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Jan 1994

Planning for costs associated with environmental clean up. (Personal Financial Planning)

by Panock, Bruce I.

    Abstract- Environmental cleanup laws need to be taken into consideration if corporate taxpayers wish to avoid potentially crippling expenditures related to the remediation of a site on which hazardous waste material is uncovered. The best way to avoid such a situation would be to conduct an environmental audit prior to a rental or purchase decision on any property that is to be used by a business. In such audits, the primary consideration must be the the investigation of prior use of the property or site. When an audit uncovers hazardous waste on a site, estimation of cleanup and mediation costs are the next step, to be followed by the determination of how and if such costs can be deducted. While the deliberation of such environmental considerations are typically the concern of commercial enterprises, they can also affect individual taxpayers, particularly those involved in renting properties for business purposes.

Hazards include asbestos removal and cleanup of spills resulting from the activities around the personal or vacation residence. For this discussion, rental properties are viewed as a place of business. Environmental cleanup problems are not relegated exclusively to industries using hazardous materials as part of their production process. Some banks have begun to request environmental surveys when loans and mortgages are requested. In areas of the country that use oil as a heating source, the issue is relevant to businesses and to homeowners.

The various cleanup laws and disposal laws have created a substantial burden on all who buy or sell property currently or previously on a site on which hazardous waste material was employed in the manufacturing process, or if the site was used for waste disposal. For example, the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), or Superfund Act |42 U.S.C. 9601-9675, identified a group known as "potentially responsible parties (PRP)." This group is liable for the investigation of the possible improper disposal of the hazardous waste, its removal, and the remediation of a hazardous waste site. A PRP includes all present and prior owners and operators of the site, as well as generators of and transporters of the hazardous waste. If the liability for the cleanup is not divisible and identifiable to specific parties, the parties become jointly and severally liable.

Cleanup Issues

Cleanup issues arise when 1) the taxpayer has been advised by Federal, state, or local EPA monitoring authorities that an event has occurred requiring cleanup and restoration; 2) as a function of the normal operation of a business, a spill event has occurred; 3) when a business property is acquired; and 4) as a result of the normal due diligence connected to the acquisition of a business or an asset, the investigation uncovers possible contamination issues. When investigating potential property acquisitions, look to the prior use of the property site becomes a focal point. Since all prior use may not be known, a survey and report should be requested. Once the taxpayer acquires the property, the potential risks to the normal conduct can be substantial if the property is closed during remediation, or the activity of the business is interrupted as the hazardous waste is removed from the property.

Since the actual cost may only be determined once the cleanup project is under way, it is difficult to estimate those costs when making the purchase decision. In the case of a factory that used toxic chemicals in the manufacturing process, if a spill took place as a result of drums of the chemical leaking into the soil around the plant, cleanup of the spill must continue until of the full extent of the spill has been remediated. For most companies, the funding for the cleanup costs will probably come from the companies' working capital, because underlying property may not provide sufficient collateral.

Since the cleanup costs and remediation of a spill site can be substantial, the question of the deductibility of the costs incurred is central to any purchase discussion. If the costs incurred are connected to the repair or maintenance of a building or piece of machinery, the costs will be deductible currently. If the costs incurred are capital in nature, they will be recoverable over time (unless they are associated with the cost of land). If the costs are incurred in connection with remediation of land, the costs of the remediation will not be deductible since land is not a depreciable asset.

A second question is the timing of the deduction of the cost, or the increase to the capital account against which depreciation may be claimed. If the taxpayer uses the cash method of accounting for income tax purposes, the timing of the deduction, or the increase to the tax basis of the asset is generally determined with reference to the time when the cost is paid. If the taxpayer uses the accrual method of accounting, the additions to the capital account are determined when the liability for the cleanup is incurred (fixed and determined) and the determination is made that the cost results in the creation of an asset. The deduction for depreciation is claimed based on when the asset is placed in service. The economic-performance tests of IRC Sec. 461(h) must be addressed as part of the analysis.

Capital Asset or Tax Deduction

There is much discussion of whether the costs to remediate assets that have been damaged in some manner due to improper disposal of hazardous waste should be deductible costs or capitalized costs.

The principles of IRC Secs. 263 and 263A are applied to determine the need for capitalization. According to Reg. Sec. 1.263(a)-1(a)(1), "no deduction is allowed for an amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate..." The tests that are applied attempt to determine whether the amounts paid add value to the property, whether the expenditures result in substantially prolonging the useful life of the asset, and whether the assets are modified for a new use. If the costs incurred place the property in a state of readiness for use rather than keep the property in its normal operating condition, it appears likely the costs should be classified as capital expenditures.

The evaluation must also consider whether the costs incurred are part of an overall plan of remediation to the property. Such a plan may exist when there are many small projects which if integrated, result in an increase in the value of the underlying property, prolong the useful life of the asset, or possibly modify the asset for a new use. If there is such a plan, the fits might argue that the project activities entered into to are not the type typically associated with the repair of property. A plan of rehabilitation can be found when work is performed on a single asset in many separate components. The determination of the actual existence of such a plan is based upon the facts and circumstances of the project.

As an example, in the PCB Ruling |TAM 9315004, December 17, 1992, the IRS determined the cleanup of environmental damage caused by the contamination to the ground was in the nature of a capital asset rather than deductible repair and maintenance incurred as a part of the ordinary operation of the business. The endeavor required the replacement and removal of substantial amounts of land due to the contamination. The IRS determined that the taxpayer's business received a benefit that would span a period of years under the rationale that the improvement to the land added substantial value to the asset. It should be noted that the remediation was performed to meet government requirements, to provide a safe working environment for the workers, and resulted in an increased market value for the land.

In the Asbestos Ruling |TAM 9240004, June 29, 1992, the IRS reasoned that the costs incurred to remove the asbestos insulation from certain machinery should be capitalized because the value of the equipment after the remediation was greatly enhanced versus its value before the repair. The IRS also looked to the increased safety to the workers, and increased marketability of the equipment in determining that the value of the machinery was substantially increased because of the repairs. The permanency and substantiality of the costs of the improvements contributed to the conclusion that the costs should be capitalized.

Timing of Deduction or Increase to Capital Account

Taxpayers may be required to make payments in direct satisfaction of known and quantifiable remediation liabilities. Such payments are required if the taxpayer becomes aware of a discharge of hazardous waste. When a taxpayer or inspector, becomes aware of such a discharge, some states require notification of the authorities. The proper agency may require necessary testing and remediation effected as necessary. All costs of such activities will likely be the burden of the taxpayer.

If there is no imposed cleanup fund, and if the taxpayer directly assumes the responsibility for the cleanup, the cost should be considered service liabilities. Accordingly, the costs are deductible when paid. If the costs are incurred regularly and minor in nature, the recurring expense exception should be reviewed.

The types of costs considered here are assumed to be substantial and unusual in nature, and not a recurring event in the operations of the business.

Impact on Individuals, Not in Connection with a Trade or Business

The consequences of environmental damages do not vest exclusively with business. Various states have enacted laws governing the cleanup of potentially dangerous waste sites. Since each state has different rules, all individuals are well advised to retain legal counsel to review the potential financial ramifications of environmental waste cleanup costs when acquiring a personal residence.

An example of such legislation is in New Jersey where specific legislation (The Underground Storage Tank Act -- USTA |P.. 1986, C. 102; N.J.S.A. 58:10A-21, et. seq.) has been written to address the issues of possible leaks from the tanks to the underground water supply. The USTA has certain exemptions, one of which exempts certain tanks used by residential structures except if the tank has a capacity of greater than 2000 gallons. This exemption is not available to sellers of personal residences if the buyer is permitted to test the tank (The New Jersey Spill Compensation and Control Act -- SPILL Act |N.J.S.A. 58:10-23.11 et seq.) If the test results indicate there is some hazardous discharge from the underground tank, then the state must be notified of the discharge. Failure to do so will result in the imposition of penalties on the owner of the property.

Clients should be advised to pay close attention to their heating systems, especially if the system is fuel oil. An individual may attempt to sell his personal residence to a purchaser who is knowledgeable about environmental cleanup issues. If the house is older and heated with oil, the buyer may insist, as a condition of sale that the seller remove the oil tank and assume all the responsibilities of the cleanup. If your client is purchasing such a home, reverse the situation or at least get the environmental hazard survey.

Conduct a Proper Investigation

As a participant in the financial planning process, the CPA should take an active role assuring that the client has secured the proper legal counsel from persons knowledgeable in the area. The tax issues of deduction or capitalization are likely to be addressed in some substantial form by the IRS in the next months. The more significant issue is the assumption of the liability of the costs associates with the cleanup process itself, regardless of the tax treatment.

Investors in business should be sure to investigate the prior operations of the potential acquisitions, whether the acquisitions will be stock or asset acquisitions. The existence of liabilities not reflected in financial statements can be substantial. It is possible that no environmental survey was ever requested, but that in the distant past, the property or property in the area was used in an industry that used highly toxic chemicals in the manufacturing process. The acquisition of real estate, whether for business or for personal use should be done after the appropriate investigation into the prior use of the asset has been performed. The client should be reminded to use legal counsel familiar with the state and local environmental laws that address in ground oil tanks, exceptions for personal residences, and other related issues.

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