Property tax: a CPA's perspective.

The pressure on businesses to reduce costs continues at an increasing pace. CPAs have long focused on Federal taxes to reduce costs, but as state and local taxes increase both in amount and in complexity, they provide opportunities to reduce costs as well. Within the state and local tax mix, the property tax is often overlooked because many CPAs are unfamiliar with property tax laws and valuation methods. However, a resourceful practitioner can find tax savings in this oldest and least popular Of taxes.

In most states, property tax is based on the property's fair market value (FMV); both real property and personal property may be subject to taxation FMV is defined as the price at which the property would sell in the open market in an exchange between a willing seller and willing buyer, both with adequate information with which to make a decision and neither being under duress. This standard is nearly universal; however, individual taxing jurisdictions may have exceptions to this standard (such as the Proposition 13 limitation in California).

The privilege tax is a tax equal to the property tax. It is imposed on property owned by an exempt entity (such as the Federal government) and leased to a taxpayer for commercial purposes. This tax generally applies to such businesses as concessionaires at national parks and companies operating at public facilities, such as airports.

Personal property is subject to taxation in 42 states and the District of Columbia. Personal property taxes are sometimes centrally administered by the state revenue agency, or they may be locally administered under uniform state statutes, regulations and guidelines. In a handful of states, local governments are authorized to impose and administer personal property taxes.

Different classes of property may be assessed by different assessing officers. It is customary for a local assessing officer to value residential and local commercial property. Centrally assessed property is usually assessed by the state taxing agency (because the business operates across county or state lines). The value of the property allocated to a particular state is usually apportioned back to the local governmental entities.

Centrally Assessed Property

Because centrally assessed property works as a unit across county lines, it is usually assessed on a unitary basis, with the entire business valued as an operating unit rather than as a collection of individual assets. Unitary assessment is more akin to business valuation than traditional real property appraisal. As a rule, utility property is classified as centrally assessed property and valued as a unit.

Sometimes, centrally assessed properties are not subject to unitary valuation methodologies. For example, in some states natural resource property is centrally assessed. However, rather than valuing, for example, an oil company as a whole, each individual well is valued using a discounted cash flow method.

The same basic approaches to value are used in valuing centrally assessed properties that are used in real estate valuation, but with several adaptations. Typically, the cost approach is computed by using historical cost less depreciation. This method is most relevant when valuing regulated utility companies subject to earnings restrictions and for newly built special purpose assets. Replacement cost (new) less depreciation is rarely used, because it is so difficult to determine.

Two income methods are often used to value these properties: direct capitalization and yield capitalization. Using the direct capitalization approach, a company's normalized net income is divided into a capitalization rate derived from an analysis of the cost of capital of comparable companies. Direct capitalization is the easiest method to use, because the value can be derived in one step. The yield capitalization method is a traditional discounted cash flow method, in which net cash flow is projected for several years into the future and discounted to present value by a rate appropriate for the type of investment and the degree of risk. A residual value is also discounted to present value.

The market method is known as "stock and debt." Accountants should be familiar with this method, because an accounting equation forms its basis. For publicly traded companies, the total market capitalization is determined by multiplying the total number Of shares outstanding by the stock price. The market value of all debt is added to the market capitalization to arrive at the FMV of liabilities and equity. Because assets equal liabilities plus equity, the FMV of all assets is therefore also determined. The value of current assets (and sometimes, intangible assets) is subtracted to arrive at the value of the property. After each of these three methods has been calculated, the results are correlated, using professional judgment to arrive at a value of the taxable assets of the subject unit.

Central assessment methodologies traditionally lead to disagreements. In both the direct capitalization and the yield capitalization methods, the cash flow used and the discount rate used are commonly disputed. When looking at the stock and debt approach, the most common area of dispute is the allocation of the stock value to nontaxable subunits of a publicly traded parent company. There are many possible methods that can be used to make the allocation; all are very subjective.

Intangibles

Taxation of intangibles is a key issue when a property is assessed using the unitary valuation methods, because the property is taxed on its business enterprise value. In addition to real and personal property, the business enterprise value may include intangibles such as goodwill, patents, trademarks and other intangibles. In states that prohibit taxation of intangibles, the taxing agencies may take the position that intangibles must be separable and subject to valuation before they will be removed from the assessment; in such situations, the taxing agency argues that the property's FMV is enhanced by the company's going concern value, and that the property is undervalued if only the replacement cost approach were used.

Taxation of intangibles is the subject of a great deal of litigation. Courts in some states have ruled against the taxation of intangibles because, while a state's constitution and statutes may generally permit their taxation, neither the legislature nor the tax administrator has promulgated a methodology for reporting, assessing or taxing such assets. Budgetary pressures and the emergence of a service economy may lead some of these jurisdictions to use their constitutional powers to formally tax more types of assets in the future. Courts in several jurisdictions have given guidance to the state taxing authorities about taxation of intangibles.

Intangible personal property is exempt from tax in about 30 states, but the specific applicability of this exemption may vary. For example, some states specifically prohibit taxation of intangible property of any kind. In other states, specific types of intangible property (such as money, stocks and bonds) are exempted, while other business intangibles (such as intellectual property, customer lists and software) are not specifically addressed by statute.

Taxation of computer software is a topic worthy of separate mention. In a number of jurisdictions, it has been ruled that "canned" software is tangible personal property subject to tax, but "custom" software is either specifically exempt or exempt under a general classification as intangible property. A slightly different theory is applied in other states in which operating software is considered part of taxable computer hardware. However, in these states, application software is exempt intangible property.

Exemptions

As with any other multistate tax topic, an astute property tax practitioner will closely examine the statutory language governing personal property taxation in each state, paying particular attention to specific property tax exemptions. Exemptions for certain types of manufacturing equipment, for property located in enterprise zones or other special districts, and for pollution or waste control equipment, are fairly common. Less common are exotic (and more poorly defined) exemptions for forms, jigs and dies, or even engineering drawings or other"soft" costs, which may suggest substantial savings to the informed professional. Case law may also define exemptions; for example, one state's highest court recently held that sales tax, freight and installation charges did not have to be included in the cost base of tangible personal property.

Tax Strategies

Beyond this, many of the same tax-saving techniques that apply in the area of real property taxation should be adapted for personal property tax purposes. In states with no personal property tax, cost classification may enable taxpayers to move real property components into an exempt category. Similarly, ascertaining the intangible components of taxable equipment can reduce the property tax burden without affecting the accelerated depreciation methods used for income tax purposes.

The FMV of personal property is usually estimated by using a depreciation table established by the state taxing agency. The depreciation tables usually have two components. First, indexing accounts for the effect of inflation on the asset since it was originally acquired. Second, a "percent good" factor reflects the asset's physical depreciation. For property tax purposes, assets in use never fully depreciate, so the "percent good" tables always have a floor. The taxpayer's acquisition cost becomes the basis for applying the table to various classes of machinery and equipment. Each asset class is depreciated over a certain estimated useful life; these class lives are often set by the state agency and may be different than the company book or tax lives. Manufacturing machinery and equipment are usually assigned an 8-15 year life, office furniture and equipment a 6-10 year life, and computer equipment a 3-5 year life. The taxpayer will customarily ask the CPA to complete the personal property tax schedules sent from the taxing authorities. The CPA will complete the schedules based on the acquisition cost shown on the depreciation schedules used for book purposes. The valuation rates applicable to different classes of taxable personal property can make a real difference in deciding where to report certain property. Finally, the elimination of "ghost" assets and property not used in business from the annual listing can reduce the overall property tax burden.

Areas to Watch

There are several steps CPAs can take to ensure that their clients are not paying too much property tax:

* Check the official record of the taxing authority for mistakes. Watch for items such as square footage of buildings and total acreage of land. Be certain the assessor is valuing the proper parcel(s). Make sure the assessor has used the appropriate personal property tax schedule and"percentage good" table for the class of property. Taxing authorities are usually very accommodating when legitimate errors in their records are discovered. CI Check the statutes for exemptions and reductions for certain classes of taxpayers. Most state laws allow tax breaks for taxpayers who meet special criteria. These tax breaks usually depend on the taxpayer's age, income, marital status or other personal characteristics (such as disability). Because many of the people eligible for these types of exemptions and abatements may have no income tax liability, they probably will not engage a CPA for property tax work. However, a current client list can yield valuable leads for identifying new clients. Ask clients if they know of anyone eligible for property tax exemptions or abatements.

* After the underlying data has been checked for mistakes, the CPA and the client should use a reasonableness test to evaluate the value arrived at by the taxing authority. If the value is within a reasonable range, it may still be worth challenging under certain circumstances. If it is known, for instance, that taxpayers who appeal generally get some sort of reduction in value, an appeal may be worthwhile. However, such challenges must be used judiciously. In some jurisdictions, once a value is challenged, it is susceptible to an increase if the evidence presented indicates that it is too low. The reasonableness test should be an indicator of a problem and should alert the practitioner to take additional steps to lower the value.

* The best evidence of FMV is an appraisal prepared by a licensed professional. Many CPAs are not trained as appraisers. (In fact, a CPA who performs an appraisal may be in violation of the state's appraisal laws.) If an initial review indicates that the property is overassessed, it should be determined whether the difference in value warrants hiring an appraiser to give an opinion. An appraisal may cost as little as a few hundred dollars (for a locally assessed residential property) or several thousand dollars (for commercial or centrally assessed property). Money spent on an appraisal may be a good investment if the value is ultimately challenged. But if the expense of an appraisal is not warranted, determine if the property has been appraised for other purposes (such as for bank loans, insurance and buy/sell agreements). In some jurisdictions, these appraisals may be enough to substantiate a lower value. In the case of real property purchased near the assessment date, a copy of the closing statement can be used to support the requested value reduction. In most cases, a closing statement is accepted without further question.

* If there is an issue worth challenging, the CPA should contact the assessing jurisdiction. Many issues may be able to be resolved through an informal meeting or phone conversation with the assessor, especially if the CPA is prepared to provide documentation to support his position. Early resolution of problems saves both the practitioner and the assessor the time and expense incurred in a formal appeal. If the issue cannot be resolved at this level, file an appeal with the assessing agency.

* Most states use a multilevel appeals process for locally assessed property tax appeals. If the issue is not resolved with the local appeals officer, the filing of an appeal with the state agency responsible for assuring equal and fair values should be considered. Administrative appeals are often quite informal and require no particular knowledge of legal procedures. In many states, a CPA can represent the client in these hearings; in other states, an attorney must be engaged. In either case, consider retaining an appraiser as an expert witness.

* Decisions of administrative agencies are generally subject to judicial review, but the taxpayer must first exhaust all administrative remedies. It is important to follow the agency's appeal procedure carefully. Always watch for filing deadlines; if a client misses a statutory deadline, all appeal rights may be forfeited. Of course, judicial review requires legal representation; an attorney specializing in property tax law should be consulted.

It may be useful to learn about the people who make the decisions in administrative appeals. In preparing possible arguments, it may be helpful to know the appeals officer's background. Published decisions, press clippings or other reports about tax disputes may reveal trends in the agency's approach to property tax issues.

Conclusion

Property tax is becoming a more significant portion of the total tax bite. By reviewing the underlying basis of the tax and the property's FMV, the CPA can help minimize the tax. Using an appraiser to prepare an appraisal is the best evidence of what the property is worth. The appraisal can help determine when and if the value of the property should be appealed to the local or state authorities. CPAs are the professionals relied on to watch for the details, and property tax is fraught with details that need checking.

FROM BRYAN RUEZ, CPA, PARTNER, STATE AND LOCAL TAX PRACTICE, ARTHUR ANDERSEN LLP, HOUSTON, TEX W. VAL OVESON, CPA, CHAIRMAN, UTAH STATE TAX COMMISSION, SALT LAKE CITY, UTAH, AND FRANK SCHAEFER, CPA, PARTNER, GRANT THORNTON LLP, NEW YORK, N.Y.

Editor's note. Ms. Manos-McHenry chairs the AICPA Tax Division State and Local Taxation Committee. Mr. Ruez, Mr. Oveson and Mr. Schaefer are members of the committee.

If you would like more information about this article, contact Ms. Manos-McHenry at [phone] or Mr. Oveson at [phone].