Deducting costs that are usually capitalized.

• Author: Bland, Larry, Jr.

Sec. 162 authorizes a deduction for ordinary and necessary business expenses paid or incurred during the tax year in carrying on any trade or business. However, Sec. 263(a) prohibits a deduction for capital expenditures, which include the cost of acquiring, constructing, or erecting buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the tax year. Furthermore, no deduction is allowed for amounts that (1) add to the value, or substantially prolong the useful life, of the property; or (2) adapt the property to a new or different use.

Paraphrasing the Sixth Circuit in United Dairy Farmers, Inc., 267 F.3d 510 (6th Cir. 2001), if an expense fits within Sec. 263(a), that section would trump the deductibility provision of Sec. 162(a), and the expense would have to be capitalized. To be deductible, the expense must be ordinary and necessary within the meaning of Sec. 162(a) and fall outside the type of capital expenditures envisioned by Sec. 263(a). Because the Code describes what should be capitalized generally but enumerates allowable deductions specifically, "deductions are strictly construed and allowed only 'as there is a clear provision therefor'" (INDOPCO, Inc., 503 U.S. 79 (1992)).This case study examines three types of expenses: environmental cleanup costs, restaurant "smallwares," and replacement tires for qualifying vehicles.

Deducting environmental cleanup costs

Environmental cleanup costs include any costs associated with the assessment, mitigation, removal, or remediation of environmental hazards (e.g., asbestos removal and encapsulation, soil remediation, groundwater remediation, and underground tank repair and removal). An environmental cleanup project may consist of one or more related environmental cleanup activities.

The deductibility of environmental cleanup costs has evolved from a requirement to capitalize all such costs to a case-by-case determination of the expense-versus-capitalization issue. IRS pronouncements and court decisions provide the following guidelines:

Cleanup

Costs (other than costs attributable to the construction of groundwater treatment facilities) incurred to clean up land (i.e., soil remediation) and treat groundwater that becomes contaminated as a result of the manufacturer's operations are deductible (Rev. Rul. 94-38). However, this applies only if the environmental remediation expenditures restore the contaminated property to its uncontaminated condition at the time it was acquired by the manufacturer (see IRS Letter Ruling 9541005). In Dominion Resources, Inc., 219 F.3d 359 (4th Cir. 2000), the court held that remediation costs must be...