IRS sharply limits deductibility of environmental cleanup costs.

Since the Supreme Court's decision in INDOPCO, 112 Sup. Ct. 1039 (1992), the IRS has sought to curtail the current deductibility of business expenses that may be viewed as creating more than an incidental future benefit for the taxpayer. Recently, the Service cited INDOPCO in ruling that a taxpayer must capitalize certain costs it incurred to clean up PCB-contaminated property (IRS Letter Ruling (TAM) 9315004).

In an unusual introductory note to the ruling, the IRS stated that it intends to give the ruling further consideration in connection with a "study project" on environmental cleanup costs. As part of that project, the Service may reexamine the tax treatment of other environmental cleanup costs that have been viewed as repairs within the meaning of Regs. Sec. 1. 162-4. Of even broader significance, the recent ruling may signal a narrower reading by the IRS of the definition of firepairs" in other contexts.

In Letter Ruling 9315004, the Service reasoned that remediation activities undertaken by the taxpayer were permanent improvements to the property, increased its value (as compared to the value of the contaminated property) and constituted a general plan of rehabilitation. The IRS concluded these remediation costs should be capitalized as an addition to the cost of the associated property and not capitalized to the land. The Service required the taxpayer to capitalize expenditures for contamination assessment; excavation, transportation and disposal of contaminated soil; new soil and backfilling; and oversight costs required as part of the cleanup operation.

By contrast, the IRS noted that costs to assess the contamination of a particular site that will not undergo rehabilitation may be deducted. The Service allowed the taxpayer to deduct legal fees related to the PCB contamination to the extent they were incurred to defend the taxpayer's business against the Environmental Protection Agency (EPA) and private claimants or to secure contractual rights with its insurers. Insufficient factual information prevented the IRS from deciding whether the taxpayer could deduct costs incurred for research and development of alternative chemical remediation technologies, environmental audits and a PCB compliance manual.

In the ruling, the Service emphasized that Regs. Sec. 1.162-4 allows current deductions only for the cost of incidental repairs that neither materially add to the value of property nor appreciably prolong its useful life, and that are intended to keep the property in an ordinarily efficient operating condition. The IRS further cited cases that have superimposed an overriding rule that expenditures for an item that is part of a "general plan" of rehabilitation or restoration of the property must be capitalized, even though, if incurred separately, the item would be deductible as a repair.

The ruling contrasts what it calls "merely incidental" maintenance expenses as part of an ongoing program of waste identification and disposal with the costs of an "extraordinary" cleanup as part of a systematic plan of "considerable significance" in view of the taxpayer's overall operations. The "taxpayer in the instant case did not institute an ongoing program of waste identification and disposal. [The t]axpayer could have disposed of the residues in a manner that would have obviated the need for the extraordinary clean-up which is at issue." This statement suggests that if the taxpayer performed recurring and ongoing identification and disposal of contaminated property, the costs would be deductible.

It appears that the IRS is distinguishing taxpayers who perform recurring and ongoing cleanup from those who perform "extraordinary" cleanup costs pursuant to a systematic or general plan to rehabilitation. Although the end result of the cleanup activities would be the same (i.e., in this case, the land would be restore to its original state and free from contamination), the tax treatment for the cleanup costs may be different. Taxpayers performing recurring and ongoing cleanup activities have a stronger position for deducting costs associated with such activities than those who perform "extraordinary" cleanup activities pursuant to a systematic or general plan of rehabilitation.

The Service stated that the cleanup costs should be capitalized because they made the property more valuable in the taxpayer's business than the contaminated property. The IRS rejected the argument that the test instead should compare post-cleanup value and precontamination value. The Service took a similar position in Letter Ruling (TAM) 9240004 (dealing with the cost of asbestos removal). In that ruling, the test compared pre-asbestos removal value with post-asbestos removal.

However, the IRS's position on comparing the value of property immediately before the repair or cleanup is inconsistent with economic reality, since this position would require capitalization in essentially all situations. For example, a relatively minor repair to a broken machine undoubtedly would be required to be capitalized since the repaired machinery would have a higher value than when broken. Requiring capitalization of almost all repairs is clearly inconsistent with the statutory intent of Sec. 162.

Letter Ruling 9315004 also held that the "general plan of rehabilitation" doctrine was not limited to cases in which modifications were made to a building or equipment, or to situations that resulted in lengthening the useful life of property. Rather, the ruling viewed as important that the cleanup operations, considered as a whole, would result in "permanent betterments" to the taxpayer's property.

Significant dollars may be at stake as a result of the Service's ongoing study of environmental cleanup costs. These expenditures may include (1) general and administrative costs associated with compliance and the monitoring of compliance with existing regulations (e.g., costs of permits, inspections, legal and consulting fees); (2) disposal of hazardous waste products; (3) the redesign of products and processes; and (4) closure or abandonment of facilities. Continued controversy between the IRS and taxpayers can be expected for these costs and other expenditures claimed as deductible repairs.