Deductibility of Environmental Remediation Costs

The United States is just beginning to realize the tremendous cost of yesterday's imperfect waste disposal practices: An estimated $750 billion will be spent between 1990 and 2020 to clean up thousands of hazardous waste sites. Companies that fail to meet their cleanup obligations are subject to civil and criminal liability under federal, state and local environmental laws and regulations. CPAs face many issues in representing clients owning contaminated real property, one of which is addressing for tax purposes the most advantageous treatment of environmental compliance and cleanup expenses. Because all expenses are not immediately deductible, companies have little incentive to undertake cleanup activities voluntarily. The overriding issue is whether a current income tax deduction is allowed for such expenses. The Internal Revenue Service addressed this issue in the form of a technical advice memorandum (TAM). Although TAMs,are private rulings issued by the IRS to provide guidance on a specific tax issue relating solely to a particular taxpayer, they nevertheless provide a basis for analysis and discussion of the issue--in this case, determining whether environmental remediation (cleanup) expenses can be deducted or must be capitalized. The IRS requested taxpayer comments on the issue and will continue to process technical advice requests pending in its national office. This process is ongoing and authoritative guidance is expected to be issued in 1994. With the Treasury estimating the amount of contested liabilities at $1 trillion over the next 30 years, a popular consensus is unlikely. This article analyzes the current IRS position and the distinguishing arguments in the environmental context. TAX ISSUES To ascertain whether an expense can be deducted or must be capitalized, all the relevant facts must be analyzed, with the burden of proof on the taxpayer. Under Treasury regulations section 1.1624, failure to satisfy the following conditions automatically results in capitalization under Internal Revenue Code section 263: * The expenditure is incidental. * The expenditure does not materially add to the property's value. * The expenditure does not appreciably prolong the property's useful life. * The expenditure's purge is to keep the property in an ordinarily efficient operating condition. TAM 9315004. The IRS position on the issue of expense versus capitalization of environmental assessment and cleanup costs is documented in TAM 9315004, issued in April 1993. The taxpayer in the TAM--we'll call it XYZ Co.--had used a lubricant containing PCBs more than 20 years ago, before their hazards were known. XYZ had broken no laws and had switched to other lubricants when the dangers of PCBS were discovered. Subsequently, the Environmental Protection Agency (EPA) ordered XYZ to clean up the contaminated sites. The TAM addresses the treatment of XYZ's costs in complying with the EPA order: * Assessment costs. The TAM defines assessment costs as those aneroid to determine if, and to what extent, a property is contaminated. The TAM permits full deduction of assessment costs when a property is found not to require remediation; if remediation is necessary, the TAM requires the costs to be capitalized to the underlying asset and depreciated over the asset's remaining useful life. * Remediation expenditures. The TAM requires such cleanup expenditures to be capitalized. The IRS noted that capitalization of such costs is deemed appropriate when there is a documented remediation plan, since having such a plan in place suggests the activities undertaken are more than incidental repairs. * Legal fees. The TAM says legal fees paid to defend XYZ from government and third-party claims, including XYZ's litigation with its insurer to establish contractual rights, are fully deductible in the year incurred. The IRS reasons these fees are separate from the remediation plan. …