With the promise of tax reform on the horizon, financial services companies have perhaps more reason than ever to obtain cost segregation studies for their fixed assets. Fortunately, the Internal Revenue Service (IRS) recently updated guidance that provides critical insights on how its agents will examine such studies.
Banks will need cost segregation studies to support the accelerated deductions necessary to make the most of a declining tax rate environment. But studies that do not anticipate the issues IRS examining agents will probe could fall flat and lead to the loss of some valuable tax benefits.
The Role of Cost Segregation Studies
Very large capital expenditures often consist of several different types of assets with different depreciation recovery periods. Taxpayers therefore typically separate them into individual components or asset groups with the same recovery periods and placed-in-service dates to properly calculate depreciation. This approach is relatively straightforward when the actual costs of each are available. But if a taxpayer has only lump-sum costs, it might need to “segregate” (or allocate) costs to individual components of property – a process commonly known as a cost segregation study.
Conducting a cost segregation study allows a taxpayer to identify those components that qualify for shorter recovery periods, accelerated depreciation methods, and bonus depreciation. Accelerating deductions is especially important in a falling tax rate environment, as moving deductions from a future lower tax rate year to the current higher tax rate year provides savvy taxpayers with timing benefits and permanent tax rate benefits that together combine to reduce their overall effective tax rates.
In addition to the permanent tax benefit associated with claiming depreciation in a higher tax rate year, the deferred tax liability associated with the accelerated depreciation deductions will be lower. This situation makes cost segregation studies more appealing to banks than they would be in a normal, static tax rate environment.
The New IRS Guidance
In general, the previous cost segregation audit techniques guide (ATG) discussed the legal framework of tax depreciation, the various methodologies for cost segregation, the principal elements of a cost segregation study, and the review of a study by the examining agent.
The updated ATG includes several changes. For example:
- The legal framework discussion has been expanded, reorganized, and updated.
- The chapter on methodologies has been renamed Cost Segregation Approaches and has been updated and expanded with discussion of approaches related to acquired properties and site visits to properties.
- The discussion of the principal elements of a cost segregation study has been expanded in particular with regard to studies of acquired or used properties.
- In the chapter addressing review and examination of a cost segregation study, significant additional discussion was added related to the review of acquired properties and the issues around allocation of costs in real property transaction.
- The previous appendices have been recast as “Special Topics Chapters,” with entirely new Special Topic Chapters added for:
- A comparison of the inherently permanent standard as it relates to Internal Revenue Code Sections 168, 263A, and 199
- A discussion of bonus depreciation
In addition, in the fall of 2016, the IRS issued an updated cost segregation ATG on the capitalization of tangible property for its examiners. The cost segregation ATG updates also generally align with a closer relationship between cost segregation and the capitalization issues addressed in the capitalization of tangible property ATG, also issued by the IRS in 2016. In that ATG, the IRS stated that the acquisition, depreciation, improvement, restoration, adaptation, and disposition of a building and its structural components are interrelated. The audit of one aspect, therefore, must include consideration of the other aspects as well. Furthermore, the cost segregation ATG should be read in context with the tangible property ATG, which requires consideration of the entire life cycle of the asset at issue.
Worth the Investment
The potential tax benefits of obtaining cost segregation studies make the cost well worth it in a falling tax rate environment. But to have the best odds of surviving a challenge from the IRS, the study should take into account both the cost segregation and the tangible property ATGs.