Over recent years, the cost segregation field has experienced explosive growth as a valuable tool in tax deferral strategies. Although hundreds of thousands of taxpayers have taken advantage of the benefits of a cost segregation study, many others are still not aware of the benefits.

Cost Segregation is a strategic tool that allows companies and individuals to increase their cash flow by maximizing depreciation benefits for tax purposes. It analyzes the capital investments made in a residential or commercial building that results in the correct classification of costs between real and personal property for the purpose of determining tax deductions for depreciation.

A cost segregation study is a formal engineering study done by qualified professionals (usually a combination of engineers and accountants) which segregates or allocates costs to specific components of property such as land, land improvements, equipment, furniture and fixtures and buildings. The purpose of a cost segregation study is to reclassify buildings and structural components to personal property. By making this reclassification from 39 (or 27.5) year life property to 15, 10, 7 or 5 year life property, depreciation can be accelerated for tax purposes resulting in increased after tax cash flows. Historically, the acquisition and construction costs of real property were allocated between land and buildings. Personal property were those assets separately acquired and not affixed to the building.

Cost segregation studies have been recognized by the IRS since 1997 when the US Tax Court ruled in Hospital Corp of America that segregating building costs for tax purposes was allowable.

In the Hospital Corporation of America vs. commissioner, non structural assets were segregated into shorter life assets according to Investment Tax Credit (ITC) rules for depreciation purposes. The Tax Court affirmed the use of this methodology for segregating depreciable assets. What this basically means is that items that qualify as tangible personal property under the ITC rules, may be separately stated under applicable depreciation methods as personal property.

There have been two tests developed by the Tax Courts which are derived from the ITC regulations. (1) the inherent permanency test and (2) the appearance and function test. If a structure or component fails either test, then in most court cases, it has not been considered a building component. If, however, a structure meets both tests, then, it will be considered a building component and is not eligible fo re-classification to personal property.

Under the Permanency Test, tangible personal property means any tangible property except land and land improvements which is contained in or attached to a building. Most courts will rule that a structure cannot be considered a building unless it is “inherently permanent”. If movement of the asset would cause significant damage or render the asset unusable, then the asset is probably “inherently permanent”. Examples would include pools, wharves, loading docks, bridges and fences.

The Appearance and Function test are a matter of facts and circumstances. In 1999, the IRS issued advice, in response to Hospital Corporation of America, which stated that “the determination of whether an asset is a structural or tangible personal property is a facts and circumstances assessment. No bright line exists.” In order to meet the functional test, the structure must look like a building and must function like a building. Factors to consider include the ease of movement and relocation, the re-usability of the asset, was the installation intended to be permanent in nature, as well as, is it necessary to the overall function of the facility. If the asset is easy to move, or it was designed for easy removal, it has an expected length of stay less than the building or does not create undo harm in removing the asset (or has a history of being moved), then the asset may well meet the guidelines to be treated as personal property under the appearance and function test. The important question to ask is, “what is the purpose of the asset.

The results of a cost segregation study increases the in depreciation expense in earlier years reducing the cash outlay for income taxes in the earlier years. Thus, causing an increase in the net present value of cash flows after tax for the life of the project. Although they are approved and accepted by the IRS, there are guidelines that must be followed. Care should be taken in selecting qualified professionals with the tax and engineering expertise necessary to prepare a study that meets IRS guidelines.

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Written by Cathleen Foley, CPA, MST, Senior Tax Manager, KAF.  Cathy has over 15 years of experience in public accounting, financial services and business consulting. Cathy specializes in tax planning and tax compliance for a variety of closely held businesses. She can be reached at 781-356-200 or by email- cfoley@kafgroup.com.

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A partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by which any business, financial operation or venture is carried on, and which is not a trust or estate or a corporation. A partnership is treated as a pass-through entity, and income earned by the partnership, whether distributed or not, is taxed to the partners. An election not to be subject to the subchapter K partnership rules was provided for certain investment partnerships, partnerships for the joint production, extraction or use of property, but not for selling services or property produced or extracted, and syndications of securities dealers formed for a short period for underwriting, selling or distributing a particular issue of securities. Otherwise, the subchapter K rules applied to a venture that is treated as a partnership for Federal tax purposes.

Individuals with self-employment income are subject to self employment tax on their net earnings from self-employment. Net earnings from self-employment is the gross income derived by an individual from any trade or business carried on by the individual, minus the deductions attributable to the trade or business that are allowed under the self-employment tax rules. If the individual is a partner in a partnership, the net earnings from self-employment generally include his or her distributive share (whether or not distributed) of income or loss from any trade or business carried on by the partnership.

New Law. Under the 2007 Small Business Act, where a qualified joint venture is conducted by a husband and wife who file a joint return for the tax year, the joint venture is not treated as a partnership for tax purposes. (Code Sec. 761(f)(1)(A) as amended by 2007 Small Business Act §8215(a)) The provision does not otherwise change the determination whether an entity is a partnership for federal income tax purposes.

All items of income, gain, loss, deduction, and credit are divided between the spouses according to their respective interests in the venture (Code Sec. 761(f)(1)(B) ), and each spouse takes into account his or her respective share of these items as if they were attributable to a trade or business conducted by the spouse as a sole proprietor. (Code Sec. 761(f)(1)(C) ) Thus, each spouse will report his or her shares on the appropriate form, such as Schedule C.

A qualified joint venture means any joint venture involving the conduct of a trade or business if:

1.  the only members of the joint venture are a husband and wife

2. both spouses materially participate (under the Code Sec. 469(h) passive loss rules (see FTC 2d/Fin ¶M-5901; TaxDesk ¶413,002; USTR ¶4694.06;) without regard to the rule that treats participation by one spouse as participation by the other) in the trade or business, and

3. both spouses elect the application of this rule.

RIA observation: The pre-2007 Small Business Act election not to be taxed as a partnership was made in a statement attached to, or incorporated in, a properly executed partnership tax return. It is unclear how this new election will be made.

Notwithstanding other self-employment rules, each spouse's share of income or loss from a qualified joint venture is taken into account under the above rules in determining the spouse's net earnings from self-employment. (Code Sec. 1402(a)(17) as amended by 2007 Small Business Act §8215(b)(1)).

Similarly, each spouse's share of income or loss from a qualified joint venture is taken into account under the above rules in determining the spouse's net earnings from self-employment for purposes of the Social Security benefits rules. (2007 Small Business Act §8215(b)(2)).

RIA observation: It appears that, under the above change for Social Security benefits, each spouse will receive credit for his or her self-employment tax contributions for purposes of receiving Social Security benefits.

However, the above change for Social Security benefits is not intended to prevent allocations or reallocations, to the extent permitted under pre-2007 Small Business Act law, by courts or by the Social Security Administration of net earnings from self-employment for purposes of determining Social Security benefits of an individual. (Com Rept, see ¶5005)

Effective: Tax years beginning after Dec. 31, 2006. (2007 Small Business Act §8215(c)).

Source: RIA Checkpoint Online Research - 9/07

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Earlier this year, Congress included new tax preparer standards and monetary penalties for those tax return preparers as part of an Iraq War funding bill. Among other things, these standards raise the threshold for correctness of positions taken by a tax preparer on a tax return and significantly increase the penalty for violating those standards.

Under the new law, a position taken by a paid preparer on a tax return must be more likely than not to prevail if not disclosed as a position on the return. Positions that are disclosed on a return need only be reasonable and have substantial authority to provide support. Under the old law, tax preparers were held to the standard of a realistic possibility of a position being sustained. Conversely, taxpayer penalties are unchanged and remain at the realistic possibility standard. The law also expands these penalties to all tax returns and forms, not just income tax returns as it had previously.

We at KAF believe this presents an inherent conflict of interest in the preparation of tax returns and transforms tax preparers from being client advocates into advance auditors of the IRS. With the disparity in standards for penalties, it is possible for a tax preparer to be penalized for an undisclosed position but not the taxpayer. It effectively puts the interests of the tax preparer and taxpayer at odds to the disclosure of and taking of positions on a tax return.

We have been lobbying the Massachusetts congressional delegation about this matter and remain somewhat hopeful that this law will be modified if not repealed entirely. In the meantime, you may notice a more detailed and questioning approach to the preparation of your tax returns as our tax preparers question any items they are unsure of.

Source: Written by David Woods, Kirkland Albrecht & Fredrickson

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October 2007
	Short Term	Mid Term	Long Term
Annual	4.19%	4.35%	4.88%
Semi annual	4.15%	4.30%	4.82%
Quarterly	4.13%	4.28%	4.79%
Monthly	4.11%	4.26%	4.77%
Adjusted AFR for Original Issue Discount (Code Sec. 1288(b))	3.60%	3.79%	4.49%
Code Sec. 382 Adjusted Federal Long Term Rate			4.49%
Long Term Tax exempt rate			4.50%
Low income Housing Credit (Code Sec. 42(b)(2))
70% present value			8.07%
30% present value			3.46%
Valuation Tables (Code Sec. 7520)			5.20%
Deemed Rate of Return for Transfers to Pooled Income Funds (Code Sec. 642(c)(5))			4.80%

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As the end of the year approaches, it is a good time for you to engage in tax planning, which will be more challenging than usual because of uncertainty over whether and how Congress will extend AMT relief to avoid millions more becoming entrapped by it in 2007, and whether Congress will extend a number of important tax breaks expiring at the end of 2007. For individuals, these include the option to deduct state and local sales and use taxes, the above-the-line deductions for qualified tuition expenses and educator expenses, the tax credit for making qualifying energy saving improvements to a home, such as insulation and energy-saving windows, and the option for individuals who have attained age 70 1/2 to exclude up to $100,000 a year for otherwise taxable distributions from an IRA (or a Roth IRA) that are paid directly to a qualifying charitable organization by the IRA trustee. For businesses, tax breaks that will expire at the end of this year unless they are extended by Congress include the research tax credit, faster write-offs for leasehold and restaurant improvements, and enhanced deductions for certain contributions to charity.

We have compiled a checklist of actions that may help you to save taxes if you act before year-end. Not all actions will apply in your particular situation, but you will likely benefit from many of them. We can narrow down the specific actions that you can take once we meet with you to tailor a particular plan. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves to make:

• Increase the amount you set aside for next year in your employer's health flexible spending account if you set aside too little for this year. Don't forget you can set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids.

• If you have any capital gains or losses from sales of stock or other capital assets or you have stock or other capital assets that are ripe for sale, it may be advisable for us to meet to discuss how you can best coordinate timing your gains and losses to minimize tax on your gains and maximize the tax benefit from your losses.

• If you or a family member are thinking of selling appreciated stock or other capital assets, and your (or their) income isn't taxed at a rate higher than 15%, it may pay to hold off on the sale until 2008. That way you may pay a zero tax on the gain; if you sell this year, you will pay a 5% tax on the gain.

• It may be advantageous to try to arrange with your employer to defer a bonus that may be coming your way until 2008.

• If you own an interest in a partnership or S corporation you may need to increase your basis in the entity so you can deduct a loss from it for this year.

• Consider using a credit card to prepay expenses that can generate deductions for this year.

• If you are thinking of making energy saving improvements to your home, such as putting in extra insulation or installing energy saving windows, consider doing so before year end in order to qualify for a tax credit that may not be available after 2007.

• If you are thinking of buying a hybrid vehicle eligible for a tax credit, purchase it before year-end after confirming that the particular model still qualifies for the credit.

• You may want to pay contested taxes to be able to deduct them this year while continuing to contest them next year.

• Business clients also should consider making expenditures that qualify for the $125,000 business property expensing option.

• You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.

• You may be able to save taxes this year and next year by applying a bunching strategy to “miscellaneous” itemized deductions, medical expenses and other itemized deductions.

• Those facing a penalty for underpayment of estimated tax may be able to eliminate or reduce it by increasing their withholding.

• Self-employed individuals should consider setting up a self-employed retirement plan.

• You can save gift and estate taxes by making gifts sheltered by the annual gift tax exclusion before the end of the year. You can give $12,000 in 2007 to an unlimited number of individuals but you can't carry over unused exclusions from one year to the next.

• This year, the kiddie tax rules apply to kids under age 18; next year they will also ensnare most children age 18 and most full time students age 19 through 23. If your child holds appreciated stock, and isn't in kiddie tax territory this year but will be in 2008, consider having him or her sell the stock this year. In many cases this will result in a 5% tax on the gain, instead of 15% if the sale is postponed till next year.

• If you're thinking of donating a used auto to charity, you may want to inquire whether the charity plans to sell the car or use it in its charitable activities; the latter may yield a bigger deduction for you.

• If you are contemplating marriage or divorce consider how marriage penalties could affect you.

• If you are age 70 1/2 or older, and own IRAs (or Roth IRAs), and are thinking of making a charitable gift before year-end, arrange for the gift to be made directly by the IRA trustee. Such a transfer can achieve important tax savings but it won't be available after 2007 under current law.

• If you are receiving Social Security benefits, there are a number of steps you can take to reduce or eliminate tax on your benefits. Consider asking your employer to increase withholding of state and local taxes to pull the deduction of those taxes into this year (but only if doing so won't cause an AMT problem)

• Consider extending your subscriptions to professional journals, paying union or professional dues, enrolling in (and paying tuition for) job-related courses, etc., to bunch into 2007 miscellaneous itemized deductions subject to the 2%-of-AGI floor.

• Depending on your particular situation, you may also want to consider deferring a debt-cancellation event until 2008, electing to deduct investment interest against capital gains, and disposing of a passive activity to allow you to deduct suspended losses.

These are just some of the year-end steps that can be taken to save taxes. Again, by contacting us, we can tailor a particular plan that will work best for you.

Source: Federal Taxes Weekly Alert, 10/04/2007, Volume 53, No. 40

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