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The Cost Segregation Study That Should Not Have Been Done

Written by Steve Beaucaire, MST, CCSP and Greg Bryant, CCSP

Over the last week, the most recent buzz in the Cost Seg world has focused on the Peco Foods case. (Peco Foods Inc. et al., TC Memo 2012-18).  Many of our clients have asked us to weigh in on this issue.   By way of reference, Peco Foods acquired two poultry plants from Green Acre Farm, Inc. in 1995 for $27,150,000.  Part of the acquisition included a very elaborate Purchase Price Allocation (PPA) between the parties.  The PPA went as far as delineating the costs for assets such as specific process related items, land improvements, buildings and goodwill.  Further, the PPA was very explicit with respect to the definitions of Real and Personal property as they pertained to the specific transaction.  These definitions were more than the generic “land and building” descriptions we normally see in a PPA.   The fact that this level of detail existed unilaterally negated Peco’s ability to conduct a cost segregation study (CSS). Additionally the PPA contained specific language that the allocations were to be used for all purposes including financial accounting and tax purposes.

Given TC Memo 2012-18, we are now fielding questions from our clients as to the validity of look-back studies and how this is going to impact our business.  Our response is “Nothing has changed!”  
This recent Tax Court case does not add anything new to the use of a CSS as a tax-planning tool. The concept of a PPA overriding a CSS has been settled for years and is found in § 1060(a). This concept is even mentioned in the Audit Techniques Guide for Cost Segregation Studies as something agents should look for when auditing a CSS. When completing Form 8594, Asset Acquisition Statement under § 1060(a), one must allocate the purchase price to general categories.

• Class I assets are cash and general deposit accounts other than certificates of deposit.
• Class II assets are actively traded personal property, for example, U.S. government
   securities and publicly traded stock.
• Class III assets are generally debt instruments (including accounts receivable) with
   some limitations.
• Class IV assets are inventory items, or property held by the taxpayer primarily
   for sale to customers.
• Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.
• Class VI assets are all section 197 intangibles, (patents, copyright, trademark or 
   trade name, or covenant not to compete), except goodwill and going concern value.
• Class VII assets are goodwill and going concern value.

The IRS, however, applies the definition of items included in the asset allocation rules very broadly. It is to the purchaser’s advantage to classify as much as possible under the rules into Class V, which is the silver lining. Class V assets can later be segregated into personal vs. real property via a cost segregation study, as these amounts do not constitute any allocations to § 1245 or § 1250 property. Peco Foods’ undoing was attaching a statement to Form 8594 allocating specific amounts of the Purchase Price to Processing Plant Buildings and Real Property Improvements, thereby casting these in stone.

We have seen punitive examples where buyers and sellers agreed to PPA resulting in unintended consequences.  Sometimes “innovative strategies” designed to minimize local items such as Real Estate Transfer tax have their unintended consequences at the Federal level, just like one of our clients who elected to have 90% of their golf course purchase allocated to land.  The good news was on that transaction, the buyer and seller were able execute appropriate amendments to the purchase agreement and our client was able to take advantage of cost segregation. An important note on amendments and PPAs – they are binding on both parties.

While the rational behind the Peco Foods decision is not new, it does point out that one must pay attention and know the rules before making decisions on performing a CSS. Communication between the taxpayer, their accountant, and the cost segregation provider is paramount.