QPP Audit Risk and IRS Scrutiny

QPP audit risk is elevated compared to standard depreciation treatment because Qualified Production Property classification requires judgment, technical analysis, and compliance with IRS guidance that may be subject to interpretation. The IRS examines QPP positions to ensure they meet statutory requirements, particularly when large depreciation adjustments or unusual property types are involved.

Understanding the factors that trigger IRS scrutiny and the documentation standards required for audit defense is essential for property owners claiming QPP treatment. While QPP is a legitimate tax strategy supported by statute and regulations, improper application or inadequate documentation increases audit risk and the likelihood of IRS challenges during examination.

For background on QPP eligibility and requirements, refer to the Qualified Production Property overview. For comprehensive depreciation strategies, see the cost segregation hub. This article focuses on IRS scrutiny of Qualified Production Property, audit defense strategies, and compliance risk factors that property owners should understand before claiming QPP treatment.

The IRS scrutinizes QPP claims based on several factors that indicate elevated risk. Large Section 481(a) adjustments from accounting method changes attract attention, particularly when the adjustment represents substantial catch-up depreciation for prior years. Significant increases in depreciation deductions coinciding with QPP elections trigger examination, especially if the increases appear disproportionate to the property value or manufacturing operations.

Property types that rarely qualify for QPP—such as warehouses, distribution centers, or office buildings—receive heightened scrutiny when taxpayers claim 20-year treatment. Inconsistent treatment of similar properties raises questions about the legitimacy of QPP positions. If some buildings on a manufacturing campus are treated as QPP while others are not, the IRS may question why the classifications differ.

Factors That Increase IRS Scrutiny

• Large Adjustments: Significant Section 481(a) adjustments or depreciation increases from QPP elections.
• Unusual Property Types: Claiming QPP for warehouses, offices, or buildings that do not typically qualify.
• Weak Documentation: Inadequate support for production use percentage or structural integration.
• Inconsistent Treatment: Different depreciation methods for similar properties without clear justification.
• After-the-Fact Elections: Form 3115 filed years after property was placed in service without contemporaneous support.
• 100% QPP Claims: Claiming entire building qualifies without allocating non-qualifying portions.

QPP documentation requirements for audit defense include engineering or architectural analysis demonstrating that the building is structurally integrated with manufacturing operations. Production use percentage calculations must be supported by building plans showing the allocation of space to production versus non-production functions. Operational documentation should evidence the manufacturing activities conducted in the building.

Contemporaneous documentation prepared when the property is placed in service or when Form 3115 is filed provides the strongest audit defense. After-the-fact documentation created in response to an audit is less persuasive and may not be sufficient to sustain the QPP position if the IRS determines that contemporaneous support should have been available. Property owners should maintain comprehensive records from the outset to minimize audit risk and strengthen their defensive position.

QPP tax audit defense requires proactive preparation and comprehensive documentation maintained from the time the QPP position is taken. The first line of defense is demonstrating that the property meets the statutory requirements through engineering analysis, production use calculations, and operational evidence. The second line is showing that the taxpayer exercised reasonable diligence in determining QPP eligibility and followed IRS guidance.

During audit, taxpayers should provide organized documentation packages that address the IRS's typical questions about structural integration, production use percentage, and qualifying activities. Responding promptly and thoroughly to information requests demonstrates cooperation and provides the examiner with the support needed to sustain the QPP position. Engaging experienced tax professionals and engineers during the audit process strengthens the technical defense and improves the likelihood of favorable resolution.

Effective Audit Defense Strategies

• Contemporaneous Documentation: Prepare engineering analysis and support when property is placed in service.
• Technical Support: Engage qualified engineers and tax professionals familiar with QPP.
• Organized Presentation: Provide well-organized documentation packages responding to IRS requests.
• Reasonable Reliance: Demonstrate reliance on professional advice and IRS guidance.
• Consistent Treatment: Apply QPP consistently across similar properties with documented reasons for differences.
• Proactive Communication: Respond promptly to IRS inquiries and provide complete information.

The most common IRS challenge to QPP positions is questioning whether the building meets the production use percentage threshold. Examiners scrutinize the allocation of space to production versus non- production functions, often requesting building plans, operational descriptions, and calculations demonstrating how the percentage was determined. Weak or inconsistent documentation of production use creates vulnerability to IRS adjustment.

Another frequent challenge involves structural integration. The IRS may argue that the building is a generic structure that could house any commercial operation rather than being integral to manufacturing. Engineering analysis demonstrating specialized features, heavy-duty construction, production-specific systems, and layout designed for manufacturing processes provides the technical support needed to counter this challenge.

If the IRS successfully challenges a QPP position, tax deficiencies result from recalculating depreciation using 39-year lives instead of 20-year QPP treatment. Interest applies to underpayments from the original due date of each affected return. Accuracy-related penalties may apply if the understatement is substantial or the position was taken negligently or with disregard of rules.

Taxpayers can avoid penalties by demonstrating reasonable cause and good faith. This requires showing that the QPP position was based on professional advice, technical analysis, and reasonable interpretation of IRS guidance. Adequate documentation and contemporaneous support for the position strengthen the reasonable cause defense. Even if the position is ultimately disallowed, penalties may be eliminated if the taxpayer acted reasonably in taking the position.

QPP compliance risk factors can be minimized through proactive planning and documentation. Apply QPP treatment only to clearly qualifying property where structural integration and production use are well-documented. Obtain engineering analysis before claiming QPP to ensure the technical support exists. Calculate production use percentages accurately and document the methodology with building plans and operational records.

File complete and accurate Form 3115 when changing accounting methods, including all required schedules and attachments. Maintain contemporaneous records that support the QPP position from the outset rather than creating documentation after an audit begins. Apply QPP consistently across similar properties and document the reasons for any differences in treatment. Working with experienced tax professionals and engineers reduces technical errors and strengthens audit defense.

For comprehensive guidance on QPP implementation and avoiding common mistakes, review the articles on common QPP mistakes and Form 3115 filing requirements. These resources provide detailed strategies for minimizing audit risk and maintaining compliance with IRS requirements.