IRS disallows deductions for asbestos removal.

Significant environmental legislation and administrative regulations promulgated during the 1980s and 1990s brought the issue of asbestos removal to the forefront of the business, legal and accounting communities. The Occupational Safety and Health Administration (OSHA) promulgated regulations in July 1986, which provided that significantly reduced levels of asbestos would be tolerated in the workplace, and many states have imposed similar restrictions. Consequently, businesses have begun spending significant sums to comply with these guidelines.

There has been considerable uncertainty concerning the proper tax treatment of costs associated with removing or encapsulating asbestos in order to comply with the OSHA regulations and applicable state laws. Many believe that such costs should be currently deductible under general tax principles applicable to ordinary repairs and maintenance, and that such a result is consistent with sound tax policy (i.e., to promote compliance with state and Federal guidelines). Unfortunately, the IRS does not agree. In its first official pronouncement on the subject, the Service issued Letter Ruling (TAM) 9240004, which held that asbestos removal costs are not deductible as ordinary repairs and maintenance, but instead must be treated as capital expenditures.

A businessman or investor who desires to modify or sell real or personal property containing asbestos must either encapsulate and continuously monitor the asbestos to ensure that permissible exposure levels are maintained, or undertake a program to remove the asbestos and properly dispose of it. If a taxpayer decides to remove the asbestos and replace it with a substitute insulating or fire retardant material, the taxpayer arguably has three choices for treating these costs: (1) Deduct both the cost of the asbestos removal and the cost of installing its replacement in the year the costs are incurred; (2) capitalize all of these costs and depreciate them over the appropriate modified accelerated cost recovery system (MACRS) period for the particular asset to which the costs relate (e.g., 31 1/2 years for nonresidential real property); or (3) as a middle ground, currently deduct the costs associated with the asbestos abatement, but capitalize the costs associated with installing the replacement insulation.

From a public policy standpoint, the first alternative would seem the most appropriate. As noted, the Federal government and many states have passed laws and regulations requiring the monitoring or removal of asbestos in an effort to protect workers as well as the environment. Therefore, taxpayers should be permitted a current deduction for expenses incurred to comply with these rules. This asbestos removal or encapsulation effort is not required because of wrongdoing on the part of business; rather, it is a reaction to technological advances that have created an awareness of the hazards of asbestos exposure. To make the Federal and state governments indirect contributors to the required, and quite costly, remedial effort seems appropriate.

This public policy approach for current deductibility is supported by a fair reading of the regulations and case law on deductions for ordinary repairs and maintenance. Regs. Sec. 1. 162-4 states that if costs are incurred that neither materially add add value to nor appreciably prolong the life of property on which repairs are being made, and such costs keep the property in an ordinarily efficient operating, condition, the costs can be currently deducted.

The distinction between deductible repairs and capital improvements is very fact specific. The following are some of the factors considered by the courts when faced with this issue. [] Magnitude of the cost relative to the value of the property: When the cost of the corrective action represents a large percentage of the overall value of the real or personal property, the IRS may question current deductibility. However, the courts have permitted current deductions despite relatively high repair costs. Taxpayers have been allowed to deduct costs relating to reinforcing floors and stopping roof and wall leaks even though the costs of these repairs were relatively great. See American Bemberg Corp., 10 TC 361 (1948), aff'd per curiam, 177 F2d 200 (6th Cir. 1949), and Buckland, 66 F Supp 681 (DC Conn. 1946). [] Prolonging useful life of the property: When the corrective action substantially prolongs an asset's useful life, it will generally be treated as a capital improvement. The useful life is typically measured before the incident that necessitates the repair occurs or is discovered. However, in Illinois Merchants Trust Co., 4 BTA 103 (1926), acq. V-2 CB 2 (involving rotted foundation pilings), the court stated that what should be examined is whether the repair increases the normal, expected useful life of the property. [] Increasing the value of the property: If the cost of the corrective action increases the value of the property, such expenditures could be considered capital in nature. Of course, virtually all repairs increase the value and often the marketability of property. However, when the expenditures merely return the property to its value before the event necessitating the repair occurred, such costs are currently deductible. In Plainfield-Union Water Co., 39 TC 333 (1962), nonacq. 1964-2 CB 8, the Tax Court held that the proper measure to be used in making this determination is by comparing the property's value after such expenditure with its value prior to discovering the condition necessitating the repair. [] Nature of the remedy: In Midland Empire Packing Co., 14 TC 635 (1950), acq. 1950-2 CB 3, the taxpayer owned a meat-packing plant. An oil-refining plant was later built near this plant and oil began to seep into the taxpayer's basement. The taxpayer was warned by Federal meat inspectors that it should oil-proof the abasement or shut down the plant. To prevent the oil seepage, the taxpayer added a concrete wall and floor lining to the basement. The Tax Court, in holding an ostensibly capital expenditure to be a repair, looked to the nature of the remedy. Factors noted by the court were that the value of the property was not increased over what it was before the oil seepage problem and that the use of the property remained the same. Another factor, although not specifically discussed by the court, was that the cause for the repair was an external event unrelated to any actions of the taxpayer, much like the legislative lowering of tolerable asbestos levels.

In the absence of IRS guidance on the asbestos abatement issue, the decision To deduct or capitalize asbestos removal expenses primarily depended on whether the expense was incurred to restore property to a condition in which the current use could be continued, to enhance its value, or to extend its original useful life based on consideration of the factors listed above.

According to Letter Ruling (TAM) 9240004, however, the Service's rationale in deciding when taxpayers are entitled to deduct repairs as current business expenses is changing, in large part based on its recent victory in the Supreme Court's, decision in INDOPCO, Inc., 112 S. Ct. 1039 (1992). In INDOPCO, the Supreme Court ruled that expenditures incurred by a target corporation to evaluate a friendly takeover bid must be capitalized, based on the principle that expenses incurred in reorganizing or restructuring a corporation are capital in nature. The Court reasoned that a target corporation would realize future benefits from these expenditures; therefore, such expenditures were not deductible in the year incurred.

In Letter Ruling 9240004, the taxpayer argued that the cost of replacing asbestos insulation in machinery with a less efficient, but safer, form of insulation constituted an incidental repair that was currently deductible. Although the costs were substantial, they were minor in relation to the taxpayer's total repair costs and in relation to the value of the equipment. The taxpayer also argued that the costs did not materially add value to, or substantially prolong, the equipment's useful life, since those costs merely restored the property to its original value (i.e., before an asbestos problem was identified); in effect, the replacement insulation performed "the same function in the same way as the asbestos insulation." Finally, the taxpayer noted that the expenditures did not relate to new assets or components parts, nor did the expenditures relate to a general rehabilitation plan, all factors normally denoting a capital expenditure.

Citing INDOPCO, the Service held that the costs of replacing the asbestos were capital expenditures because the taxpayer received long-term future benefits that were expected to accrue beyond the year in which the costs were incurred. The IRS believed that these benefits were not incidental, since the value of the taxpayer's machinery was increased and removing the asbestos made the property more marketable. Moreover, by satisfying state and Federal guidelines, the likelihood of being required to suspend operations to remove excessive asbestos concentrations was eliminated, which made the machinery more valuable. Furthermore, since asbestos removal was (according to the service) a one-time "permanent improvement," the deduction prohibition under Sec. 263 applied. Finally, the health risks associated with the asbestos were reduced and, as a result, the employer's liability with respect to potential health care costs for its employees was reduced, clearly a benefit with future implications. Based on these factors, the IRS concluded that the asbestos removal costs were improvements to the equipment and therefore had to be capitalized under Sec. 263A (and Sec. 263 for years prior to 1987).

This letter ruling has engendered a great deal of controversy. The Service's position appears contrary to established authority with respect to deductions for ordinary repairs and maintenance. There is also concern that the current deductibility of other expenses may fall victim to the same rationale that was applied to asbestos removal costs. Most practitioners would agree that applying the INDOPCO "future benefit" rationale outside of the corporate reorganization and restructuring area is misplaced. Taxpayers must play the waiting game, however, since the IRS has indicated that it will provide further guidance on which expenses the INDIPCO rationale will apply to.

An equally important issue is whether the Service will force taxpayers to lobby Congress in order to obtain tax treatment for asbestos removal costs that would encourage the remedial efforts required by OSHA. The primary focus of the OSHA asbestos standards is to promote safety in the workplace, not to further the financial interests of business. Therefore, businesses should be rewarded with income tax incentives that provide government subsidies for making the workplace and environment safer; at a minimum, tax policy should not provide a disincentive for compliance. Accordingly, the IRS should reconsider its position, and instead follow a policy consistent with the significant OSHA policy encouraging asbestos abatement.