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By Roy Whitehead, Jr., Brenda Yelvington, Bill Humphrey, and Pam Spikes


Get the EPA on the Phone

When the IRS issued Revenue Ruling 94-38, the issue of the deductibility of environmental cleanup costs appeared to be put to bed. Cleanup costs were said to be deductible; they did not materially add to value, prolong the life of the property, or adapt the property to a new use. However, the IRS issued a technical advice memorandum that disallowed a deduction for such expenses when they were incurred to correct a preacquisition condition. The TAM was subsequently withdrawn, but based only on a more careful review of the facts in the case. The issue became whether the owner acquired the property before or after the contamination occurred. It appears the philosophy of such disallowance still stands. This leaves the IRS appearing to discourage the expenditure of funds to cleanup the environment and therefore at odds with the EPA.

Environmental cleanup costs and the IRS's approach to the deductibility or capitalization of such costs continue to be one of the most significant tax uncertainties confronting U.S. companies and their accountants.

There are currently no court decisions that provide clear judicial guidance concerning the tax treatment of environmental cleanup costs. The IRS has, however, issued Revenue Ruling 94-38 [1994 1 C.B. 35 (June 2, 1994)], allowing a deduction of environmental remediation costs under IRC Sec. 162(a) for "all the ordinary and necessary expenses paid or incurred during a taxable year in carrying out any trade or business." The key fact relied on in Revenue Ruling 94-38 was that the "effect of the soil remediation and groundwater treatment will be to restore (the taxpayer's) land to essentially the same physical condition that existed prior to the contamination." The ruling did not discuss preacquisition contamination.

Capital Expenditure vs.
Current Expense

To determine whether environmental cleanup costs are a capital expenditure or current expense, IRC sections 162 and 263 and related regulations must be examined. Regulation section 1.162-4 provides that "the costs of incidental repairs which neither materially (emphasis added) add to the value of the property nor appreciably (emphasis added) prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense." In contrast, "repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property," must be capitalized.

IRC section 263(a)(1) states that no deduction shall be allowed for "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." IRC Sec. 263(a)(2) denies deduction of "any amount expended in restoring property or making good the exhaustion thereof for which an allowance is or has been made."

Reg. section 1.263(a)-1(b) provides that, in general, expenditures are capital if they are paid or incurred to "add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or to adapt property to a new or different use."

Thus, the two key issues raised by the regulations that must be examined in connection with any expenditures for cleanup costs are whether the property's life is appreciably prolonged or whether the value of the property has materially increased as a result of the expenditure. If neither of these conditions is present and the expenditure merely restores the property or keeps it in an efficient operating condition, it is a maintenance or repair expense and, therefore, deductible.

On the issue of whether an expenditure adds to or increases the value of property, the Tax Court has ruled that the proper test is to compare the value after the repair has been completed with the value prior to the existence of the condition necessitating the repairs and not with the value immediately prior to making the repair [Plainfield Union Water Co. v. Commissioner, 39 TC 333 (1962)].

In Revenue Ruling 94-38, the IRS dealt with a situation where the taxpayer owned, contaminated, and then merely restored the property to its original condition. In that situation, the IRS held that soil remediation expenditures and ongoing groundwater treatment expenditures "do not produce permanent improvements to the taxpayer's land within the scope of IRC Sec. 263(a)(1) or otherwise provide significant future benefits." Citing Plainfield Union Water Co., the IRS applied the so-called three prong or three-factor test to determine whether or not cleanup costs must be capitalized. Cleanup costs are not a repair and not deductible if they--

* materially add to the value of the

* appreciably prolong the useful life of the property; or

* adapt the property to a new or different use.

For a detailed discussion of the IRS' handling of cleanup costs prior to and in conjunction with Revenue Ruling 94-38 see Whitehead et al., "Finally...Someone at the IRS Called the EPA," The CPA Journal (Jan. 1995).

The IRS Shies Away from
Revenue Ruling 94-38

The earlier article concluded the IRS had removed some of the economic disincentives to environmental land cleanup by adopting a position that such costs were deductible if they merely restored the land to its original condition in accordance with the three factor test. A careful reading of Revenue Ruling 94-38 indicates the three factor test was applied by comparing the value, life, and use of the property after the cleanup to when it was acquired by the taxpayer. Because the contamination was not present when the property was acquired, and the land was merely restored to its original condition, deductions were allowed. Deductions were also justified because the land was not subject to depreciation, amortization, or depletion, and therefore work could not be capitalized as restoring an allowance previously taken under IRC Sec. 263(a)(2).

Unresolved Issue

The ruling did not address the issue of whether it applied to remediation of pre-acquisition contamination and whether the taxpayer's state of knowledge at acquisition affects the scope of capitalization required.

A recent Technical Advice Memorandum (TAM) clearly signals that the IRS intends to limit Revenue Ruling 94-38 to its fact pattern and not allow the deductibility of cleanup costs for pre-acquisition contamination. In TAM 9541005 (September 27, 1995), the IRS dealt with a situation where it originally concluded a taxpayer acquired the land in a contaminated condition. The issue in that case was whether the taxpayer could rely on the rationale of Revenue Ruling 94-38 to permit a deduction under IRC Sec. 162 for "costs paid to assess and investigate the extent of an environmental contamination remediation." In a subsequent ruling, the IRS withdrew the TAM based on the specific facts in the case. To appreciate the holding of the cited TAM and the subsequent ruling, a review of the facts is critical.

In TAM 9541005, a subsidiary (Subsidiary) of the taxpayer is the successor of an entity that purchased land in year one. The Subsidiary is a member of a consolidated group of companies referred to as the taxpayer. The Subsidiary's predecessor purchased the land in year one. The land was used as a farm until the early part of decade one. Beginning in decade one and continuing to the middle of decade two, the land became a site for the disposal of industrial waste such as agriculture chemical waste and agricultural by-products.

In year three, Subsidiary contributed the land to the county. The county planned to construct a recreational park on the land. Subsidiary originally claimed a deduction under IRC Sec. 170 for its contribution of the land to the county based on the fair market value of the land. After an IRS examination, the contribution deduction was reduced to the Subsidiary's original basis in the land. The charitable contribution deduction reduced the taxpayer's consolidated taxable income in years two, three, and four.

In year four, the county discovered the land was contaminated and ceased developing the park. In year five, the county conveyed the land back to the Subsidiary for $1.00. Subsidiary recorded a $1.00 basis for the land for book and tax purposes. The taxpayer has never recaptured or otherwise taken back into income any portion of the charitable contribution deductions reported on the taxpayer's tax returns. For the years at issue in the TAM, these adjustments concern closed tax years.

In year six, the state and the Environmental Protection Agency conducted tests and an evaluation of the land, soil, and drainable outfall. The tests revealed the land was contaminated by several toxic wastes.

In year seven, the land was designated as a superfund site under the provisions of the Comprehensive Environmental Response Compensation and Liability Act [42 U.S.C. section 9601-9675 (CERCLA)]. Subsidiary then entered into a consent order with the EPA in year eight for the purpose of completing a remedial investigation and feasibility study to determine the extent of the contamination, recommend actions necessary to remedy the condition, and estimate the risk of release of hazardous substances in the process of remediation. Subsidiary was liable for the remediation costs under CERCLA. Subsidiary has no business activity other than its holding of the land.

The Subsidiary incurred several types of cost in years six, seven, and eight related to the cleanup of the land. These costs include environmental cleanup costs and legal and consulting fees. The environmental cleanup costs were actually expenses paid to an engineering firm for the performance of a hazardous waste study and the investigation required by the consent order with the EPA.

The taxpayer argued the costs are environmental remediation expenditures deductible as ordinary and necessary expenses of carrying on a trade or business pursuant to Revenue Ruling 94-38. The taxpayer alleged the costs did not result in improvements or increase or improve the value of the property compared with its condition and value at
the time the taxpayer originally acquired the property.

Revenue Ruling 94-38
Did Not Apply

In TAM 9541005, the IRS stated that Revenue Ruling 94-38 does not apply to the cleanup of land acquired in a contaminated condition. The ruling applies only if the taxpayer's environmental remediation expenditures restore the contaminated property to its original uncontaminated condition at the time it was acquired by the taxpayer. The IRS said the reasoning in Revenue Ruling 94-38 is based on the restoration principle announced by the tax court in the Plainfield Union case. The restoration principle envisions the taxpayer acquiring the property in a clean condition, contaminating the property in its everyday operations, and incurring costs to restore the property to its clean condition at the time the taxpayer acquired the property. The Plainfield Union case indicated the proper test is to determine whether or not the repairs materially add to the value of the property, appreciably prolong the life of the property, or adapt the property to a new or different use. In this fact situation, the IRS argues, the cleanup costs fail the Plainfield Union test because the value of the property, when restored, will materially increase in relation to its value when acquired by Subsidiary in a contaminated condition.

The IRS stated Revenue Ruling 94-38 did not apply in this instance because the Plainfield Union restoration principle had not been met. According to the IRS, the Subsidiary acquired the property in its contaminated condition in year five when it purchased the land back from the county for $1.00. Therefore the ruling by its facts is inapplicable to the taxpayer's situation.

The IRS' holding is a clear indication the IRS intends to narrowly interpret Revenue Ruling 94-38. Thus, those who purchase or acquire, knowingly or unknowingly, contaminated property may not safely rely on Revenue Ruling 94-38.

The Rest of the Story

Interestingly, in reaction to TAM 9541005, the Internal Revenue Service received a written request for reconsideration from the office of the district director with jurisdiction over the taxpayer. One of the reasons for the conclusions reached was based on a perceived absence of proof regarding the amount and purpose of the costs. However, the district director did not dispute the amount, or purpose of the costs incurred by the taxpayer. Pursuant to the district director's request, the IRS reexamined the facts of the case. Upon reexamination, in January 1996, the IRS revoked the adverse ruling (released as LTR 9627002), and concluded Rev. Rul. 94-38 did apply, and the taxpayer may currently deduct the costs at issue. The IRS decided that:

* While Rev. Rul. 94-38 addresses facts different than those involved here--e.g., there was no interim break in ownership under the facts of the revenue ruling--the theory underlying the revenue ruling would apply to this unique set of facts.

* 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 IRC Sec. 162. The contamination to the land and the taxpayer's liability for remediation were unchanged during the break in ownership.

Based on the IRS's analysis, the deciding factor was the interim break in ownership rather than the purchase of precontaminated land. In TAM 9541005, the IRS disallowed the deduction because, theoretically, the taxpayer purchased the land back from the county in a precontaminated state in year five for $1.00. In this ruling, the IRS ducks the precontamination issue by considering the interim break not to be a true break in ownership due to the unique facts. It is therefore apparent that the nondeductibility philosophy for precontamination property expressed by the IRS in TAM 9541005 stands undisturbed.

Where Are We Now?

It is clear the IRS intends to narrowly restrict the deduction of cleanup costs to the facts of Revenue Ruling 94-38. Businesses involved in acquisition of property by purchase or merger should expect the IRS will not allow a current deduction of cleanup costs for property received in a contaminated condition. As indicated in the January 1995 article, the IRS seems to have extraordinary difficulty making up its mind about the correct position to adopt in regard to the deductibility of environmental cleanup costs. We previously advanced the argument that the IRS' flip-flopping on the issue of cleanup costs was creating predictability problems for American business and was, in effect, a powerful economic disincentive to voluntarily cleanup land. It must be concluded, therefore, that the IRS is still focusing on the collection of revenue rather than the encouragement of good stewardship of the land.

What are the implications to the otherwise responsible taxpayer of the IRS's obvious attempt to limit the deductibility of cleanup costs? Several implications come to mind. First, purchasers of property will have to carefully avoid the acquisition of precontaminated property. Based on the philosophy expressed in TAM 9541005, innocent purchasers will be liable for cleanup costs for which they may not take a deduction under IRC Sec. 162. Second, property obtained through acquisition or merger may bring with it unexpected costs. If the acquired entity has property obtained by the entity in a precontaminated condition, the cleanup costs will not be currently deductible. The third involves the responsible party provisions of CERCLA.

Under CERCLA, the costs of cleanup are the responsibility of 1) the person who generated the waste, 2) the person who transported the waste to the site, 3) the person who owned or operated the site, or 4) the current owner or operator [42 U.S.C. section 9607(a)]. From a pure liability standpoint, because parent companies have been found liable as an operator for cleanup costs at property owned by a subsidiary (United States v. Kayser-Roth Corp., 910 F.2d 24), there was no legal basis for the IRS's argument that the interim break in ownership should result in a disallowance of the cleanup costs. Under CERCLA all responsible parties are regarded as having joint and several liability. If so, does not the restoration principle announced in Plainfield Union and followed in Revenue Ruling 94-38 apply? Clearly the property is merely being restored to its original condition that existed prior to the contamination. Consequently, there is no material addition to the original value of the property, its useful life is not prolonged, and the property is not yet being adapted for a new use. It is merely being restored to its original condition prior to contamination. In a CERCLA situation in which cleanup costs are shared by all responsible parties, the net result
under the IRS's philosophy is to require capitalization of cleanup costs by the current owner and allow a current deduction to the remaining responsible parties. Such an approach does not recognize the utility of encouraging cleanup of land and invariably leads to an inequitable treatment of the parties. Imagine the reaction when a CERCLA mandated responsible party, who has unknowingly acquired the contaminated property through a merger or acquisition, discovers it is responsible for cleanup costs that are not currently deductible.

We believe it is better public policy for the IRS to encourage American business to be regarded as a good-faith steward of land, buildings, and machinery when they are honestly dealing with environmental cleanup costs. When a taxpayer has made good-faith and prudent maintenance decisions unaware of any environmental hazards, and when the EPA or other government agencies later determine the need for major cleanup ex post facto, as a matter of policy, the IRS should permit the current deduction
of government mandated cleanup

The position that cleanup costs should only be deducted when the land was purchased in an uncontaminated condition, then contaminated, and then cleaned up is logically inexplicable. If the purpose is to clean up the land and protect the public, what difference does it make, when a company is acting in good faith, or whether or not the
land was purchased in a contaminated condition? The IRS position can only lead to an increase in land purchase costs, a concern about predictability of costs, and frankly, in some cases, an avoidance of dealing with environmental concerns.

Any indication of bad faith on the part of a landowner or company should,
and can, be dealt with under the
current environmental laws through the administrative and criminal process without relying on the IRS to hamstring American business.

Please Call Again

In our previous article, we indicated that apparently someone at the IRS had called the EPA about the utility of a liberal deductibility policy for cleanup costs. Obviously, someone at the IRS needs to call again. Perhaps a discussion of the utility of providing economic incentives for taxpayers to voluntarily clean up environmental problems will encourage the IRS to correct their expressed economic
disincentives. *

Roy Whitehead, Jr., JD, LLM, is an assistant professor of business law, Bill Humphrey, PhD, CPA, a professor of accounting, and Pam Spikes, PhD, CPA, an associate professor of accounting, at the University of Central Arkansas. Brenda Yelvington, CPA, is a doctoral student at the University of Mississippi.

The authors wish to express their appreciation to Lavon Morton, partner, Ernst and Young (Little Rock) for his assistance and comments in the preparation of this article.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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