[IMGCAP(1)]The IRS recently made it clear that even if taxpayers engage a third party to perform a cost segregation analysis, they cannot avoid penalties for aggressive positions taken in the cost segregation report.
The recently released Chief Counsel Memo #20125201F involved the issue of improperly classifying a parking deck as a 15-year land improvement instead of a 39-year building. A taxpayer had attended a presentation that addressed open-air parking structures in which the presentation slides indicated certain regulations “support the argument that parking structures belong in the land improvement category.”
The taxpayer hired the firm to conduct a cost segregation study and received a memo concluding that a parking structure generally does not meet the definition of a building. During an audit, the taxpayer argued there was reasonable cause to take this position because the extensive research conducted on the issue was “supported by the issuance of a study provided by a firm with technical expertise in the subject matter.” However, the study contained no analysis of the facts regarding the parking structure at issue.
The IRS Chief Counsel said the cost segregation study in question “lacks the factual information upon which its conclusions are based.” Based on these deficiencies, it was not reasonable for the taxpayer to have relied on the cost segregation study as a defense against an accuracy-related penalty. Under Section 6662 of the Tax Code, the negligence penalty is 20 percent of the underpayment in tax. This case further emphasizes the importance of using a trustworthy cost segregation firm that has significant experience dealing with IRS audits.
The taxpayer was a partner in an entity that was previously examined for the issue of open-air parking structures in which the IRS disallowed a 15-year recovery period. Under appeal, the IRS and the taxpayer reached a settlement on that issue. Under the more recent examination, the taxpayer placed a new parking structure into service and referred to it as “Parking Garage.” They hired a third party firm to conduct a cost segregation study. The taxpayer received a memo concluding that a parking structure generally does not meet the definition of a building. This suggestion came despite the discussion in the memo of the “function test” in Section 1.48-1(e), which states that a structure is a “building if its purpose is, for example, to provide parking.”
The memo acknowledges that in most cases, a parking structure will meet the “function test since parking is one of the enumerated purposes in the regulation,” but then incorrectly states that the appearance test is the “decisive factor” because a parking structure does not have walls or a roof, is open to the elements, and is not designed to provide shelter. The memo contains no discussion of the numerous cases that disregarded the appearance test over the function test, nor of the cases that have disregarded the argument that “walls” are necessary under the appearance test. Further, the applicable authorities are clear that a structure is not required to have walls to enclose its space.
The taxpayer provided a number of additional arguments to defend their position and avoid penalties. However, I believe the IRS was correct in their conclusion. The function test in Section 1.48-1(e) provides that a “building” generally means a structure, “the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as apartment houses, factory and office buildings, warehouses, barns, garages, railway or bus stations, and stores.” The purpose of the parking structure in this case was to provide parking, so it clearly meets the function test.
In 2009, the IRS released a coordinated issue paper (LMSB4-0709-029) regarding the applicable recovery period under Section 168(a) for open-air parking structures. The paper concluded that, based on Rev. Proc. 87-56 (Asset Class 00.3) and Section 1.48-1(e), an open-air parking structure is a building and therefore has a 39-year depreciable life. While this coordinate issue paper was released after the taxpayer filed its tax return, the cases and regulations upon which the coordinated issue paper is based existed well before the taxpayer filed their tax return and is authority for the purpose of evaluating reasonable basis.
This case emphasizes the risks of not using an established cost segregation firm with significant experience. Many careless cost segregation providers have taken the exact same position in their reports without advising their clients of the risk associated with it. The negligence penalty under Section 6662 explicitly excludes opinions rendered by tax professionals, so selecting the right cost segregation provider is critical. The only way to ensure a cost segregation provider meets the highest industry standards is asking them if they are a Certified Cost Segregation Professional, or CCSP, with the American Society of Cost Segregation Professionals. Any other credential is substandard. You should also request multiple references of clients that have gone through audit where IRS engineers actually reviewed the cost segregation study.
Gian Pazzia, CCSP, is a principal with KBKG and its National Practice Leader for Cost Segregation, as well as a subject matter expert on repair vs. capitalization issues. He currently serves on the board of directors of the American Society of Cost Segregation Professionals and has previously been chair of their Technical Issues Committee.