Illinois Cereal Mills: The Case That Reinforced Functional Allocation

Illinois Cereal Mills, Inc. v. Commissioner, 789 F.2d 1234 (7th Cir. 1986), is an important part of the legal history behind functional allocation of electrical distribution systems. The Seventh Circuit affirmed the Tax Court's use of functional allocation after the Fourth Circuit had rejected that methodology in A.C. Monk. The 2025 IRS Cost Segregation Audit Technique Guide reports that the electrical distribution system at issue was allocated 95% to § 1245 property and 5% to § 1250 property. That percentage is memorable, but it is also easy to misuse. For CostSegRx engineers, the real lesson is not that electrical systems are usually 95% § 1245 property. The lesson is that a supported allocation must be developed from the actual electrical system, loads, and property facts.

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Key Takeaways

• Illinois Cereal Mills reinforced the functional allocation approach for electrical distribution systems.
• The Seventh Circuit affirmed a system-specific allocation between § 1245 property and § 1250 property.
• The case created a direct conflict with the Fourth Circuit's adaptability approach in A.C. Monk.
• The current ATG uses demand load and electrical design information to apply functional allocation.
• The 95% result from Illinois Cereal Mills is a case result, not a standard percentage for other properties.
• Two buildings can have identical electrical costs but very different supported allocations.
• Functional allocation must be rebuilt from the actual electrical design and end-use loads of each property.

What Did Illinois Cereal Mills Decide?

Illinois Cereal Mills, Inc. v. Commissioner involved the classification of an electrical distribution system.

The ATG's court-case table identifies the system as 95% § 1245 property and 5% § 1250 property. It also states that the Seventh Circuit affirmed the Tax Court decision using the functional allocation approach.

That makes the case important for more than its unusually high percentage.

The case supported the idea that one interconnected electrical distribution system does not necessarily have to receive one undivided property classification.

Instead, portions of the system can be associated with different property categories based on the functions and electrical loads the system was designed to serve.

That concept traces back to Scott Paper Co. v. Commissioner, where the Tax Court allocated electrical distribution based on the power demand or design load of end-use machinery and equipment. The ATG describes the power demand of that end-user machinery and equipment as the basis of the functional allocation approach.

Illinois Cereal Mills reinforced that methodology at the appellate level.

For CostSegRx, that is the important takeaway.

The property contains one electrical network, but engineering analysis can reveal that the network supports more than one type of property.

How Did Functional Allocation Survive the A.C. Monk Challenge?

The legal history is important because functional allocation was not universally accepted.

The Fourth Circuit rejected the approach in A.C. Monk & Co. v. United States. Under Monk, electrical wiring and other components that could be reasonably adapted to more general uses were treated as structural components of the building.

Illinois Cereal Mills went the other direction.

The Seventh Circuit affirmed the Tax Court's use of functional allocation.

The United States Supreme Court later denied certiorari in Illinois Cereal Mills. According to the ATG, that left the conflicting Seventh Circuit Illinois Cereal Mills opinion and Fourth Circuit A.C. Monk opinion intact.

So the Supreme Court did not resolve the methodological disagreement.

That matters when explaining the history accurately.

Illinois Cereal Mills did not erase A.C. Monk.

It provided competing appellate support for functional allocation.

Later developments strengthened the functional-allocation position further. In Morrison, the Eleventh Circuit adopted the Illinois Cereal reasoning and rejected the Monk reasoning.

This history is why electrical cost segregation requires understanding both the property facts and the applicable legal framework.

Why Did Illinois Cereal Mills Matter to the IRS Position?

The IRS did not immediately accept the functional allocation result.

The ATG's court-case table says that in AOD 1988-20, the IRS non-acquiesced to the use of functional allocation for electrical systems in Illinois Cereal Mills.

The position later changed.

After the Eleventh Circuit decided Morrison, the IRS revised its Action on Decision in AOD 1991-019.

The ATG explains that the Commissioner concluded further litigation was not warranted because the Eleventh Circuit had rejected the Monk standard in favor of the functional allocation method approved by the Seventh Circuit in Illinois Cereal Mills, and the Supreme Court had declined to review Illinois Cereal Mills.

The revised position stated that the IRS would not challenge the functional allocation approach set forth in Scott Paper for determining eligibility of building electrical systems as § 38 property.

That history matters because it shows how several cases fit together:

Scott Paper developed the functional allocation method.

A.C. Monk rejected it in the Fourth Circuit.

Illinois Cereal Mills affirmed it in the Seventh Circuit.

Morrison later adopted the Illinois Cereal reasoning.

The IRS then stated that it would not challenge the Scott Paper functional allocation approach.

For CostSegRx, these cases are not isolated trivia. Together, they explain why the current ATG contains an entire issue-specific chapter devoted to engineering-based functional allocation of electrical distribution systems.

How Does the Current ATG Apply Functional Allocation?

The current ATG does not tell engineers to look up the percentage from Illinois Cereal Mills.

It tells them to analyze the property.

Chapter 8 describes the functional allocation approach as the methodology used to properly identify, separate, and allocate the costs of a building's electrical distribution system. The ATG says that when a taxpayer properly applies the functional allocation methodology described in the chapter, the allocation should not be challenged.

The ATG lays out a structured process.

First, the electrical components are considered under the applicable permanence and property-classification framework.

Next, the engineer determines whether the electrical distribution system serves operation and maintenance of the building, tangible personal property, other qualifying property, or a combination of those uses.

Then all property served by the system is analyzed and costs are allocated proportionally by electrical demand load.

Finally, the demand load associated with § 1245 property and § 1250 property is recorded and totaled so the proportional allocation can be determined.

This requires actual electrical information.

Demand load affects equipment such as conductors, circuit breakers, transformers, switchgear, capacitors, and conduit. The ATG explains that the size of this equipment directly affects installed cost and is therefore central to determining the proper basis associated with § 1245 property under functional allocation.

CostSegRx explores this methodology further in Electrical Distribution Systems in Cost Segregation Studies.

The engineering work produces the percentage.

The case percentage does not replace the engineering work.

Does Illinois Cereal Mills Mean 95% of Electrical Is § 1245 Property?

No.

This is the most important misconception to prevent.

The ATG reports that the Illinois Cereal Mills electrical distribution system was allocated 95% to § 1245 property and 5% to § 1250 property.

That tells us what happened in that case.

It does not establish a standard ratio for manufacturing facilities, grain facilities, industrial buildings, or any other property.

The ATG explicitly cautions against rule-of-thumb methodologies in cost segregation. It describes approaches using fixed industry percentages with little or no documentation as lacking sufficient support.

Chapter 8 takes the same property-specific approach.

It notes that there can be vast differences in the physical characteristics and engineering design criteria between a large manufacturing plant and public buildings such as offices, retail stores, and restaurants.

Those differences affect electrical demand.

They affect equipment sizes.

They affect distribution design.

And they affect the resulting allocation.

This is why a quality cost segregation study needs to explain its methodology and support its classifications rather than simply present an attractive percentage.

For CostSegRx engineers, 95% is not a target.

It is a historical case result.

Can Two Similar Electrical Systems Produce Very Different Percentages?

Illustrative example only. Actual classifications, demand loads, costs, recovery periods, depreciation deductions, and tax results depend on the specific property, engineering analysis, electrical design, documentation, applicable authority, and taxpayer circumstances.

Assume two industrial properties each have $1,200,000 of supported primary and secondary electrical distribution system cost.

Property A contains extensive production machinery.

After reviewing the electrical one-line diagrams, panel schedules, equipment schedules, demand-load calculations, and actual end uses, the engineering analysis determines that a substantial proportion of system demand supports qualifying § 1245 property.

Property B has the same $1,200,000 electrical cost.

But most of its electrical demand supports building lighting, HVAC, general-use outlets, and other building-related loads.

Its supported allocation to § 1245 property may therefore be much lower.

The system cost is identical.

The percentage does not have to be.

That is why using the Illinois Cereal Mills 95% result as a shortcut would be inappropriate.

The ATG states that proper functional allocation involves determining the costs of the relevant electrical components, analyzing overall electrical demand load, and allocating the primary and secondary electrical distribution systems appropriately between § 1245 property and § 1250 property.

CostSegRx engineers therefore ask what each electrical system was actually designed to support.

That is the calculation that matters.

What Is the Most Important Lesson From Illinois Cereal Mills?

Illinois Cereal Mills helped reinforce functional allocation at an important point in the development of electrical cost segregation.

The Seventh Circuit affirmed the methodology after the Fourth Circuit had rejected it in A.C. Monk.

The Supreme Court declined to resolve the circuit disagreement.

Morrison subsequently adopted the Illinois Cereal reasoning and rejected Monk, and the IRS later stated that it would not challenge the Scott Paper functional allocation approach.

That legal history helps explain the detailed electrical methodology contained in today's ATG.

But the 95% allocation reported in Illinois Cereal Mills should not become the takeaway.

The real lesson is how the percentage was conceptually supported.

Functional allocation ties electrical distribution to the property and loads the system serves.

CostSegRx engineers therefore need to understand the electrical design, trace end uses, evaluate demand loads, and connect those engineering facts to the appropriate property classifications.

A court's allocation percentage is evidence of what happened in that property, not a shortcut for the next one. Functional allocation must be rebuilt from the actual electrical loads and design of each building.