Life after Hospital Corp. of America.

Tax practitioners enthusiastically greeted the Tax Court's decision in Hospital Corp. of America and Subsidiaries (HCA), 109 TC 21 (1997). In this case, the court concluded that certain properties in a building that qualify as tangible personal property under the former investment tax credit (ITC) rules may also qualify as tangible personal property for depreciation purposes. In other words, practitioners relying on this case can look to the guidance of the old ITC rules when determining whether property is real property (27.5- or 39-year recovery period) or personal property (five- or seven-year recovery period).

In reaching its decision, the court reviewed the multi-factor analysis described in Whiteco Industries, Inc., 65 TC 664 (1975), which asked six pertinent questions:

1. Is the property capable of being moved, and has it in fact been moved?

2. Is the property designed or constructed to remain permanently in place?

3. Do circumstances show the expected or intended length of affixation (i.e., that the property may or will have to be moved)?

4. How substantial and time-consuming a job is removal of the property? Is it readily movable?

5. How much damage will the property sustain on removal?

6. What is the manner of affixation of the property to the land/building?

The taxpayer in HCA argued that the items in dispute were in fact tangible personal property eligible for a five-year recovery period in accordance with the asset guidelines for the taxpayer's particular business. The taxpayer looked to the definitions in the ITC rules to identify items constituting tangible personal property. In addition, the taxpayer based its classification in part on the property's primary use, particularly for the electrical, plumbing and mechanical systems. The IRS argued against the five-year recovery period and in favor of treating the disputed items as Sec. 1250 real property, on the basis that the items were structural components of the buildings and thus should be treated as part of the building. The Service's position was that the old ITC rules should not be relied on when classifying property items for depreciation purposes and that permitting such a classification essentially amounted to component depreciation. The Tax Court rejected the IRS's primary argument of prohibiting component depreciation and concluded that, to the extent disputed property would qualify as tangible personal property for ITC purposes under pre-1981 law, it will also qualify as tangible personal property for depreciation purposes.

Post-HCA

On April 1, 1999, the Service released CCA 9921045, stating the Chief Counsel's response to HCA and the position examiners should take in light of the Tax Court's decision. As the CCA states, there is still no bright-line test to determine what is tangible personal property versus a structural component, and the determination is still a highly factual one. However, pre-1981 law is relevant to the assessment of whether disputed items are tangible personal property or real property. The CCA stated that cost-segregation studies must be specifically applied by the taxpayer and that certain "allocated" equipment must be depreciated over the same period as the buildings to which they relate, if the records do not provide any "logical and objective measure" of the portion of the equipment that would constitute Sec. 1245 property. In addition, an accurate cost-segregation study may not be based on noncontemporaneous records, reconstructed data or taxpayer's estimates or assumptions that have no supporting records. Although the CCA is not legally binding, it cautioned examiners to closely scrutinize cost-segregation studies.

On Aug. 30, 1999, the IRS acquiesced in result only to HCA on the issue of whether the tests developed under the ITC rules were applicable in determining a structural component for depreciation purposes. The Service also stated its nonacquiescence in result only to the issue of whether certain items treated as tangible personal property and depreciated over a five-year recovery period were in fact structural components of the buildings to which they relate that must be depreciated, under Sec. 168, over the same recovery period as the buildings.

Field Service Advice (FSA) 200033002 was issued in response to the question of whether certain raised flooring installed during the construction of an office building to facilitate the installation of computer systems was personal property under Sec. 168 or a structural component of a building. In this instance, the taxpayer was in the business of providing various computer-related services to banks. During the tax year, the taxpayer placed in service a data center consisting of a three-story building, with tyro floors devoted to offices and computer equipment and one floor described as a parking garage. The first floor of the building was constructed with a raised floor to facilitate the installation of wiring, plumbing and ventilation for computers and other equipment. The raised floor included removable panels that provided access to the space between the raised floor and the sub-floor. There was no finished floor below the raised floor. The raised floor was installed in most of the first floor of the building, including a computer room, printer room, storage rooms, mail room, conference rooms, offices, customer service areas, mechanical and electrical rooms and telecommunications rooms. The only areas without the raised floor were the main lobby, restrooms, stairwells and the corridors connecting the stairwells to emergency exits.

The taxpayer engaged an outside firm to conduct a cost-segregation study in support of its position that the raised floor was Sec. 1245 tangible personal property with a five-year recovery period. According to Regs. Sec. 1.167(a)-11(b)(4)(iii)(b), property is included in the asset guideline class for the activity in which it is primarily used. Property is classified according to primary use, even though the activity in which such property is primarily used is insubstantial in relation to all the taxpayer's activities. The examining agent believed the raised floor to be a structural component of the building (i.e., nonresidential real property). However, Rev. Rul. 74-391 considered a raised floor built over an existing floor to permit wiring, air-conditioning ducts and other services for computer equipment to be installed. The ruling stated that the raised flooring was a necessary part of the installation and operation of the computer equipment, an accessory of such equipment. Referring to the ITC rules, the ruling provided that the raised flooring was not a structural component. Citing Rev. Rul. 74-391 as well as the multiple factors analyzed in Whiteco Industries, the FSA concluded that the raised flooring did in fact qualify as tangible personal property, barring additional factual findings.

However, the IRS later issued FSA 200110001, which reconsidered the conclusion reached in FSA 200033002. On reconsideration, the Service distinguished Rev. Rul. 74-391 on the basis that the removal of the floor would constitute an extensive renovation or that the building would lose its functionality. Also, the lack of a finished floor on the subfloor made the raised floor more like a catwalk and a structural component of a building. Applying the multiple factors in Whiteco Industries, the IRS concluded the raised floor should be treated as a structural component due to its apparent permanence.

In L.L. Bean, Inc., 145 F3d 53 (1998), aff'g TC Memo 1997-175, the First Circuit affirmed the Tax Court's decision denying the taxpayer's claims that certain disputed items qualified as tangible personal property and were not entitled to ITC for such costs. Of particular interest was the issue of whether 75% of the cost of the building's electrical system was tangible personal property. L.L. Bean cited three cases that allocated electrical system costs to the ITC in proportion to the percentage of the electrical load that powered certain machines: Morrison, Inc., 891 F2d 857 (11th Cir. 1990); Illinois Cereal Mills, Inc., 789 F2d 1234 (7th Cir. 1986); and Scott Paper Co., 74 TC 137 (1980). L.L. Bean apparently introduced no evidence as to the proportion of electricity used by the equipment at hand; nor did it claim that 75% of the electrical system, as measured by cost, comprised separate components used only to power the equipment and so arguably was part of the machinery that it powered. Rather than introducing a detailed analysis supporting the percentage determination, only evidence regarding a "discussion" with professional engineers was introduced. According to the First Circuit, the Tax Court was apparently prepared to consider an ITC based on relative use, but found that the evidence presented did not prove that 75% of the electricity was used by the equipment. Thus, the entire credit was denied.

In Boddie-Noell Enterprises, Inc., 36 Fed C1772 (1996), the court denied the taxpayer's ITC claims for certain costs associated with several hundred restaurant franchises the taxpayer owned and operated. In this case, the taxpayer had obtained a cost-segregation study performed by another company for Hardee's Food Sytems. The cost-segregation summary indicated that 24% of the Hardee's restaurants qualified for the ITC. Applying the study to its restaurant's costs and plans, a similar percentage was determined. The studies on which it had relied were performed not for Boddie-Noell Enterprises, but for a typical Hardee's restaurant for use by Hardee's franchisees. The court denied the taxpayer's claims, primarily on the basis that it failed to present sufficient documentary evidence and testimony that it was eligible for the credits. The court held the taxpayer could not rely on studies performed 12 years after construction that determined the percentage of an individual restaurant's costs eligible for the credit and then apply that percentage to other restaurants and other tax years.

The Next Step

Based on HCA, as well as other relevant cases and IRS positions, there is authoritative guidance supporting the application of the ITC rules in determining the proper classification of items as either tangible personal property or structural components. It also appears clear that identifying a property's primary use plays a significant role in determining the proper asset class and depreciable recovery period. Of particular significance is the multiple-factor analysis described in Whiteco Industries, Inc.

Taxpayers and practitioners trying to obtain faster depreciation deductions should be well-versed with these cases and rulings, including those prior to HCA. As proven in L.L. Bean, Inc. and Boddie-Noell Enterprises, Inc., taxpayers should use qualified and experienced appraisers, architects, engineers and tax professionals when performing cost-segregation studies. Such studies should be performed for the actual taxpayer seeking to identify tangible personal property items, and should be thorough, well-documented and supported with relevant information. Whether the depreciation system will undergo a complete IRS overhaul or not (as recommended by many), practitioners should watch the courts and the Service for signs of what might happen next.

FROM JAY SATTLER, CPA, BLUM, SHAPIRO & COMPANY, P.C., HARTFORD, CT