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Environmental cleanup costs as business expense and....

While concern for the environment by the mass population is admirable, the legislative strength placed into the hands of governmental agencies has created stagnant and debilitating business growth in our country.

The ability of many manufacturing plant owners to expand operations by moving to enlarged quarters or selling existing cramped quarters to other interested manufacturers is often stymied by strict and overzealous environmental regulations; the prospect of costly cleanup expenses effectively prevents many business moves.

On June 1, 1994, in Rev. Rul. 94-38, the IRS addressed the tax treatment of the current costs required to remedy any existing soil and water contamination, and for costs incurred to construct treatment facilities to prevent future contamination of the soil or water.

At issue was whether the costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business were deductible by the taxpayer as a business expense or did they have to be capitalized.

In Rev. Rul. 94-38, an accrualbasis corporation owned and operated a manufacturing plant that it built on land purchased in 1970; the land was not contaminated when the company bought it. The company's manufacturing operations discharged hazardous waste, which was then buried on portions of the company's land.

In order to comply with presently applicable and reasonably anticipated Federal, state and local environmental requirements, in 1993 the company decided to remediate the soil and groundwater that had been contaminated by the hazardous waste. It also decided to establish an appropriate system for the continued monitoring of the groundwater to ensure that all hazardous waste had been removed.

Accordingly, the company began excavating the contaminated soil, transporting it to appropriate waste disposal facilities and backfilling the excavated areas with uncontaminated soil. The soil cleanup activities began in 1993 and will be completed in 1995. The company also began constructing groundwater treatment facilities (including wells, pipes, pumps and other equipment) to extract, treat and monitor contaminated groundwater. Construction began in 1993 and the facilities will remain in operation until 2005.

The effect of the cleanup and treatment will be to restore the company's land to essentially the same physical condition that existed before the contamination. During and after the cleanup and treatment, the company will continue to use the land and operate the plant in the same manner as before the cleanup except that it will dispose of any hazardous waste in compliance with environmental requirements.

Sec. 162 generally allows a deduction for the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Even though a particular taxpayer may incur an expense only once in the lifetime of the business, it may qualify as ordinary and necessary if:

* The expense is appropriate and helpful in carrying on that business.

* The expense is commonly and frequently incurred in the type of business conducted by the taxpayer.

* The expense is not a capital expenditure.

In H.G. Fenton Material Co., 74 TC 584 (1980), Sec. 162 was applied to allow business expense deductions for the costs of removing and disposing of waste materials produced in a taxpayer's business.

Sec. 263 generally prohibits deductions for capital expenditures; Sec. 263(a)(1) provides that no current deduction shall be allowed for any amounts paid for new building or permanent improvements or betterments made to increase the value of any property.

In determining whether a particular expenditure must be currently deducted or capitalized, it is important to consider the extent to which the expenditure will produce significant future benefits. Under the facts of Rev. Rul. 94-38, the test for determining whether the expenditures increase the property's value is to compare the status of the asset after the expenditure with its status before the condition arose that necessitated the expenditure. It was determined that the soil remediation and ongoing groundwater treatment expenditures did not result in improvements that increased the property's value, but had merely restored its soil and groundwater to their approximate condition before they were contaminated by the taxpayer's manufacturing operations.

Under the facts presented, the IRS held that the taxpayer's soil remediation expenditures and ongoing groundwater treatment expenditures did not produce permanent improvements to the land or otherwise provide significant future benefits. The soil remediation and ongoing groundwater treatment expenditures represented ordinary and necessary business expenses that were appropriate and helpful in carrying on the taxpayer's manufacturing business, and were commonly and frequently required in the taxpayer's type of manufacturing business.

However, the groundwater treatment facilities constructed by the taxpayer have a useful life substantially beyond the tax year in which they were constructed. Thus, the costs of that construction will be capital expenditures.

The ruling also emphasized that these results would apply whether the taxpayer planned to continue manufacturing operations that discharged the hazardous waste or planned to discontinue those manufacturing operations and hold the land in an idle state.
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Author:Waltemyer, Edward L.
Publication:The Tax Adviser
Date:Dec 1, 1994
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