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IRS Issues Revised Audit Technique Guide for Cost Segregation Analysis

  • Written by Peter J. Scalise

On June 9th, the Internal Revenue Service (hereinafter the “Service”) issued a revised Audit Technique Guide to assist examining agents in evaluating the validity of cost segregation studies submitted by taxpayers to substantiate accelerated depreciation deductions. These far reaching updates were needed due to the vast changes in the tax laws over recent years in connection to the Protecting Americans from Tax Hikes Act of 2015; the Tax Cuts and Jobs Act of 2017; the Coronavirus Aid, Relief, and Economic Security Act of 2020; the Consolidated Appropriations Act of 2020; and of course revised guidance based upon examining agents observations from recent cost segregation examinations on what is deemed acceptable qualitative and quantitative procedures in order to get to a tax return filing position per Circular 230.  Just some of the many sweeping updates are in connection to I.R.C. § 263A, Change of Accounting Method, I.R.C. § 179 Deduction, I.R.C. § 179D Deduction, Bonus Depreciation, and Qualified Improvement Property.

As a synopsis, a Cost Segregation analysis will methodically review property, plant and equipment and properly reclassify real property (e.g., property that is generally depreciated for tax return purposes over a period of either 27.5 years in the case of a commercial residential apartment buildings or 39 years in the case of a commercial office buildings, shopping complexes, hotels and casinos) into personal property (e.g., property that is generally depreciated for tax return purposes over a period of either 3, 5, or 7 years) and land improvements (e.g., property that is generally depreciated for tax return purposes over a period of 15 years) by reviewing all of the structural components within the building structure (e.g., exterior walls, roof, windows, doors, etc.) and the building systems (e.g., lighting, HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security systems, gas distribution systems, etc.). In general, floor plans and blueprints are meticulously reviewed and site inspections are conducted to review the building envelope as part of an engineering based Cost Segregation analysis to ensure sustainable tax return filing positions per Circular 230.

From a risk management perspective, in order to mitigate or avoid income tax return paid preparer penalties pursuant to I.R.C. § 6694 (e.g., penalties that are assessed on both paid tax return preparers and tax advisers that are deemed paid tax return preparers due to their consulting on matters that constitute a substantial portion of their client’s tax returns even if they were not engaged to prepare nor review the tax return), a “More-Likely-Than-Not” standard should be satisfied.

The subsequent standards of the applicable levels of opinions should be assiduously analyzed when assessing a tax return filing position:

  • Will” Standard: Generally, a 95% or greater probability of success if challenged by the IRS. A “Will” opinion generally represents the highest level of assurance that can be provided by an opinion;
  • Should” Standard: Generally, a 70% or greater probability of success if challenged by the IRS. A “Should” opinion provides a lower level of assurance than is provided by a “Will” opinion, but a higher level of assurance than is provided by a “More-Likely-Than- Not” opinion;
  • More-Likely- Than- Not” Standard: A greater than 50% probability of success if challenged by the IRS. The “More-Likely-Than-Not” standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under I.R.C. 6662A;
  • Substantial Authority” Standard: Typically, greater than a “Realistic Possibility of Success” standard and lower than “More-Likely-Than-Not” standard (i.e., 40% probability of success);
  • Realistic Possibility of Success” Standard: Approximately a one-in-three or greater possibility of success if challenged by the Service;
  • Reasonable Basis” Standard: Significantly higher than the “Not Frivolous” standard (i.e., that is, not deliberately improper) and lower than the “Realistic Possibility of Success” standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority;
  • Non-Frivolous” Standard: Approximately a 10% chance of being upheld upon examination by the Service and accordingly under no circumstance should a tax professional ever render services with this level of comfort; and
  • Frivolous” Standard: Approximately a percentage less than a 10% chance of being upheld upon examination by the Service and accordingly under no circumstances should a tax professional ever render services with this level of comfort.

It should be duly noted that each of the aforementioned standards above has a relevant meaning to both the taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. Noting, the percentages listed for “More-Likely-Than-Not” and “Realistic Possibility of Success” are specifically provided for and discussed in the treasury regulations. In contrast, the percentages for “Substantial Authority”, “Reasonable Basis”, “Non-Frivolous”, “Frivolous” have been developed based upon their relative importance in the hierarchy of standards of opinion as principally provided for in congressional committee reports. Moreover, while not mathematically calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

In conclusion, the revised Audit Technique Guide for Cost Segregation services should be carefully analyzed to ensure continued and full compliance with this new form of administrative authority when determining the sustainability of a tax return filing position in connection to a cost segregation matter per Circular 230.

The revised IRS Cost Segregation Audit Technique Guide can be referenced at  https://www.irs.gov/pub/irs-pdf/p5653.pdf

About the Author

Peter J. Scalise serves as the Federal Tax Credits and Incentives Practice Leader for the Americas at Prager Metis CPAs, LLC, a member of the Prager Metis International Group. Mr. Scalise is a highly distinguished Big Four Alumni Tax Practice Leader with approximately thirty years of progressive public accounting firm experience developing, managing, and leading large scale tax advisory practices on a regional, national, and global level.

Mr. Scalise is also a prominent philanthropist who champions over a dozen charities nationwide in connection to poverty and hunger alleviation; economic development; health and social services; veteran and military service personnel along with preserving arts and cultural programs. Mr. Scalise is currently serving on the National Board of Directors for the Prager Metis Charitable Foundation Inc, a I.R.C. § 501(c)(3) organization and is the Founding Chairman of the Accounting Industry Leadership Council to benefit the Alzheimer’s Association. Mr. Scalise is the former NYC - Manhattan Event Chairman and Sponsorship Chairman for the Alzheimer’s Association’s annual signature fundraising event entitled “The WALK to END ALZ” at the historic South Street Seaport District.

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