Electrical Distribution Systems

Chapter 8 - Issue Specific Guidance

A. Electrical Distribution System

A.1. Introduction

(1) This chapter provides procedures for the proper allocation of a building’s electrical distribution system (EDS) in connection with a cost segregation study. To properly identify, separate and allocate the costs of a building’s overall EDS, various sources of information are relied on such as engineering design practices and terminology, case law, and Internal Revenue Service (IRS or Service) guidance.

(2) The method discussed herein, the functional allocation approach, has been developed over decades by various courts. See Section A.3, Legal Background.

(3) Although this chapter utilizes/references the functional allocation approach, a taxpayer may use other methods to reasonably allocate a building’s EDS to § 1245 property or § 1250 property. If a taxpayer properly uses the functional allocation approach outlined within this chapter to allocate the costs associated with a building’s EDS, the allocation should not be challenged and no adjustments to categorization and lives of the various components of the EDS are necessary.

(4) If the taxpayer either purports to follow the functional allocation method, but its method differs from that outlined within this chapter or allocates the costs of its EDS under a method other than the functional allocation method, the examiner should risk assess the position and determine if further examination is warranted. In such case, advice from an Engineer should be requested.

(5) Note 1.1: Examiners should carefully consider the extent to which a detailed examination of this issue is viable without engineering support.

A.2. Definitions and Building Electrical System Illustration

(1) The following definitions were derived from published court decisions with some additional industry terms for clarification.

(2) Connected Load – an Industry term used for the actual power required by the specific circuit to safely operate the attached end-use equipment. This is the unfactored load of the branch circuit but is the load to which the Demand Factor is applied to get the Demand Load. See Section 4 of this chapter.

(3) Demand Load - an Industry term used for the factored load for the design of the overall electrical system of a building. The demand factors used are applied to the EDS portions of the electrical system (NEC Article 220) and are a key part in the design and cost of a building’s EDS. See Section 4 of this chapter.

(4) Functional Allocation Approach – term coined by courts to describe how a building’s EDS is allocated proportionally by electrical Demand Load to the various items served. This approach was first utilized in the case of Scott Paper v. Commissioner, 74 T.C. 137 (1980) to allocate the EDS between § 1245 property and § 1250 property.

(5) Overall Electrical System – the entire electrical system of a building that includes the Primary EDS, the Secondary EDS, and the branch circuits including the wires that provide the connections to the end-use equipment “hook-ups.”

(6) The following terms are for the various portions of a building’s overall electrical system, defined below and shown on Figure 2.1:

• Primary EDS – the electrical equipment that receives the electrical service from the outside source (power utility company) to the main distribution panels (MDPs) and transformers (also known as “switchgear” on large building projects), that deliver power at the correct voltages to the secondary EDS. This includes large feeder circuits, power service entrance equipment, transformers, and conduit. In some instances, motor control centers, power transfer switches and meters are included.
• Secondary EDS – the electrical equipment that brings the electrical power from the MDP to the local distribution panels that feed the branch circuits. There are typically several distribution panels in a building facility, each one constituting a part of the secondary EDS for its specific function or location. (There are two separate systems shown in the Figure 2.1, L1 – “Lighting” and P1- “Power.”) This includes feeder circuits leading from the MDP to the secondary distribution panels and any transformers in between. It also includes subpanels, whose power is fed from a secondary distribution panel, for servicing specific equipment in areas such as kitchens, laundry rooms or even specialty lighting panels.

(7) For small buildings, the power from the electrical utility generally feeds directly to a main electrical panel instead of an MDP or transformer, thus eliminating the primary and secondary designation. In any case, the EDS should be allocated in the same manner, by design load of the end-user equipment as defined below.

• Branch Circuits – the electrical connections between a distribution or subpanel and the final electrical device. This includes wire and conduit, junction boxes, wall switches, cut-off switches, duplex outlets (receptacles), quad outlets, specific NEMA outlets (alternate plug configurations), and special connections to lights, appliances, and end-use equipment. Branch circuits are not part of the building EDS.
• Hook-Ups – the labor and materials necessary to make an electrical connection from the power source to the end-use equipment. This could be as simple as the act of plugging an electrical plug into an electrical outlet, or a more complex task like “hard wiring” appliance motors to junction boxes (j-boxes) or connecting light fixtures with flexible conduit and wiring to a j-box connected to a three-way electrical on/off switch. Hook-ups are not part of the building EDS.
• End-use equipment “consumptive devices” – the actual equipment, machinery, or appliances to which the overall electrical system provides power. This could include process equipment (such as manufacturing machinery), building equipment (such as lighting, HVAC, and outlets for general accessibility), or other personal property (such as computers, printers, ovens, lamps etc.). This equipment is not part of the building EDS.

(8) Note 2.1: Risk Analysis Item – Some buildings and facilities may not have a substantial amount of cost in the EDS, such as in a renovation of an existing building. Therefore, a risk assessment should always be made to see if the project warrants such in-depth analysis.

(9) Figure 2.1 shows a simple illustration of a building’s electrical distribution system from the power source to the end use equipment. From right to left: the Primary EDS - electrical power source comes from the utility company through the main power feeder into the Main Distribution Panel (MDP). Secondary EDS- from there the power is split to two electrical panels via two feeder circuits; one to panel P1 for Power, and the second to panel L1 for lighting. These constitute the entire EDS for the illustration. Branch Circuits - from these panels power is fed via branch circuits to junction boxes or “J-boxes”. From these J-boxes there are circuits connecting to the hook-ups for the end-use equipment in the interior of a building room. The P1 panel j-box feeds to two separate wall outlets; one for equipment and the other to machinery or appliance. The L1 panel j-box feeds to two separate ceiling lights layed into the ceiling tile. The interior of the building room has the hook-ups to the End-Use equipment or consumptive devises used in that room; the two lights in the ceiling and the wall outlets for the equipment and the machinery or equipment.

(10) Figure 2.1

FIGURE 2.1 Simple Illustration of a Building’s Electrical Distribution System (EDS)

(Diagram depicts: Power From Utility → Main Power “Feeder” → Main Distribution Panel “MDP” → Feeder Circuits → Secondary EDS: “L1” Lighting Electrical Panel and “P1” Power Electrical Panel → Branch Circuits → J-Boxes → Interior of Building: Ceiling lights, Wall Outlets, Equipment, Machinery/Appliance → “Hook-Ups” to End-Use Equipment “Consumptive Devices”)

A.3. Legal Background

(1) This section provides a brief overview of the legal principles involved in understanding the functional allocation approach of EDS to § 1245 and § 1250 property.

(2) Tangible property can be divided into ”§ 1250 property” and ”§ 1245 property” under the IRC. ”§ 1250 property” is any real property, other than § 1245 property, which is, or has been, of a character subject to the allowance for depreciation provided in § 167. ”§ 1245 property” includes any property that is of a character subject to the allowance for depreciation under § 167 and is, among other things, either personal property or other tangible property (not including a building or its structural components) used as an integral part of certain specified activities. The regulations under §§ 1250 and 1245 reference the regulations under former § 48 (pertaining to the Investment Tax Credit (ITC), which was eliminated in 1990) for definitions of the terms “tangible personal property,” “other tangible property,” “building,” and “structural components” (Treasury Regulation (Treas. Reg.) § 1.48-1).

(3) The depreciation deduction provided by § 167 for tangible property placed in service after 1986 generally is determined under § 168, the Modified Accelerated Cost Recovery System (MACRS). Courts have determined that the tests developed to ascertain whether property constituted tangible personal property for purposes of ITC equally are applicable to decide whether the property constitutes tangible personal property for purposes of MACRS. Accordingly, to the extent a property item would have qualified as tangible personal property for ITC that property also will qualify as tangible personal property for purposes of MACRS.

(4) In Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980), the court allowed an allocation of a paper plant facility’s overall electrical systems between: 1) property qualifying for the ITC because it was or related to tangible personal property (i.e., § 1245 property), or 2) property not qualifying for the ITC because it was related to the operation or maintenance of a building (i.e., § 1250 property). The allocation was based on the power demand or design “load” (expressed in kilo-Volt amperes or kVA) of the machinery and equipment for which it was designed. Thus, the power demand of the end-user machinery and equipment forms the basis for the functional allocation approach.

(5) The Fourth Circuit rejected the functional allocation approach in A.C. Monk and Co., Inc. v. United States, 686 F.2d 1058 (4th Cir. 1982), and held that the proper approach was to determine whether the electrical system had more general uses than simply operating specific items of machinery. Thus, if the wiring and other components of the electrical system could be reasonably adapted to more general uses, they were structural components of the building. The Federal Claims Court takes a third approach in determining whether any portion of the EDS is allocable to § 1245 property. In Boddie-Noell Enterprises, Inc. v. United States, 36 Fed. Cl. 722, 740-1 (1996), aff’d without opinion by 132 F.3d 54 (Fed. Cl. 1997), the court took the approach that since “electric wiring and lighting fixtures” are explicitly mentioned as in Treas. Reg. § 1.48-1(e)(2) as structural components, no portion of the EDS is allocable to § 1245 property. These alternate approaches, however, have not been followed by other courts.

(6) In Illinois Cereal Mills, Inc. v. Commissioner, 789 F.2d 1234 (7th Cir. 1986), the Seventh Circuit affirmed the opinion of the Tax Court and its use of the functional allocation approach. The U.S. Supreme Court denied certiorari in Illinois Cereal Mills, Inc. v. Commissioner, 479 U.S. 995 (1986), concerning the different methodologies in the two Circuit Courts. Therefore, the conflicting opinions of the Seventh Circuit for Illinois Cereal Mills and the Fourth Circuit for A.C. Monk remain intact.

(7) In Morrison, Inc. v. Commissioner, T.C. Memo 1986-129, the court dealt in part with the primary EDS of cafeteria buildings. The court allowed a portion of the primary electric as tangible personal property for purposes of the ITC. In its findings, the Tax Court again followed the functional allocation approach it espoused in Scott Paper. On appeal, Morrison, Inc. v. Commissioner, 891 F.2d 857 (11th Cir. 1990), the Circuit Court concluded that the Tax Court correctly used the “functional allocation approach” and held as follows, at 863:

(8) First, we accept Morrison’s argument that taxpayers can claim investment tax credit on a percentage basis. In this regard, we adopt the reasoning in Illinois Cereal and reject the reasoning in Monk. … Second, we adopt the Tax Court’s method of focusing on the ultimate use of electricity distributed by Morrison’s primary electrical systems. … Third, the Tax Court’s method is consistent with the investment tax credit’s purpose.

(9) Subsequent to the Eleventh Circuit’s opinion in Morrison, in 1991 the IRS revised an AOD on Illinois Cereal Mills, AOD 1991-019. In the AOD, the Commissioner stated:

(10) In view of the Eleventh Circuit’s rejection of the Monk standard in favor of the functional allocation method approved by the Seventh Circuit in Illinois Cereal, and the Supreme Court’s rejection of the government’s petition for certiorari in Illinois Cereal, further litigation of this issue is not warranted. Accordingly, the IRS will not challenge the functional allocation approach set forth in Scott Paper to determine the eligibility of electrical systems of a building to qualify as § 38 property.

(11) In Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997) (HCA), the court found that the standards for determining the categorization of property under ACRS and MACRS were the same as for the ITC, at 55:

A.4. Functional Allocation – Illustration

(1) Step 1 of the audit, as outlined in Scott Paper, is to determine whether the components of the EDS are inherently permanent structures by applying the six-factor Whiteco test. See Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975). Accordingly, one needs to determine whether each component constitutes “tangible personal property” or “other tangible property,” rather than a “building,” or a “structural component.” See Morrison, 891 F.2d at 860-861.

(2) Step 2 of the audit is to determine if the EDS serves the operation and maintenance of a building or if it serves to supply power for the taxpayer’s tangible personal property or other tangible property. It is possible that the EDS, or certain components thereof, may serve both purposes.

(3) Step 3 of the audit is to use the functional allocation approach as illustrated below. All of the types of property served by the EDS must be analyzed and their costs should be allocated proportionally by electrical demand load to the various items served. The building’s electrical design plans must be studied to perform this step.

(4) Step 4 of the audit is to record and tally the electrical demand load for every item of § 1245 property as well as every item of § 1250 property. Once the entire electrical demand load is totaled, the proportion of § 1245 property versus § 1250 property of the EDS can be determined.

(5) Please note that there are vast differences in the physical characteristics and engineering design criteria between a large manufacturing plant and a public building such as an office building, retail store, or restaurant.

(6) NOTE 4.1: It is highly advised to verify the total cost of the EDS before applying resources and personnel to perform the following tasks. In certain instances, the total costs of the system may not warrant significant resources allocated to such an in-depth analysis.

(7) NOTE 4.2: The electrical drawings or “Plans” of the building contain vital information for this approach. The electrical panel schedules and the “Electrical Load Summary” or “Calculation” (per the National Electric Code (NEC)) are required to be included in the electrical drawings and should be used as source documents for all calculations. All Watts or volt-amps should match to the totals shown on the calculation or panels.

(8) It is NOT appropriate to use a residual method to analyze the loads of the building. It is highly recommended that a qualified and knowledgeable person, such as an engineer, perform the analysis.

Load Analysis Located on Electrical Plans:

• Generally, there is a table included on the plans for a building facility that will provide the total amount of power intended to be used by the facility. This table shows the load requirements of National Electric Code (NEC) Article 220 “Branch-Circuit, Feeder, and Service Calculations” and is referred to in the industry as the “Electrical Load Calculation.” The city or municipality typically requires this calculation in the plan review stage before the project is approved for construction by the city. The building contractor typically cannot begin construction without this information.
• This table serves many functions: 1) it lets the municipality know the amount of power the facility is intended to use for the proper permits and fees to be set on a project; 2) the local power company must be aware of the power consumption of the facility to know how, or if, it will affect the local power grid thereby getting sufficient time to make the proper preparations, if needed; and 3) the designers of the electrical system of the facility and the electrical engineers use this information to properly size the necessary equipment so the capacity of the system is adequate to provide for the power requirements of the building and also the required fire code and safety standards.
• The Electrical Load Schedule or Calculation is typically located with the electrical drawings of the building’s plans or “Blueprints” as commonly known. Usually, it is on or close to the “One-Line Diagram” of the entire building’s power system or is included on the Electrical Panel Schedules. The following table shows an example of an electrical load calculation for a large supermarket with a restaurant, bakery, deli, and other areas.

Table 4.1: Large Supermarket Electrical Load Calculation

• This schedule shows the “Connected” Watts which is the power required if the item were to run at 100% capacity. The “Demand Factor” is a diversity factor applied to the power usage of that equipment for the design of the feeders and other parts of the EDS. The NEC Article 220 provides guideline Demand Factors (diversity factors or percentages) that are to be used as a minimum for calculating a demand load on the feeders and service of a building, or the EDS (see Note 4.2a.). All states and municipalities in the U.S. have adopted some version of the NEC as the minimum requirement for electrical construction in their region.
• In the electrical design industry, “Demand Load” means the factored load for the design of the overall electrical system. In general, the items that require full 100% demand load are the dedicated pieces of equipment that are: 1) necessary to operate at all times, at near full capacity during operation; or 2) required by the NEC to be designed at full capacity. The lower “demand” percentages are placed on non-crucial equipment that may only be turned on part of the time during the operation of the facility. For example, not every outlet in a building will have equipment plugged into it at all times, or there may be equipment plugged in but turned off, and there may also be many outlets that remain entirely unused. The NEC specifies a minimum Demand Factor to be applied, about 50-70%, which is intended to approximate real-world scenarios, but still allow for safe operation of the entire system.
• NOTE 4.2a: These Demand Factors are not used for designing the branch circuits which must comply with the required circuit design in NEC Article 220 Part I. However, the Demand Factors are applied to feeders and service (EDS) under specific NEC tables and rules as covered in NEC Article 220 Parts II, III, and IV.
• The total demand load determines the size and type of electrical power service required to supply the facility. This information is also used to specify the proper sizes of the electrical equipment; conductors (wires), circuit breakers, transformers, switchgear, capacitors, conduit, etc., so the system will work safely during peak operating hours of the facility. The size of the equipment directly affects the cost of the equipment installed and is the primary focus of the proper basis of § 1245 property in the functional allocation approach. NOTE 4.3: An energy usage study, measured in kilowatt-hours (kWh), which is performed for energy efficiency purposes by measuring the amount of energy used within a specified period, is a completely different study from the demand load analysis performed when designing and sizing building electrical equipment. The energy efficiency study should not be used as part of the functional allocation approach.

Watts versus Volt-Amperes – Power Factor

• The load calculation in Scott Paper is illustrated with units of kilovolt-amperes (kVA). The typical electrical load schedule for a building may be seen with units in kVA or in kilowatts (kW), or both.
• The difference is something called a power factor. The kilowatts can be easily converted to kVA by the simple formula: Kilowatts = kilovolt-Amperes X Power Factor,
• Or simply: kW = kVA x pf
• For the purposes of this chapter, the power factors will be assumed to equal “1”; therefore, kW will equal kVA.
• Accordingly, an analysis of a building’s EDS using units in kVA or in kW will yield the same results. However, the units may not be mixed, and one must be consistent with the unit used.

Item Cost versus Electrical Load

• The costs of the individual portions of the building overall electrical system are usually addressed in the cost segregation study. These costs are either estimated using costing data or are taken directly from general or electrical contractor payment records.
• The costs of the individual branch circuits for the end-use equipment are usually addressed in the detailed estimate of the cost segregation study. The circuits to the qualified § 1245 property are typically identified and are allocated to that property.
• The total costs of the entire building’s EDS, including all the transformers, panels, subpanels, feeder circuits, etc., must be distinguished in the cost segregation study and must reconcile with the amount actually paid by the taxpayer for the corresponding electrical system.
• The functional allocation approach uses the electrical loads, not the costs of the specified circuits, to determine the proper portion of the EDS that is allocable to § 1245 property.
• As an example, for the supermarket electrical load calculation in Table 4.1, the cost segregation study shows $2,500,000 in costs for the entire electrical contract for the project. This is verified on the Taxpayer’s cost records for the construction project. A study of the individual items in the Electrical Contract reveal that the primary EDS costs are $500,000, the secondary EDS costs are $500,000, the branch circuits are $1.1 million, and the various hook-ups to the end-use equipment are $400,000.
• The cost that will be involved in the functional allocation is the $1,000,000 for the combined primary and secondary distribution system costs. The asset classification of the remaining $1.5 million of the electrical contract consisting of branch circuit and equipment hook-up costs identified in the cost segregation study follow the same recovery period as the dedicated end-use equipment or as the building if they relate to the operation thereof.

Example 1 – Large Supermarket

• Steps 1 and 2. Using the electrical load calculation in Table 4.1, the field examination of the grocery store facility and an end-use analysis from the information on the electrical plans for the building show the following facts:

  • The exhaust fans for the kitchen pull 100,000 of the Connected Watts of the HVAC’s total 1,320,000 Connected Watts. Therefore, the HVAC load must be split between § 1245 and § 1250 property.
  • The Refrigerator & Freezer Compressors were found to qualify as § 1245 property, as well as the Display Signs/Exterior Lighting, Cardboard Balers, Trash Compactors and Cash Registers. These loads do not need to be split; they are all for § 1245 property.
  • For the Lunch Counter/Restaurant, only 35,000 of the 125,000 Connected Watts are dedicated to qualifying § 1245 property. The remainder are for general use and do not qualify as § 1245 property. The Lunch Counter/Restaurant load should be split between § 1245 and § 1250 property.
  • The Customer Service/Office end-use equipment was all found to be electrical outlets for general use and accessibility and should remain as § 1250 property. The Interior Lighting, Generator, and Backroom electrical were all found to be for § 1250 property as well. These loads do not need to be split; they are all for § 1250 property.
  • In the meat cutting department, 30,000 of the 50,000 total Watts were found to be for dedicated § 1245 equipment, the remainder are for electrical outlets of general use and do not qualify as § 1245 property. This item load should be split between § 1245 and § 1250 property.
  • The circuits for the floor outlets labeled as “Rolling Refr. Cases” served also for regular maintenance equipment such as floor polishers, and vacuums. The IRS and the Taxpayer agree that this item should be split 50/50 as § 1245 and § 1250 property. Therefore, this item load should be split between § 1245 and § 1250 property.

• Step 3. Table 4.2, below, shows the resulting Personal Property/Real Property split for each line item on the Load Calculation of Table 4.1. The functional allocation calculation concentrates on the demand loads. Therefore, the connected loads should be multiplied by the corresponding Demand Factor to achieve the Demand Watts. The total Demand for this project is 2,563,800 Watts.

  • Each line item is allocated to either Personal Property (§ 1245 property) or Real Property (§ 1250 property) based on their qualifying demand loads. The line items that required splitting and allocation between personal property and real property are shown on Table 4.2 with the § 1245 property in italics. The Load % shown on the table is the items portion of the total 2,563,800 Demand Watts.
  • Taking the HVAC as an example, the total Connected Watts is 1,320,000 with a Demand Factor of 100%. The 100,000 Watts for the kitchen exhaust fans is separated as qualified § 1245 personal property and the remaining 1,220,000 Watts is for § 1250 real property.
  • These are both proportioned to the total Demand Watts to calculate their percent allocation:
  • Load % for 1250 HVAC: Demand Watts HVAC/Total Demand Watts Building = 1,220,000 ÷ 2,563,800 = 47.6%
  • Load % for Kitchen Equipment: Demand Watts Kt. Equip./Tot. Demand Watts Building = 100,000 ÷ 2,563,800 = 3.9%
  • Each line item on the Load Calculation is allocated according to the facts and circumstances found in the examination. The results are shown on Table 4.2.

• Step 4. Each load line item was examined and the demand load for the § 1245 property was separated from the demand load for the § 1250 property. The segregated totals are shown on the bottom of Table 4.2. The total portion of the electrical load determined to be for the § 1245 property is 38.4%.

  • Applying this percentage to the total cost of the building primary and secondary EDS, $1,000,000, yields the correct basis of the § 1245 portion of the EDS:

• The remaining EDS costs, 61.6% or $616,000 would be allocated to § 1250 property.
• Therefore, the functional allocation of the building’s EDS yields:
• § 1245 Property $384,000 + § 1250 Property $616,000 = Total Cost Elect. Dist. System $1,000,000
• These totals are then added to the results of the branch circuit and equipment hook up allocation to get the total § 1245 and 1250 allocation of the entire electrical portion of the building project. Table 4.2 - 1250/1245 Analysis of Large Supermarket

Asset Classification for § 1245 Property Portion of the EDS

• Once the functional allocation of the EDS is complete, you will need to determine the depreciation deduction for the § 1245 property portion of the EDS. The depreciation deduction for tangible property placed in service after 1986 generally is determined under § 168 using a prescribed depreciation method, recovery period, and convention. The applicable recovery period is determined by reference to class life or by statute.
• Revenue Procedure 87-56, 1987-2 C.B. 674, sets forth the class lives of property that are necessary to compute the depreciation allowances under § 168. The revenue procedure establishes two broad categories of depreciable assets: 1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and 2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities. The same item of depreciable property can be described in both an asset category (asset classes 00.11 through 00.4) and an activity class (asset classes 01.1 through 80.0), in which case the item is classified in the asset category. See Norwest Corp. & Subs. v. Commissioner, 111 T.C. 105 (1998) (items described in both an asset and an activity category should be placed in the asset category).
• If a particular asset is used in more than one activity, the cost of the asset is not allocated between the two activities. Rather, the total cost of the asset will be classified according to the activity in which the asset is primarily used, regardless of whether the activity is insubstantial in relation to all the taxpayer’s activities. For example, if a taxpayer operates a hotel/casino, decorative lighting used in the casino area would be classified in activity class 79.0, Recreation, with a 7-year recovery period whereas decorative lighting used in the hotel lobby area would be classified in activity class 57.0, Distributive Trades and Services, with a 5-year recovery period. Also, for depreciation purposes, the lessor of assets generally classifies such assets according to the activity they are primarily used in by the lessee.

A.5. Summary

(1) The Courts have accepted the functional allocation approach and have used it in different types of buildings. The appropriate application of this approach is complex and labor intensive. It entails: Determining the proper cost of the specific parts of the overall EDS, includes the hook-ups, branch circuits, various sections of the secondary EDS, and the primary EDS, analyzing the over-all electrical demand load for the building, and allocating the primary and secondary EDS to § 1245 and § 1250 appropriately.

(2) The costs of the hook-ups and branch circuits that service building related items, such as HVAC, power outlets for general use, lighting, and other building services, should be recovered over the recovery period of the building. The costs of the hook-ups and branch circuits that supply power to dedicated machinery and equipment used as an integral part of the taxpayer’s business should be recovered over the appropriate recovery periods of the equipment that they serve based on § 168 and Rev. Proc. 87-56.

(3) The primary and secondary EDS components of a building or other inherently permanent structure used in the operation or maintenance of the building or necessary to provide general building services (such as lighting, heating, ventilation, air conditioning, etc.), including electrical outlets of general applicability and accessibility, are § 1250 property and are recovered over the same recovery period as the building.

(4) Examiners are encouraged to risk assess the taxpayer’s EDS allocation using the analyses discussed in this chapter to verify that the claimed functional allocation method is applied correctly and that it yields the appropriate percentage for § 1245 property portion of the EDS of the building.

(5) If the taxpayer uses a correct functional allocation approach as illustrated in this chapter to define which parts of a building’s primary and secondary EDS were designed to service § 1245 property, the examiner should not challenge the use of the functional allocation approach.

B. Stand-Alone Open-Air Parking Structures

B.1. Introduction

(1) The IRS and the taxpayer agree that stand-alone open-air parking structures are inherently permanent. Accordingly, the issue is whether these parking structures are buildings or land improvements for depreciation purposes. Taxpayer asserts that the parking structures are land improvements with a 15-year recovery period and 150% declining balance method of depreciation (under GDS) while the IRS asserts that the parking structures are buildings with a 39-year recovery period and straight-line method of depreciation (under GDS).

(2) The specialized Uniform Issue List (UIL) code for this issue regarding the proper classification of a stand-alone open-air parking structure is: 168.20-00.

B.2. Description of Stand-Alone Open-Air Parking Structures

(1) Open-air parking structures have been constructed since the mid-1950s. Stand-alone open-air parking structures typically provide multi-level parking accessed by a ramp system. These parking structures have at least two sides that are approximately 50 percent open to the outside because they were designed to eliminate the need for heating and ventilation systems. Aside from those vehicles parked on the top level, the vehicles are protected from sun, rain, and snow. Moreover, drivers and passengers are protected from these elements as well as from ice and to some degree, wind. In almost all parking structures, the top, exposed level has the fewest vehicles.

(2) The parking structures are normally constructed of concrete and supported by steel-reinforced concrete pillars. The garages have foundations, concrete decks, steel-reinforced concrete support pillars, partial walls, concrete ramps connecting each floor, concrete wheel stops, bollards, and guardrails. Some have underground parking levels, which have full walls. The parking structures typically have hydraulic elevators and internal stairwells (every parking structure is required by the Uniform Building Code to have a minimum of two means of egress (stairs) which are separated from each other). The elevator mechanical systems (hydraulics and motors) are housed in an equipment room located adjacent to the elevators.

(3) The parking structures also have interior lighting (pole-mounted lighting on the top level), security cameras, fire sprinklers (depending on the height and area of the structure), and signage to facilitate safe and speedy evacuations during an emergency. While fires in parking structures are generally more related to the vehicles parked within them than to the typical structural materials, the fire system (if required by code provisions) is usually comprised of the fire alarm wiring, pull stations, strobes, annunciators, and exit signage. Many parking structures have a separate area or room for electric metering and switching.

B.3. Applicable Tax Law

(1) § 168 set forth the MACRS depreciation system. MACRS generally applies to tangible property placed in service after December 31, 1986. § 168(a) provides that the depreciation deduction provided by § 167(a) for any tangible property is determined by using the applicable depreciation method, recovery period, and convention. Under MACRS, the recovery period of property is determined by reference to its class life or by statute.

(2) Nonresidential real property is § 1250 property that is not (1) residential rental property or (2) property with a class life of less than 27.5 years. § 168(e)(2)(B). § 1250 property is any real property (other than § 1245 property, as defined in § 1245(a)(3)) which is or has been property of a character subject to the allowance for depreciation provided in §§ 167, 168(i)(12) and 1250(c). The cost of nonresidential real property placed in service after May 12, 1993, is generally recovered over 39 years.

(3) Taxpayers argue that stand-alone open-air parking structures are land improvements, with a recovery period generally of 15 years. Land improvements are defined in Rev. Proc. 87-56, 1987 2 C.B. 687 (Asset Class 00.3), which states, “Includes improvements directly to or added to land, whether such improvements are § 1245 or § 1250 property.” The revenue procedure provides specific examples of land improvements including, but not limited to, sidewalks, roads, canals, waterways, drainage facilities, sewers, wharves and docks, bridges, fences, landscaping, shrubbery, radio and television transmitting towers, and parking areas. The issue is whether stand-alone open-air parking structures fit within the definition of land improvements. Taxpayers have argued that parking areas are specifically listed in Asset Class 00.3 as a land improvement, and that stand-alone open-air parking structures should be treated the same as parking areas.

B.4. IRS Position

(1) The IRS position is that stand-alone open-air parking structures are buildings, not land improvements. The IRS position is based on Treas. Reg. § 1.48-1(e)(1), which provides a definition of a “building” and includes an explanation of what constitutes building components. The definition is not exhaustive but provides examples of building functions including:

(2) The Treas. Reg. § 1.48-1(e)(1) explicitly lists “parking” as a building function. This definition also provides guidance on what constitutes a building. The regulation provides that a building is a structure with walls and a roof which is designed to enclose a space and which is suitable for sheltering persons or property. In the case of parking, the structure is designed to provide parking space. Whether a structure actually has four fully enclosed sides or is partially open is not the critical issue, as the regulation provides that buildings may be “enclosed or partially enclosed.”

(3) Treas. Reg. § 1.48-1(e)(1) defines a building as “a structure with walls and a roof which is designed to enclose a space and which is suitable for sheltering persons or property.” It is the IRS position that a stand-alone open-air parking structure meets this definition because:

• The structure has walls (partial walls and pillars that define the boundary of the structure).
• The structure has a roof (upper level decking and/or canopy).
• The structure is designed to enclose a space (the parking bays).
• The structure is suitable for sheltering persons or property (vehicles and occupants are protected from sun, rain, and snow).

(4) The parking structure is designed with each upper floor serving as a ceiling for the level below. This is evidenced by the fact that the structure has drainage systems on each level to remove water from the parking surface down to the next level, or to ground level. Thus, both the “appearance test” and “function test” indicate that the parking structure is a building.

B.5. Analysis

(1) Appearance Test: A structure with walls and a roof enclosing a space appears to be a building. Although stand-alone open-air parking structures do not have four fully enclosed sides, the regulation specifically acknowledges that buildings can be “enclosed or partially enclosed.” The parking structure is designed such that each upper floor level serves as both the parking surface and the ceiling (protection) for the level below. The vertical supporting columns and railings create a defined boundary. The structure is designed to shelter persons and property.

(2) Function Test: Treas. Reg. § 1.48-1(e)(1) explicitly lists “parking” as one of the enumerated functions of a building. It states that a building designed to provide parking includes structures which are “enclosed or partially enclosed and designed to provide for the parking of vehicles or equipment.” A stand-alone open-air parking structure is designed to provide parking and meets this specific description.

(3) Integral Part Test: The structure cannot be moved or modified without substantial loss of utility and value. The parking structure is an integral part of the real estate and is not property that is readily removable.

(4) Inherently Permanent Structures Test: The parking structure is constructed of concrete and steel, designed to remain in place, and would require substantial effort to demolish or remove.

B.6. Penalties

(1) Under § 6662, taxpayers are subject to an accuracy-related penalty (typically 20%) for substantial understatement of income tax or negligence. A substantial understatement exists when the understatement of tax for the tax year exceeds the greater of 10% of correct tax or $10,000.

(2) The deficiency attributable to a taxpayer’s position that stand-alone open-air parking structures are land improvements rather than buildings would typically result in a substantial understatement because a 15-year asset class results in significantly less depreciation per year than a 39-year asset class.

(3) Under § 6664(c), the reasonable cause exception to the penalty might apply if the taxpayer can demonstrate reasonable cause for the underpayment and that the taxpayer acted in good faith. However, this exception is unlikely to apply given that Treas. Reg. § 1.48-1(e)(1) explicitly lists “parking” as a building function and provides that buildings can be “enclosed or partially enclosed.” The regulation is clear and unambiguous.

(4) The taxpayer’s burden of proof requires demonstration that the taxpayer reasonably believed that the treatment was proper under tax law. The explicit language of the regulation and prior authority make this burden very difficult to meet. The taxpayer’s position that parking structures are land improvements would be considered frivolous when Treas. Reg. § 1.48-1(e)(1) explicitly designates “parking” as a building function.