engineering “Take-Offs.” The process of breaking down total project costs into each unit or class of property must be carefully documented and the methodology used to assign costs to each asset should be clearly explained.
- Organization of Assets Into Lists or Groups. Asset listings should also tie to the taxpayer’s fixed ledger.
- Reconciliation of Total Allocated Costs to Total Actual Costs. The best way to confirm the accuracy of the allocations in the study is to reconcile them to actual costs. It’s also important to consider and list separately acquired Section 1245 property to avoid duplication.
- Explanation of Indirect Cost Treatment. All costs associated with a particular project, both direct and indirect, should be listed and the treatment of indirect costs should be explained. That explanation should include the purpose of the indirect cost, its allocation and any deviations from commonly accepted practice.
- Identification and Listing of Section 1245 Property. Clearly identify and list 1245 property and show any Section 1250 property that has been reclassified to Section 1245 property.
- Consideration of Related Aspects. Related audit issues, such as IRC Section 263A, changes in accounting method, and sampling techniques should be addressed in the study. This element should include comments on the treatment of these items for tax purposes, especially if amounts are restated for prior years.
Almost every business has some unique quirks and unusual processes that come to light when an outsider looks in. The key to translating those processes into a quality cost segregation study is finding a partner with a strong focus on cost segregation and experienced resources who understand both the construction process and the accounting rules associated with real property.