IRS remediates environmental-cost deduction mess.

Introduction

During the last few years, the Internal Revenue Service has struggled with the tax treatment of environmental clean-up costs. In June 1994, the IRS published Revenue Ruling 94-38, 1994-1 C.B. 35, in which it allowed a current business expense deduction under section 162 of the Internal Revenue Code for soil remediation and groundwater treatment costs (while requiring capitalization of costs attributable to the construction of groundwater treatment facilities, which were determined to be capital expenditures under section 263). In technical advice memorandum (TAM) 9541005, dated September 27, 1995, the IRS refused to apply the principles of Revenue Ruling 94-38 to a situation that was not distinguishable in any material way from the facts of that ruling. On January 17, 1996, however, the IRS released to the taxpayer a new TAM that revokes and supersedes TAM 9541005.(1) In the new TAM, the IRS permits the costs to be deducted. The IRS's initial unwillingness to apply the principles of Revenue Ruling 94-38 in TAM 9541005, and its subsequent reversal only a few months later, provide insight into the IRS's evolving thinking about the deductibility of environmental clean-up costs.

Tax Treatment of Environmental Clean-up Costs

In general, the Internal Revenue Code allows deductions for ordinary and necessary business expenses under section 162 but requires that expenditures producing significant value beyond a taxable year be capitalized pursuant to section 263. Behind the deduction/capitalization distinction is the principle that deductions for costs incurred should be matched with the income produced by such costs. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Rev. Rul. 94-38, 1994-1 C.B. 35, 35-36.

Section 162 generally allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An expense incurred in a taxpayer's trade or business may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. Commissioner v. Tellier, 383 U.S. 687 (1966); Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933). Applicable regulations specifically allow a deduction for repair costs so long as the following conditions are met: (1) the repair is incidental; (2) the cost of the repair does not materially add to the value of the property; (3) the repair does not appreciably prolong the useful life of the property; and (4) the purpose of the expenditure is to keep the property in ordinarily efficient operating condition. Treas. Reg. [sections] 1.162-4.

Under sections 261 and 263, no deductions are allowed for capital expenditures. Section 263(a)(1) provides that no deduction shall be allowed for "[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." The regulations provide additional guidance for determining what constitutes a capital expenditure. Specifically, Treas. Reg. [sections] 1.263(a)-1(b) provides that expenditures that are subject to capitalization:

... 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. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures....

Identifying the applicable statutory and regulatory provisions is easy; determining how to apply them is not. In this regard, the IRS has recognized that " 'the decisive distinctions [between capital and ordinary expenditures] are those of degree and not of kind,' and a careful examination of the particular facts of each case is required." E.g., Rev. Rul. 94-38, 1994-1 C.B. at 36, quoting Welch v. Helvering, 290 U.S. at 114, and Deputy v. du Pont, 308 U.S. at 496.

Thus, the proper tax treatment of environmental cleanup costs depends on whether the particular expenditure is for a repair or an improvement. In each situation, the main question is whether the environmental clean-up costs restore damaged property to its previous condition (a repair) or increase the value of property (an improvement). The problem has been ascertaining the correct baseline with which to compare post-expenditure property.

Background to the IRS's Position in Revenue Ruling 94-38

In each of three TAMs issued prior to Revenue Ruling 94-38, the IRS concluded that environmental clean-up expenditures added value to the taxpayer's property and were therefore capital in nature. In TAM 9240004 (dated June 29, 1992), the IRS concluded that expenditures to remove and replace asbestos insulation in certain furnaces added value to the taxpayer's property, and the costs therefore were a depreciable improvement to the furnaces. In TAM 9315004 (dated December 17, 1992), the IRS concluded that expenditures to remove and replace contaminated soil added value to land.(2) In TAM 9411002 (dated November 19, 1993), the IRS found that expenditures to remove and replace asbestos, in connection with the conversion of a boiler room to a garage and office space, were capital expenditures because the costs adapted the property to a new and different use but that costs of encapsulating exposed asbestos in an adjacent warehouse were deductible. In concluding that the expenditures at issue in these TAMS (with the exception of the encapsulation expenditures in TAM 9411002) added value to property, the IRS compared the property after the expenditure with its pre-expenditure state.

The IRS's use of property's pre-expenditure state as the baseline for determining whether there has been an increase in value was inconsistent with a large body of case law that holds that the proper comparison is between the post-clean-up value of the property and the value of the property before the occurrence of the condition necessitating the expenditure. In Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962), nonacq. on other grounds, 1964-2 C.B. 8, the Tax Court considered the deductibility of costs incurred in cleaning out water pipes and lining them with cement. The IRS argued that the value of the pipe was materially increased by the cleaning and cement lining and the expenditure was therefore capital. Id. at 338. As in the three TAMs discussed above, the IRS's argument arose from comparing the post-clean-up value of the property with its pre-clean-up state. The Tax Court rejected the IRS's contention, explaining that by that logic "any properly performed repair adds value as compared with the situation existing immediately prior to that repair." Id. Instead, the court said:

The proper test is whether the expenditure materially

enhances the value, use, life expectancy,

strength, or capacity as compared with the status

of the asset prior to the condition necessitating the

expenditure."

Id. (emphasis added).

In Plainfield-Union, the Tax Court acted in accord with well-established precedent. E.g., Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103 (1926) (costs of replacing rotted wooden pilings with cement supports, removing a portion of the building's floor and shoring up a wall were deductible repairs); American Bemberg Corp. v. Commissioner, 10 T.C. 361 (1948), aff'd per curiam, 177 F.2d 200 (6th Cir. 1949) (costs of filling in underground cavities that caused cave-ins under taxpayer's building were deductible repairs); Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950) (costs of lining walls and floors with concrete to prevent seepage of oil spilled by upriver refinery into taxpayer's meat packing plant were deductible repairs); Southern Ford Tractor Corp. v. Commissioner, 29 T.C. 833 (1958) (costs of filling in and grading property after a new building blocked the drainage ditch, causing water to puddle and seep into taxpayer's facilities, were deductible repairs).

Subsequent cases have followed the Plainfield-Union rule that "restoration" costs are deductible. E.g., Munroe Land Co. v. Commissioner, 25 T.C.M. 3 (1966) (costs of fixing leaking roof deductible); Oberman Mfg. Co. v. Commissioner, 47 T.C. 471 (1967) (same); Hudlow v. Commissioner, 30 T.C.M. 894 (1971) (costs of pouring concrete over cracked and unusable floor deductible); Chicago, Burlington Quincy R.R. v. United States, 455 F.2d 993 (Ct. Cl. 1972) (costs of various projects directed to protecting and maintaining rail embankments near waterways deductible); Niagara Mohawk Power Corp. v. United States, 558 F.2d 1379 (Ct. Cl. 1977) (per curiam) (costs of installation of clamps to repair leaking joints in cast iron gas pipelines deductible); L&L Marine IRS, Inc. v. Commissioner, 54 T.C.M. 312 (1987) (costs of repairing barges deductible). But see Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1 (1979) (costs to restore irrigation system to original condition must be capitalized and amortized over their appropriate lives of 5, 10 or 30 years, depending on the portion of the irrigation system involved, since expenditures create independent assets that must be depreciated over their useful lives).

In the three TAMS, the IRS rejected taxpayer arguments based on Plainfield-Union.(3) In TAM 9249994, the IRS held that Plainfield- Union was not applicable for three reasons. First, the IRS stated that the Plainfield-Union test is relevant only in situations where repairs are necessary because the property has progressively deteriorated. Second, the IRS noted that since the furnaces were manufactured with asbestos, it was impossible to value them prior to the existence of asbestos (i.e., prior to the condition necessitating the expenditure). Third, the IRS attempted to distinguish Plainfield-Union because the increase in the property's value following the asbestos removal and replacement in the TAM was based on subjective factors such as safer working conditions and improved marketability.

In TAM 9315004, the IRS rejected the taxpayer's Plainfield-Union argument in favor of reliance on Wolfsen Land Cattle Co. v. Commissioner, 72 T.C. 1 (1979), finding that the soil remediation was part of a plan of rehabilitation. And in TAM 9411002, the IRS rejected the taxpayer's Plainfield-Union argument by reciting all the reasons the value of the boiler room would be increased once it was asbestosfree, concluding that the removal of asbestos "increased the value, use, and capacity of the taxpayer's facility as compared to its original asbestos-containing condition."

Revenue Ruling 94-38

In Revenue Ruling 94-38, the IRS accepted the holding of Plainfield-Union that the appropriate test for determining whether an expenditure increases the value of property (and thus must be capitalized under section 263) is to compare the status of the asset after the expenditure with the status of the asset before the condition arose that necessitated the expenditure. The taxpayer in Revenue Ruling 94-38 purchased land, contaminated that land by its business activities, then incurred the costs of cleaning up the land. In Revenue Ruling 94-38, application of the Plainfield-Union test meant that the taxpayer's clean-up expenditures were deductible because they did not add value to the land; they merely restored the land to its status before it was contaminated by the taxpayer.

TAM 9541005

In TAM 9541005, a company(4) acquired land and conducted activities on it that caused the land to become contaminated with industrial wastes. The land was designated as a Superfund site after tests revealed various hazardous substances. The company entered into a consent order with the Environmental Protection Agency for the purpose of completing a study to determine the extent of the contamination and to recommend actions necessary to remedy the condition. In the years under review the company deducted the costs of the study and associated consulting and legal fees (collectively, "the costs"). On audit, the IRS disallowed deductions for the costs.

The key distinction between the factual situations in TAM 9541005 and Revenue Ruling 94-38 is that, after causing the contamination but before incurring the remediation costs, the company contributed the land to a local municipality (the county) for the purpose of developing a recreational park. When it discovered the hazardous substances in the land, the county ceased park development. Within three years after the land was contributed to the county, the county and the company entered into a rescission agreement and the land was reconveyed to the company for $1.

The IRS refused to apply Revenue Ruling 94-38 to the situation in TAM 9541005 on the basis that, in the ruling, the taxpayer owned the contaminated property continuously (i.e., when the property was contaminated through the time when clean-up costs were incurred). In the TAM, the IRS required capitalization of the costs solely because for three years the land rested with the county as a consequence of the ultimately rescinded gift. The IRS decided that the proper baseline with which to compare the post-expenditure land was the land at the time of the reconveyance. Using this comparison, the costs added value to the land and, the IRS concluded, were subject to capitalization.

Criticism of TAM 9541005

The IRS's conclusion in TAM 9541005 that the costs must be capitalized solely because of the later-rescinded gift was quickly criticized by practitioners, who did not believe that the company's break in ownership should remove the situation in TAM 9541005 from the ambit of Revenue Ruling 94-38.(5) Since the contamination occurred before the contribution to the county and since the company held the land at all relevant times, the commentators agreed, it is appropriate to treat the company as if it stood in the same posture as the taxpayers in Plainfield-Union and Revenue Ruling 94-38 and, accordingly, to measure the value of the property after the costs were expended against the value of the property before the contamination (i.e., before the event necessitating the costs). Applying this standard, the costs add no value to the land; they me contribute to the restoration of the land to the condition it was in before it was contaminated by the company's operations.

In TAM 9541005, the IRS ignored the fact that the company's liability to incur the costs derived from its ownership of the land prior to the contribution to the county. That liability remained with the company throughout the period the land was owned by the county; it was neither transferred to the county when the land was contributed to the county nor was it acquired by the company upon the rescission of the contribution three years later. Thus, the company's liability for the costs was not a liability incurred as a result of -- or in connection with -- the reacquisition of the land upon the rescission. The liability was imposed by the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA), and held nothing to do with whether the company currently owned the land.

The IRS also disregarded the significance of the fact that the reconveyance was due to a rescission upon the county's discovery of contamination. The IRS refused to look past the rescission in determining the proper point for determining whether the costs add value to the land. The IRS insisted that the state of the land at the time of its reconveyance by the county to the company constituted the benchmark from which to determine whether the costs increased the land's value. The IRS's view seemed to rely on Revenue Ruling 80-58, 1980-1 C.B. 181, which holds that where a sale and rescission occur in different taxable years, the annual accounting principle mandates that the sale is reported in one year and the reconveyance is taken into account in determining the basis of the property in the later year.

Finally, the IRS initially failed to take into account the unique factual situation presented in TAM 9541005, where the party incurring the costs was the same party who contaminated it, and that party had owned the land continuously except for the three years when the county had title. The IRS appeared oblivious to the absurd results arising from its fixation on the company's break in ownership of the land. If the company had never contributed the land to the county, the company would have been entitled to deduct the costs. In fact, such a situation would replicate the factual scenario of Revenue Ruling 94-38 itself If the company had contributed the land to the county and the gift had not been rescinded, the company would have been entitled to deduct the costs because there would have been no asset to which the costs could properly have been attributed, nor would the costs have produced significant future benefits for the company. See Treas. Reg. [sections] 1.263(a)-1(b) (referring to "property owned by the taxpayer"); INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) (expenditures are subject to capitalization if they produce significant long-term benefits for a taxpayer, even if no asset is created or enhanced).(6)

New TAM

The IRS reversed itself in the new TAM. In the new TAM, the IRS explains that TAM 9541005 "was based in large part on a perceived absence of proof regarding the amount and purpose' of the costs. Thus, the IRS attributes its reversal of TAM 9541005 to clarification of factual issues, reporting that the District Director with jurisdiction over the company no longer disputes the amount or purpose of the costs. The new TAM, however, manifests a significant change in the IRS's view of the applicability of Revenue Ruling 94-38.

In TAM 9541005, the IRS refused to apply the restoration principle evidenced in Revenue Ruling 94-38 because of the break in ownership. The IRS concluded that the company's break in ownership meant that Revenue Ruling 94-38 "by its facts" was inapplicable. In contrast, in the new TAM, the IRS holds that --

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.(7)

The IRS notes that "[t]he contamination to the Land and the Taxpayer's liability for remediation were unchanged during the break in ownership."

After determining that the restoration principle of Revenue Ruling 94-38 applies to the company's situation, the IRS proceeds to address the deductibility of the specific costs at issue. With respect to the expenditures for the performance of a hazardous waste study and the investigation required by the consent order entered into between the company and the EPA, the IRS notes that the costs of environmental impact studies are deductible under section 162 unless chargeable to a capital account. The IRS then holds that, "[a]s with the expenditures at issue in Rev. Rul. 94-38, the costs at issue here did not create or enhance an asset, nor did they produce a long-term benefit."

The key point is that the environmental study fees did not "enhance an asset." This conclusion is made possible by the IRS's revised conclusion that the proper benchmark for determining whether value is enhanced is the uncontaminated state of the land when it was first acquired by the company. Similarly, the IRS holds that the legal fees and consulting fees are deductible under section 162 because they neither created or enhanced an asset nor produced a long-term benefit.(8)

In the new TAM, the IRS does not elaborate on the legal doctrine supporting its conclusion that the break in ownership does not remove the deductibility of the costs from the ambit of Revenue Ruling 94-38. However, there are well-established legal doctrines that support such a conclusion. Since the company's liability to remedy the contamination pre-dates the contribution to the county, it is proper under the "origin of the claim" doctrine to disregard the contribution to the county solely for the purpose of fixing the point in time that provides the relevant benchmark value of the land, i.e., the value against which the post-expenditure value is measured. See United States v. Gilmore, 372 U.S. 39 (1963) (origin of claim determines whether legal expenses incurred in divorce action were business or personal expenses); Woodward u. Commissioner, 397 U.S. 572 (1970) (extending application of origin of the claim test to determine whether litigation expenses were ordinary or capital). For this limited purpose, since the contamination occurred before the contribution to the county and since the company was responsible for rectifying the contamination, it is appropriate to treat the company as if it stood in the same posture as the taxpayers in Plainfield-Union and Revenue Ruling 94-38 and, in so doing, to measure the value of the property after the expenditures against the value of the property before the contamination (i.e., before the event necessitating the expenditure).

Similarly, the IRS may have looked to the Arrowsmith doctrine to compare the post-expenditure status of the land with its condition before its contamination by the company. Cf Arrowsmith v. Commissioner, 344 U.S. 6 (1952) (determining the tax consequences of a payment in a later year by looking back to an earlier tax year which was the genesis of the later year's payment); Rees Blow Pipe Mfg. Co. v. Commissioner, 41 T.C. 598, 603 (1964) (citing Arrowsmith for the proposition that "[t]he rule that each year stands on its own feet does not mean, however, than an examination of a previous year's return may not be made in order to determine the nature of the new fact for the purpose of ascertaining how the new fact is to be classified in computing taxable income for the year in which the new fact ... happened").

Conclusion

In Revenue Ruling 94-38, the IRS took a major step toward resolving one of the many difficult issues surrounding the tax treatment of environmental clean-up costs. TAM 9541005 was a step backward. The revocation of TAM 9541005 signals that the IRS recognized the error of its way. The new TAM holds that the restoration principle of Revenue Ruling 94-38 applies even when there is a break in the taxpayer's ownership of the property. Since the IRS does not explain the legal doctrine or doctrines on which it based its reversal of TAM 9541005, however, it remains difficult to determine the scope of Revenue Ruling 94-38. Nevertheless, the IRS's reversal of TAM 9541005 is commendable, and taxpayers should hope that additional guidance will be forthcoming from the IRS National Office to answer the myriad questions presented with respect to the deductibility of environmental clean-up costs.

(1) The new TAM has not yet been formally issued and therefore does not have a number; its text, however, is available in Tax Notes Today at 96 TNT 13-3 (Jan. 19, 1996). (2) Even though the costs were incurred primarily for soil remediation, the IRS allowed the taxpayer in TAM 9315004 to add the amount of the expenditures to its depreciable basis in a pipeline system. See Juliann Avakian-Martin & Marlis Carson, News from the ABA Tax Section's Annual Meeting, 60 Tax Notes 925, 926 (Aug. 16, 1993) (reporting that IRS Assistant Chief Counsel Glenn R. Carrington stated at an ABA Tax Section meeting that the clean-up costs were amortized to a piping system; the identity of the asset had been blacked out in TAM 9315004). Capital improvements to soil are not ordinarily depreciable because soil is not a depreciable asset. Rather, the capital expenditure is simply added to the taxpayer's basis in the land. One commentator has speculated that perhaps the IRS allowed the costs to be capitalized to the pipeline because the IRS recognized the weakness of its position. Carol Conjura, IRS Reverses Course and Allows Current Deductions for Cost of Environmental Cleanup in Rev. Rul. 94-38, 10 Tax Mgmt. REAL EST. J. 135, 136 (1994). Similarly, a Treasury Department official criticized the result in TAM 9315004, stating that, if the costs should be capitalized, they should be capitalized to the land and that the IRS was simply trying to be "nice" in allowing the costs to be capitalized to the pipeline. Avakian-Martin & Carson, supra, at 927 (reporting on the comments of Robert Kilinskis, an attorney in the Treasury Department's Office of Tax Legislative Counsel, at an ABA Tax Section meeting). (3) The IRS also rejected other taxpayer arguments. For more thorough discussions of the three TAMs, see Conjura, supra note 2, at 135-37; Blake D. Rubin & Seth Green, The Tax Treatment of Environmental Cleanup Costs, 8 Prac. Tax Law. 25 (1994). (4) The particular corporate entity that owned the land changed twice as a result of tax-free transactions within an affiliated group. Issues about the impact of these transactions on the character of the environmental liability were raised by the IRS during consideration of the request for technical advice. In Revenue Ruling 95-74, 1995-46 I.R.B. 1, the IRS held that contingent environmental liabilities transferred from a parent to a subsidiary in a section 351 transaction are deductible by the subsidiary if they would have been deductible by the parent, notwithstanding Holdcroft Transp. Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946). Apparently, Revenue Ruling 95-74 was, at least in part, an outgrowth of the situation presented in TAM 9541005. Since the environmental liability moved with the land from entity to entity and did not change character, the owner of the land is referred to in this article simply as "the company" for the sake of brevity and clarity. (5) E.g., Legal Fees and Study Costs Incurred in Assessment of Contaminated Land not Deductible under Rev. Rul. 94-38, 11 Tax Mgmt. Real Est. 302 (Dec. 1995); Mark J. Silverman, Attorney Calls for Reconsideration of TAM on Environmental Cleanup Costs, 95 TNT 208-25 (Oct. 20, 1995); Juliann Avakian Martin, Tech Advice on Environmental Cleanup Professional Fees Draws Fire, 95 TNT 203-2 (Oct. 18, 1995). (6) Other commentators agree that such expenditures should be currently deductible. See, e.g., Conjura, supra note 2, at 142; James R. Walker, The Deductibility of Environmental Cleanup Costs, 23 Colo. Law. 1825, 1827 (1994); Thomas H. Yancey, Emerging Doctrines in the Tax Treatment of Environmental Cleanup Costs, 70 948, 964 (1992). (7) The IRS does not limit its holding to breaks in ownership due to later-rescinded gifts. In fact, the IRS continues to refer to the reconveyance as a "purchase," as it did in TAM 9541005. Indeed, an argument can be made that expenses such as the costs should also be deductible where the property is sold (rather than gifted) and the sale is subsequently rescinded upon the discovery of contamination. Although TAMs are not entitled to precedential value, see I.R.C. [sections] 61100)(3), the reasoning evidenced by the IRS's position in the new TAM supports such an argument. Moreover, TAMs do constitute substantial authority for filing positions. Treas. Reg. [sections] 1.6662-4(d)(3)(iii). (8) In the new TAM, the IRS appears to have employed a two-step process. First, the IRS determined that the principles of Revenue Ruling 94-38 applied, and that the costs did not add value to the land relative to the value of the land prior to its contamination by the company. Second, the IRS determined that the costs were deductible under section 162 and did not have to be capitalized. See Rev. Rul. 94-38, 1994-1 C.B. 35, 36 (costs of groundwater treatment facilities were subject to capitalization pursuant to section 263 because the facilities had a useful life substantially beyond the taxable year in which they were constructed and pursuant to section 263A because their construction constituted production).

The applicability and implications of this two-step process are unclear. For example, if a taxpayer acquired contaminated land and incurred similar costs with respect to that land, would the IRS view Revenue Ruling 94-38 as determinative and as requiring capitalization, or would it separately analyze the deductibility of the expenditures under section 162 apart from the Revenue Ruling? Similarly, could the taxpayer in such a scenario argue that: (i) the expenditures were not environmental clean-up costs and Revenue Ruling 94-38 was inapplicable; (ii) the deductibility of the expenditures should be evaluated individually, i.e., simply as environmental study fees, legal fees, and consulting fees; and (iii) the expenditures added no value to the property so as to warrant capitalization.

MARK J. SILVERMAN and SUSAN H. SERLING are partners at Steptoe & Johnson LLP, where JODI H. EPSTEIN is an associate. The authors represented the taxpayer in connection with the request for technical advice that culminated in the issuance of TAM 9541005 on September 27, 1995, and its subsequent revocation.