Audit Guide – Ch. 6
Published on Monday 8, 2010 in Allen Consulting
UNIFORM CAPITALIZATION
INTRODUCTION
The allocation of project costs in cost segregation studies for self-constructed assets may be impacted by the Uniform Capitalization (UNICAP) rules of IRC § 263A(a). In addition, the interest capitalization rules of IRC § 263A(f) may also apply. A brief summary of these provisions is presented below.
APPLICATION OF THE CAPITALIZATION RULES UNDER IRC § 263A
The uniform capitalization (UNICAP) rules require the capitalization of all direct costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer. For purposes of the uniform capitalization rules, to “produce” means to construct, build, install, manufacture, develop, improve, create, raise or grow [§ 263A(g)(1); Treas. Reg. § 1.263A-2(a)(1)(i)]. Self-constructed assets and property built under contract are treated as property “produced” by the taxpayer and the rules under IRC § 263A(a) govern.
In addition, § 263A(f) requires the capitalization of interest expense when the taxpayer produces certain property. The interest capitalization rules under Treas. Reg. § 1.263A-8 contain precise definitions of designated property and include inherently permanent structures in the definition of real property. In summary, all real property and certain tangible personal property are subject to the interest capitalization rules. Therefore, any change in the allocation of costs between real and tangible personal property may have an impact on the amount of capitalized interest. Many taxpayers attempt to exclude all § 1245 property from interest capitalization arguing that the § 1245 property is tangible personal property that does not meet the classification thresholds of Treas. Reg. § 1.263A-8(b)(1). Most of the § 1245 property in these situations are inherently permanent structures (real property) subject to interest capitalization without any restrictions.
The following text summarizes the capitalization rules of § 263A(a) and the interest capitalization rules of § 263A(f). Further detail and updates can be obtained from the § 263A Technical Advisors.
Capitalization of Costs under IRC § 263A(a)
How does § 263A identify the costs subject to capitalization? As a threshold requirement, one must determine whether the costs would, but for § 263A, be otherwise deductible. A cost that is not otherwise deductible may not be allocated to property produced or acquired for resale.
In addition, any cost required to be capitalized under § 263A may not be included in inventory or charged to capital accounts or basis any earlier than the taxable year during which the amount is incurred within the meaning of § 1.446-1(c)(1)(ii).
What costs are capitalized under § 263A? Except as otherwise provided, direct and indirect costs that directly benefit or are incurred by reason of the performance of production or resale activities must be capitalized to the property produced or acquired for resale. For a producer the direct costs generally include direct material and direct labor. The regulations include examples of indirect costs [see § 1.263A-1(e)(3)(ii)]. Examples of indirect costs required to be capitalized are:
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bidding costs
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capitalizable service costs (including capitalizable mixed service costs)
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cost recovery allowances (however, remember depletion is only allocated to inventory produced and sold during the year)
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engineering and design
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employee benefit expenses
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handling costs
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indirect labor costs
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indirect material costs
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insurance
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interest (see special rules under § 263A(f))
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licensing and franchise costs
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officers’ compensation
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pension and other related costs
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purchasing costs
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quality control
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rent
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repairs and maintenance
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spoilage
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storage costs
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taxes
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tools and equipment
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utilities
Producers must capitalize costs (other than interest) whether incurred before, during, or after the production period of property. Interest is only capitalized during the production period of property. Pre-production costs are subject to capitalization if the property is held for future production or if it is reasonably likely that the property will be produced at a future date. Thus, costs of storing raw materials and carrying costs of realty held for development are required to be capitalized. Some issues may arise in determining the taxpayer’s intent and the taxpayer’s change in intent. Production period costs are costs incurred beginning on the date on which production of the property begins and ending on the date on which the property is ready to be placed in service or is ready to be held for sale. Post-production costs are costs incurred after the actual production and may include costs of storage, warehousing, insurance, materials, and handling.
Treas. Reg. § 1.263A-1(f) sets forth various detailed or specific cost allocation methods that a taxpayer may use to allocate direct and indirect costs to property produced. Under § 1.263A-1(f) a taxpayer may use a specific identification method, burden rate method, standard cost method, or any other reasonable method to allocate costs. In addition, in lieu of these methods, producer taxpayers may use the simplified production method provided in § 1.263A-2(b).
Capitalization of Interest under IRC § 263A(f)
Treas. Reg. §§ 1.263A-8 through 1.263A-15 provides guidance with respect to the capitalization of interest under IRC § 263A(f). These regulations are effective for 1995 and after, or at taxpayer’s election, 1994. For years prior to the final regulations, Notice 88-99, 1988-2 C.B. 422, and temporary regulations provide guidance with respect to the capitalization of interest.
Interest is capitalized with respect to each unit of designated property. Interest is capitalized during each computation period; the amount of interest that is capitalized is a function of two components:
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the amount of accumulated production expenditures; and,
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the amount of outstanding debt on each measurement date.
In determining the amount of outstanding debt, traced debt is considered first. The excess expenditure amount is the amount (if any) by which the accumulated production expenditures exceed the amount of traced debt. Interest on non-traced debt, up to the excess expenditure amount, must be capitalized, based upon a weighted average interest rate.
Designated property is defined in IRC § 263A(f)(1) and Treas. Reg. § 1.263A-8(b)(1). In general, §263A(f) applies to designated property. Designated property is any property that is produced and that is:
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real property; or,
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tangible personal property that meets any of the following classification thresholds:
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Property with a class life of 20 years or more that is not inventory in the hands of the taxpayer or a related person;
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Property with an estimated production period exceeding 2 years; or
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Property with an estimated production period exceeding 1 year and estimated cost of production exceeding $1,000,000.
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Note: All real property is subject to the rules of § 263A(f); the classification thresholds only apply to tangible personal property.
The classification thresholds are applied individually to each unit of property.
Treas. Reg. § 1.263A-8(c)(1) defines real property. Real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property, including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property. Unsevered natural products of land include growing crops and plants (that have a preproductive period in excess of 2 years), mines, wells, and other natural deposits. Real property includes the structural components of both buildings and inherently permanent structures.
Inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Examples are swimming pools, roads, bridges, tunnels, paved parking areas and other pavements, special foundations, wharves and docks, fences, inherently permanent advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and signals, telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment, grain storage bins and silos. For purposes of this section, affixation to real property may be accomplished by weight alone. [Treas. Reg. § 1.263A-8(c)(3)]
Property may constitute an inherently permanent structure even though it is not classified as a building for purposes of former IRC§ 48(a)(1)(B) and Treas. Reg. § 1.48-1. Any property not otherwise described in this paragraph (c)(3) that constitutes other tangible property under the principles of former IRC § 48(a)(1)(B) and Treas. Reg. § 1.48-1(d) is treated for the purposes of this section as an inherently permanent structure. [Treas. Reg. § 1.263A-8(c)(3)]
A structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. A structure may be an inherently permanent structure, and not property in the nature of machinery or essentially an item of machinery, even if the structure is necessary to operate or use, supports, or is otherwise associated with, machinery. [Treas. Reg. 1.263A-8(c)(4)]
CHANGE IN ACCOUNTING METHOD
INTRODUCTION
A taxpayers may conduct a cost segregation study on used property and then recompute its depreciation deductions for prior years. Examiners need to be aware of the potential issues relating to these recomputations, including changes in accounting method. This chapter provides a brief overview of the applicable law in this area.
HISTORICAL SERVICE POSITION
In general, it has been the long-standing position of the Service that, in the year an asset is placed in service, an accounting method is adopted relative to the depreciation method, recovery period, or convention for the depreciable property. In any subsequent year after the placed-in-service year, a change in depreciation method, recovery period, or convention resulting from a reclassification of such property, results in a change in method of accounting. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file Form 3115, Application for Change in Accounting Method), and the adjustment to income is made pursuant to IRC § 481(a). If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended returns or claims for adjustment, based on a cost segregation study performed after the original return was filed (for the placed-in-service year), should generally be disallowed on the basis that the taxpayer is attempting to make a retroactive method change.
RECENT LITIGATION
In recent years, the historical position of the Service was challenged in several court cases. The Fifth Circuit, affirming the Tax Court, held that the reclassification of gas station properties as 15-year property for MACRS purposes was not a change in accounting method requiring the Secretary’s consent [Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), aff’g T.C. Memo. 2001-150, reh’g denied (March 31, 2003)]. The Circuit Court agreed with the Tax Court that the then-existing regulations were meant to allow taxpayers to make temporal changes in their depreciation schedules without the consent of the IRS. The Court also affirmed that Brookshire’s change in the classification of its gas station properties from straight-line depreciation of non-residential real estate to declining balance depreciation of 15-year property was not a change in Brookshire’s method of accounting under IRC § 446.
The decision of the Fifth Circuit in Brookshire conflicts with the opinion of the Tenth Circuit in Kurzet v. Commissioner, 222 F.3d 830, 842-845 (10th Cir. 2000). In Kurzet, the taxpayer sought to change the classification of a reservoir from nonresidential real property to 15-year property under § 168, thereby resulting in a change in recovery period from 31.5 years to 15 years. The taxpayer did not change the method of depreciation for the reservoir, which was the straight-line method of depreciation. Although the Tenth Circuit found “some persuasive value to the [taxpayer’s] argument that a change in recovery period under MACRS should be treated like a change in useful life,” the court concluded that the Commissioner’s interpretation of § 1.446-1(e)(2)(ii) as requiring a taxpayer to obtain permission for a change in recovery period is not “plainly erroneous” or “inconsistent” with § 1.446-1(e)(2)(ii).
In addition, the Tax Court in Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349, 410-411 (1981), held that a change in depreciation method resulting from a reclassification of depreciable property from section 1250 property to section 1245 property is a change in method of accounting. In reaching its decision, the court cited to §§ 1.167(e)-1 and 1.446-1(e)(2)(ii)(a), and explained “It is unquestioned that a change in the method of computing depreciation is a change in method of accounting.” Id. at 410. (But see, Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, which followed Brookshire by holding that a change in computing depreciation from the general depreciation system in § 168(a) (GDS) to the alternative depreciation system in § 168(g) (ADS) is not a change in method of accounting, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003), rev’g in part 2002-1 U.S.T.C. (CCH) ¶ 50,235 (D. Minn. 2001), which also followed Brookshire by holding that a change in classification under MACRS is not a change in method of accounting.)
NEW REGULATIONS
Clearly, this area of law has been unsettled in recent years, due to the conflicting court opinions. However, new regulations covering this issue have been promulgated. Treas. Reg. § 1.446-1T(e)(2)(ii)(d)(2)(i), effective for taxable years ending on or after December 30, 2003, provides that a change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset is a change in method of accounting. See Example 9 of Treas. Reg. § 1.446-1T(e)(2)(iii), which specifically relates to changes based on a cost segregation study. On January 28, 2004, Chief Counsel Notice CC-2004-007 was issued, setting forth Chief Counsel’s Change in Litigating Position on the application of § 446(e) to changes in computing depreciation. It provides, in relevant part:
The Service’s position continues to be that a change in computing depreciation under section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or ACRS generally is a change in method of accounting under section 446(e) for which the consent of the Commissioner of Internal Revenue is required. However, for depreciable or amortizable property placed in service by the taxpayer in taxable years ending before the effective date of Treas. Reg. § 1.446-1T(e)(2)(ii)(d), the Service will not assert that a change in computing depreciation under section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or ACRS for depreciable or amortizable property that is treated as a capital asset under the taxpayer’s present and proposed methods of accounting is a change in method of accounting under section 446(e). Consequently, if, for example, a taxpayer completes a cost segregation study in 2004 for its MACRS property placed in service in 2001 and, as a result, reclassifies that property from nonresidential real property to 15-year property under section 168(e), the Service will not assert that the change in computing depreciation resulting from this reclassification is a change in method of accounting under section 446(e) and, accordingly, the taxpayer may file amended federal tax returns for 2001 and any affected subsequent taxable year to effect this change in computing depreciation. Alternatively, the taxpayer may treat this change in computing depreciation as a change in method of accounting and, thus, file a Form 3115 under new section 2.01 of the Appendix of Rev. Proc. 2002-9 for the current taxable year (provided the filing requirements of Rev. Proc. 2002-9 are met, and the taxpayer and the property are within the scope of Rev. Proc. 2002-9 and new section 2.01 of the Appendix of Rev. Proc. 2002-9).
Similarly, if, for example, the same cost segregation study determined that some of the taxpayer’s MACRS property that is reported as being placed-in-service by the taxpayer in 2002 was actually placed-in-service by the taxpayer in 2001, the Service will not litigate whether or not the change in computing depreciation resulting from this change in placed-in-service date is a change in method of accounting under section 446(e) and, accordingly, the taxpayer may file amended federal tax returns for 2001 and any affected subsequent taxable year to effect this change in computing depreciation. Alternatively, the taxpayer may treat this change in computing depreciation as a change in method of accounting and, thus, file a Form 3115 under Rev. Proc. 97-27, 1997-1 C.B. 680, for the current taxable year (provided the filing and scope limitations of Rev. Proc. 97-27 are met). New sections 2.01, 2.02, and 2B of the Appendix of Rev. Proc. 2002-9 do not apply to a Form 3115 filed for taxable years ending on or after December 30, 2003, for a change in computing depreciation resulting from a change in placed-in-service date. This change in the Service’s litigating position does not apply to an adjustment in useful life under section 167 (other than under MACRS, section 1400I, section 1400L, or ACRS) if the useful life is not specifically assigned by the Internal Revenue Code, the regulations thereunder, or other guidance published in the Internal Revenue Bulletin, to any adjustment to correct an incorrect classification or characterization of depreciable property for which depreciation is determined under Treas. Reg. § 1.167(a)-11 (CLADR property), or to a change in computing depreciation or amortization due to a posting error, a mathematical error, a change in underlying facts (other than a change in the placed-in-service date), a change in use of property in the hands of the same taxpayer, the making of a late election, or a revocation of an election. These changes in depreciation or amortization are not a change in method of accounting. Accordingly, field personnel should consult with their local Chief Counsel attorneys when a taxpayer asserts that such a change is a change in method of accounting.
Similarly, the change in the Service’s litigating position does not apply to a change in the treatment of property from a non-capital asset (for example, inventory, materials and supplies) to a capital, depreciable or amortizable asset (or vice versa), or to a change from expensing the cost of depreciable or amortizable property to capitalizing and depreciating or amortizing such cost (or vice versa). These changes are a change in method of accounting under section 446(e). Accordingly, field personnel should consult with their local Chief Counsel attorneys when a taxpayer asserts that these changes are not a change in method of accounting.
LOOK-BACK STUDIES
Taxpayers may prepare cost segregation studies on existing assets and recompute depreciation for prior tax years based on the reallocated asset costs. In some cases, the taxpayer may file amended returns (claims) for the prior years and, in other cases, the taxpayer may simply deduct the additional depreciation from prior years on the first return filed after the study is complete. Neither of these actions is proper, given the Service position that changes to the recovery period resulting from the reclassification of assets constitutes a change in accounting method. However, see Notice CC-2004-007 (January 28, 2004), quoted on page 6.2-2 of this Appendix.
The correct procedure for a taxpayer to change its accounting method is the timely filing of Form 3115, Request for Change in Accounting Method. Pursuant to Revenue Procedure 2002-9, 2002-3 I.R.B. 327, a taxpayer may request automatic consent for the change. Revenue Procedure 2004-11 modifies Rev. Proc. 2002-9 and other revenue procedures to conform with § 1.446-1T(e)(2)(ii)(d) of the temporary Income Tax Regulations. Although Form 3115 is subject to National Office review, it is generally the responsibility of the examiner to verify the accuracy of the § 481(a) adjustment at the time of the examination. A Schedule M-1 adjustment may also be an indication of the taxpayer’s change in accounting method. The examiner should evaluate the need to review the study that formed the basis for the depreciation recomputations and the resultant change in accounting method.
If the years the assets were placed in service end before December 30, 2003, and are still open under statute, taxpayers may file amended returns to correct the depreciation deductions for those years. They may also file a Form 3115 as a “protective” measure. In either case, the issue would generally warrant examination.
Table 1 to this appendix provides a listing of revenue procedures that are most frequently used by taxpayers to implement accounting method changes based on cost segregation studies. Taxpayers generally argue that they are simply reclassifying property placed in service in prior years to “correct” class lives. This results in recovery period, depreciation method, and convention changes. The following is a list of the more common compliance issues involving accounting method changes.
1. Compliance issues for non-automatic method changes made using Rev. Proc. 97-27, 1997-1 C.B. 680, or Rev. Proc. 92-20, 1992-1 C.B. 685:
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Was the accounting ruling letter properly applied?
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Was the §481(a) adjustment amount determined correctly?
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Did the taxpayer change to a proper method of accounting?
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Was a TAM obtained in a situation where an accounting ruling letter is to be modified or revoked (correcting the §481(a) adjustment amount is not a modification of the ruling letter)?
2. Compliance issues for automatic method changes made using Rev. Proc. 96-31, 1996-1 C.B. 714; Rev. Proc. 97-37, 1997-2 C.B. 455; Rev. Proc. 98-60, 1998-2 C.B. 761; Rev. Proc. 99-49, 1999-2 C.B. 725; Rev. Proc. 2002-9, 2002-1 C.B. 327; or Rev. Proc. 2004-11:
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Was the change made within the scope of the procedure?
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Was the change from an impermissible to a permissible method?
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Were all the applicable provisions properly applied?
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Was the §481(a) adjustment amount determined correctly?
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Was a change made to a proper method?
SUMMARY AND CONCLUSIONS
It is the position of the Service that a change in recovery period is a change in accounting method. Accordingly, a taxpayer is required to obtain the consent of the Commissioner by filing a timely Form 3115. However, the issue regarding a change in accounting method with respect to the recomputation of depreciation (e.g., those based on cost segregation studies) is quite complex. Examiners should consult Notice CC-2004-007 (January 28, 2004) and Treas. Reg. § 1.446-1T(e), and contact the Change in Accounting Method Technical Advisors for ongoing developments in this area. Examiners should also contact the Change in Accounting Method Technical Advisors for assistance regarding ongoing developments in this area, as well as determining the taxpayer’s compliance with the proper procedures for changing the accounting method and computing the adjustment pursuant to IRC § 481(a).
DEPRECIATION OVERVIEW
INTRODUCTION
In order to compute depreciation using proper class lives and recovery periods, assets must be assigned to the proper asset classes. Cost segregation studies generally produce listings or groups of assets, based on asset classes under ACRS (Accelerated Cost Recovery System) or MACRS (Modified Accelerated Cost Recovery System). This chapter provides a summary of the applicable authorities and available guidelines for classifying property into its appropriate class.
HISTORICAL BACKGROUND – A BRIEF RECAP
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Pre-ACRS/ MACRS Depreciation Methods – Prior to 1981
Prior to the enactment of ACRS in 1981, depreciation deductions were generally calculated by applying the appropriate depreciation method to the basis, useful life, and salvage value of the asset. Taxpayers were permitted to use component depreciation, whereby assets were segregated into separate components with different useful lives, which were depreciated separately. Alternatively, taxpayers could elect to use the Asset Depreciation Range (ADR) system for computing depreciation deductions. Property was generally classified as either § 1245 or § 1250 property, based on the rules governing Investment Tax Credit (ITC), pursuant to Code § 48 and the regulations thereunder. -
ACRS /MACRS Depreciation Methods – Post-1980
Following the enactment of the ACRS depreciation system in 1981, component depreciation was specifically prohibited. The Service position has been that this prohibition continued under the MACRS depreciation system, enacted in 1986. Generally, ACRS is effective for property placed in use between 1981 and 1986, and MACRS is effective for property placed in use after 1986. -
Hospital Corporation of America, Inc. v. Commissioner, 109 T.C. 21 (1997) (“HCA”)
In HCA, the Tax Court concluded that the taxpayer was permitted to apply ITC principles to classify property as either § 1245 property or § 1250 property for purposes of determining asset classes and recovery periods under ACRS and MACRS. In effect, the HCA decision has reinstated a form of component depreciation. -
Action on Decision (AOD) Number CC-1999-008
In Action on Decision (AOD) Number CC-1999-008, the Service acquiesced to the application of ITC principles in the HCA case. However, the Service did not acquiescence to the particular results in this case (i.e., the Service did not agree with the classification of specific assets as qualifying § 1245 property). -
Use of Cost Segregation Studies to Compute Depreciation Deductions
Based on these developments, the use of cost segregation studies by taxpayers to accelerate depreciation deductions is expected to increase. The assignment of assets to the appropriate asset class is critical in determining the proper recovery period and, accordingly, the amount of depreciation.
GUIDELINES FOR THE CLASSIFICATION OF ASSETS – MACRS
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MACRS Rules – IRC § 168
Code § 168(e) specifies the classification of property for purposes of computing the cost recovery allowance provided by MACRS. Property is classified according to class life as determined in Revenue Procedure 87-56, 1987-2 C.B. 674, unless statutorily classified otherwise in § 168. There are no other exceptions. (Refer to the more detailed discussion of Rev. Proc. 87-56 on page 6.3-3, Item 4). -
Asset Guideline Class
Code § 168(i)(1) establishes the class life for assets, as defined in Code § 167(m) which, in turn, refers to Regulations § 1.167(a)-11 for rules regarding the classification of property under the class life system. Reg. § 1.167(a)-11(b)(4)(iii)(b) states that the selection of the appropriate asset guideline class is based on the business activity in which the asset is primarily used. -
General Depreciation System (GDS) and Alternative Depreciation System (ADS)
Under MACRS, taxpayers must generally use the General Depreciation System (GDS), unless specifically required by law to use the Alternative Depreciation System (ADS), or unless the taxpayer elects to use ADS. (Refer to IRC §§ 167 and 168, as well as IRS Publication 946, How to Depreciate Property, for additional details and explanations.)A. GDS (General Depreciation System)
The GDS system contains nine property classes, based on the recovery period of an asset (3, 5, 7, 10, 15, 20, 25, 27.5, or 39 years). The taxpayer may generally utilize the 200% declining balance method, 150% declining balance method, or straight-line method for computing depreciation for most GDS property. However, 27.5-year property (residential rental property) and 39-year property (non-residential real property) must be depreciated using straight-line depreciation.B. ADS (Alternative Depreciation System)
The ADS system must be used for the following property:-
Listed property used 50 % or less for business;
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Tangible property used predominantly outside the U.S. during the year;
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Tax-Exempt use property;
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Tax-Exempt bond financed property; and
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Property used predominantly in a farming business and placed in service in any tax year during which an election has been made not to apply the uniform capitalization rules to certain farming costs.
The use of ADS may also be elected for any property eligible for depreciation under GDS. The recovery periods under ADS are generally longer than the recovery periods under GDS, and straight-line methods must be used.
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Revenue Procedure 87-56, 1987-2 C.B. 674
Revenue Procedure 87-56 contains the “Table Of Class Lives And Recovery Periods,” which is reproduced as “Table B” in IRS Publication 946, “How to Depreciate Property.” This table provides guidance as to the classification of assets and for the determination of the proper recovery period. -
IRS 6 Publication 946, “How to Depreciate Property”
Publication 946 explains how to compute depreciation deductions. Appendix B in the publication reproduces the “Table Of Class Lives And Recovery Periods” from Rev. Proc. 87-56, which provides guidance for classifying an asset according to the business activity in which the asset is primarily used.The publication divides the table into two sections (Tables B-1 and B-2). Both tables must be consulted in determining the correct recovery period for specific assets. Table B-1, Specific Depreciable Assets Used In All Business Activities, Except As Noted, generally lists assets used in all business activities. Table B-2, Depreciable Assets Used In The Following Activities, lists assets used in certain activities, as described therein.
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How to Use Table B (Publication 946)
In general, if the property is described in Table B-1, the recovery period shown in that table is the recovery period for the asset. However, if the property is specifically listed in Table B-2 under the type of activity in which the asset is used, the recovery period listed under the activity in Table B-2 should be used. Further direction on the use of these tables is explained below.(a) Table B-1, Specific Depreciable Assets Used In All Business Activities, Except As Noted
First, check Table B-1 to see if it contains a description of the asset in question. If the subject asset is described in Table B-1, then check Table B-2 to find the activity to which the property relates or in which it is being used. If the activity is described in Table B-2, read the text (if any) under the title to determine if the property is specifically included in the asset class listed in Table B-2. If it is, then use the recovery period shown in the appropriate column of Table B-2 following the description of that activity. If the activity to which the property relates is not described in Table B-2, then use the recovery period shown in the appropriate column following the description of the property in Table B-1. Also, if the activity is described in Table B-2, but the property either is not specifically included in or is specifically excluded from that asset class, then use the recovery period shown in the appropriate column following the description of the property in Table B-1.
(b) Table B-2, Depreciable Assets Used in the Following Activities
If the asset is not listed in Table B-1, then check Table B-2 to find the activity to which the property relates or in which the property is primarily being used, and use the recovery period shown in the appropriate column following the asset description.
(c) Property not in either table
If the property is not listed in Table B-1 and the activity to which it relates is not included in Table B-2, then check the end of Table B-2 to find “Certain Property for which Recovery periods Assigned (Personal Property/Section 1245 Real Property With No Class Life).” Property in this category generally has a recovery period of 7 years for GDS or 12 years for ADS. For residential rental property, and nonresidential real property, see Appendix A in Publication 946. -
Examples (from Publication 946, Appendix B)
The following examples appear in Appendix B of Publication 946, and illustrate the use of these tables for determining the proper asset recovery period.
(a) Example 1
Richard Green is a paper manufacturer. During the year, he made substantial improv 0fe6 ements to the land on which his paper plant is located. He checks Table B-1 and finds land improvements under Asset Class 00.3. He then checks Table B-2 and finds his activity, paper manufacturing, under Asset Class 26.1, Manufacturer of Pulp and Paper.If Richard had looked only at Table B-1, he would have incorrectly selected Asset Class 00.3, Land Improvements, and incorrectly used a recovery period of 15 years for GDS or 20 years for ADS. However, Richard uses the recovery period under Asset Class 26.1, because it specifically includes land improvements. The land improvements have a 13-year class life and a 7-year recovery period for GDS. If he elects to use ADS, the recovery period is 13 years.
[Note: It is presumed in this example that the subject land improvements are directly associated with the factory site or production process, in the likeness of effluent ponds or canals necessitated by the production process, or parking lots utilized by employees directly involved with the production process. Those land improvements that are more closely associated with non-production activities, such as administrative or retail activities of the taxpayer, would fall into Asset Class 00.3 and have a 15-year recovery period under GDS. See Revenue Ruling 2003-81, 2003-2 C.B. 126, discussed in section 9 of this chapter.]
(b) Example 2
Sam Plower produces rubber products. During the year, he made substantial improvements to the land on which his rubber plants are located. He checks Table B-1 and finds land improvements under Asset Class 00.3. He then checks Table B-2 and finds his activity, producing rubber products, under Asset Class 30.1, Manufacture of Rubber Products. Reading the headlines and descriptions under Asset Class 30.1, Sam finds that it does not include land improvements. Therefore, Sam uses the recovery period under Asset Class 00.3. The land improvements have a 20-year class life and a 15-year recovery period for GDS. If he elects to use ADS, the recovery period is 20 years.(c) Example 3
Pam Martin owns a retail-clothing store. During the year, she purchased a desk and a cash register for use in her business. She checks Table B-1 and finds office furniture under Asset Class 00.11. Cash registers are not specifically listed in any of the asset classes in Table B-1. She then checks Table B-2 and finds her activity, retail store, under Asset Class 57.0, Distributive Trades, and which includes assets used in wholesale and retail trade. This description for this asset class does not specifically list office furniture or a cash register.She looks back at Table B-1 and uses Asset Class 00.11 for the desk, since it constitutes office furniture. The desk has a 10-year class life and a 7- year recovery period for GDS. If she elects to use ADS, the recovery period is 10 years. For the cash register, Pam uses Asset Class 57.0, because cash registers are not specifically listed in Table B-1 but are assets used in retail business. Accordingly, the cash register has a 9-year class life and a 5-year recovery period for GDS. If she elects to use the ADS method, the recovery period is 9 years.
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General Rules for Classifying Assets
In most cases, a single industry asset guideline class will cover all the production machinery and equipment that is typically used in that particular industry. Asset Guideline Classes 1.1 through 80.0 (Table B-2) list depreciable assets used in specific, primary business activities (the “activity” category).Specific depreciable assets used in and common to all business activities (the “asset” category) cross all industry lines and are covered by Asset Guideline Classes 00.11 through 00.4 (Table B-1). For most taxpayers, three or four asset class guidelines will encompass all of their depreciable assets, such as autos, computers, and furniture & fixtures. The rule is that these classes (from Table B-1) must be applied first 04fd to determine the asset classification before applying and determining the primary business asset class (the “activity” category).
The exception to this rule is that certain activity categories, such as those described in Asset Classes 48.11 and 57.1, specify the assets that are section 1245 or section 1250 property. Other activity classes, such as Asset Class 28.0, include all land improvements, which takes priority over the asset category, such as Asset Class 00.3. [Note: As in Example 1 on page 6.3-5, only those land improvements associated with the plant site or production process, such as effluent ponds and canals, should be included in Asset Class 28.0. General land improvements, such as parking lots, should be included in Asset Class 00.3.]
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Application of Asset Classification Rules
Asset classification pursuant to the rules in Rev. Proc. 87-56 is not always a straight-forward determination, particularly where the taxpayer is involved in a number of related business activities. The proper steps to follow in assigning assets to the appropriate asset or activity or class may be summarized as follows:
1. Ascertain and fully understand the primary business activity of the taxpayer.
2. Determine the specific function and use of the assets in the taxpayer’s business.
3. Apply the clear and plain language contained in the asset guideline classes of Rev. Proc. 87-56 with respect to the assets in question.The application of these steps may be illustrated by the analysis used in a sampling of court cases, private letter rulings, and revenue rulings, which are summarized below. The analysis in each citation is based on a strict reading of Rev. Proc. 87-56, including historical reference to original asset and activity class descriptions from which later classes have been derived. Note that, for those instances in which a taxpayer was permitted to use an asset class that was different from its primary business activity, the taxpayer was able to demonstrate that it did, in fact, have a separate trade or business for that property item.
Revenue Ruling 77-476, 1977-2 C.B. 5
Conclusion: The primary business activity of the taxpayer determines the appropriate activity class.
Analysis: An oil pipeline owned by an electric utility company and used to transport oil between the company’s dock and its inland generating facility is “public utility property” (Asset Guideline Class 49.13, Electric Utility Steam Production Plant). Since the taxpayer is not in the trade or business of transporting oil by pipeline, the pipeline should not be classified as “pipeline transportation property” (Asset Guideline Class 46.0, Pipeline Transportation).
Revenue Ruling 80-127, 1980-1 C.B. 53
Conclusion: Assets specifically excluded from a certain activity class must be classified in the appropriate asset class.
Analysis: The taxpayer leases shipping containers to a shipping company. The containers are designed to transport cargo over the road on trailers and by water on cargo ships and should be classified in Asset Guideline Class 00.27, which includes “trailer-mounted containers.” Activity Guideline Class 44.0, Water Transportation, which describes assets used in the commercial and contract carrying of freight by water, specifically excludes assets included in classes with a 00.2 prefix. (Note: the result would be the same if the shipping company owned the containers.)
Private Letter Ruling 9101003 (Sept. 25, 1990)
Conclusion: Property is classified according to the primary business activity of the taxpayer, even though the activity in which such property is primarily used is insubstantial in relation to all the taxpayer’s activities. In determining the primary business activity included in a current activity class, it is helpful and appropriate to analyze the historic business activities included in the classes from which it is derived.
Analysis: The taxpayer’s business activities include the acquisition, processing, and sale of various types of scrap materials. Asset Guideline Class 57.0, Distributive Trades and Services, includes assets used in wholesale and retail trade. The description for this class includes no further detail. However, the predecessor to Asset Guideline Class 57.0 included Asset Guideline Class 50.0, Wholesale and Retail Trade, which included assets used in the acquisition and processing of goods at both the wholesale and retail level. The description for Asset Guideline Class 50.0 also specifically referenced the brokerage of scrap metal and various pre-sale processing activities.
Private Letter Rulings 9502001, 9502002, and 9502003 (June 30, 1994)
Conclusion: Property is included in the asset class in which the property is primarily used, even if it is used in more than one activity or the activity is not specifically defined.
Analysis: The taxpayer uses a factory trawler to harvest and process various species of fish. There is no specific Asset Guideline Class for the fishing industry. Asset Guideline Class 20.4 covers the Manufacture of Other Food and Kindred Products, but does not specifically list water vessels. However, Asset Guideline Class 00.28 includes Vessels, Barges, Tugs, and Similar Water Transportation. Accordingly, the trawler is a specific asset described in Asset Guideline Class 00.28, which includes all water vessels without regard to the business activity.
Private Letter Ruling 9548003 (July 31, 1995)
Conclusion: Assets engaged in more than one activity must be classified to the activity in which they are primarily used.
Analysis: The taxpayer is a public utility company supplying electric and gas utility service. Through a number of subsidiaries, the taxpayer also owns and operates several natural gas gathering systems, processing plants, and pipeline systems. Most of the pipelines are not connected to the taxpayer’s processing plants; thus, the taxpayer is engaged in two separate business activities. The gathering pipelines are appropriately included in Asset Class 46.0 (Pipeline Transportation), while the processing plants are included in Asset Class 49.23 (Natural Gas Production Plant).
Duke Energy Natural Gas Corporation v. Commissioner, 109 T.C. 416 (1997), rev’d, 172 F.3d 1255 (10th Cir. 1999), nonacq., 1999-2 C.B. xvi.
Conclusion: The class life of an asset is based on the asset’s primary use in relationship to the classes in question.
Analysis: The taxpayer was a natural gas corporation. At issue was the classification of its natural gas gathering systems as either assets used in the production of gas or assets used in the transportation of gas. It was determined that the plain language of the asset descriptions supported the contention that the gathering systems constituted assets used in the taxpayer’s production of natural gas.
Saginaw Bay Pipeline Co., et al v. United States, 124 F. Supp. 2d 465 (E.D. Mich. 2001), rev’d and rem’d, 2003 FED App. 0259P (6th Cir.) (No. 01-2599)
Conclusion: The proper asset class is determined by the use of the property rather than the activity of the owner of the property.
Analysis: The 6th Circuit held that, because the taxpayer’s underground natural gas pipelines were used primarily by natural gas producers and functioned as gathering pipelines in the natural gas production process, the taxpayer’s underground natural gas pipelines are includible in Asset Class 13.2. The 6th Circuit reached this result, even though the taxpayer was not a producer of natural gas (that is, not engaged in the activity described in Asset Class 13.2).Â
Clajon Gas Co. LP, et al v. Commissioner, 119 T.C. 197 (2002), rev’d, 2004 U.S. App. LEXIS 284 (8th Cir. Mo. Jan. 12, 2004)
Conclusion: Classification of property as to the proper asset class is based on the use of the property in a manner as described in an asset class.
Analysis: The taxpayer was not a natural gas producer and the taxpayer used the gathering lines to transport gas. At issue was the classification of taxpayer’s gathering lines as either assets includible in Asset Class 13.2 (Exploration for and Production of Petroleum and Natural Gas Deposits), which has a MACRS recovery period of 7 years, or Asset Class 46.0 (Pipeline Transportation), which has a MACRS recovery period of 15 years. The 8th Circuit determined that Clajon primarily used the gathering system in a manner consistent with the description of Asset Class 13.2 (i.e., as gathering pipelines). The descriptive language of the asset class does not require that the producer be the owner of the gathering system assets. The result is that there is no distinction between the gathering system assets of producers and nonproducers, for purposes of depreciation deductions.
Revenue Ruling 2003-81, 2003-2 C.B. 126
Conclusion: An asset included in both an asset category and an activity category is placed in the asset category, unless it is specifically excluded from the asset category or specifically included in the activity category. [Reference is to Norwest Corporation & Subsidiaries v. Commissioner, 111 T.C. 105 (1998).]
Analysis: The taxpayer was engaged in the business activity of producing and selling electricity generated from steam, which is described in activity class 49.13, Electric Utility Steam Production Plant.
A workbench used to repair machinery and equipment damaged during the production of electricity was classified in activity class 49.13, because it was used in the activity described in that class and not specifically included in another asset class.
A bookcase used to hold training manuals and operation protocols was classified in asset class 00.11 (even though it was used in connection with the taxpayer’s business activity of producing electricity) because it is not specifically excluded from asset class 00.11 or specifically included in asset class 49.13.
Parking Lot A, located outside the plant facility and used by employees at the plant, was classified in asset class 49.13, because that asset class specifically includes land improvements that are related to assets used in the production of electricity from steam. Although asset class 00.3, Land Improvements, also includes parking lots, it specifically excludes land improvements that are explicitly included in any other asset class.
Parking Lot B, located 100 miles away from the plant and adjacent to the corporate headquarters, was classified in asset class 00.3. This parking lot was used by employees at the headquarters office and was not related to the activity of producing the electricity. Therefore, it did not constitute a land improvement related to assets used in the production of electricity from steam and the proper classification was in the asset category, rather than the activity category.
RELEVANT COURT CASES
INTRODUCTION
This chapter is intended to assist examiners in determining whether certain assets constitute § 1245 or § 1250 property. In addition to the legal framework presented in Chapter 2, the court cases listed below provide further guidance. Although the issue in many of the cited cases below relates to ITC, these cases remain important in determining whether property constitutes § 1245 property for purposes of ACRS and constitutes tangible personal property for purposes of MACRS. Hospital Corporation of America and Subsidiaries v. Commissioner, 109 T.C. 21, 54-55 (1997), acq. on this issue and nonacq. on other issues, 1999-2 C.B. xvi.
Unfortunately, there are no bright-line tests for distinguishing § 1245 property from § 1250 property. All of the cases are factually intensive and quite often the opinions of the courts conflict. Therefore, the examiner’s ultimate determination generally cannot be based merely upon reading one case. In addition to reading all the cases on point, the Service’s position must be reviewed and followed; as well, the examiner must also consider whether the Service has acquiesced to a particular position or case.
CASE CITATIONS
A.C. Monk & Co. v. United States, No. 78-126-CIV-4, 1981 U.S. Dist. LEXIS 17764 (E.D.N.C. Mar. 30, 1981), aff’d in part, rev’d in part, vacated and rem’d, 686 F.2d 1058 (4th Cir. 1982), on remand, 577 F. Supp. 4 (E.D.N.C. 1983).
Albertson’s v. Commissioner, 94-1 U.S. Tax Cas. (CCH) P50,016; 73 A.F.T.R.2nd (RIA) 558 (9th Cir. 1993); rev’g. 95 T.C. 415 (1990).
Boddie-Noelle Enters. v. United States, 96-2 USTC ¶ 50,627 (Fed. Cl. 1996), aff’d without published opinion, 132 F. 3d 54 (Fed. Cir. 1997).
Central Citrus Co. v. Commissioner, 58 T.C. 365 (1972).
Circle K Corp. v. Commissioner, T.C. Memo. 1982-298.
Consolidated Freightways, Inc. v. Commissioner, 74 T. C. 768 (1980), aff’d in part and rev’d in part, 708 F.2d 1385 (9th Cir. 1983).
Consolidated Freightways, Inc. v. United States, 79-2 USTC ¶ 9440 (Ct. Cl. 1979).
Consolidated Freightways, Inc. v. United States, 620 F.2d 862 (Ct. Cl. 1980).
Dixie Manor, Inc. v. United States, 79-2 USTC ¶ 9469 (W.D. Ky. 1979), aff’d, 81-1 USTC 9332 (6th Cir. 1981).
Duaine v. Commissioner, T.C. Memo. 1985-39.
Grinalds v. Commissioner, T.C. Memo. 1993-66.
Hospital Corp. of Am. & Subs. v. Commissioner, 109 T. C. 21 (1997), acq. in part and nonacq. in part, 1999-2 C.B. xvi.
Illinois Cereal Mills, Inc. v. Commissioner, T.C. Memo. 1983-469, aff’d, 789 F.2d 1234 (7th Cir. 1986), cert. denied, 479 U.S. 995 (1986).
King Radio Corp. v. United States, 486 F.2d 1091 (10th Cir. 1973), aff’g D.C. No. KC-3320).
La Petite Academy v. United States, 95-1 USTC ¶ 50,193 (W.D. Mo. 1995), aff’d in unpublished opinion, 72 F.3d 133 (8th Cir. 1995).
L.L. Bean, Inc. v. Commissioner, T.C. Memo. 1997-175, aff’d, 145 F.3d 53 (1st Cir. 1998).
Mallinckrodt, Inc. v. Commissioner, T.C. Memo. 1984-532, aff’d, 778 F.2d 402 (8th Cir. 1985).
McManus v. United States, 700 F. Supp. 994 (W.D. Wis. 1987), aff’d, 863 F.2d 491 (7th Cir. 1988).
Metro Nat’l Corp. v. Commissioner, T.C. Memo. 1987-38.
Minot Fed. Sav. & Loan Ass’n v. United States, 313 F. Supp. 294 (D.N.D. 1970), aff’d, 435 F.2d 1368 (8th Cir. 1970).
Morrison, Inc. v. Commissioner, T.C. Memo. 1986-129, aff’d, 891 F.2d 857 (11th Cir. 1990).
Munford, Inc. v. Commissioner, 87 T.C. 463 (1986), aff’d, 849 F.2d 1398 (11th Cir. 1988).
Piggly Wiggly Southern, Inc. v. Commissioner, 84 T.C. 739 (1985), aff’d, 803 F.2d 1572 (11th Cir. 1986), nonacq., 1988-2 C.B. 1.
Publix Supermarkets, Inc. v. United States, 92-1 USTC ¶ 50,240 (Cl. Ct. 1992).
Schrum v. Commissioner, T.C. Memo. 1993-124, aff’d in part and vacated in part, rem’d, 33 F.3d 426 (4th Cir. 1994), on remand, T.C. Memo. 1995-103, aff’d in part and vacated in part without published opinion, 114 F.3d 1177 (4th Cir. 1997).
Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980).
Shoney’s South, Inc. v. Commissioner, T.C. Memo. 1984-413, action on dec., 1986-048 (September 19, 1986).
Texas Instruments Inc. v. Commissioner, T.C. Memo. 1992-306.
Walgreen Co. & Subs. v. Commissioner, 103 T.C. 582 (1994), rev’d, rem’d, 68 F.3d 1006 (7th Cir. 1995), supplemental op., T.C. Memo. 1996-374.
Westroads, Inc. v. Commissioner, 69 T.C. 682 (1978), acq., 1979-2 C.B. 2.
Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975), acq., 1980-2 C.B. 2.STATISTICAL SAMPLING
A memorandum on March 14, 2002 (which follows) was issued to provide field guidance on statistical sampling. Examiners can also contact their local Computer Audit Specialist (CAS) for assistance. Note that Attachment A contains complex formulas and can be viewed at the following link: http://www.irs.gov/pub/irs-utl/dir_use_prob_sampling.pdf
March 14, 2002
MEMORANDUM FOR INDUSTRY DIRECTORS, LMSB
DIRECTOR, PRE-FILING & TECHNICAL GUIDANCE, LMSB
FROM: Keith M. Jones
Director, Field Specialists
SUBJECT: Field Directive on the Use of Estimates from Probability Samples
The purpose of this memorandum is to establish guidelines for the Internal Revenue Service in evaluating samples and sampling estimates by taxpayers. These guidelines are intended to promote efficiency and consistency of the probability samples performed and examined by the IRS. They are not intended to be a technical position but to provide audit issue direction to effectively utilize our resources. Further, as more fully described below, they are not intended to replace or supersede specific statutory or regulatory requirements for substantiation or record keeping.
Examiners should perform a two-step inquiry in evaluating a taxpayer’s probability sample. First, they should determine whether the taxpayer has appropriately used a probability sample to support or be the primary evidence of tax amounts. Second, they should determine whether the final answer represents a valid estimate.
The appropriateness of using a probability sample is a facts and circumstances determination. Some of the factors to be used in determining whether a probability sample is appropriate include the time required to analyze large volumes of data, the cost of analyzing data, and other books and records that may independently exist or have greater probative value.
Probability samples generally should be considered appropriate if there is a compelling reason for their use and taxpayers cannot reasonably obtain more accurate information. However, probability samples generally should not be considered appropriate if evidence is readily available from another source that can be demonstrated to be a more accurate answer, or if the use of sampling does not conform to Generally Accepted Accounting Principles (GAAP).
Once examiners determine that the use of a probability sample is appropriate, they should determine the validity of the final estimate. In general, an estimate from a taxpayer’s sample should be considered valid (without regard to adjustment(s) based on audit issues) if all of the following conditions are met.
Attribute Sampling Plans:
The allowance of a taxpayer’s estimate does not correspondingly require acceptance of the taxpayer’s use of such estimate for the determination of associated adjustments, allocation, or subdivision of the findings for other purposes unless statistically determined according to these guidelines and applied on a basis appropriate for the circumstances. These guidelines address only the statistical requirements that must be met for a probability sample to meet preliminary acceptance and are not intended to further require acceptance of individual sample unit determinations. Valuation or attribute determinations remain subject to independent verification along with other non-statistical issues such as missing sampling items. Likewise, the statistical procedures followed may be examined and adjusted when discovered in error. Corrections to statistical methodology are permitted where possible to place the method in compliance with these guidelines. Any fatal error in statistical methodology which renders the probability sample invalid will preclude the use of any statistical estimate based on the sample and will only allow for consideration of the sample findings on an actual basis. Where a probability sample is determined to be not appropriate and raised as an issue, the examining agent may pursue a more accurate determination or allow the findings of units examined on an actual basis. However, the computational validity of the estimator should still be considered and addressed along with other alternative issues in unagreed cases.
This memorandum is not intended to supersede formal regulations, rulings, or procedures that address the specific application of statistical principles. It is recognized that existing industry practices and specific taxpayers may be using techniques that are not covered by this directive or other published documents. If a taxpayer has employed a probability sample or method not covered, the estimate will be referred to a Statistical Sampling Coordinator for resolution or issue development.
These guidelines do not relieve taxpayers of their responsibility to maintain any documentation required by section 6001 of the Internal Revenue Code, other sections, or subsections, which have specific documentation requirements for the entire population. Issues regarding documentation or support may be raised as appropriate.
This Field Directive is not an official pronouncement of the law or the Service’s position and cannot be used, cited, or relied upon as such.
Attachment
cc: Commissioner and Deputy Commissioner, LMSB
Director, Compliance, SBSE
Director, Employee Plans, TEGE
Director, Exempt Organizations, TEGEFootnotes:
1. The first variable used for the difference, ratio and regression estimators must be the variable used in the mean estimator. The second variable used for the difference, ratio and regression estimators must be a variable that can be paired with the first variable and should be related to the first variable. For example, in a typical audit-sampling situation, the first variable would be the audited value of a transaction and the second variable would be the originally reported value of the same transaction.
2. [Standard Error of the Total "y" Variables] / [Point Estimate of the Total "y" Variables]. Where the “y” variables are commonly the reported values in accounting situations.
3. [Standard Error of the Total "x" Variables] / [Point Estimate of the Total "x" Variables]. Where the “x” variables are commonly the corrected values in accounting situations.
4. [Standard Error of the Total "y-x" or Total "d" Variables] / [(Total Population Value Represented by "Y") – (Point Estimate of the Total "y-x" or Total "d" Variables)]. Where the “y-x” variables are commonly represented by the difference (“d”) between the reported (“y”) and corrected (“x”) values in accounting situations.
CONSTRUCTION PROCESS
In order to better understand how a cost segregation study is conducted, it is helpful to understand the construction process (i.e., how a building is constructed). The following discussion provides a general overview of this process, from the conceptual stage through the bidding, construction, payment, and completion stage of a project. Although there may be certain facts and circumstances in specific geographic locales that vary from what is presented here, the basic construction concepts are similar in all locales. For purposes of this discussion, it is assumed that a fee contractor, rather than an in-house labor force, performs the construction.
STAGES IN THE CONSTRUCTION PROCESS
The Construction Process is composed of six distinct stages, which are:
Each of these stages is discussed below in more detail.
1. Concept
All construction projects begin with planning and design, also referred to as “architectural programming.” Numerous overlapping steps occur during this conceptual or design phase, prior to actual construction of the project.
An architect is the primary designer of a building or project and controls the overall design, specifications, finished materials (e.g., brick, paint, carpet, wall covering, etc.), and other architectural features of the building. In addition, the architect supervises the engineers responsible for the structural, mechanical, electrical, lighting and plumbing design of the building. Engineers must always conform to the design requirements of the architect. Each member of the design team must also be licensed with the proper state licensing authorities where the facility is located.
During the initial stages of the design process, the architect(s) and engineer(s) have a number of client meetings in order to determine the purpose and objective of the proposed construction. The primary activities, for which the project is being constructed, as well as the relationships between spaces, are reviewed. Consideration is also given to how well the completed project relates to adjacent buildings (if any) and its surroundings. The preliminary programming produces a list of solutions, alternatives, feasibility studies and costs estimates. After a review of the programming statement, schematic plans are prepared.
Schematic plans are the first plans of a facility and show the interrelationship between spaces and activities. All of the parties (architects, engineers, and the client) review the schematic plans and make recommendations, as necessary. Any changes are then incorporated into the final schematic plans. Revised schematic plans are also known as “preliminary plans,” and provide a graphic view of the project, the refined details of how the project will look, and the relationship of all spaces.Once the preliminary planning phase is complete, the project then enters a stage involving the preparation of contract bid documents and working drawings.
2. Contracts and Bid Documents
In order to solicit construction bids, the builder must provide potential bidders with working drawings and plans for the proposed structure, as well as project specifications, the terms of which are spelled out in contracts.
All projects, whether they involve new construction or expansion of an existing structure, require the preparation of contract documents. The contract working drawings and plans provide a pictorial representation of the construction work, and specify or lay out the designer’s intentions for the facility. The drawings illustrate, among other things, the appearance, layout, equipment, and amenities of the project. These drawings show the architect’s plan/design for the building’s overall appearance, such as finish materials, floor plans, sizes, and use of each building area. Engineers design the building’s structural, mechanical, electrical, plumbing and communication systems.The architect also begins to gather project data to deal with problems or situations that are expected to arise during the construction process, such as local zoning requirements, local infrastructure, traffic, environmental and population impact, acoustic, energy, lighting, and aesthetic considerations. Various consulting engineers may also be utilized to solve specific project problems.
Numerous drawing plans are involved in a construction project, including the following.
The architectural plans indicate the layout of the project, such as floor plans, elevations, and details of the construction and architectural finishes. These plans are typically numbered sequentially with the prefix “A” for “architectural.” “Plan view,” the most common type of an architectural plan, is an overhead view of the spaces on a specific floor. These plans also indicate the length, width and various heights of the structure and floor elevations. Plans may show notes of specific construction information and may also contain details on a specific portion of work.Exterior elevations show the exterior and the exterior finishes, and are similar to photographs of the exterior. Architectural schedules on the plans indicate the door types, windows, hardware, plumbing, and light fixtures in each room.
In preparing the plans, the architect utilizes graphic symbols, instead of words, to indicate various facility conditions. These symbols indicate the various types of material, sizes, and room finishes to be used. Symbols may be shown on the plans themselves or in the legends of the plans. [A list of general symbols is shown in the Appendix of Plan Reading and Material Takeoff, by Wayne J. DelPico, published by R. S. Means Company.]
A civil engineer is responsible for the proper drainage of a site, as well as the design of land improvements, such as paving, curb and gutter design, retaining walls, and drainage culverts. Site plans prepared by the civil engineer indicate the existing and proposed grades of the land and the specific location of the facility on the land.
The structural plans are prepared by structural engineers and show the structural design of a building. These plans incorporate foundation planning with considerations for rain, snow, wind, earthquakes, and other natural phenomena. Structural engineers design the facility for both “live” and “dead” loads of the building. Live loads consist of the people, furniture, and other items that are not part of the building, but are supported by the building. Dead load is simply the weight of the building or structure itself.
Mechanical plans are prepared by a mechanical engineer to show the design of the various mechanical systems in the building. These systems must be designed to incorporate the proper air conditioning, heating, and ventilation equipment, as well as adequate plumbing, to meet the needs for all of the building’s designated activities.
Like the structural engineer, the mechanical engineer must design the mechanical building systems to meet building “loads.” For example, office work produces a certain level of heat load, whereas cooking in a commercial kitchen may produce greater heat loads. The energy use of the air conditioning, heating, pumps, and other building equipment are monitored by the mechanical engineer and are considered when specifying building equipment for an efficiently designed building system. Mechanical plans are numbered with the prefixes “P” for “plumbing” and “H” for “heating, ventilating, and air conditioning.”
- Electrical Plans
Electrical plans are prepared by an electrical engineer, and show the electrical distribution system for the efficient distribution of power in a building. The plan design includes the distribution of electrical power from the utility company and the distribution to power-specific equipment. Engineering design factors for the overall electrical “load” of a building must also be considered (e.g., proper sizing and arrangement of transformers, panel boards, circuits, wires, conduits and power to the various machines, equipment and activities in the building). Electrical engineers may also handle the lighting design requirements of the building, as well as specialty areas such as a central security monitoring system, a computerized control system, and fire and smoke management systems. Electrical plans are numbered with the prefix “E” for “electrical.”- Contract Specifications
The second part of the contracts and bid documents stage is the preparation of project specifications, also known as “specs.” Specs instruct the contractor how to build the project, and consist of contract documents, the technical specifications of the materials and the quality of the materials to be installed, and the workmanship for installation of the materials. Given the amount of information that is required to be included, specs have to be organized in a coherent manner. The most widely accepted system for arranging construction specifications is called the CSI Master Format. The CSI format, developed by the Construction Specification Institute, requires four categories of information: bidding requirements, contract forms, contract conditions, and technical specifications.
Bidding requirements describe the conditions of the bid to the owner, and encompass the Invitation to Bid, the Instructions to Bidders, the Information Available to Bidders, the Bid Forms and Attachments, and the Bid Security Forms. The type of contract between an owner and a contractor dictates the form of the bidding conditions.
Contract forms are divided into sections, including the Agreement, the Performance and Payment Bonds, and the Certificates.
The contract conditions include the General Conditions and Supplementary Conditions.
The technical specs are generally prepared for each specific project in the CSI Master Format and these include hundreds, perhaps thousands of individual items that will be installed in the project.The CSI Format consists of 16 “Divisions of the Work”, which are:
Each CSI Division is further sub-divided into three additional parts, called General, Products, and Execution (Installation).
Document A201 provides legal definitions of the elements in the construction process and the items that will be provided by the contractor. Document A201 also details how to prepare material submittals, shop drawings, and interim payment requests.
3. Bidding
The third stage of the construction process is bidding. Once an owner determines that a project is feasible and that construction financing is available, the owner will solicit bids or proposals from general contractors and/or specialty contractors. Owners generally use trade publications and newspapers in order to invite contractors to bid on a construction job. A copy of “The Notice to Contractors” will be shown in the project’s specifications, providing contractors with the bidding procedures.
The following is the sequence of events to prepare a contract bid:
The preparation of a bid is the first step in the cost control system of a construction project. The agreed-upon bid price then becomes the budget by which the actual expenditures are measured and drawn against. The object of a cost control system is to provide the general contractor and/or owner with information regarding actual project costs versus the anticipated or budgeted costs. These cost comparisons become essential for internal control purposes.
Standard cost manuals, such as the “R. S. Means Building Construction Cost Data,” are used by a general contractor to compute a bid. These guides contain a compilation of cost data for each phase of construction. There are also construction cost data guides for both union and non-union wage rates. If the Service examiner needs to estimate construction costs as part of the analysis of a study, it is important to use the proper wage rates.
Subcontractors bid jobs in much the same way that a general contractor does. A subcontractor may also solicit bids from sub-subcontractors for specialty construction.
Working drawings and specifications provide information to allow general contractors to estimate the project’s construction costs. Along with using their own estimators, a contractor usually has the subcontractor’s and the material supplier’s information readily available. If necessary, a general contractor can perform the preliminary details and/or shop drawings (see discussion on Appendix page 6.6-10) in order to estimate the proper costs to construct various parts of a building. The general contractor gathers all the information from his estimators and subcontractors and then adds in an amount for overhead and profit. This final cost estimate is used in the competitive bidding for the construction of a project.
The cost estimate of a building or project is broken down and organized by the construction divisions shown in the specifications. The cost estimate is further detailed by trade and by item. The general contractor may also have a bank of information in order to estimate labor and material costs. Otherwise, the contractor will rely on any of several cost estimating manuals [e.g., R. S. Means Building Construction Cost Data (highly detailed), Marshall Valuation Services, etc.]
4. Construction (Field Work)
The fourth stage of the construction process, called fieldwork, is the actual construction of the project. Fieldwork is broken down into building permits, subcontractors, scheduling subcontractors, shop drawings, project submissions, and change orders.
Before construction can begin, the appropriate municipality must issue a building permit. Specifications and blueprints must be provided to the municipality’s building department, along with the application for a permit. The period of time for a permit to be approved can be lengthy, especially in the case of new construction. The general contractor or owner may also be required to submit results of soil testing, environmental impact studies, and any other necessary testing or studies. Sometimes, a public hearing is mandated, if there is opposition to the project. In most cases, a permit is issued within a few months. The cost of the permit and any related studies may be the responsibility of either the owner or the general contractor.Construction projects must also follow the standards of the applicable building code. A building inspector will be involved at various construction stages in order to verify that the project is being constructed according to municipal code.
Subcontractors range from a one-man operation to nationwide, publicly traded corporations, or divisions of larger corporations. Subcontractors are distinguished from general contractors by their limited scope of work, which usually involves a special skill, knowledge, or ability. Subcontractors, which include plumbers, electricians, framers, and concrete workers, generally enter into contracts with the general contractor and may provide the raw materials used in their specialty areas. The general contractor, not the owner of the property, pays the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors’ work may either be completed in stages, or it may be continuous.
The general contractor schedules the subcontractor’s work so that the construction runs smoothly and is completed on schedule. The general contractor is also responsible for scheduling the subcontractor in such a way that one subcontractor does not hold up another. This order on subcontractor sequencing is known as the “critical path.”An example of the sequence in scheduling subcontractors for a small project is as follows:
Working drawings only include enough detail to show the general contractor the overall layout of the building. The individual specialty trades and suppliers use working drawings to produce shop drawings for items such as granite finishing, cabinets and countertops, structural steel, etc. Shop drawings detail the specific building components and are usually produced after the final design phase but before the beginning of the construction phase. Drawings are prepared in accordance with the instructions on Document A201. The architect/engineer will also check each shop drawing for precise measurements and for compliance with the intended building design.
Project submissions are an important part of the construction process. Each installed building item must receive the architect’s approval to ensure that the item or product is in conformance with technical specifications. Project submissions illustrate each item’s intended use, function, method of attachment or installation requirements, and placed-in-service date. When the project is started, the architect and /or engineer monitors the contractor’s progress and often approves the progress payments made to the contractors. The architect/engineer may also make modifications to the building plans as needed.
Change orders are the written contract revisions that increase or decrease the total contract price. Change order documents contain the change order number, change order date, a description of the change, and the amount of the change order. Contractors, based on the terms of the contract, may also issue orders.5. Construction Payments
The fifth stage of the construction process is the construction payments stage. All construction contracts extend over a period of time. The order of any business operation is to collect money as soon as work is complete. When a contractor completes a prescribed amount of work, the owner pays the contractor for the completed work.
The specifications for contract payments are shown in Document A201, under the “General Conditions for Construction Contracts.” Document A201 contains AIA Forms G701 and G702. Form G702 requires that the contractor break down the bid into various parts of work. The project designer (architect or engineer) critically reviews the G702 schedule of values that are prepared by the contractor and either accepts or rejects them. The close scrutiny of this form is due to the future release of funds that will be used to pay for the progress (and ultimately the completion) of construction. This form also provides the first basis for the construction cost control on a project. The architect and/or engineer have a legal and fiduciary responsibility for the accuracy of the cost allocations. The architect and the owner also want an adequate and timely distribution of funds to ensure smooth progress payments and to ensure that there will be the necessary funds to pay for the completion of the last portion of the project.It is also to the contractor’s benefit that items of construction be broken into as many parts as possible. The more individual items of work that the contractor can identify and complete, the more items of work he/she will be entitled to bill and for which he/she will be timely paid. Typical schedules of values in the G 702 may be 15 to 20 pages long and may contain hundreds, if not thousands, of individual cost items.
The contractor submits the G702 to request payment on a regular basis. The contractor completes the G702 by listing the total construction cost for each item of work completed to date. The amount previously paid for the work and the amount accomplished in this billing period are subtracted from the total amount to arrive at the amount of money remaining, minus a retainage for the completion of the work.
It is extremely important for the Service examiner to analyze the G702. This document provides a breakdown and analysis of the construction costs and, since it is prepared by 3rd parties, it provides an element of objectivity.
The architect/engineer may make modifications or change orders to the construction plans as needed. Change orders should be reviewed for any agreed changes to the payment schedule.6. Completion
The final phase of the construction process is known as the completion stage, and it readies the building for occupancy.
After a facility or project is completed, the architect and contractor prepare a set of plans known as the “as built plans.” These plans represent exactly how the facility was constructed and they also incorporate all the changes to the original construction plan. It is very important that the Service examiner utilize the “As-Built Plans” when reviewing a cost segregation study because these represent the actual construction of the project.
In some instances, the owner may desire to occupy a portion of the completed building. In that case, local building officials conduct an inspection to determine if that portion of the facility meets all building codes and is safe to be occupied. If approval is granted, a “Certificate/Notice of Partial Occupancy” is issued.
Local building officials issue this notice when 95 % of the construction is complete.
A “Notice of Completion” is requested by the contractor/owner when the building is 100% complete. The project must pass a final inspection by local building officials in order for the “Notice of Completion” and the “Certificate of Occupancy” to be issued. These documents are recorded at the office of the local recorder and the property will be then appraised for property tax purposes.SUMMARY AND CONCLUSIONS
This chapter provides an overview of the construction process and should assist Service examiners in understanding terminology used in the construction industry. In turn, this will assist in the review of cost segregation studies.
INFORMATION DOCUMENT REQUESTSINTRODUCTION
Appropriate documentation is needed to support the conclusions in a cost segregation study. Once an examination has revealed the use of cost segregation techniques, the examiner needs to review the supporting documentation to determine whether an examination is warranted and, if so, the scope of the examination.
The use of appropriate Information Document Requests ["IDR’s"] will facilitate the identification of available records for review and the solicitation of records from the taxpayer. The sample IDR language is intended as a suggestion for obtaining records. One or more IDR’s may need to be issued and examiners should “tailor” the language to each specific case.
Taxpayer, Inc., made changes to cost recovery deductions for its properties based upon recommendations from its consultant through Cost Segregation reports. A review of these recommendations is necessary.
The Engagement Letter/Letter of Understanding between Consultant and Taxpayer, Inc., is requested to show the extent of the Cost Segregation engagement, the steps taken to gather information, and the way in which the work was to be reported.
Additionally, a conference is requested with a representative from Consultant to describe the Cost Segregation process and to answer questions concerning the style and general cost computations. It is expected that a telephone conference will be suitable, provided the Engagement Letter/Letter of Understanding has been furnished.
Please provide the names and locations of properties visited and inspected by Consultant for use in its Cost Segregation analysis. By reviewing the same properties visited by Consultant, a better understanding of the Cost Segregation Report is achieved.
Please provide access to the construction drawings and specifications used by Consultant to perform its Cost Segregation Study. It is not necessary to duplicate the drawings; all that is requested is access to perform an adequate review in a location where the drawings may be unrolled and reviewed easily.
Please provide a copy of the complete Cost Segregation Study, to include all schedules, spreadsheets, and attachments referred to in the Study.Please locate the related workpapers for the Cost Segregation Study and hold available for review.
The Cost Segregation Study is described as containing numerous spreadsheets and schedules used in arriving at the summary recommendations. Please provide a machine sensible copy of the data files used in preparing and printing the spreadsheets and schedules.Please include a description of the software used in preparing the spreadsheets and schedules.
Please provide an index to the machine sensible files, (or other description of the file titles and how the files are identified). If the machine sensible copy is a visual copy, or value only copy, then an additional description and presentation of the mathematical formulae used to perform the computations is also requested.
The blueprint review is complete. Specific questions about the study remain.With regard to the “Quantity Take Off” schedules prepared by Consultant for the properties, there are certain unidentified assets that would fit into more than one MACRS class, depending upon location and use in the taxpayer’s business. Please provide a copy of the detailed listing of the Consultant’s selected assets, showing use and location for:
Receptacles in Kitchen
Junction Boxes in Kitchen
Disconnect Switches in the Kitchen
Receptacles in Offices
Junction Boxes in Offices
Circuit Breakers in Offices
Receptacles in Lab areas
Junction Boxes in Lab areas
Floor Drains in Kitchen
Sinks in Kitchen
3″ pipe in Lab areas
1″ pipe in Lab areasThese assets were opined to have shorter lives than the building lives.
1. Please provide copies of all construction contracts, addenda, purchase orders, change orders (including the Contract Bid breakdowns) for each item listed below. Note: The Property Unit numbers and Descriptions were obtained from the formal Cost Segregation Analysis.