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Cost segregation studies can improve your business's cash flow

Is your business seeking quick ways to improve cash flow? Look no further than to a new building you've acquired or renovated or a recent improvement to your production line.

Cost segregation is an asset depreciation technique that identifies, separates and quantifies the cost of an acquisition into its individual (property) components. Parts of a building. usually nonstructural elements such as carpeting, wall coverings, lighting, signage and certain mechanical, plumbing and electrical costs, can be depreciated more quickly. Items of personal property and land improvements or non-structural components are given shorter, favorable asset classifications and recovery periods.

While the typical depreciation schedule for a building is 39 years, a cost segregation study can identify many nonstructural assets and exterior site improvements that can be depreciated more quickly -- five to seven years for personal property and 15 years for land improvements. That accelerated depreciation can reduce a company's current taxable income and improve short-term cash flow.

Cost segregation studies

Cost segregation studies began in the late 1980s, when Congress extended the depreciation period on commercial property from 19 to 31.5 years. That period was further extended to 39 years in 1993. Because of those changes in the tax law, financial managers had greater incentive to separate the asset value of an actual building from the value of other nonstructural assets -- such as landscaping, carpeting, wall coverings, specialized plumbing and electrical costs, and certain equipment and furnishings. Those assets can usually be depreciated on a five- to seven-year schedule.

For-profit and profitable companies benefit from cost segregation. Cash flow savings can be gained by rectifying misclassifications, including repair and maintenance items; removing prior improvements upon disposal; and taking advantage of accelerated and bonus depreciation of costs associated with construction, renovation, or asset purchase of a company, including building or leasehold improvements.

Because proper asset classification is key to an effective cost segregation study, most experts recommend a detailed "engineering approach" over a less-rigorous invoice analysis. The engineering model involves a blueprint review, physical inspections to characterize on-site assets and tax research. While this process is more costly and time-consuming, it also provides a defensible paper trail that can greatly reduce the risk of an Internal Revenue Service audit adjustment. The investment in this approach, however, often pays for itself seven to 10 times over.

Although the IRS does not require any one methodology, a combination of accounting and engineering disciplines into a full-service engagement that pairs knowledge of IRS regulations and engineering know-how is more credible. The quality of the preparer, coupled with reliable taxpayer's information and report content reduce the likelihood of adjustments and possible penalties.

Factors to consider when deciding on cost segregation study

In general, tax professionals say that business leaders may want to take a closer look at potential cash flow and tax opportunities if:

  • The company has built a new facility, purchased real property, renovated or made leasehold improvements during the past 17 years.
  • The cost of the projects exceeds $500,000.
  • The company is in the manufacturing and distribution, public utility, telecommunications, commercial construction, banking, entertainment/leisure or restaurant industries (though other businesses with a high level of specialized capital equipment may also benefit).

- Bob Weigel is a state and local tax manager with RSM McGladrey. He can be reached at (217) 398-9400 or bob.weigel@rsmi.com.

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