By: Donald Archer
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.