An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation? 

Cost Segregation and Buying a Business

Have you heard of cost segregation studies? This is an engineering-based study, usually conducted in tandem with an accounting firm, to break-out the cost of real estate and improvements into more tax-advantaged asset categories. For example, a sidewalk can be depreciated faster than a building. It would therefore be tax-advantageous to separate the cost of the sidewalk from that of the building and claim the faster depreciation. A virtual cottage industry has sprung up in the profession to do these cost segregation studies.

What if you buy a business and simultaneously do a cost segregation study? Sounds like the perfect time to do one. What if you buy a business and do the study later?

Let’s talk about Peco Foods Inc (Peco).

Peco is the parent of a consolidated group engaged in poultry processing. Through subsidiaries, Peco acquired its Sebastopol, Mississippi plant in 1995.  Peco and the seller agreed to allocate a $27,150,000 purchase price among 26 asset categories, including:

·         Processing plant building

·         Hatchery real property

·         Waste water treatment plant

·         Furniture and equipment

·         Machinery and equipment

Peco obtained an appraisal in connection with this acquisition. The appraisal listed more than 750 separate assets.

Peco acquired a second plant in Canton, Mississippi for $10,500,000 in 1998. This time Peco and the seller allocated the purchase price across only three asset categories:

·         Land

·         Land improvements

·         Machinery, equipment, furniture and fixtures

Peco obtained an appraisal on Canton after-the-fact. The appraisal included more than 300 separate assets. 

In 1999 Peco hired Moore Stephens Frost (MSF) for a cost segregation study of the two plants.  According to the study, Peco was entitled to additional depreciation expense of $5,258,754 from 1998 through 2002.

            NOTE: I will pass on saying that $5.2 million is not chicken feed.

Peco was now required to alert the IRS that it was changing its depreciation. It was changing what it earlier called a “building” to “machinery” or “equipment” or whatever. It had to attach a form - Form 3115 – to its tax return. Peco explained that it was breaking-out the Sebastopol and Canton depreciation schedules into more categories.

The IRS nixed the whole thing.

Why? There are special rules when someone acquires enough assets of another business to constitute the purchase of that business. This is referred to as an “applicable” asset acquisition, and the seller and buyer have to alert the IRS of how the purchase price is to be allocated. Here is Code Section 1060:

If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Each party’s argument is straightforward:

         IRS:    Taxpayer has to allocate according to the acquisition agreement.
           Peco:  No, I don’t because the wording is vague.          

The Court pointed out that the Sebastopol agreement used the phrase “processing plant building.” The inclusion of the word “building” was important. The Court even read the description of “building” from the Merriam Webster College Dictionary.  Equipment inside a building is not the same as the building. Why would Peco use the word “building” if it did not in fact mean a building?

The Court went through the same exercise with the Canton property.

The Court pointed out that – for it to set aside the written agreement – it would have to hold that the language was vague and ambiguous. Problem is, the Court did not think the language was vague or ambiguous at all. The Court observed that Peco had an appraisal prior to entering into one of the contracts, but it saw no need to further detail or reword its asset acquisition schedule. The second schedule was even more restrained, having only three categories. The Court observed that Peco did not seem to have any trouble with its schedules and categories until after it met Moore Stephens Frost (MSF), who clued them in on the advantages of cost segregation. The Court hinted its disapproval over retroactive tax planning, and it decided that it could not determine that the allocation was inappropriate. That meant that Peco was bound by the documents it signed. 

What is the moral of the story? The first of course is the importance of words in tax practice. Sometimes there is no room for “you know what I mean.” This is one of those areas.

The second moral is cynical. Had there been no written allocation of the assets, or even an incomplete allocation, then Peco might have won the case. Why? Because both sides would not have named every dollar in the deal. This would have left unclaimed ground, and Peco could have claimed that ground.

To be fair, the IRS is not keen on cost segregation. It is aware of the cottage industry that has sprung up after Hospital Corporation of America. It is one thing to be tracking the cost breakout as a building is being constructed or renovated. It is another to have an engineer come in and submit “what-if” numbers on an existing building or land improvement. Notice that the IRS did not contest the validity or credibility of MSF’s cost segregation study. All it did was hold Peco to its own (and) earlier cost allocation when it purchased the two businesses. That was enough.