IRS remediates environmental-cost deduction mess.

• Author: Silverman, Mark J.

Introduction

During the last few years, the Internal Revenue Service has struggled with the tax treatment of environmental clean-up costs. In June 1994, the IRS published Revenue Ruling 94-38, 1994-1 C.B. 35, in which it allowed a current business expense deduction under section 162 of the Internal Revenue Code for soil remediation and groundwater treatment costs (while requiring capitalization of costs attributable to the construction of groundwater treatment facilities, which were determined to be capital expenditures under section 263). In technical advice memorandum (TAM) 9541005, dated September 27, 1995, the IRS refused to apply the principles of Revenue Ruling 94-38 to a situation that was not distinguishable in any material way from the facts of that ruling. On January 17, 1996, however, the IRS released to the taxpayer a new TAM that revokes and supersedes TAM 9541005.(1) In the new TAM, the IRS permits the costs to be deducted. The IRS's initial unwillingness to apply the principles of Revenue Ruling 94-38 in TAM 9541005, and its subsequent reversal only a few months later, provide insight into the IRS's evolving thinking about the deductibility of environmental clean-up costs.

Tax Treatment of Environmental Clean-up Costs

In general, the Internal Revenue Code allows deductions for ordinary and necessary business expenses under section 162 but requires that expenditures producing significant value beyond a taxable year be capitalized pursuant to section 263. Behind the deduction/capitalization distinction is the principle that deductions for costs incurred should be matched with the income produced by such costs. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Rev. Rul. 94-38, 1994-1 C.B. 35, 35-36.

Section 162 generally allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An expense incurred in a taxpayer's trade or business may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. Commissioner v. Tellier, 383 U.S. 687 (1966); Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933). Applicable regulations specifically allow a deduction for repair costs so long as the following conditions are met: (1) the repair is incidental; (2) the cost of the repair does not materially add to the value of the property; (3) the repair does not appreciably prolong the useful life of the property; and (4) the purpose of the expenditure is to keep the property in ordinarily efficient operating condition. Treas. Reg. [sections] 1.162-4.

Under sections 261 and 263, no deductions are allowed for capital expenditures. Section 263(a)(1) provides that no deduction shall be allowed for "[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." The regulations provide additional guidance for determining what constitutes a capital expenditure. Specifically, Treas. Reg. [sections] 1.263(a)-1(b) provides that expenditures that are subject to capitalization:

... include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures....

Identifying the applicable statutory and regulatory provisions is easy; determining how to apply them is not. In this regard, the IRS has recognized that " 'the decisive distinctions [between capital and ordinary expenditures] are those of degree and not of kind,' and a careful examination of the particular facts of each case is required." E.g., Rev. Rul. 94-38, 1994-1 C.B. at 36, quoting Welch v. Helvering, 290 U.S. at 114, and Deputy v. du Pont, 308 U.S. at 496.

Thus, the proper tax treatment of environmental cleanup costs depends on whether the particular expenditure is for a repair or an improvement. In each situation, the main question is whether the environmental clean-up costs restore damaged property to its previous condition (a repair) or increase the value of property (an improvement). The problem has been ascertaining the correct baseline with which to compare post-expenditure property.

Background to the IRS's Position in Revenue Ruling 94-38

In each of three TAMs issued prior to Revenue Ruling 94-38, the IRS concluded that environmental clean-up expenditures added value to the taxpayer's property and were therefore capital in nature. In TAM 9240004 (dated June 29, 1992), the IRS concluded that expenditures to remove and replace asbestos insulation in certain furnaces added value to the taxpayer's property, and the costs therefore were a depreciable improvement to the furnaces. In TAM 9315004 (dated December 17, 1992), the IRS concluded that expenditures to remove and replace contaminated soil added value to land.(2) In TAM 9411002 (dated November 19, 1993), the IRS found that expenditures to remove and replace asbestos, in connection with the conversion of a boiler room to a garage and office space, were capital expenditures because the costs adapted the property to a new and different use but that costs of encapsulating exposed asbestos in an adjacent warehouse were deductible. In concluding that the expenditures at issue in these TAMS (with the exception of the encapsulation expenditures in TAM 9411002) added value to property, the IRS compared the property after the expenditure with its pre-expenditure state.

The IRS's use of property's pre-expenditure state as the baseline for determining whether there has been an increase in value was inconsistent with a large body of case law that holds that the proper comparison is between the post-clean-up value of the property and the value of the property before the occurrence of the condition necessitating the expenditure. In Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962), nonacq. on other grounds, 1964-2 C.B. 8, the Tax Court considered the...