Environmental issues: an overview of tax policy.

While U.S. environmental policy encourages cleanup and development, the overall tax policy does not provide incentives for cleaning costs. It is unlikely that the IRS will reconsider its current position or that Congress will subsidize cleanup costs through changes to the tax law. Therefore, any taxpayers facing significant environmental costs, such as the development of wetlands, the costs of soil conservation or the removal of hazardous substances, should consider the important tax issues related to the capitalization of cleanup costs.

Wetlands

For many years, the Internal Revenue Code indirectly supported the development of wetland resources. For example, provisions that encouraged the destruction of wetland areas for agriculture or investment purposes allowed any profits realized on land converted from wetlands for irrigation purposes to be deducted as conservation expenses. Also, a deduction was allowed for expenses incurred in land clearing activities. All of these provisions have been amended to remove the tax incentives for the destruction of wetland areas.

Sec. 1257 creates ordinary income on the disposition of converted wetlands and eliminates the prior incentive of treating profits from the sales as capital gains. This section specifically pertains to the sale of converted wetlands or highly erodible cropland. Profits from the sale of land previously converted from wetland must be treated as ordinary income. The wetland provisions of this section apply both to any person who has caused the conversion of wetland to farmland and to any person who has farmed the converted land area at any time. In addition to the elimination of the capital gain incentive in Sec. 1257, Sec. 182 has been repealed, eliminating deductions for expenses incurred in land clearing activities.

Other provisions that allow deductions for soil and water conservation expenditures no longer apply to expenditures related to wetlands destruction. Sec. 175, which provides a deduction for soil and water conservation expenses, specifically excludes expenditures in connection with the draining or filling of wetland areas.

Soil Conservation

Farmers who implement soil conservation activities, even if they are capital in nature, may deduct their expenses. Expenditures incurred for soil and water conservation related to land used in farming, or for prevention of erosion on land used for farming, are deductible costs. To qualify for the deduction, the farmer must meet certain criteria defined in Sec. 175. If these criteria are not met, the expenditures merely increase the basis of the property.

Until 1986. national tax policy on soil conservation was generally inconsistent. Tax incentives, such as the investment tax credit (ITC) and accelerated depreciation, made conversion of land to agriculture economically feasible. However, as a result of the Tax Reform Act of 1986 (TRA), the ITC was abolished and accelerated depreciation was limited to personal property.

Previously, accelerated depreciation deductions and ITC were available for purchases of most farm equipment. Additionally, income from the sale of farm assets was subject to relatively modest capital gain rates of taxation. The TRA extended the period over which depreciation deductions have to be taken and ended preferential treatment of any income from the sale of assets, including land, breeder livestock and some unharvested crops. There are also additional limits on the tax treatment of "passive" investments in agriculture. Overall, farmers lost specific tax benefits and received far less savings than nonagricultural taxpayers from the tax rate reductions.

Cleanup Costs

The distinction between deductible repairs and capital costs is based on the purpose of the expenditures: the purpose of a repair is to restore property back to an efficient operating condition, while the purpose of capital expenditures is to extend the property's life, increase its value or make it adaptable to a new use.

The courts generally have relied on one or more of the following factors to distinguish between capital expenditures and repairs. An expenditure is generally a capital cost if it:

* Materially increases the property's value.

* Appreciably prolongs the property's original useful life.

* Adapts the property to a new or different use.

* Represents part of a general plan of rehabilitation or restoration for the property.

* Brings the property into compliance with government regulations.

* Permanently improves property, rather than maintaining it or restoring it to a previously useful condition.

* Represents part of the property's acquisition cost.

Although these factors have not been applied to the specific facts of environmental cleanup cases, the courts have used them in analogous situations, with mixed results.

In various IRS rulings, cleanup costs have been deemed capital expenditures if they add more value to the property after restoration from a prior contaminated state. Any costs that restore property to essentially the same physical condition that existed prior to the contamination do not add value or change the property's use. For example, Rev. Rul. 94-38 held that costs incurred solely to clean up land and to treat groundwater contaminated with hazardous waste were deductible as ordinary and necessary business expenses under Sec. 162. However, costs allocable to constructing groundwater treatment facilities were improvements treated as capital expenditures under Sec. 263.

Additionally, Letter Ruling (TAM) 9411002 held that the removal of asbestos from a boiler house represented permanent improvements that increased the value, use and capacity of property, and adapted it to a new and different use. Only the costs attributable to encapsulation of asbestos-containing materials were deductible as business expenses related to residential repairs.

Conclusion

The bottom line in the rulings is that any permanent improvement or benefit from the removal of hazardous substances will result in treatment as a capital expenditure. Most environmental cleanup costs are intended to create a permanent improvement of the property. Obviously, this treatment is inconsistent with important issues underlying our environmental policies. It is very important that the IRS consider how these policies may be supported by a more favorable tax outcome. To the extent possible, and consistent with general tax principles, the Service should seek to adopt positions that will neither impede nor discourage effective environmental remediation.

From Thomas G. Barker, Jr., CPA, Schmitt, Griffiths, Smith & Co., Ogden, Utah (Not a DFK Affiliate)