Contingent Pre-Acquisition Environmental Clean-Up Liabilities: Where's the Value?

More than a decade ago, the Internal Revenue Service and Treasury's Office of Tax Policy began to consider various tax implications of costs incurred by taxpayers in cleaning up environmental contamination. One context involved the consideration of the proper tax treatment of contingent liabilities - such as retiree health benefits and product warranties in addition to environmental clean-up obligations - assumed in connection with taxable asset acquisitions. The other context, in the wake of the Supreme Court's decision in INDOPCO, Inc. v. Commissioner, focused generally on whether common environmental clean-up expenses were currently deductible as ordinary and necessary business expenses or must be capitalized. Ultimately, Rev. Rul. 94-38 was issued regarding the latter context, concluding that some land remediation costs were currently deductible. No general guidance was issued for contingent liabilities. This report focuses on the position the IRS has adopted in recent years in both private rulings and litigation regarding costs incurred by a taxpayer in cleaning up environmental contamination that occurred before the time the taxpayer acquired the contaminated property. Simply stated, the IRS's position appears to be that these costs always must be capitalized. In the author's view, that position is flawed in that it (i) fails to acknowledge the contingent liability aspect of the issue, and (ii) either ignores or minimizes the analysis underlying the conclusions reached in Rev. Rul. 94-38. In lieu of the IRS's current all costs must be capitalized position, the author recommends an approach that looks primarily to whether the taxpayer took into account, in negotiating the price at which the taxpayer would acquire the property, the possibility of having a future environmental clean-up obligation.