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Deductibility of environmental remediation costs.

The United States is just beginning to realize the tremendous cost of yesterday's imperfect waste disposal practices: An estimated $750 billion will be spent between 1990 and 2020 to clean up thousands of hazardous waste sites. Companies that fail to meet their cleanup obligations are subject to civil and criminal liability under federal, state and local environmental laws and regulations. CPAs face many issues in representing clients owning contaminated real property, one of which is addressing for tax purposes the most advantageous treatment of environmental compliance and cleanup expenses. Because all expenses are not immediately deductible, companies have little incentive to undertake cleanup activities voluntarily.

The overriding issue is whether a current income tax deduction is allowed for such expenses. The Internal Revenue Service addressed this issue in the form of a technical advice memorandum (TAM). Although TAMs,are private rulings issued by the IRS to provide guidance on a specific tax issue relating solely to a particular taxpayer, they nevertheless provide a basis for analysis and discussion of the issue--in this case, determining whether environmental remediation (cleanup) expenses can be deducted or must be capitalized.

The IRS requested taxpayer comments on the issue and will continue to process technical advice requests pending in its national office. This process is ongoing and authoritative guidance is expected to be issued in 1994. With the Treasury estimating the amount of contested liabilities at $1 trillion over the next 30 years, a popular consensus is unlikely. This article analyzes the current IRS position and the distinguishing arguments in the environmental context.


To ascertain whether an expense can be deducted or must be capitalized, all the relevant facts must be analyzed, with the burden of proof on the taxpayer. Under Treasury regulations section 1.1624, failure to satisfy the following conditions automatically results in capitalization under Internal Revenue Code section 263:

* The expenditure is incidental.

* The expenditure does not materially add to the property's value.

* The expenditure does not appreciably prolong the property's useful life.

* The expenditure's purge is to keep the property in an ordinarily efficient operating condition.

TAM 9315004. The IRS position on the issue of expense versus capitalization of environmental assessment and cleanup costs is documented in TAM 9315004, issued in April 1993. The taxpayer in the TAM--we'll call it XYZ Co.--had used a lubricant containing PCBs more than 20 years ago, before their hazards were known. XYZ had broken no laws and had switched to other lubricants when the dangers of PCBS were discovered. Subsequently, the Environmental Protection Agency (EPA) ordered XYZ to clean up the contaminated sites. The TAM addresses the treatment of XYZ's costs in complying with the EPA order:

* Assessment costs. The TAM defines assessment costs as those aneroid to determine if, and to what extent, a property is contaminated. The TAM permits full deduction of assessment costs when a property is found not to require remediation; if remediation is necessary, the TAM requires the costs to be capitalized to the underlying asset and depreciated over the asset's remaining useful life.

* Remediation expenditures. The TAM requires such cleanup expenditures to be capitalized. The IRS noted that capitalization of such costs is deemed appropriate when there is a documented remediation plan, since having such a plan in place suggests the activities undertaken are more than incidental repairs.

* Legal fees. The TAM says legal fees paid to defend XYZ from government and third-party claims, including XYZ's litigation with its insurer to establish contractual rights, are fully deductible in the year incurred. The IRS reasons these fees are separate from the remediation plan.

* Oversight expenses. Oversight expenses are costs incurred to monitor or manage an environmental cleanup. The TAM requires these expenses to be capitalized.

* Environmental audit costs. The TAM says there were insufficient facts to address the treatment of XYZ's environmental audit costs. The tax treatment of the costs of developing XYZ's compliance manual as required by the EPA depends on whether it is part of the remediation plan, whether it is a separate asset of XYZ or whether it will undergo periodic modification with attendant recurring costs. This rationale is consistent with the IRS requirement that environmental cleanup expenses be capitalized.

* Research and development expenses. The TAM does not address the proper treatment of expenses incurred to develop an alternative cleanup plan; however, if such expenses are part of the plan (because XYZ or some other taxpayer might incur them to determine the best method of cleaning up the contamination), the IRS generally requires capitalization.

Analysis of the TAM. The IRS reasons extensive modifications to XYZ's property constitute replacements and betterments that benefit the property. The TAM relies on earlier cases in which a taxpayer that had chosen to forgo (whether innocently or intentionally) annual maintenance, which later resulted in the need for extensive remedial operations, was required to capitalize remedial expenditures.

In Wolfsen Land & Cattle (72 T.C. 1 [1979]), for example, Wolfsen was required to capitalize the costs of draglining ditches to clear a farm irrigation system of sediment because the expenditures were more than merely incidental: They made the property more efficient, more productive and more valuable.

XYZ distinguished Wolfsen on the basis that cleaning Wolfsen's irrigation system restored it to functional use after it had become dysfunctional. However, XYZ's operating facilities were never dysfunctional and operated continuously. The TAM rejects this distinction and recognizes that an expense incurred as part of a general plan of remediation most likely will be capitalized even though the same expense, if it was not incurred as part of such a plan, would be deductible as an ordinary and necessary business expense. Although XYZ was ordered to clean up the affected properties as opposed to voluntarily undertaking the cleanup, the deductibility versus-capitalization treatment of the expenditures appears to be the same under the TAM.

The TAM discourages socially responsible behavior from a tax standpoint because taxpayers have no incentive to assess and clean up contamination voluntarily until they are legally required to do so. The TAM's prohibition of a current deduction of cleanup expenditures that could have been avoided through prior periodic maintenance is not troubling in and of itself. However, XYZ did not violate any laws at the time of its PCB disposal and, thus, could not have implemented a regular maintenance program to prevent the required remediation expenditures. Permitting a current deduction for the full amount incurred does not lead to any mismatching of revenues and expenses because XYZ actually expended the funds for which it claimed a business expense. In addition, the TAM violates the underlying tax concept of "wherewithal to pay," which requires that the income recognition or tax benefit be matched to the fiscal period in which the actual cash was received or disbursed (such as permitting postponement of revenue recognition under the installment sales method or prohibiting a current deduction for estimated warranty claims).

Unless companies are threatened with civil or criminal liability for violating environmental laws, the TAM will have a chilling effect because it will deter socially and environmentally conscious companies from voluntarily undertaking assessment and remedial environmental measures that otherwise are not explicitly required. Although tax laws frequently are socially inspired (as is the case with the nondeductibility of fines and the deductibility of charitable contributions), the basic tax treatment of envionmental costs should not override the regulatory agencies' role of ensuring environmental compliance.

In rejecting XYZ's view that environmental cleanup operations were repairs, the IRS reasons the cleanup operations, taken in their entirety, resulted in improvements to XYZ's properties. The alleged improvements included remediating contaminated land and making it more marketable, avoiding further penalties by bringing the properties into compliance and providing a safer environment for workers and owners of adjoining property. This reasoning again ignores that the cleanup expenditures merely restored the property to its uncontaminated condition.

While the rules regarding capitalization of environmental treatment costs appear consistent with IRS and Financial Accounting Standard Board pronouncements, the TAM's treatment of remediation costs conflicts with the FASB's. Specifically, Emerging Issues Task Force Issue no. 90-8, Capitalization of Costs to Treat Environmental Contamination, generally permits a current deduction for environmental contamination treatment costs unless, as in the TAM, they extend the life, increase the capacity or improve the safety or efficiency of a property. For financial accounting purposes, Issue no. 90-8 does not differentiate between the timing of the remedial expenditures (expensed in the year incurred to match income produced, irrespective of whether they are part of an overall plain of rehabilitation), the reasons substantiating the required cleanup (whether self-directed or government-imposed) or who caused the contamination (a taxpayer or another potentially responsible party). XYZ's argument in the TAM is more consistent with the FASB interpretation. The TAM's departure from the matching concert essentially leads to taxation of capital.


Rate of recovery through capitalization.

The TAM does not discuss to which underlying asset expenditures should be capitalized. With the exception of the contamination of buildings with, for example, asbestos or lead paint, most contamination affects real property, a nondepreciable asset; therefore, absent any clear IRS guidance, prudent tax practitioners should amortize cleanup expenditures to assets with the shortest remaining recovery periods. The Treasury conceded the permitted amortization to XYZ's piping system was a compromise, as it later said it would have required capitalization to land.

Environmental audit costs. Given the national consensus that the best method of complying with environmental laws and minimizing liability is to establish and maintain a comprehensive environmental compliance program, such expenditures should be deductible as ordinary and necessary business expenses in accordance with IRC section 162(a). Examples of such costs might include self-imposed compliance audits and environmental training courses and employee manuals. Because of the TAM's reference to "plan of remediation," taxpayers are cautioned when using such references.

Other TAM factual scenarios. The TAM did not address the tax treatment of the following situations: (1) A taxpayer knowingly caused contamination and intentionally forwent maintenance-type expenditures, (2) the contamination was not caused by the taxpayer, (3) a taxpayer purchased property contaminated by another party at a substantial discount with knowledge of the contamination and (4) the contamination occurred suddenly and accidentally, not gradually.

In the first situation, the tax treatment should be at least as restrictive as that prescribed in the TAM and might even be disallowed in its entirety, as is the case with the nondeductibility of fines and penalties, particularly if noncompliance was willful. Alternatively, a more equitable approach might be to permit a current deduction for the deferred maintenance amount and to require capitalization of the excess attributable to poor management that permitted the property to get into such disrepair.

In the second situation, the tax treatment should be the same as in the first. Additionally, a taxpayer could argue cleanup expenditures should be a currently deductible expense under regulations section 1.165-3(b), which, for example, permits a deduction for discovery of latent structural defects in the building after their acquisition."

In the third situation, such expenditures arguably should be capitalized as follows:

* All costs necessary to get the property ready for its intended use should be capitalized.

* Since contamination of real property is the owner's personal legal obligation and does not run with the land as does a lien or mortgage, the discounted sales price was given to cure the contamination problem, with the property's fair market value always equaling the value of contaminated property.

In the fourth situation, CPAS should review IRC section 165(a), which provides, in part, that "there shall be a deduction for any loss sustained during the taxable year and not compensated by insurance or otherwise." For example, a taxpayer should be able to currently deduct the expenses required to be capitalized in the TAM if the contamination was caused, for example, by a fuel vendor that overfilled an underground tank.

Other factors that might be persuasive in distinguishing the TAM include

* Whether the expenditures relate to new or existing property.

* Whether the taxpayer owns the affected property.

* Whether the expenditures will generate future income.

* Whether the expenditures existed when the property was acquired or resulted from the taxpayer's operations.

* Whether the expenditures were involuntary or voluntary.

* The label given the expenditure (penalty, remedial cost, legal fee, etc.).

The IRS currently is considering a few "bright line" tests regarding the deductibility versus capitalization of environmental costs. Some potential tests include permitting a current deduction for cleanup costs

* When the taxpayer does not own the land.

* When the taxpayer owns the land but stops production on it.

* To the extent the costs exceed the land's value.

Treatment of probable and reasonably estimable recoveries. IRC section 165(a) permits a deduction of losses net of any insurance or other probable and reasonably estimable recoveries, such as those obtained through indemnifications, contribution claims, insurance and state petroleum reimbursement programs. Taxpayers should deemphasize such recoveries to book the maximum currently deductible expenditures and simply report as income any subsequent actual recoveries.


The IRS has taken a middle ground on the issue of the deductibility of environmental expenses. As a social consideration, the courts and taxing authorities should support those who undertake environmental cleanup voluntarily rather than issue punitive rulings. The proper tax treatment of environmental expenditures should not be subordinate to any suggestion of mismatching the cash outlays to the periods when the tax benefit can be derived. Until governing pronouncements are clarified, interpreting and reporting environmental expenditures and exposures should be done on a case-by-case basis in light of the above principles.

DANIEL J. GIBBY, CPA, JD, is an associate specializing in environmental law with the law firm of Hill, Ward & Henderson, P.A., Tampa, Florida.. He is a member of the American Institute of CPAs and the Florida Institute of CPAs. RONALD PATELLA, CPA, is a senior associate of Sanders, Fernandez & Associates, Coral Gables, Florida. He is a member of the AICPA and the Florida Institute of CPAs.
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Article Details
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Author:Patella, Ronald
Publication:Journal of Accountancy
Date:Dec 1, 1993
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