Cost Segs Defer Taxes, Save Clients Big Money

Scott Gammill is like an accounting archaeologist.

He’ll dig through clients’ dusty boxes looking for evidence of past construction on a particular building. He’s been in grain silos and railroad cars turned storage sheds looking for blueprints, schematics and remodeling plans — anything that might document the various stages of a building’s history.

Gammill, the manager of cost segregation services for Little Rock’s Moore Stephens Frost Financial Group, will gladly do anything to save a property owner money. But in order to do it, he has to count the electrical outlets, linear feet of Ethernet cable — anything the Internal Revenue Service might consider personal property — and document its age and cost.

Along with that sometimes comes the arduous task of reconstructing a building’s additions or expansions. Therefore, Gammill is willing to roll up his sleeves and rummage for any shred of documentation to back up his depreciation claims, lest they come under scrutiny from the IRS.

Such is the life of a cost segregation specialist — a sort of accountant slash engineer slash Indiana Jones.

The practice of cost segregation is a relatively new accounting method, allowable since 1999, that has property owners deferring federal taxes on new and existing buildings and increasing immediate cash flow.

It’s a way to accelerate depreciation on various levels of assets and pay for them later.

Essentially, the components of a building are reclassified into proper lives (either seven-, 15- or 39-year lives) by the modified accelerated cost recovery system and IRS rulings.

Golden Opportunity

There’s no time like the present, because a 50-percent, first-year bonus depreciation expires on Dec. 31.

The bonus has been a culmination from Section 168 of the Jobs Creation and Workers Assistance Act of 2002, which gave a 30 percent bonus, and the Jobs Growth and Tax Relief Reconciliation Act of 2003, which increased the bonus to 50 percent, said Keith Ekenseair, a CPA and manager of Moore Stephens Frost’s Rogers office.

Essentially, the bonus allows property owners to claim up to 50 percent of the seven-year and 15-year depreciations within the first year, leaving them a cash flow windfall.

But even without the bonus, a cost segregation will provide property owners greater cash flow almost immediately.

According to a schedule Gammill prepared for one Northwest Arkansas client, MSF has saved them $198,400 in taxes over the course of 40 years on a $5.46 million building.

Because of confidentiality agreements, Moore Stephens Frost could not divulge the client’s name or building.

The client will have a combined $295,031 of extra cash flow in the first seven years, through 2010. The $96,631 difference will eventually be paid back to the IRS by the property owner sometime after year 16 (2019), according to the schedule.

However, the schedule is figured at a conservative 5 percent reinvestment rate (the discount factor in the chart). Many property owners will be able to earn an even greater return on their money.

Seven years is the depreciation life set by the IRS for personal property that could be reclassified under a cost segregation, 15 years is for land improvements and 39 years is the depreciation life for real property, such as a building.

“When you go through a cost-segregation analysis, you take the completed cost of putting a structure together and getting it ready for commercial use, and then you go in and segregate the costs into separate components,” Ekenseair said.

Traditionally, a property that cost, say $1 million to build would depreciate for 39 years at the full price of $1 million.

Through cost segregation, the building’s owner can look at the permanent structure, or the shell, of the building as a real property asset. Then they can look at the assets used to appoint the building — light switches, conduit, electrical outlets, even the parking lot — as personal property assets or land improvements that are a smaller component of the building.

“For example, the carpet is not a permanent piece of the building. So, by using the cost segregation, the carpet cost doesn’t get spread over the 40-year depreciation life, it gets spread over a personal property life, which is seven years,” Ekenseair said.

Cost segregation is intended to maximize the allowable depreciation within the IRS guidelines, thus increasing cash flow, he said.

The faster an item such as the carpet depreciates, the more tax can be deferred and the less tax a property owner has to pay early on.

In the Northwest Arkansas building example given, Moore Stephens Frost segregated out 10.6 percent of the $5.46 million into a seven-year depreciation of personal property and 15.3 percent into a 15-year depreciation of land improvements, leaving only 74.1 percent for the 39-year depreciation.

“Most of the real estate holdings up here are in LLCs and most of the LLCs are taxed as partnerships,” Ekenseair said. “So if you can go in and do a cost segregation for an LLC and generate a depreciation benefit, then that benefit will pass directly down to the individual’s tax returns.”

Those individuals are saved cash flow taxes, he said.

All things being equal, Ekenseair said, between two building owners with one doing a cost segregation and the other not, the one doing the segregation is “going to cash flow better because he’s going to pay less tax — at the end of the day — no ifs, ands or buts about it.”

Digging the Foundation

Gammill said each building is a case-by-case basis, so there’s no way for him to give an average of what he can save a client unless he’s asked to do a formal estimate.

Gammill said he’s never missed a savings calculation. He has come in with higher savings in a few instances, but he’s never missed the estimate.

The cost to an owner for MSF’s services and Gammill’s expertise vary, too. The pair said a good rule of thumb is between 7 percent and 10 percent of the estimated savings.

“The sales pitch is: If I can save you $100,000, but I’m going to charge you $8,000, would you pay $8,000 to save [a total of] $92,000? The answer is yes,” Ekenseair said.

Gammill said a lot of the up front costs depend on the complexity of the building.

“It all hinges on how much information you have and how much work you have to build up,” Gammill said.

Ekenseair and Gammill said cost segregation is perhaps most beneficial to property owners if it’s done the first year a building goes into service, opposed to a retroactive study, because most of the tax savings will occur within the first seven years. That’s the time frame many new businesses will need the money most, they said.

But, Gammill said, a cost-segregation study can be done on buildings up to 18 years old, which will present the owner with a windfall of tax savings the first year after the segregation is done.

A lot of accounting-savvy businesses have done this, leaving Gammill to help poke through boxes and call architects to piece a building’s history back together with long-forgotten blueprints.

“I’ve had good luck with the IRS on combining known costs with an engineering-based approach,” Gammill said.

“If I have hard, known costs for certain things, it makes it easier,” he said. “You can’t argue when you’ve got an invoice for $100,000 for computer wire.”

“It is a blend of accounting, law and engineering,” Ekenseair said, noting that he’s seen Gammill work in a tiny space with all manner of large documents spread over a desk and chair.

Gammill is often asked if a cost segregation will be an immediate red flag to the IRS.

A cost segregation on an existing building will essentially result in a change of accounting method, Ekenseair said. Property owners are required to file Form 3115 with the first return indicating the change.

“Nobody has been audited specifically because of a cost seg or a change in accounting method that we’ve filed, to my knowledge,” Gammill said.

Ekenseair said a segregation simply means that if a business does get audited, the IRS will have additional information to look at.

Banks, auto dealerships, manufacturing facilities and office buildings are immediate candidates for cost segregation, the duo said, but the possibilities are virtually endless.

Far East

Moore Stephens Frost has performed about 50 cost-segregation studies in Northwest Arkansas and about 200 companywide. A brochure on the topic claims to have saved clients “over $32 million in present cash flow benefit.”

Howard Millard, director of tax for Perdue Farms Inc. in Salisbury, Md., used MSF to do a cost segregation on the entire company.

Perdue Farms is the most familiar poultry producer in the eastern part of the U.S. with about $2.7 billion in annual sales.

Millard said he was shopping around the Big Five accounting firms for a cost segregation when he ran across MSF. They did a presentation that saved almost twice what the other firms proposed and cost about half the fee.

Plus, being based in Arkansas, MSF already had some knowledge of the poultry industry and how it works.

The decision was a no-brainer, he said.

Perdue did a companywide, retroactive multi-building segregation. Total taxes deferred were about $13 million, Millard said, which will add up to a total of about $8 million in total savings by the end of the schedule.

“It’s a timing issue,” Millard said. “They accelerated millions of dollars of deductions — it was seven figures at least in interest play …”

The segregation was so large, Perdue asked the IRS to do a pre-filing audit to make sure everything was in order.

The IRS allowed about 97 percent of the claims the company asked for, and Millard was pleased.

Perdue now calls in MSF when it erects a new building, and has done at least three other segregations with the firm, he said.

Gammill did the work, traveling back and forth to Maryland.

“It seemed like he was here forever,” Millard said.