Deducting environmental cleanup costs.

Since the Environmental Protection agency (EPA) was established and the Hazardous Substance Response Trust Fund ("Superfund") legislation was enacted, environmental cleanup activity has increased quite extensively. At the same time, the IRS position on the tax treatment of cleanup costs has also evolved over the past few years. In addition, recent legislation has provided much-needed guidance on the costs associated with environmental cleanup.

Sec. 162 generally allows a deduction for the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Sec. 263 generally prohibits deductions for capital expenditures, and Sec. 263(a)(1) provides that no deduction is allowed for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property. Sec. 263(a)(2) provides that no deduction is allowed for any amount spent to restore property or to make good the exhaustion thereof for which an allowance has been made in the form of a deduction for depreciation, amortization or depletion.

Regs. Sec. 1.263(a)-1(b) provides that capital expenditures 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. Regs. Sec. 1.263(a)-2(a) provides that capital expenditures include the costs to acquire, construct or erect buildings, machinery md equipment, furniture and fixtures, and similar property with a useful life extending substantially beyond the tax year.

In Rev. Rul. 94-38, the Service allowed a deduction for costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business, other than costs attributable to the construction of groundwater treatment facilities determined to be capital expenditures under Sec. 263. In this ruling, the taxpayer acquired the land in a clean state, polluted it with waste from its manufacturing operations, and then stored the waste on its land. The cleanup involved the removal of the contaminated soil, its replacement with clean soil and the installation of pumping and filtration equipment to clean the groundwater contaminated by seepage of the waste. The IRS ruled that the remediation and ongoing groundwater treatment expenditures did not result in improvements that increase the value of the property; the taxpayer "merely restored its soil and groundwater to their approximate condition before they were contaminated by the taxpayers manufacturing operations." The ruling cited Plainfield Union Water Co., 39 TC 333 (1962), in its analysis to determine whether a taxpayer is adding value or simply restoring value to the property.

In Letter Ruling (TAM) 9541005, the Service held that the deduction of environmental cleanup costs under the restoration principle set forth in Rev. Rul. 94-39 was applicable to land contaminated in the course of business operations, but not to land acquired in a contaminated condition. However, in an unreleased TAM, the National Office withdrew TAM 9541005, and, based on a "unique set of facts," permitted a deduction for the costs at issue.

In TAM 9541005, the taxpayer purchased land that had previously been used as a farm. The land was acquired in a clean condition, but was subsequently contaminated in the course of the taxpayers industrial operations. The taxpayer contributed the land to a county government, which intended to construct a recreational park on the land. When the contamination of the land was discovered, the county government conveyed the land back to the taxpayer, who in turn incurred costs related to the contamination (e.g., a hazardous waste study and legal fees).

In the unreleased TAM, the National Office stated that Rev. Rul. 94-38 applied if a taxpayers environmental remediation expenditures restore contaminated property to what was its uncontaminated condition at the time it was acquired by the taxpayer. The National Office noted that the taxpayer acquired the property in a clean condition and contaminated it in the course of its business operations. Because the same taxpayer contaminated the property and incurred the costs concerning the contamination, the interim break in ownership should not, in and of itself, operate to disallow a deduction under the general principles of Sec. 162. The unreleased TAM stated:

According to the Taxpayer, the Costs are environmental remediation costs that, like the costs at issue in the revenue ruling, did not result in improvements that increased or improved the condition or value of the property vis a vis its condition at the time of the Taxpayer's original acquisition of the property. Revenue Ruling 94-38 applies if a taxpayer's environmental remediation expenditures restore contaminated property to what was its uncontaminated condition at the time it was acquired by the taxpayer. This determination is made by comparing the status of the asset after the expenditure with the status of that asset before the condition arose that necessitated the expenditure (i.e., before the land was contaminated by the taxpayers hazardous waste)....Because the same taxpayer contaminated the property and incurred the Costs, the interim break in ownership should not, in and of itself, operate to disallow a deduction under the general principles of Section 162 of the Code. The contamination to the Land and the Taxpayers liability for remediation were unchanged during the break in ownership.

If a taxpayer purchases property when it is already contaminated, it would appear as if the costs relating to the cleanup would not be deductible, since the taxpayer is adding or enhancing its value. The argument could be made, however, that the value of the contaminated property when a taxpayer acquires it is not the purchase price, but rather the value taking into account the contamination, as such, the cleanup expenses are only serving to restore (rather than add) value. When a property is acquired without knowledge of its contaminated condition, the remediation expenditures appear top be deductible under the Plainfield Union test. If, however, the contaminated condition was known by the purchaser, the expenditures must be capitalized. Unfortunately, the IRS applies Plainfield Union narrowly to property acquired in an already contaminated condition, regardless of whether the taxpayer knew of the contamination when the property was acquired.

The attorney who represented the unnamed taxpayer who received the unreleased TAM noted that if the client had acquired the land in a different manner (i.e., if a charity had turned over a contaminated property to the company and the company cleaned it up), the costs would have had to have been capitalized because the usage of the land would have improved.