Auditor’s Eye View:
New Audit Technique Guideline Takes Readers into the Mind of an IRS Examiner

No one wants to get audited. But, like Mondays and leftovers, it can happen to the best of us.  And an important note before the discussion begins – the performance of a cost segregation study does not increase the likelihood of an audit.

The IRS has given taxpayers a way to be better prepared in the case of an audit.  A recently updated and highly detailed Audit Technique Guideline (ATG) literally spells out what examiners should be looking for when reviewing a cost segregation study.  This “Auditor’s Eye View” is a gift – by knowing exactly what points examiners must scrutinize, taxpayers can make certain that all crucial areas of their reports are in order, and may feel confident in the outcome of a potential audit.  The ATG can be used to evaluate cost segregation providers as well – by selecting a firm that consistently engages in practices recommended by the document, one can truly rest assured that he has done his due diligence in the event of an audit.

Let’s take a look at some of the practical direction the ATG offers examiners:

  • Examiners must request a copy of the Letter of Engagement to verify the scope of the study and to examine the fee structure.   Auditors are explicitly told to closely scrutinize studies performed with contingency fees, as this incentive may encourage cost segregation providers to be more “aggressive” than appropriate.  Capstan Tax Strategies never uses a contingency fee structure, and our flat fee is completely independent of the final tax savings received by the client.
  • Examiners must do an in-depth review of the study to ensure that assets are assigned to correct categories.  This is a particular area of concern when allocating specific components or portions of a building system to 5 or 7-year property.  The ATG specifically calls out electrical systems as a tricky wicket that might require attention, and warns against the use of “standard” percentages to determine electricity allocation to a specific type of personal property.  Instead, the Guideline clearly states that this type of allocation must be based on usage or load studies.  Capstan Tax Strategies consistently uses electrical load analysis.
  • Examiners must reconcile the total cost basis of assets in the taxpayer’s records to the total project cost of the study.  Seems like a no-brainer, but it is crucial to have all documentation available, including that reflecting other costs that may have since been expensed.
  • Examiners must determine all land preparation costs included in the project, analyze them, and allocate them appropriately, whether the costs were included in the cost segregation study or not.  Costs for site grading, preparation, compaction, etc. are usually non-depreciable costs allocable to land, and as such are generally not included in a cost segregation study.  However, taxpayers be warned, the examiner is instructed to analyze and allocate all land preparation costs even if they were not included in the scope of the study.
  • Examiners must confirm that actual cost records are used, as opposed to some type of property-cost estimate.  Capstan Tax Strategies uses actual client-provided costs whenever available.
  • Examiners must scrutinize cost estimates derived using the residual approach.  The residual method involves estimating personal property costs and then simply assigning the remaining basis to 39-year, without checking for reasonableness.  This method is inaccurate and the ATG advises auditors to closely scrutinize conclusions drawn using this approach.  Capstan Tax Strategies generally does not apply the residual method.
  • Examiners must reconcile cost estimates from data sources with contractor-supplied actual price records.   There are often discrepancies here, as real-world economies of scale, bulk discounts, and competitive pricing may result in a cost other than the one fixed in the database.   Capstan Tax Strategies uses actual client-provided costs whenever available.

There is a wealth of useful information in this ATG, and the proactive and thoughtful taxpayer can use this guidance to ensure best practices in his cost segregation studies and positive outcomes in the unlikely event of an audit. To learn more about Capstan’s best practices, feel free to give us a call at 215.885.7510.