Cost Segregation and Asset-based Acquisitions

A cost segregation study can be an extremely beneficial tax planning tool; however, it is often an afterthought rather than a proactive conversation. A reactive approach is often acceptable but does not come without its dangers.

In 2012, the U.S. Tax Court’s ruling in Peco Foods, Inc., T.C. Memo. 2012-18 disallowed Peco Foods, Inc.’s post-acquisition cost segregation study allocation of 1250 and 1245 property due to binding language and asset value allocations in the original purchase agreement.

There were no issues with the cost segregation study itself, only the purchase agreement contracts that preceded the study. A closer examination of Peco’s purchase agreement missteps makes it clear the situation could have been avoided had a cost segregation expert been consulted throughout the acquisition process.

As an addendum to their purchase agreements, Peco and the seller included purchase price allocation schedules that further detailed the assets and their respective values included in the purchase. For example, the purchase of one facility denoted a total purchase price and an allocation of the purchase price to land, improvements, machinery, equipment, and furniture. Furthermore, definitions were established for these allocated categories. Since the assets were clearly defined and given a value, Peco did not have the right to subdivide those assets further to gain an accelerated depreciation deduction.

Despite the allocation schedules of asset values, Peco maintained the terms used in the allocation were ambiguous and, therefore, unenforceable. The U.S. Tax Court used these purchase price allocation schedules and explicit definitions included in the contract as direct evidence to disallow Peco’s cost segregation study results.

The fact that the purchase price was allocated into these distinct categories at the time of purchase revealed Peco was aware of the practice of subcomponent assets. It was proven after Peco realized their initial allocation provided a less favorable tax position that they looked to further divide these assets. The U.S. Tax Court referenced a previous ruling from Commissioner v. Danielson to maintain that the original allocation was enforceable and binding.

Lastly, the most obvious error was the inclusion of a simple contract clause. When drafting purchase agreements for the two poultry processing plants, Peco agreed to allocate each plant’s purchase price among various assets “for all purposes (including financial accounting and tax purposes).” Simply put, excluding this clause — or replacing it with “the allocation in this agreement is not intended for federal income tax purposes” — would have voided the controversy.

Roughly 10 years after their cost segregation study, Peco Foods was served a notice of income tax deficiencies. Once the case was heard three years later, it was confirmed their cost segregation study depreciation deductions would be disallowed, forcing them to pay penalties for the improper reduction of income. A conversation with CPA and cost segregation expert could have prevented this unfortunate scenario and would have saved Peco Foods significant time and investment.

Interested in discussing a potential client or current cost segregation project? Reach out to the McGuire Sponsel Fixed Asset Services team today to start the conversation.