Owners of real estate are often required to remove hazardous waste from their land because of environmental laws or a commendable desire to maintain a dean environment. One issue that arises is whether the cleanup costs are currently deductible as ordinary and necessary repair expenses under IRC Sec. 162 or whether the costs must be treated as a capital expenditure that must be capitalized under IRC Sec. 263.

There are currently no court decisions that provide judicial guidance concerning the tax treatment of cleanup costs. The IRS has, however, issued a Revenue Ruling and two Technical Advice Memoranda (TAM) concerning the treatment of cleanup costs associated with removal of hazardous wastes from land.

Capital Expenditure vs. Current Expense

Making the distinction between a capital expenditure and one that can be currently deducted is often difficult and must be based on the facts of each particular situation. IRC Sec. 162(a) allows deductions of "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying out any trade or business."

In contrast, IRC Sec. 263 allows no deduction for a capital expenditure- -an "amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate."

The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery. While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise.

Reg. Sec. 1.162-4 dealing with repairs states, "The cost of incidental repairs which neither materially add to the value of property nor appreciably prolong its life but keep it in ordinary efficient operating condition, may be deducted as an expense... Repairs in the nature of replacements, to the extent that they arrest deterioration or appreciably prolong the life of the property, shall be capitalized and depreciated..."

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 if the expenditure merely restores the property or keeps it in an efficient operating condition, it is a maintenance or repair expense and is 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 the making of the repair Plainfield Union Water Co. v. Commissioner, 39 TC 333(1962).

On the issue of whether an expenditure appreciably or substantially prolongs the useful life of the property, the Tenth Circuit has indicated that there is no absolute rule requiring the automatic capitalization of every expenditure providing the taxpayer with a benefit enduring for a period in excess of one year. The issue whether the life of the asset is prolonged is a question of fact for a jury to decide U.S. v. Wehrli, 400 F. 2d 686 (10th Cir. 1968).

Court Cases

As previously indicated, there appear to be no cases directly involving land cleanup costs. On February 26, 1992, however, the U.S. Supreme Court decided the case of Indopco, Inc. v. Commissioner 112 S. Ct. 1039 (1992) holding that a taxpayer has the burden of showing that costs for investment banking fees and expenses incurred during a friendly acquisition were not capital in nature and instead were deductible as ordinary and necessary business expenses. Citing Commissioner v. Lincoln Savings and Loan Association 403 U.S. 345 91 S. Ct. 1893 (1971) the Court set out a five-part test to qualify for a deduction under IRC Sec. 162(a). The Court stated an item must 1) be paid or incurred during the taxable year, 2) be for carrying on any trade or business, 3) be an expense, 4) be a necessary expense, and 5) be an ordinary expense. The Court went on to state that the term "necessary" imposes "only the minimum requirement that the expense be appropriate and helpful for the development of the taxpayer's business."

IRS Guidance

Prior to June, 1994, the IRS had issued two TAMs on specific cleanup costs that were disappointing to most taxpayers. While the TAMs did not address the broad issue of environmental cleanup costs, they did provide the rationale the IRS had adopted in determining capitalization versus current deductibility issues. On June 2, 1994, the IRS issued Rev. Rul. 94-38 relating to the tax treatment of certain hazardous waste cleanup costs. The IRS's position outlined in the revenue ruling represents a complete reversal on some of the issues from the IRS's previous holdings in the TAMs.

In order to fully understand the implications of Rev. Rul. 94-38 and the IRS's significant departure from its previous position on deductibility of cleanup costs, the specific facts of the TAMs and the basis for the IRS's holdings are discussed below. Some of the problems with the IRS's rationale in the TAMs is also presented. Finally, Rev. Rul. 94-38 is summarized.

Relying on the Indopco case, the IRS first released a TAM concerning the costs to remove and replace asbestos insulation in manufacturing equipment. It stated that the cost of removal and replacement of asbestos in equipment was in the nature of a capital expenditure because, by eliminating the human health risks, the expenditures increased the value of the taxpayer's equipment and made the property more marketable.

In a second TAM released in February 1993, the IRS revisited the capitalization of cleanup costs in the context of the clean up of land. In this TAM, the taxpayer used a synthetic lubricant in some of its equipment before 1972 that contained PCBs. The taxpayer was notified of the PCB contamination in 1972 by the manufacturer and ceased to use the lubricant. The company, however, was faced with the task of disposing of the waste generated from the routine maintenance of the equipment. The waste was placed into numerous earthen pits and trenches on its property.

Subsequently, consistent with its regulatory authority, the EPA required the company to perform tests to determine the extent to which soil near the pits was contaminated with PCBs. The process revealed the soil was contaminated, and the EPA filed a complaint alleging that PCBs had been illegally disposed of by the taxpayer. The company and the EPA then reached an agreement that required the company to initiate a cleanup program.

In the TAM, the costs anticipated being incurred by the company included the following:

1. Soil and groundwater assessment to determine the level and location of PCB contaminated sites; and

2. Soil remediation that included the excavation and transportation of PCB-contaminated soil and backfilling.

The cleanup program was expected to take several years and cost millions of dollars. In addition, although the specific figure was not known, the total projected cleanup costs represented a significant percentage of the book cost of the taxpayer's system.

The taxpayer argued that all of the environmental cleanup costs were deductible as ordinary and necessary business expenses under IRC Sec. 162 and fell under the definition of repairs and were not for the acquisition of an asset. Finally, the company reasoned that because the costs were incurred to correct activities undertaken in the past, the amounts should be deducted currently.

The IRS Says No

The IRS rejected the company's position that the cleanup costs were ordinary and necessary business expenses under IRC Sec. 162. Specifically, the IRS outlined the four conditions that must be met under Reg. Sec. 1.162-4 for a repair cost to be taken as a deduction. The four conditions Include that 1) the repair is incidental; 2) the repair does not materially add to the value of the property; 3) the repair does not appreciably prolong the useful life of the property; and 4) the purpose of the expenditure is to keep the property in ordinarily efficient operating condition. The IRS concluded that the taxpayer failed to meet conditions one, two, and four.

Relying on Wolfsen Land & Cattle, Co. v. Commissioner 72 T.C. 1 (1979), the IRS stated that the "costs of the cleanup project are more appropriately classified as capital expenditures than as maintenance or repair charges." In Wolfsen, the taxpayer incurred the costs of draglining ditches in a farm irrigation system to dear them of sediment to keep the ditches functioning (i.e., water flowing). The ditches were cleaned out every 10 years rather than every year. The court held that draglining the ditches constituted a systematic plan that had a significant impact on the value of the irrigation system and thus, should be capitalized, i.e., the draglining materially increased the value of the property.

In the TAM, the IRS found the taxpayer's situation to be similar to Wolfsen, in three ways. First, the taxpayer chose to do an extensive cleanup project rather than annual waste identification and disposal. The fact the company was unaware its method of disposal would require cleanup in the future was considered irrelevant to the proper characterization of the cleanup costs. Second, in both Wolfsen and the TAM, the costs were undertaken as part of a systematic plan. Third, based on Wolf sen, the taxpayer's property will be more valuable in its business after the cleanup of the PCB residues.

As in the first TAM issued in 1992, the IRS rejected the test used in Piainfield-Union by the Tax Court for determining whether an expenditure increased the value of the property. The Court stated that the property's value after the expenditure must be compared to its value prior to the existence of the condition necessitating the expenditure in order to determine if its value was enhanced.

The position of the IRS regarding the Plainfield-Union case was that the cleanup operations were non-essential repairs; the cleanup operations did materially add to the value of the property; and the purpose of the expenditures was not to keep the property in ordinary efficient operating condition, but to effect a general restoration of the property that should be treated as an addition to the capital investment.

Ingenious But Inappropriate

IRS reliance on the Indopco and Wolfsen cases was ingenious but inappropriate for several reasons. First, the Tax Court, in Plainfield- Union, ruled that the proper test is to compare' the value after the repair has been completed with the value prior to the existence of conditions necessitating the repairs, not with the value immediately prior to the making of the repair. The cleanup of hazardous wastes restores the land to its condition and value prior to the existence of the contamination necessitating the repairs, not to the value immediately prior to commencing the cleanup. In other words, the cleanup merely restores the land to its original value prior to its contamination. Unlike the equipment in the first TAM, the value of land prior to its contamination and its value after cleanup can be objectively determined by real estate appraisals.

Second, concerning the issue of whether the cleanup appreciably or substantially prolongs the useful life of the property, there is no absolute rule requiring automatic capitalization of every expenditure providing the taxpayer with a benefit enduring for a period in excess of one year. Given the cleanup only restores the property to its original condition, it follows that the taxpayer has not actually received a benefit enduring for a period in excess of one year because the property owner only has regained the asset he originally possessed. Finally, even if the cleanup is considered to be a benefit prolonging the life of the property, the Wehrli case indicates there is no absolute rule requiring an automatic capitalization of every expenditure providing the taxpayer with a benefit enduring for a period in excess of one year. The question is one of fact.

Third, from a public policy perspective, such a position creates an economic disincentive that would result in the avoidance or delay of the cleanup of hazardous wastes. Given the position of the current national administration on environmental policy, landowners can expect greater opportunities to make contributions in the area of cleanup costs and should be encouraged to make those contributions voluntarily.

Fourth, the IRS position that the property was somehow made more valuable because of the cleanup cannot be objectively supported. The more rational position is that the land is no more valuable than it would have been had not the hazardous waste condition occurred. The logical test, supported by Plainfield Union, is to compare the value after the cleanup with the value prior to the existence of the condition necessitating the cleanup.

Fifth, the costs associated with cleanup costs should be considered as "ordinary and necessary expenses," deductible under IRC Sec. 162(a) because they are necessitated by governmental and environmental policy. The purpose of the cost is to properly utilize the land and protect the public rather than to create a more valuable mechanical or manufacturing asset.

Finally, there is a striking analogy between environmental cleanup costs and the tax treatment of land reclamation costs in the mining context. Costs incurred to reclaim mining land are clearly deductible under Tax Court decisions. After all, the cleanup is a mere mending of the property rather than an addition to its value for its highest and best use.

Revenue Ruling 94-38

There were numerous flaws in the IRS's arguments that supported its conclusion of capitalization of cleanup costs. It appears that the IRS has, at least in part, corrected its reasoning in Rev. Rul. 94-38.

The facts outlined in Rev. Rul. 94-38 are very similar to the facts present in the second TAM. Indeed, it may be concluded the Revenue Ruling was written in response to the taxpayer's situation described in the TAM.

In Rev. Rul. 94-38, the taxpayer was an accrual basis corporation that operated a manufacturing plant purchased in 1970. Due to manufacturing operations, hazardous waste was discharged, and the taxpayer buried the waste on potions of its land. In 1993 to comply with Federal, state, and local environmental requirements, the taxpayer undertook soil and groundwater remediation procedures and established a system for the continued monitoring of the groundwater to ensure the remediation had removed all hazardous waste. The taxpayer also began constructing groundwater treatment facilities to extract, treat, and monitor contaminated groundwater.

An important fact stipulated in the revenue ruling is 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." This was the exact situation outlined in the second TAM where the IRS concluded that the costs should be capitalized. The IRS's holding in the revenue ruling, however, is completely different, and in the authors' opinion correct, as it removes the economic disincentives of the previous positions.

Based on the circumstances presented in the revenue riding, the IRS concluded that the costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business are deductible by the taxpayer as ordinary and necessary business expenses under IRC Sec. 162. The costs attributable to the construction of groundwater treatment facilities are capital expenditures under IRC Sec. 263A.

In the revenue ruing, the IRS first stated that the IRC "generally endeavors to match expenses with the revenues of the taxable period to which the expenses are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes." In addition, relying on Indopco, the IRS acknowledged that in determining whether expenditures may be currently deductible or capitalized, it is important to consider the extent to which the expenditure will produce significant future benefits.

Applying the above points to the taxpayer's situation described in the revenue ruling, the IRS held that the 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." Furthermore, the riding concluded that the appropriate test for determining whether the expenditures increase the value of property is the test outlifted in Plainfield-Union. In evaluating the potential increase in value to the taxpayer's land due to the soil remediation costs, the IRS concluded that the taxpayer "merely restored its soil and groundwater to their approximate condition before they were contaminated by its manufacturing operations."

In the riding, the IRS also supports the current deduction for the soil remediation expenditures and ongoing groundwater treatment expenditures by indicating the costs are not subject to capitalization under IRC Sec. 263(a)(2) as land and are not subject to an allowance for depreciation, amortization, or depletion. Finally, the IRS concluded that the expenditures (other than the costs attributable to the construction of facilities) are "appropriate and helpful in carrying on the taxpayer's business and are commonly and frequently required in the taxpayer's type of business."

As expected, the IRS concluded that the groundwater treatment facilities constructed by the taxpayer have a useful life beyond the taxable year in which they are constructed. Consequently, these costs are capital expenditures under 1RC Sec. 263(a). In addition, the taxpayer is required to capitalize the direct costs and a proper share of allocable indirect costs of constructing these facilities under IRC Sec. 263A.

Someone Must Have Called

Fortunately, the IRS has changed its position on cleanup costs as reflected in Rev. Rul. 94-38. Taxpayers (at least with similar circumstances as outlined in the riding) who comply with Federal, state, and local environmental laws may now deduct these expenses currently. Perhaps, someone at the IRS did call the EPA and with the result, the IRS decided to correct the economic disincentives created by the IRS's holding in the two previous TAMs.

Roy Whitehead, Jr., JD, LLM, is Assistant Professor of Business Law, Pam Spikes, PhD, CPA, is Assistant Professor of Accounting, Joan Pritchard, CPA, is Assistant Professor of Accounting, all at the University of Central Arkansas. Brenda Yelvington, CPA is a doctoral student at the University of Mississippi.