The Internal Revenue Service issued a revised Audit Technique Guide last week to help examining agents evaluate 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 with the PATH Act of 2015, the Tax Cuts and Jobs Act of 2017, the CARES Act of 2020, the Consolidated Appropriations Act of 2020 and 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 with the Section 263A change of accounting method, Sections 179 and 179D deductions, bonus depreciation and qualified improvement property.
A cost segregation analysis will methodically review property, plant and equipment and properly reclassify real property (property that is generally depreciated for tax 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 (such as property that is generally depreciated for tax return purposes over a period of either three , five or seven years) and land improvements (property that is generally depreciated for tax return purposes over a period of 15 years). The analysis will review all of the structural components within the building structure (exterior walls, roof, windows, doors, etc.) and the building systems (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 Section 6694 (penalties that are assessed on both paid tax preparers and tax advisers who are deemed to be 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 Section 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 IRS;
- “Reasonable basis” standard: Significantly higher than the “not frivolous” standard (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 IRS and accordingly under no circumstance should a tax professional ever render services with this level of comfort; and,
- “Frivolous” standard: Approximately a less than a 10% chance of being upheld upon examination by the IRS and accordingly under no circumstances should a tax professional ever render services with this level of comfort.
Note that each of the standards above has a relevant meaning to both taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. 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” and “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 downloaded at https://www.irs.gov/pub/irs-pdf/p5653.pdf.
