Environmental remediation expenditures are capitalizable to contaminated property.

In Letter Ruling 200108029, the IRS reiterated its position that environmental remediation expenditures are not deductible if a taxpayer purchases contaminated property, even if he had no knowledge of the contamination at the time of purchase and, as a result, presumably overpaid for such property. Additionally, the Service determined that insurance proceeds received as a reimbursement for the incurrence of environmental remediation expenditures were a nontaxable return of capital in the tax year that the taxpayers received the proceeds, to the extent they do not exceed the basis in the property.

Letter Ruling 200108029

In the letter ruling, the taxpayers had to capitalize costs incurred to remediate land purchased in a contaminated state. The costs included expenses paid for consultants, testing, supplies, equipment, labor and legal fees.

Prior to the taxpayers' purchase, the former owners had used the land for storing equipment, oil and empty perchloroethylene (PCE) tanks. The PCE had contaminated the land, which was unknown to the taxpayers when they purchased it. After learning of the previous owners' contamination and being informed by a regulatory agency that the land was contaminated, the taxpayers engaged various consultants to test the extent of the contamination and to remove the equipment causing the contamination. The taxpayers and the regulatory agency eventually reached an agreement that the agency would control all of the environmental assessment and cleanup work, charging the costs to the taxpayers.

Relying on Rev. Rul. 94-38, the IRS determined that the taxpayers had to capitalize the costs incurred to remediate the land. In Rev. Rul. 94-38, the taxpayer had purchased uncontaminated property, but subsequently contaminated it. The taxpayer then incurred costs to clean up the soil and to construct groundwater treatment facilities to remediate the contaminated land. The expenditures for remediating the soil were currently deductible, because the effect of the cleanup was simply to restore the property to its condition prior to the contamination. However, the Service did require the taxpayer to capitalize the costs for the groundwater treatment facilities, because the facilities' value extended substantially beyond the tax year.

In the letter ruling, the IRS determined that, because the land was already contaminated when the taxpayers purchased it, the taxpayers' remediation of the property not only restored the property to its previous condition, but also increased its value. The IRS distinguished Rev. Rul. 94-38, which clearly requires that the taxpayer must both own and contaminate the property with hazardous waste from its business to qualify for a current deduction. Thus, the Service required the taxpayer to capitalize the cleanup costs.

INDOPCO Implications

The first interesting feature of this letter ruling is that the taxpayers requested a ruling as to whether they could capitalize the costs under Sec. 263. Pursuant to Rev. Proc. 98-17, a taxpayer could request a letter ruling on the proper tax treatment of environmental remediation expenditures, when the cleanup project spans several years and the years involved both already-filed tax returns and tax returns to be filed in the future. The special procedures in Rev. Proc. 98-17 expired in February 2000, so it is no longer available.

It is not entirely evident why the taxpayers requested a determination that such expenditures were capitalizable instead of currently deductible. Since the ruling letter does not indicate the tax years at issue, we can only speculate on what the taxpayers' reason or reasons are. One possible reason for the taxpayers to prefer capitalization of the environmental remediation expenditures is that the taxpayers may have had expiring net operating losses (NOLs) that they otherwise would not have been able to use in the years in which they incurred such costs. Another possible reason is a change in the top marginal income tax rate for both individuals and corporations. For high-income individuals, the top marginal income tax rate changed from 31% to 39.6% for tax years beginning after Dec. 31, 1992; for corporations, the top marginal income tax rate changed from 34% to 35% for tax years beginning on or after Jan. 1, 1993. The ruling also implies that the insurance proceeds may have exceeded the taxpayers' basis in the land, so the taxpayers would presumably want to minimize the excess amount that would be includible in income at the higher marginal tax rate. Also, a deduction in a year with a lower marginal tax rate is generally worth less to a taxpayer. The time value of money or cost of funds is also a factor in ascertaining the optimal tax treatment. Examples 1 and 2 illustrate this scenario.

Example 1: The taxpayers (individuals) incur $100 for environmental
remediation expenditures, their current basis in the property is $100
and they receive $250 of insurance proceeds. At the time the taxpayers
could have deducted their environmental remediation expenditures,
the top marginal tax rate for individuals is 31%, and the top marginal
rate at the time the taxpayers received the insurance proceeds is
39.6%.

                                      Expense          Capitalize

Basis in land                         $100             $100
Environmental expense                    0              100
Adjusted basis in land                $100             $200

Insurance reimbursement               $250

Marginal tax effect @ 31%             ($31)
(benefit)                             [$100 x 31%]

Insurance reimbursement in excess     $59.40           $19.80
of adjusted basis in land @ 39.6%     [$150 x 39.6%]   [$50 x 39.6%]

Net tax effect                        $28.40           $19.80

After-tax benefit from capitalizing                    ($8.60)
Example 2: Assuming the same facts as in Example 1, this example
illustrates the benefit for a corporation, except that the top
marginal tax rate is 34% at the time the taxpayers could have
deducted the expenditures and 35% at the time the insurance proceeds
were received.

                                      Expense        Capitalize

Basis in land                         $100           $100
Environmental expense                    0            100
Adjusted basis in land                $100           $200

Insurance reimbursement               $250

Marginal tax effect @ 34%             ($34)
(benefit)                             [$100 x 34%]

Insurance reimbursement in excess     $52.50         $17.50
of adjusted basis in land @ 35%       [$150 x 35%]   [$50 x 35%]

Net tax effect                        $18.50         $17.50

After-tax benefit from capitalizing                  ($1.00)

The ruling also noted that the taxpayers originally expensed some environmental remediation costs and then sought to capitalize them all.

Because the taxpayers requested a ruling that they could capitalize instead of expense their environmental remediation expenditures, it is unclear whether the IRS still would have concluded that the costs had to be capitalized. The letter ruling, however, states that the taxpayers "must capitalize" the environmental remediation expenditures. Thus, it appears that the Service explicitly prohibited a deduction for environmental remediation costs, because the contamination pre-existed the taxpayers' ownership of the property (acquired in a taxable acquisition). As such, the IRS reiterated the Rev. Rul. 94-38 rule that remediation costs were an improvement and had to be capitalized if the land was contaminated at the time of purchase. Since the letter ruling merely recites the Service's earlier position in Rev. Rul. 94-38, it is not widening the scope of INDOPCO, Inc., 503 US 79 (1992). Thus, the letter ruling provides further support for the current deduction of costs incurred to remediate land, if the taxpayers contaminated the land.

Another interesting feature of the letter ruling is that (as previously mentioned) the types of costs at issue included those paid for soil testing, environmental consultants, supplies and equipment, labor and legal fees. Because the ruling does not specify which types of expenses the taxpayers had deducted and now seek to capitalize, it is not clear whether the IRS required the taxpayers to capitalize some of the costs that, in general, could be currently deductible under Sec. 162.

For instance, the taxpayers incurred attorneys' fees for representation at various meetings with the regulatory authority. The taxpayers met with the regulatory authority only in an effort to reach an agreement on the proper assessment plan for the cleanup. In Wells Fargo, 224 F3d 874 (2000), the Eighth Circuit held that INDOPCO did not require the capitalization of employees' salaries not conditioned on a capital transaction. In addition, courts have held other costs as deductible if they do not directly facilitate a capital transaction; see A.E. Staley Manufacturing Co., 119 F3d 482 (7th Cir. 1997), and In re: Federated Department Stores, Inc., 135 B.R. 950 (Bankr. DC Ohio 1992). Thus, it can be argued that, under the letter ruling, the taxpayer must capitalize only costs that relate directly to remediation, in addition to the cost of acquiring the assets.

To the extent the Service required the taxpayers to capitalize legal costs associated with its meetings with the consultants and regulatory authorities, the determination in the letter ruling is inconsistent with the weight of the law. Thus, that aspect of the letter ruling requires caution; presumably, the purpose of the legal costs associated with such meetings was to minimize any need to remediate the land and, therefore, such costs would not result in a future benefit to the taxpayers.

Insurance Proceeds

In addition to ruling that the taxpayers had to capitalize environmental remediation expenses incurred because of the pre-acquisition contamination, the IRS also ruled that the insurance proceeds received as a reimbursement for the incurrence of environmental remediation expenditures were a non-taxable return of capital. As such, the proceeds would reduce the taxpayers' basis in the contaminated property by an amount equal to the insurance proceeds received and were includible in gross income only to the extent they exceeded the taxpayers' basis in the property. Of course, this treatment of the insurance proceeds depends on the fact that the proceeds were a recovery of damages to the taxpayers' property, rather than a reimbursement of lost profits; see Rev. Rul. 81-277 and Collins, TC Memo 1959-174. Finally, because there was substantial doubt (and indeed no expectation by the taxpayers) of insurance reimbursement, the Service held that the taxpayers were not required to reduce their basis in the property until they actually received payment.

FROM CAROLYN OSSEN, J.D., AND PAUL GIBBS, CPA, WASHINGTON, DC