Scott Paper: Why Electrical Systems Can Require Functional Allocation

A building's electrical system does not necessarily receive one classification simply because it operates as one interconnected system. Scott Paper Co. v. Commissioner, 74 T.C. 137 (1980), established an important approach for analyzing electrical distribution based on what the electricity ultimately serves. The 2025 IRS Cost Segregation Audit Technique Guide identifies Scott Paper as the landmark case that established the functional allocation method for allocating portions of primary and secondary electrical distribution systems between § 1245 property and § 1250 property. The court distinguished electrical loads serving general building operation from loads serving production machinery and other qualifying uses. For CostSegRx engineers, that creates a practical principle: electrical classification can require tracing power through the building to understand what the system actually supports.

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Key Takeaways

• Scott Paper established the functional allocation approach for certain building electrical distribution systems.
• The analysis focuses on the ultimate use of the electricity distributed through the system.
• Electrical loads serving general building operation can remain associated with § 1250 property.
• Electrical loads serving qualifying machinery or equipment can support allocation to § 1245 property.
• The ATG's functional allocation method uses electrical demand load rather than an arbitrary standard percentage.
• Electrical drawings, load schedules, branch circuits, feeders, and end-use equipment help engineers perform the analysis.
• Scott Paper does not mean every electrical component serving equipment automatically becomes § 1245 property.
• A mixed-use electrical system shows why contractor cost categories alone are insufficient.
• For electrical distribution, engineers need to know where the power goes and what it serves.

What Was Scott Paper Co. v. Commissioner About?

Scott Paper Co. v. Commissioner involved electrical distribution at a paper plant.

The ATG's court-case table identifies both the primary electrical distribution system and the secondary electrical distribution system as containing § 1245 and § 1250 property. It describes Scott Paper as the landmark case establishing the functional allocation method for dividing components of an electrical distribution system between those two property categories.

The important question was not simply whether electrical wiring is listed as a structural component.

The court examined what the electricity delivered through the system ultimately served.

According to the ATG, Scott Paper distinguished electrical power used for the overall operation or maintenance of the buildings from power used to operate the taxpayer's production machinery. General building uses included lighting, heating, ventilation, and air conditioning.

To the extent the primary electrical system carried loads serving production processes or other qualifying uses, the court allowed the corresponding treatment under the Investment Tax Credit framework. To the extent it served overall building operation or maintenance, the electrical property remained a structural component of the building.

That became known as the functional allocation approach.

What Does “Ultimate Use of Electricity” Mean?

The concept is straightforward in principle.

An electrical distribution system exists to deliver power somewhere.

The engineering question is:

What does the power ultimately operate?

A commercial building may distribute electricity to general lighting, HVAC, ordinary receptacles, elevators, life-safety systems, manufacturing equipment, kitchen equipment, specialized medical equipment, computers, process machinery, and many other loads.

Those end uses are not necessarily identical for classification purposes.

Scott Paper focused on that destination.

The ATG explains that the functional allocation approach allocates electrical distribution based on the power demand or design load of the machinery and equipment the system was designed to serve. It states that the power demand of the end-user machinery and equipment forms the basis for the approach.

That turns an abstract classification issue into an engineering investigation.

Instead of asking only, “How much did the electrical contractor cost?” the engineer asks, “Where does this electrical capacity go?”

This is also why CostSegRx treats electrical distribution systems in cost segregation as a functional engineering issue.

Which Electrical Loads Are Associated With Building Operation?

The ATG identifies several familiar building loads when explaining Scott Paper.

These include lighting, heating, ventilation, and air conditioning used for the overall operation or maintenance of the building.

Chapter 8 expands on the point.

Its summary states that primary and secondary electrical distribution system components used in the operation or maintenance of the building, or necessary to provide general building services such as lighting, heating, ventilation, and air conditioning, are § 1250 property. It also includes electrical outlets of general applicability and accessibility in this building-related treatment.

This is important because electrical infrastructure can be physically substantial.

Switchgear may be large.

Transformers may be expensive.

Feeders may run throughout a property.

But size and cost do not determine classification.

The system's function matters.

If the infrastructure supplies general building services, that fact supports its relationship to the building.

Can Electrical Distribution Serving Equipment Be Allocated to § 1245 Property?

Potentially, when the facts and applicable framework support it.

The ATG explains that Scott Paper allowed allocation of the facility's primary electrical system based on the electrical loads attributable to production processes or other qualifying uses versus overall building operation.

Chapter 8 similarly states that the costs of hook-ups and branch circuits supplying 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 they serve, based on § 168 and Rev. Proc. 87-56.

The word dedicated becomes important.

Consider a circuit installed specifically for one qualifying piece of machinery.

That presents different facts from a convenience outlet that can serve many different uses.

The ATG's audit guidance gives this exact type of warning. It explains that an outlet, switch, or branch circuit may be allocated to the tangible personal property it supports, but if the same component can be used for other equipment, an examiner may consider it part of the general building electrical system.

So “it powers equipment” is not enough by itself.

CostSegRx engineers need to understand the actual circuit, its endpoint, its design, and its ability to serve other loads.

How Does Demand Load Affect Functional Allocation?

The 2025 ATG gives unusually detailed engineering guidance on this question.

It defines the functional allocation approach as the proportional allocation of a building's electrical distribution system by electrical Demand Load to the various items served. The ATG says the approach was first used in Scott Paper to allocate electrical distribution between § 1245 property and § 1250 property.

Demand load is not simply the amount of electricity consumed during a particular month.

The ATG describes it as the factored load used in designing the building's overall electrical system. Demand load affects the size and type of electrical service, conductors, breakers, transformers, switchgear, conduit, and other infrastructure needed for safe operation.

This distinction matters because the ATG specifically warns that an energy usage study measured in kilowatt-hours is different from the demand-load analysis used for functional allocation.

In practical terms, the engineer is trying to understand how much of the electrical distribution system was designed around particular qualifying loads.

That requires more than a utility bill.

It may require electrical plans, panel schedules, equipment loads, demand calculations, feeder sizes, transformer information, and other design data.

How Do CostSegRx Engineers Analyze Functional Allocation?

The ATG's Chapter 8 methodology reinforces the need for engineering support.

The analysis begins with the electrical system itself.

An engineer needs to understand the primary electrical distribution system, secondary distribution, branch circuits, hook-ups, and the end-use equipment being served.

The ATG describes the primary EDS as infrastructure receiving service from the utility and delivering power through major distribution equipment such as main panels, transformers, feeders, service entrance equipment, and conduit.

From there, the engineer can trace how the system distributes power through the property.

Useful documentation may include:

• One-line electrical diagrams
• Panel schedules
• Load schedules
• Electrical construction drawings
• Equipment schedules
• Transformer information
• Switchgear documentation
• Branch circuit information
• Contractor cost records
• Field observations

The ATG also makes an important administrative point: if the functional allocation approach outlined in Chapter 8 is properly applied, the allocation should not be challenged. If another approach is used or the claimed method differs from the ATG methodology, the guide recommends risk assessment and engineering assistance.

That demonstrates the technical depth of the issue.

The allocation is not supposed to be a guess.

Does Scott Paper Allow a Standard Percentage of Electrical Costs?

No standard percentage should be assumed.

This is one of the most important practical lessons from the ATG.

The guide identifies use of a “standard” percentage of primary electrical feeder costs as a common issue. It states that, in the Service's view, these allocations should instead be based on usage or load studies designed to determine the percentage of electricity allocable to specific § 1245 property rather than general building function or maintenance.

That aligns closely with the CostSegRx principle that percentages are the result, not the methodology.

Imagine two manufacturing properties.

One may contain production equipment representing a substantial share of the designed electrical demand.

Another may use comparatively little specialized electrical capacity.

Applying the same assumed electrical allocation to both properties would ignore how their systems were actually designed.

Functional allocation works in the opposite direction.

First establish the loads.

Then determine what those loads serve.

Then analyze the electrical infrastructure designed to support them.

The percentage is an output of that work.

It is not the starting assumption.

How Can Functional Allocation Work in a Commercial Facility?

Illustrative example only. Actual asset classifications, electrical 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 a manufacturing facility contains a primary and secondary electrical distribution system with $1,000,000 of supported cost.

The electrical plans show several major categories of demand.

One portion of the system supplies general lighting, HVAC, ordinary receptacles, and other building services.

Another portion supplies dedicated production machinery.

A third portion supplies equipment whose function or classification requires additional analysis.

An arbitrary approach might say that 30 percent of the electrical system is “typically” associated with equipment.

Scott Paper does not support that kind of reasoning.

Instead, the engineering team studies the actual electrical design.

What is the demand load associated with the qualifying machinery?

What portion belongs to building services?

How are the primary and secondary systems sized to support those loads?

Which branch circuits and hook-ups are dedicated?

What costs correspond to the different portions of the electrical system?

The resulting allocation may be 10 percent, 30 percent, 60 percent, or another supported result.

The percentage itself is not the lesson.

The methodology is.

CostSegRx engineers work from the property's electrical facts rather than from an expected allocation.

What Is the Most Important Lesson From Scott Paper?

Scott Paper demonstrates why an electrical distribution system may require functional analysis rather than one blanket classification.

The court focused on the ultimate use of the electricity.

The ATG continues that framework in Chapter 8, where it defines functional allocation using electrical demand load and explains how primary and secondary electrical distribution can be proportionally allocated based on the items served.

The approach is technical enough that the ATG describes proper application as complex and labor intensive. It requires determining the cost of specific portions of the electrical system, analyzing overall demand load, and appropriately allocating the primary and secondary distribution systems.

That makes the CostSegRx engineering lesson clear.

Do not start with the electrical contractor's total.

Do not start with a standard percentage.

Do not assume every circuit serving equipment receives the same treatment.

Trace the power.

Understand the load.

Determine what the system serves.

Then apply the classification framework.

For electrical distribution, classification can follow function. Engineers need to know where the power goes and what it serves.