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IRS's mixed treatment of asbestos abatement costs.

Over the past two years, the IRS has addressed the deductibility of environmental remediation costs in several technical advice memorandums. In these rulings, the Service has generally concluded that the costs directly associated with remediation must be capitalized. In Letter Ruling (TAM) 9240004, for example, the IRS required the taxpayer to capitalize the costs it incurred, in response to regulatory standards, for the removal and replacement of asbestos insulation in manufacturing equipment. In Letter Ruling (TAM) 9315004, the Service reached the same conclusion with respect to costs incurred in response to legal actions to remediate PCB-contaminated soil resulting from the prior use of the taxpayer's equipment.

In each of these rulings, the IRS concluded that the costs did not qualify as currently deductible repair costs because the costs either increased the value of the property or enhanced its use to the taxpayer, thereby resulting in permanent improvements the costs of which must be capitalized. The Service's conclusions in the rulings have been publicly challenged by both taxpayers and members of Congress, and the IRS has responded by forming an IRS-Treasury study group to revisit these conclusions and provide more guidance on the Service's application of the current law to different types of environmental remediation programs.

Pending the final results of the study group, the IRS is continuing to resolve individual cases that arise in current examinations and has released a third technical advice memorandum dealing with an environmental remediation fact pattern. In contrast to the Service's previous conclusions, the conclusions in Letter Ruling (TAM) 9411002 are mixed: while the IRS concluded that asbestos removal costs must be capitalized, it permitted the taxpayer to currently deduct asbestos encapsulation costs as incidental repairs.

Letter Ruling 9411002 involved a corporation engaged in the sale of rental warehouse space and related services. In order to secure a bank loan for expansion of its facilities, the taxpayer was required to --remove all asbestos-containing materials from its boiler house that was to be converted into a two-truck garage and office space; and --encapsulate exposed and damaged asbestos-containing pipe insulation located in its adjacent warehouse.

In requiring capitalization of the removal costs, the Service distinguished the taxpayer's asbestos removal costs from the pipe lining replacement costs found to be currently deductible in Plainfield-Union Water Co., 39 TC 333 (1962), nonacq. 1964-2 CB 8, one of many cases taxpayers have relied on to support a current deduction for environmental remediation. The IRS cited the following reasons for requiring capitalization:

* The expenditures eliminated health risks.

* The property was rendered significantly more attractive to potential buyers, investors, lenders and customers.

* The expenditures enhanced the usefulness of the taxpayer's property by enabling the taxpayer to provide office space and a garage, which constituted a new or different use of the property.

* The expenditures provided a permanent cure to a preexisting problem.

Because the asbestos removal costs were required to be capitalized as an improvement to the taxpayer's building, the Service required the capitalized costs to be depreciated as an improvement to real property and thus over a recovery period of 31.5 years using the straight-line method.

In allowing a current deduction for the encapsulation costs, the IRS cited the following reasons:

* The expenditures did not appreciably increase the property's value or prolong its life.

* The expenditures reduced, but did not eliminate, the health threat of expsoure to asbestos.

* The expenditures did not enable the taxpayer to operate on a changed, more efficient or larger scale.

* The effects of the encapsulation on the taxpayer's property were temporary in nature.

Similar to the prior ruling on soil remediation costs, Letter Ruling 9411002 cautioned taxpayers that this ruling will be given further consideration in connection with the pending study project. Therefore, until the study project is complete, the precedential value of this ruling in determining the Service's ultimate position will remain in doubt.

The conclusions and rationale in the ruling, however, will no doubt be analyzed and evaluated by taxpayers in connection with the resolution of their own remediation situations. One question that arises from TAM 9411002 is whether the IRS would reach the same result today that it did in TAM 9240004. Unlike the costs incurred by the taxpayer in TAM 9411002, the asbestos removal costs in the earlier ruling were not accompanied by a change in the property's use.

In TAM 9411002, the Service linked the asbestos removal costs with the taxpayer's conversion of the boiler house. Because the boiler house renovation converted this property to a new and different use, the conversion costs clearly would be subject to capitalization. Although the asbestos removal could have been performed separate from the conversion, it appeared that the taxpayer undertook to remove the asbestos because the taxpayer's lender required the removal in order for the taxpayer to obtain a loan for the expansion. Based on this connection, the IRS concluded that the removal itself "enhanced the usefulness and capacity of the taxpayer's property by enabling the taxpayer to provide office space and a garage." Because the Service appeared to rely so heavily on this change in use to require capitalization in TAM 9411002, it could be considering the application of a more favorable standard in situations in which the asbestos removal is not accompanied by expenditures that, standing alone, clearly constitute capital improvements.

Although the IRS's conclusion on encapsulation is favorable, taxpayers may not agree with several aspects of the IRS's unfavorable conclusion on the removal costs. In Plainfield-Union, the Tax Court held the taxpayer's pipe relining expenditures to be currently deductible repair costs because the expenditures did not increase the value of the property (in comparison to its value before the damage), its useful life or its function. Under this test, asbestos removal should be currently deductible. The fact that the asbestos removal is required to get a loan, which is necessary to expand operations, does not mean that the asbestos removal costs must be capitalized. The use of the property is only improved to the extent the taxpayer incurs expenditures to convert the boiler house. While the conversion costs clearly must be capitalized, it does not follow that the asbestos removal costs also improve the property's function merely because they must be incurred to get a loan to incur the improvement costs. Accordingly, taxpayers may argue that the removal costs must be analyzed separately from the conversion costs, and as separately analyzed, the costs should be currently deductible.

Furthermore, the Service's mixed conclusion is difficult to justify under the facts of the ruling. To reach a favorable conclusion with respect to the encapsulation costs, the IRS must have concluded that such costs, unlike the removal costs, did not enable the taxpayer to adapt the property to a new and different use. However, based on the facts in the ruling, the taxpayer incurred the encapsulation costs for exactly the same reason that it incurred the removal costs. The taxpayer's lender required the taxpayer to incur both types of costs before it would agree to lend the taxpayer money for the expansion. In addition, the taxpayer's boiler room, where the asbestos removal occurred, and the warehouse, where the encapsulation occurred, were treated as a single asset for depreciation purposes.

Finally, on numerous recent occasions, government representatives have commented that mathing principles may be an appropriate test for determining whether environmental remediation costs may be currently deducted or capitalized. If matching principles are applied, the determination of whether removal and encapsulation costs are capital or ordinary should not depend on whether the taxpayer happens to be planning an expansion of its facility, which provides an indirect link with a capital expenditure. The purpose and effect of both types of costs is generally the same regardless of the taxpayer's independent plans for expansion. The costs of both removal and encapsulation are directly associated with eliminating a problem that arose with the discovery of toxicity in these building materials. Similarly, neither removal nor encapsulation "restores" any property to a prior condition; the property would not have been originally constructed with asbestos if the health hazards had always been known.

Despite the Service's attempt to distinguish Plainfield-Union, and its attempt to link the removal with the taxpayer's expansion program, taxpayers may continue to conclude that the current deductibility of asbestos removal is supported by Plainfield-Union and similar cases, even if the taxpayer is also required to perform the removal to receive a loan (i.e., as a precondition to a program that involves a capital expenditure).
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Article Details
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Author:Conjura, Carol
Publication:The Tax Adviser
Date:Jun 1, 1994
Previous Article:IRS continues challenge of the components-of-cost LIFO method.
Next Article:1994 Letter Ruling revokes a 1981 Letter Ruling.

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