Environmental remediation costs ineligible for claim-of-right treatment.

• Author: O'Driscoll, David

The IRS recently ruled that the current costs of remediating environmental contamination occurring in prior tax years do not qualify for Sec. 1341 treatment.

Situation 1: N manufactures products that it sells to wholesalers and retailers. Its manufacturing process creates hazardous waste. N uses an accrual method and a calendar tax year. From the inception of its business in 1950, and until 1979, N buried hazardous waste on its land in accordance with then-applicable state, Federal and local environmental laws; it accounted for waste disposal costs as a deducible business expense under Sec. 162. In 2004, to comply with current environmental laws, N incurs expenses for all necessary services to eliminate soil and water contamination caused by the buried waste, transport the waste to a disposal facility that complies with current environmental laws and restore the land.

Situation 2: The facts are the same as in Situation 1, except that N accounted for waste disposal costs as a production cost in calculating its inventory costs for all years.

Law and Analysis

Sec. 1341 applies if: (1) the taxpayer included an item in gross income for a prior tax year(s) because it appeared that the taxpayer had an unrestricted right to the item, (2) after the close of the tax year(s) of inclusion, it is established that the taxpayer did not have an unrestricted right to the item or to a portion of the item and (3) the deduction exceeds $3,000.

Sec. 1341 ensures that the taxpayer's position is not worse than it would have been had the taxpayer not included the item in gross income in the earlier year (except for the time value of money). If Sec. 1341 applies, the tax for the tax year is the lesser of the tax computed (1) with the current deduction or (2) without the deduction, less the decrease in tax for the prior tax year(s) that would have occurred had the item been excluded from gross income. The repayment must arise out of the same circumstances, terms and conditions as the original payment of the item to the taxpayer (Griffiths, 54 Fed. Cl. 198 (2002)). The fact that the repayment amount bears no relationship to the amount included in income indicates that the repayment does not arise from the same or specific circumstances, terms and conditions as the original transaction (Bailey, 756 F2d 44 (6th Cir. 1985); Uhlenbrock, 67TC 818 (1977)).

In both Situations 1 and 2, the environmental remediation costs N incurs in 2004 do not qualify for treatment under...