Major developments in cost segregation.

• Author: Malloy, John M.

Because of two important cases, 2012 and 2013 proved to be critical years for the practice of cost segregation, which involves breaking down one asset into many smaller components with varying useful lives. The benefits of cost segregation are immediately obvious in the area of depreciation. If a taxpayer takes a large asset (e.g., an apartment building) and breaks it down for depreciation purposes into groups of smaller assets (e.g., the appliances are treated separately from the shell building), many of those smaller assets can be depreciated using shorter useful lives. This results in a substantially reduced tax liability in the near term if the practice is used to its maximum effect.

The use of cost segregation has proved to be so lucrative since the Tax Court decided the Hospital Corp. of America (1) case that many financial planning firms have come to specialize in the practice. These firms have created divisions tasked with creating cost-segregation studies that break down a large asset into separate components for depreciation purposes.

Two recent Tax Court cases have limited the use of cost segregation, however. The first case is Peco Foods (2)--a case that was recently affirmed on appeal. This case demonstrates the importance of drafting a purchase agreement with purchase price allocations that will support post-acquisition cost segregation. Peco Poods shows that a cost-segregation study's benefits are eliminated when a purchase agreement has wording that contradicts that study.

The second case is AmeriSouth (3) In this case, the taxpayer used a cost-segregation study to break down a single apartment complex into more than 1,000 assets, classifying everything from plumbing to molding as shorter-life depreciable assets. The IRS challenged this treatment, and the Tax Court mostly sided with the IRS. The case introduced a stricter definition of what components count as structural components.

While the 1997 case Hospital Corp. of America greatly increased the benefit of cost-segregation studies, AmeriSouth and Peco Foods from 2012 and 2013, respectively, tend to restrict it. It should be noted, however, that both cases uphold the overall concept of cost segregation. As the general concept of cost segregation undoubtedly still applies, this article discusses the rules that must be followed to use the principle of cost segregation in any form.

Peco Foods

In the 1990s, Peco Foods was intent on expanding its primary business of poultry processing. Using its subsidiary businesses, Peco Foods acquired two poultry plants in Mississippi: one in Sebastopol and the other in Canton. The purchase agreement for the Sebastopol plant allocated the $27.15 million purchase price for the plant over 26 assets, including one asset denoted as a "processing plant building." In the acquisition of the Canton plant, the $10.5 million purchase price was allocated to only three assets classified into the three categories: (1) land, (2) improvements, and (3) machinery, equipment, furniture, and fixtures. In both acquisitions, Peco Foods agreed with the seller to an allocation of the total purchase price to certain assets "for all purposes (including financial accounting and tax purposes)." (4)

However, Peco Foods was unsatisfied with the depreciation expense available based on the allocations from the purchase agreements because most of the value was tied up in buildings with long useful lives. To meet its goals of greater cost recovery, the taxpayer sought the help of two third parties to perform cost-segregation studies on the plants.

The taxpayer's objective was to perform a lookback study on the properties previously purchased to claim depreciation not previously deducted. These catch-up deductions, which can be used on the current tax return without amending previous returns, require an automatic change in accounting method obtained by filing Form 3115, Application for Change in Accounting Method, with the taxpayer's current-year tax return.

Before the cost-segregation study and Form 3115 filing, Peco Foods had only 29 assets on its books from both acquisitions. After the study, there were well over 1,000 separately identifiable assets from the two plant purchases. As a great majority of the new assets had shorter useful lives than buildings, the upfront savings based on the additional depreciation were significant. Overall, the studies entitled Peco Foods to an additional $5,258,754 in depreciation from 1998 to 2002, which also resulted in immediate tax savings. (Of course, this is only a timing difference, as the overall depreciation would be the same under both methods.)

In 2008, the IRS issued a notice of deficiency stating that the taxpayer owed deficiencies of $120,751, $678,978, and $727,323 for the years 1997, 1998, and 2001, respectively, based primarily on the determination that Peco Foods was...