Engineer is Potentially Subject to Penalty for Overly Aggressive Cost Segregation Study

In a Chief Counsel Memorandum (CCA 201805001), the IRS found that a “tax-consultant engineer” could be held liable for a penalty under IRC §6701 for aiding and abetting another person in the understatement of that person’s tax liability.  In the matter at hand, the engineer had advised the taxpayer to, at least in the IRS’s view, overly aggressively attempt to reclassify portions of a building to have their costs recovered under much shorter lives.

IRC §6701(a) provides in part:

(a) Imposition of penalty

Any person—

(1) who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,

(2) who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and

(3) who knows that such portion (if so used) would result in an understatement of the liability for tax of another person,

shall pay a penalty with respect to each such document…

In this situation, the IRS asserted the engineer had gone well beyond the bounds of what was justified in taking portions of the cost of the building out of a 39-year life into much shorter lives. As the memo notes:

The IRS determined that the S incorrectly reclassifies property in order to accelerate or “front-load” depreciation deductions during the first 5 years the property is placed in service, thereby creating larger tax losses for P's clients. The IRS considers the portions of the S categorizing certain structural components as 5-year property to be the most egregious misrepresentations concerning the classification of property for tax purposes. You requested our views on whether P is liable for a $1,000 penalty for each taxpayer's return upon which an excessive depreciation deduction was claimed as a consequence of following the conclusions in the S.

For purposes of this analysis, accepting that finding as correct, the question arises regarding whether such conduct would subject the engineer to a potential penalty under IRC §6701 and how many such penalties the engineer might owe.

The memo concludes that this sort of work (that is, a cost segregation study) is subject to the penalties found in IRC §6701 should the engineer advance an unjustifiably aggressive position.

As the memorandum concludes:

The written S satisfy the elements of a section 6701 penalty. P prepared and furnished to each of his clients a detailed S. Consequently, the S fall within the requirements of section 6701(a)(1). The S also meet the criteria of section 6701(a)(2) and (3); P knew that they would be used in connection with the preparation of individual and corporate tax returns. Thus, P knew or had reason to believe that his clients, both individual and corporate taxpayers, would use the S as guidance in claiming depreciation deductions on returns, a material matter under the internal revenue laws, and that the S would (if so used) result in understatements of tax liability of other persons. Thus, each S is a document that supports a penalty in an amount determined under section 6701(b). To the extent the S related to the tax liability of a corporation, the penalty amount is $10,000 per S furnished. For S furnished to taxpayers other than corporations, the penalty equals $1,000 per S furnished. I.R.C. § 6701(b)(1).

As well, the penalty would apply to each year the study was made use of to reduce the taxpayer’s tax liability. The memo goes on:

Each of P's clients had to file a Form 1040 or 1120 with the IRS in order to claim a deduction for depreciation. P aided or assisted in the preparation of each individual or corporate tax return upon which a client claimed a depreciation deduction in an incorrect amount by virtue of misclassifying personal or real property in accordance with the S. The purpose behind P's review, analysis and classification of a client's articles of property was to assist his client in preparing and filing a tax return that included a depreciation deduction exceeding the allowable amount under the Code and thereby understating taxable income. By furnishing a S to a client that classified certain real property as personal property, with purported useful life of only 5 years, P aided or assisted his clients in the preparation of incorrect returns for 5 different tax periods. As a result, he is liable for one penalty for each of the years for which a return was filed with the IRS claiming an excessive deduction for depreciation. In regard to P's individual clients, the penalty on P would be $5,000 ($1,000 for each of the 5 understatements reflected in 5 separate tax returns) and for corporate clients the penalty is $10,000 per return.