Environmental cleanup costs.

In much anticipated Rev. Rul. 94-38, the IRS addressed the tax treatment of environmental cleanup costs, contradicting two previously issued technical advice memoranda. The ruling concluded that costs to clean up and treat contaminated land and water were deductible expenses, but the costs related to construction of treatment facilities were capital expenditures.

The ruling arose from a case involving a manufacturing plant built on uncontaminated land purchased in 1970. The company's manufacturing process produced hazardous waste and in the past the company buried the waste on portions of its own land. In 1993, in compliance with current and reasonably anticipated future Federal, state and local environmental regulations, the company began soil and groundwater remediation and monitoring. The company excavated the contaminated soil, transporting it to waste disposal facilities, and backfilled and replaced the cleanup areas with uncontaminated soil. The company also constructed a facility to extract, treat and monitor hazardous groundwater. The intent of these actions was to restore the company's land to the same physical condition before the contamination occurred.

Rev. Rul. 94-38 concluded that costs incurred to clean up the land and groundwater were deductible by the company as ordinary and necessary business expenses. However, the costs associated with constructing the groundwater treatment facility were capital expenditures. The Service stated that "[i]n determining whether current deduction or capitalization is the appropriate tax treatment for any particular expenditure, it is important to consider the extent to which the expenditure will produce significant future benefits." The IRS concluded that costs associated with soil cleanup and ongoing water treatment costs, other than facility construction costs, did not result in permanent land improvements, or significant future benefit, but merely restored the land to its prior condition.

Letter Rulings (TAMs) 9315004 and 9240004 had seemed to rely on the assumption that the condition of the properties after cleanup had been significantly improved, thus materially adding to the properties' value. Under the facts of the current ruling, the Service cited Plainfield-Union Water Co., 39 TC 333 (1962); "the appropriate test for determining whether the expenditures increase the value of the property is to compare the status of the asset after the expenditure with the status of that asset before the condition arose that necessitated the expenditure."

Several observations are worth noting: (1) After remediation, this particular company intended to continue to use the land and operate its manufacturing facility in the same manner as it did before the cleanup. However, the IRS stated that the results of the ruling would be the same whether the company planned to continue a manufacturing process that produces hazardous waste or decided to discontinue operations and hold the land idle. (2) Rev. Rul. 94-38 more readily embraces the matching principle, while the two TAMs pushed costs relating to cleanup into future periods when in fact the revenue related to these costs was in prior periods. (3) The ruling was silent on land purchased already in a contaminated state or unknowingly purchasing land that would require cleanup. In this case the land was free from contamination and became contaminated through the owners' discharge of hazardous material. One can only surmise that the results would hold true for similar cleanup costs. (4) The Supreme Court has specifically recognized the "decisive distinctions between capital and ordinary expenditures are those of degree and not kind. " Therefore, in determining whether the appropriate treatment of a cost should capitalized or expensed, it is important to consider the extent, if any, to which the cost will produce significant future benefit. Part of this assessment should include comparing the value of the property after the expenditure with the value before the condition arose that necessitated the expenditure. A careful examination of the particular facts of each case is required.

From Lynn Raber, Charlotte, N.C.