“Cost segregation” studies have been a popular tax saving strategy ever since the Tax Court’s 1997 decision in Hospital Corporation of America[i] and the Service’s subsequent acquiescence in 1999.
In short, cost segregation studies involve breaking down the cost of a building that would ordinary be depreciated over 39 or 27.5 years into its components assets,[ii] some of which can be depreciated over shorter 7, 10 , or 15 year lives. These studies are often performed several years after the acquisition, with the building owner entitled to a “catch-up” of the depreciation they would have been permitted to deduct had they performed the study prior upon the building’s purchase. This catch-up is captured in the form of a change in accounting method and a favorable I.R.C. § 481 adjustment.
Yesterday, the Tax Court dealt a blow to the cost segregation movement, ruling that cost segregation was not permitted when the taxpayer purchased the building as part of a larger asset acquisition in which the buyer and seller allocated the purchase price among the transferred assets — including the building — and reported the allocation on Form 8594.[iii]
Peco Foods was the common parent of a consolidated group of corporations. In 1995, the group entered into two assets acquisitions in which it acquired processing plants as well as other hard assets and goodwill. Peco and the two sellers agreed to an allocation of the purchase price among all the transferred assets, including the two buildings. As required, the parties reported the allocations on the Forms 8594 attached to their 1995 tax returns.
In 1999, Peco engaged a firm to perform a cost segregation study related to the acquisition of the plants. The study resulted in nearly $6,000,000 in additional depreciation deductions by reclassifying amounts previously allocated to the buildings to shorter-lived assets. Peco reported these adjustments as a I.R.C. § 481 adjustment on a Form 3115 attached to its 1998 tax return.
The IRS disallowed the I.R.C. § 481 adjustment, and the Tax Court upheld the disallowance. In reaching its conclusion, the court ruled that the original allocation of the purchase price was binding, and Peco could not subsequently reclassify amounts previously allocated to buildings to other assets:
…amended section 1060(a) [provides] that where the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, that agreement is “binding” on the transferee and the transferor unless the Commissioner determines that the allocation (or fair market value) is not appropriate.
The purpose for this unyielding flexibility, in the eyes of the court, was to protect the IRS against the potential whipsaw the Form 8594 was designed to prevent:
In binding Peco to that schedule, [the IRS] ensures that the transferee (Peco) and the transferor treat the assets consistently for Federal tax purposes. Allowing Peco to treat the acquired assets in a way other than the one in which it agreed to, subjects [the IRS] to a potential whipsaw. Such a whipsaw might occur if, for example, Peco treated certain property as section 1245 property but Marshall Durbin treated that property as section 1250 property. Even if a danger of whipsaw did not occur, binding Peco to the original allocation schedule prevents it from realizing a better tax consequence than the one it bargained for.
So how does the Tax Court reconcile its decision in Peco with its previous landmark decision in Hospital Corp. which opened the door to cost segregation studies?
The dispute in the instant case is far more simplistic than the one presented in Hosp. Corp. of Am. Unlike the taxpayers in Hosp. Corp. of Am., Peco is bound by the clear and unambiguous terms of the original allocation schedules. Thus, whether the acquired assets may be subdivided into component assets is immaterial because Peco may not deviate from its characterization of those assets as stated in the original allocation schedules.
This differentiation by the IRS would seem to be the death knell for cost segregation studies performed on a building acquired as part of an asset acquisition with an agreed upon purchase price allocation. In the coming days, I will be reaching out to WS+B’s cost segregation experts to see if they agree.
[i] 109 T.C. 21
[ii] Such as land improvements, parking lots, landscaping, etc…
[iii] The purpose of the Form 8594 is to alert the IRS to an asset acquisition so it may ensure that both parties have treated the acquisition the same. In the absence of such a form, the seller may allocate the majority of the purchase price to self-created goodwill (to achieve long-term capital gains), while the buyer could allocate the majority of the purchase price to machinery and equipment to take advantage of a 5 year depreciation period, allowing them to recover the purchase price three times faster than if the purchase price were allocated to goodwill.