Following
the Tax Court decision regarding Hospital Corporation of America (HCA)
in 1997, the application of cost segregation methodology to all
commercial, industrial and retail facilities became widespread. Based
loosely on the provisions of the Investment Tax Credits of the late
1970s, cost segregation became a popular means for deferring a company’s
tax liability and providing a short-term cash flow increase. Recall
that the basic premise of cost segregation is to identify the elements
and/or systems of a facility that may be reclassified as personal or
land improvement property and depreciated at the appropriate accelerated
rate. The problem that arose immediately was the absence of a detailed
list of acceptable items eligible for accelerated depreciation. This
problem also presented obstacles for the Field Auditors of the IRS since
some of the segregated components were technical in nature – a fact
that was not lost on the Service.
To
combat this deficiency, the IRS prepared several Audit Guideline
Directives for their field inspectors to use in audits of specific
businesses (i.e. restaurants, automobile dealerships, pharmaceutical
companies and casinos/hotels). One of the major points presented by the
new guidelines included a requirement for the cost segregation study be
performed by an individual with expertise and experience in facility
design/construction and the tax law related to depreciation. This
provision detailed the qualifications of individuals performing a cost
segregation study and a detailed description of the methodology,
reconciliation of total costs, and the treatment/identification of
indirect costs among other things.
Cost
segregation has now evolved through the years as a method to depict a
company’s depreciation expense more accurately and to allow a business
to recover their investment costs in a more timely manner. Simply put,
cost segregation, when applied properly, allows a company to increase
its short-term expenses and simultaneously decrease their short-term tax
liability. By comparing the straight-line depreciation of a facility
versus a segregated depreciation distribution, a company can realize a
positive cash flow annually before the straight-line method exceeds the
segregated depreciation total on an annual basis. The cash flow is a
real cash savings in tax liability. It is helpful to keep in mind that
depreciation is not a cash transaction whereas the tax expenditures are,
thus creating a real cash flow that is cumulative until the
straight-line depreciation exceeds the segregation depreciation annual
amounts.
Business
owners would be well-advised to investigate the applicability of a cost
segregation study for their newly acquired properties (whether
constructed or purchased) as soon as is practical. The starting point is
to consult the company’s accounting firm to determine whether a study
makes sense and is practical in terms of timing.
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