Capitalization of environmental cleanup costs.

• Author: Strong, David L.

Rev. Rul. 2004-18 addressed the treatment of environmental cleanup costs related to Sec. 263A and capitalization of those costs into inventory. Specifically, it analyzed the remediation costs incurred by a manufacturer that continues to use contaminated property in its operations.

Under Sec. 263A, a taxpayer has to capitalize all direct and certain indirect costs properly allocable to the production of real or tangible personal property. In Rev. Rul. 2004-18, the taxpayer incurred costs currently for soil and groundwater remediation for contamination from hazardous waste disposal in prior years. The IRS concluded that the costs incurred for environmental cleanup were indirectly related to the taxpayer's production activities and had to be capitalized into inventory under Sec. 263A.

Background

Rev. Rul. 94-38 used to be considered the general authority on how to treat environmental remediation costs. In that ruling, the IRS determined that costs incurred to clean up contaminated land and to treat groundwater were not capitalizable, because they did not extend the property's useful life. The taxpayer had buried hazardous waste generated by its manufacturing operations on property it owned. In a subsequent year, to comply with stricter environmental requirements, the taxpayer began remediation of the contaminated soil and groundwater. The costs incurred for the environmental cleanup were considered current deductions, not capitalizable under Sec. 263.

Rev. Rul. 2004-18 also cited Rev. Rul. 98-25 to support the conclusion that environmental cleanup costs may be deductible as ordinary and necessary business expenses. The general issue in Rev. Rul. 98-25 was the deductibility of costs to replace underground storage tanks (USTs) used to store waste generated by the taxpayer's production activities. The IRS concluded that the "costs of removing, cleaning, and disposing of the old USTs, and filling and on going monitoring of the new USTs are deductible as business expenses under section 162."

Rev. Rul. 2004-18

The IRS's premise in Rev. Rul. 2004-18 for capitalizing the environmental cleanup costs is that both prior rulings dealt only with the capitalization of items under Sec. 263(a) and did not address the Sec. 263A inventory capitalization rules. Its basic argument was that...