The Age Old Question:
Is it a building or personal property? (Part II)
 
Written by Steven D. Beaucaire, MST
Vice President, Tax - Bedford Capital Consulting

In the June edition, “The Bottom Line” focused on the first of two tests the courts use in determining whether a structure is a building, the “inherent permanency” test. The second common method is “the appearance and function test”. As mentioned last month, the two tests must be applied concurrently because a structure is not considered a building by most courts if it fails either test. Let’s examine more closely this side of the regulations which is based on Reg. §1.48-1(e). It provides (in part):

“The term “building” generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as apartment houses, factory and office buildings, warehouses, barns, garages, railway or bus stations, and stores…Such term does not include (i) a structure which is essentially an item of machinery or equipment…”

It is very easy to call any structure that encloses a space within its walls and is covered by a roof a building. However, that only addresses the “appearance” and looks can be deceiving. Thankfully for the taxpayer, the Tax Court has indicated that the second part of the test, “function”, is the more important of the two.

The “function” test requires that the building operate as a building. In applying this function test, the courts have primarily focused on whether the structure provides working space for employees that is more than merely incidental to the primary function of the structure. Both the quantity and quality of human activity inside the structure are generally considered in this regard. In the Munford, Inc. case (Munford, Inc. v. Commissioner, 87 T.C. 463 (1986), aff'd, 849 F.2d 1398 (11th Cir. 1988)), the taxpayer owned a 35,000 square foot refrigerated structure that was designed to maintain sub-zero temperatures to prevent spoilage of frozen foods prior to shipment to grocery stores. The Tax Court ruled that this structure was not a building. Even though employees worked in the structure this decision was reached due to the limited time they could spend inside the structure as a result of the sub-zero temperature. Similar holdings have been made in other refrigeration and storage buildings.

However, it does not always go the taxpayer’s way as can be seen in the L.L. Bean, Inc. case (L.L. Bean, Inc. v. Commissioner, T.C. Memo. 1997-175, aff'd, 145 F.3d 53 (1st Cir. 1998)). The company designed and built a specially designed structure for housing high-volume merchandise in floor-to-ceiling storage racks that supported the frame and roof. The Tax Court ruled that this was a building because the human activity inside was essential, rather than merely incidental to the function of the facility. In addition, the taxpayer could not prove that the HVAC systems were so closely related to the function of the structure (as in Munford) that they were incidental to the human activity. In one case the human activity was severely limited (in the freezer), while in the other no limitation existed.

Property which is in the nature of machinery is considered tangible personal property even though located outside of a building (Reg. §1.48-1(c)). The Regulations cite, by way of example, gasoline pumps, hydraulic lifts, and automatic vending machines. The Regulations further provide that a structure or structural component that is essentially an item of machinery or equipment is considered a part of the machinery (Reg. §1.48-1(e)). The IRS initially took the position that any structure inherently permanent was a building even if it was essentially an item of machinery or equipment. After losing a number of cases, the IRS finally conceded that a structure which is essentially an item of machinery is depreciated as part of the machinery (J.B. Weirick, 62 TC 446). In this case, the Tax Court held that the towers that supported the cable pulley mechanisms and cables at a ski resort were so closely related to the function of the pulley mechanism (machinery) that the towers were also considered part of the machinery even though the towers were permanently affixed to the ground.

It is easy to walk away from the above thinking that you can justify any position but as the case record proves, facts and circumstances govern the classification of assets. An engineering-based cost segregation study can help work through the complexity of both the regulations and their interpretation by the courts so that the client gets the right answer and maximizes his/her deductions.