Maximizing Impact: Understanding Cost Segregation and the IRS Audit Technique Guide

The IRS Approach: Audit Technique Guides

When IRS agents assess a tax return, they often rely on a specific resource to determine its validity: the Audit Technique Guide (ATG). These guides are tailored to various industries, providing auditors with a deep dive into the financial practices and common issues within each sector, as outlined in the Internal Revenue Manual.

Numerous ATGs cover everything from tanning salons to construction auditing. Among these is the crucial guide on Cost Segregation, which the IRS takes very seriously and spans 261 pages of detailed guidance.

The Essence of Cost Segregation Audits

For building owners and investors, understanding the highlights of the Cost Segregation ATG is crucial. The guide is designed to assist IRS examiners in reviewing and examining cost segregation studies, helping them grasp:

• How these studies are prepared.
• Key aspects to focus on during review.
• When certain findings require further scrutiny.

Key Insights on Cost Segregation Studies

Cost segregation studies are complex and require meticulous attention. Here are some vital points:

• Construction projects invariably include elements of tangible personal property, such as carpeting and lighting fixtures, which can be classified as §1245 property.
• §1245 property refers to building components removable without damaging others or that supply utilities.
• Conversely, §1250 property includes structural components that cannot be accelerated for depreciation purposes.

Complexity in Detail

The intricacies of cost segregation demand careful consideration. For example:

• Studies might classify parts of a building's electrical system as both §1245 and §1250 property.
• The study will identify costs specific to components like branch circuits for §1245 property and allocate costs accordingly.
• For instance, if 15% of a building’s electrical distribution supports specialized equipment, that percentage is classified as §1245 property.

Defining a Quality Cost Segregation Study

A thorough cost segregation study should:

• Categorize assets into property classes.
• Provide a rationale, supported by legal citations, for asset classification as §1245 or §1250 property.
• Substantiate the cost basis and reconcile allocated costs with actual costs.

A quality study, characterized by accuracy and comprehensive documentation, minimizes the IRS audit burden. It should include these 13 principal elements:

1. Expertise and experience in preparation.
2. Detailed methodology description.
3. Appropriate documentation usage.
4. Interviews with relevant parties.
5. Common nomenclature adoption.
6. Standard numbering system.
7. Legal analysis explanation.
8. Unit cost determination.
9. Asset organization into groups.
10. Cost reconciliation.
11. Indirect cost treatment explanation.
12. Identification of §1245 property.
13. Consideration of related aspects (e.g., accounting changes).

Steps for Reviewing a Cost Segregation Study

1. Initial Risk Analysis: Weigh potential examination benefits against resource needs.
2. Verify and Reconcile: Ensure study results match the taxpayer’s depreciation records.
3. Conduct Risk Analysis: Evaluate audit potential and determine scope.
4. Request Additional Information: Gather supporting documents as needed.
5. Examination: Proceed if audit potential is identified.

Each study should conclude with a comprehensive report summarizing:

• Background of the property.
• Methodology explanation.
• Asset classification details.
• Applicable class lives and recovery periods.
• Classification rationale and authority.

In summary, understanding and conducting a quality cost segregation study is pivotal. Avoid "drive-through" studies and rely on experts who thoroughly comprehend the tax code and will be around to support their work in the future. A well-prepared study keeps the IRS at bay and ensures compliance with regulatory standards.