MCLE Article and Self-Assessment Test
To avoid problems with the IRS, tax advisers need to consider the imprecise distinctions between environmental remediation costs that can be expensed and those that must be capitalized
By Marvin Leon
Most real property owners who are faced with environmental remediation or compliance costs attempt to expense those costs for tax purposes. However, several Internal Revenue Service rulings and technical advice memoranda, as well as an important tax court case, suggest that in most instances environmental remediation costs must be capitalized. Similar tax issues, for which there is little or no authority, lurk in virtually every sale or lease of property affected by environmental damage, so real estate lawyers must consider these issues when they negotiate transfers or leases of real property.
Unfortunately, there is no bright-line test to determine whether environmental cleanup costs should be expensed or capitalized. When faced with a claim for the deduction of environmental remediation costs, the IRS and the courts have resorted to time-honored concepts regarding the age-old dichotomy between costs that must be capitalized and those that can be expensed.
IRC Section 162(a) establishes the basic requirements for the deduction of expenses. To be deductible, an expenditure must be ordinary and necessary as well as be paid or incurred in the carrying on of a trade or business. IRC Section 263 prohibits deductions for permanent improvements or betterments. These expenditures, which result in an increase in the value of property, are treated as capital expenditures.1 Amounts expended to restore unusable property to usable status may also be deemed capital expenditures.2 Ordinary repairs, on the other hand, that merely maintain property and do not increase its value, are generally deductible as ordinary and necessary expenses.3
Deductibility is an exception to the general rule of capitalization and is a matter of legislative grace. The burden is on the taxpayer to justify expense deduction rather than capital treatment.4 The distinction between a repair and an improvement is often difficult to draw. At each end of the spectrum, determining whether an item is capital in nature or a repair generally appears clear. Ordinary repairs merely mend or maintain what exists and can be expensed. Equally clear are new improvements to a property, such as erecting a structure on a vacant lot, which obviously add value and have a long life and therefore must be capitalized. However, despite much litigation between taxpayers and the IRS, a considerable gray area remains.
For example, in Appeal of Illinois Merchants Trust Company,5 a taxpayer was allowed to deduct the cost of rebuilding foundations in concrete when the underlying rotted wooden pilings supporting its building became exposed due to receding waters. In Midland Empire Packing Company v. Commissioner,6 the taxpayer, a meat packer, was allowed to deduct the cost of relining the walls and basement of its plant with concrete to prevent oil seepage into its premises from a nearby refinery. On the other hand, in Levy v. Commissioner,7 the taxpayer was required to capitalize the encasement of roof supports by steel plates, and in Croff v. Commissioner,8 the taxpayer was required to capitalize the cost of adding steel beams to support a cracked wall. Unfortunately, environmental remediation costs often fall precisely in the gray area between what would clearly be considered an expense and what would clearly be considered an improvement.
IRS and Court Rulings
Several IRS rulings have authorized expense deductions for environmental remediation costs. In Revenue Ruling 98-25,9 the IRS held that costs incurred to replace underground storage tanks (USTs) containing waste byproducts were deductible as ordinary and necessary business expenses. However, the facts on which the ruling was based were unusual. The taxpayer had removed the old USTs and installed new ones, but then filled the newly installed USTs with waste byproducts from the old ones. The taxpayer then demolished the old USTs and sealed up the new USTs now containing the old wastes. The IRS determined that the new USTs had no salvage value and did not improve the value of the property, as the property still had the waste material buried in it. Therefore, the removal and installation costs were incurred merely to facilitate the sealing up of existing waste. The IRS held that such costs were more akin to costs for material consumed and used in operations than capital improvements.
That ruling generally followed a determination promulgated by the IRS four years earlier regarding a taxpayer that had purchased uncontaminated land and later discharged hazardous materials onto it.10 In response to government-mandated requirements, the taxpayer undertook to remediate the contaminated soil and groundwater and to construct and install new groundwater treatment facilities. The effect of the soil and groundwater remediation was to restore the taxpayer's land to essentially the same condition that had existed prior to the contamination. The new groundwater treatment facilities were designed to monitor and prevent future contamination. The IRS ruled that the soil and groundwater remediation costs could be currently expensed. On the other hand, the IRS ruled that the cost of constructing the new groundwater treatment facilities had to be capitalized. The IRS determined that the new facilities increased the value of the property and had a useful life far beyond the taxable year in which they were constructed.
Seemingly as many authorities, however, require capitalization treatment of environmental cleanup costs. In Norwest Corporation v. Commissioner,11 a taxpayer removed asbestos-containing material from a building that it was renovating and claimed a $902,000 expense deduction for the removal. The tax court, relying in part on Indopco v. Commissioner,12 denied the taxpayer's claim that the asbestos removal cost could be expensed. The tax court found that the removal was essential to and part of a general plan to rehabilitate and renovate the building. Therefore, the tax court held that the asbestos removal increased the value of the taxpayer's building and thus should be capitalized.
Three technical advice memoranda (TAMs) and one private letter ruling have dealt with similar issues. In TAM 9240004, issued in June 1992, the IRS concluded that the cost of removal of asbestos had to be capitalized because, it argued, the installation of environmentally sound material in place of asbestos-containing material added value to the property. Similarly, in TAM 9315004, issued in December 1992, the IRS determined that the costs of removal of PCBs also added significant value to the taxpayer's property and had to be capitalized. In Private Letter Ruling 9541005, issued in September 1995, the IRS required the capitalization of costs paid to assess and investigate the extent of environmental contamination and possible remediation alternatives. The IRS also required capitalization of legal fees incurred to negotiate a consent order with the EPA. In contrast, in November 1993, in TAM 9411002, the IRS allowed deductions for asbestos encapsulation costs as an incidental repair expense that neither increased value nor prolonged useful life.
More recently, a federal court in Virginia ruled on a refund claim asserting deductibility for expenses incurred in cleaning up contamination. In Dominion Resources, Inc. v. United States,13 the taxpayer claimed that $3 million spent to remove asbestos and other contaminated materials from real property was deductible. The taxpayer had obtained the property in a corporate reorganization after the property had been decommissioned as a hydroelectric generating facility. Some years later, the taxpayer began to explore the potential of redeveloping and leasing the property as office space. The taxpayer was advised that the property would not be leasable unless existing environmental contamination was removed. The taxpayer performed the remediation work and attempted to expense the cost.
The taxpayer argued before the court that the cleanup of the contamination simply removed the hazardous materials and eliminated the potential liability associated with the existence of contamination. Relying on Revenue Ruling 94-38,14 the taxpayer further claimed that the work did not prolong the useful life of the property nor add value. The IRS argued that the remediation was undertaken to prepare the property for a future alternative use and constituted a capital improvement under Norwest.
The federal court adopted neither the taxpayer's nor the IRS's theory on the tax treatment of the remediation costs but instead invoked a long-ignored formulation for determining expense or capitalization treatment of expenditures that was first enumerated in Walling Estate v. Commissioner.15 The test established by the Walling decision was to determine whether the expense was incurred to put the property in efficient operating condition or to keep the property in efficient operating condition. If the reason for the expenditure was to put the property in operating condition, the expenditure must be capitalized. If the expenditure merely keeps the property in operating condition, it will be deductible as a repair. In Dominion, the court determined that, despite the taxpayer's contentions, it was clear the expenditure was incurred to adapt the property to a new use and put it in position to be marketed. Thus, the expenditure had to be capitalized.
It should be noted that the taxpayer's position in Dominion was especially weak. Despite the taxpayer's claim that no new value was created by the remediation, the IRS was able to introduce evidence that, after the expenditure of $3 million for remediation, the value of the property increased from approximately $1.5 million to $9 million. In the future, taxpayers litigating the deductibility of the costs of environmental remediation must take into account disparities between appraisals and their potential effect on the taxpayer's claims.
Dominion's "put or keep" test may not be helpful in other situations, but real estate lawyers must be aware of it. It is a federal court's latest contribution to the determination of the character of environmental remediation, and it is likely to have special application if the property in question contains facilities that have been closed or are being prepared for a new use.
A certain liberalization of the rules recently occurred when Congress enacted IRC Section 198, under which taxpayers are permitted to expense certain environmental remediation expenditures that would otherwise have to be capitalized. To qualify, the expenditure must relate to abatement or control of hazardous substances at qualified contaminated sites-that is, sites that an appropriate state agency has designated as targeted areas. These areas must have a poverty rate of not less than 20 percent of the population and meet certain other tests. Sites in the National Priorities List under the Comprehensive Environmental Response and Liability Act (CERCLA) are excluded. Any deductions taken under Section 198 must be recaptured as ordinary income on the resale of the property. The statute will sunset in 2000 and appears to have little application to typical situations.
A more promising development is the promulgation of Revenue Procedure 98-17,16 which provides that taxpayers can request written guidance from the IRS on the tax treatment of environmental cleanup costs incurred or to be incurred in projects that span several years, including into the future. Provided that the request for guidance is made sufficiently early, this may be an invaluable aid in negotiating transactions.
Real estate practitioners dealing with the tax treatment of environmental matters should also not overlook the provisions of IRC Section 165, which deals with casualty losses. Casualty losses are those that generally arise from a sudden catastrophic event such as fire, storm, or earthquake. Progressive deterioration from steadily operating causes is generally not considered a casualty loss.17 While most environmental damage occurs over a long period and therefore would generally not meet the test of a casualty loss, there are situations in which an event such as an explosion or pipeline leak causes a sudden migration of hazardous materials onto a taxpayer's property. That kind of migration may be tantamount to a casualty event, and the resulting loss may be deductible as a casualty loss.
If a taxpayer, however, has a reasonable claim for reimbursement for a casualty loss and a reasonable prospect of recovery, the casualty loss cannot be expensed until it is clear that the reimbursement will not be received. That is a question of fact. Thus, if an oil pipeline suddenly leaks petroleum onto a taxpayer's property and the party owning or operating the pipeline bears responsibility, no casualty loss will be available until it is determined that recovery will not be obtained. Further, if the taxpayer deducts a casualty loss and in a subsequent year receives reimbursement for the casualty loss, the taxpayer cannot recompute the tax for the year in which the casualty loss deduction was taken, but rather is required to include the reimbursement as taxable income for the year in which the reimbursement is received, but only to the extent that the casualty loss deduction reduced taxes in the prior year.18
Taxpayers should also be aware that even if environmental remediation might normally be treated as a repair by the taxpayer based on the theory that it was necessary and did not prolong the life of the property, the taxpayer may, nevertheless, be required to capitalize the costs under a line of cases that suggest that expenditures made to comply with governmental regulations are capital by definition. For example, in Teitelbaum v. Commissioner,19 the taxpayer was required by the City of Chicago to convert its electrical system from DC to AC as required by city code. Although the expenditure did nothing to prolong the life of the building, the court determined that it increased the value of the property by bringing it into compliance with the law. Similarly, in Hotel Sulgrave v. Commissioner,20 the costs of installing a sprinkler system mandated by the City of New York to create additional fire protection for guests were required to be capitalized even though the tax court found that the sprinkler system did not increase the value of the property or increase its useful life.21
Finally, taxpayers making environmental repairs must be wary of IRC Section 162(f), which prohibits the deduction of fines or penalties paid to a government for the violation of any law. It is possible to argue that environmental remediation costs required of a property owner are akin to a fine or penalty for the prior pollution caused by that owner. A stronger analysis is that the liability mandated under CERCLA is for remedial-not punitive-purposes, and remediation costs are therefore either deductible or capitalizable under normal rules.22 For example, the IRS has distinguished between a nondeductible fine paid by the manufacturer of motor vehicles for selling a motor vehicle not covered by a required certificate of conformity and expenditures incurred by the manufacturer to remedy the nonconformity. The remedial expenditures were held to be deductible.23
Tax issues arise not only when property owners remediate hazardous materials that they have discharged, but also when negotiating purchases and sales or leases of real property. In such situations taxpayers may be remediating hazardous materials discharged by another party or paying for the remediation of hazardous materials on property that they no longer own, or in which they no longer have an interest, or in which their interest is less than a fee. The tax treatment of these remediation costs is even murkier. At the time of the closing of a purchase of real property, the extent of environmental damage frequently is not known or even suspected. Even if environment damage is suspected, its extent and the cost of its remediation will likely not be known. Moreover, governmental agencies may not yet have begun investigations, and there is no certainty that remediation will ever be required. Buyers and sellers in such circumstances have many choices concerning the allocation of unknown environmental liability:
- Sellers may not know or disclose environmental damage.
- Buyers may seek to require sellers to retain liability for environmental matters.
- Sellers can require buyers to acquire on an as-is basis, or specifically assume liability for environmental remediation.
- The parties can agree to remain silent on environmental matters.
How the parties exercise these choices can have a significant impact on the tax treatment of environmental remediation costs for the buyer and seller.
A seller who indemnifies a buyer for environmental remediation may be in an extremely difficult tax position. In a series of cases decided in the 1960s, the courts developed a line of reasoning that leads to the conclusion that the seller of real property cannot offset the anticipated cost of that environmental remediation against the purchase price in the year of sale. In those cases, the courts dealt with the general issue of whether taxpayers could either defer income received for services to be performed in a later tax year or deduct the anticipated cost of those obligations. In American Automobile Association v. United States,24 the U.S. Supreme Court determined that AAA had to report full membership dues in the year received, even though a portion of those dues represented a prepayment on services that AAA was going to provide in later years.
Similarly, in Schlude v. Commissioner,25 the Supreme Court required the operator of an Arthur Murray dance studio to report lesson revenue in the year of receipt even though the lessons were to be given in later years.26 Thus, under AAA and Schlude, if a seller of real property retains liability for environmental remediation, the obligation to be performed in a later year cannot be used to reduce the sale income in the year of sale. Even if the seller satisfies the environmental remediation liability in a later year, the expenditure does not appear to meet the tests for expense deductibility. The expenditure in the later year certainly is not ordinary, and it does not appear to have any relationship to the carrying on of business by the seller in the later year. Thus, the expenditure may result only in an unusable capital loss.
In Arrowsmith v. Commissioner,27 the taxpayers liquidated a corporation, but four years later a judgment was rendered against it. The taxpayers, as transferees of the corporate assets, were required to pay the judgment, and they claimed a business loss in the year of payment. The Supreme Court disagreed. The payment of the judgment was not based on any business transaction of the taxpayers apart from the liquidation of the corporation. If the judgment had been paid in the year of liquidation, it would have reduced the capital gain of the taxpayers in that year. The payment four years later cannot change the character of the later-year expenditure and was therefore held to be a capital expenditure. Unfortunately, the taxpayers had little or no capital gain in the later year against which the capital expenditure could be offset.
Following Arrowsmith, Congress enacted IRC Section 1341, which applies to taxpayers who incur environmental remediation expenses exceeding $3,000 in a tax year after the year of sale. In that case, the seller's taxable income for the year in which the seller actually pays the remediation costs will be the lesser of 1) the tax payable by the seller for that later year, considering the remediation costs as a capital loss in that later year, or 2) the tax payable by the seller for that later year minus the decrease in tax for the prior tax year which would have resulted from the reduced capital gain in the year of sale, as though such remediation costs had been paid in that prior year. However, in each case the taxpayer is subject to the limitations on capital losses. In light of American Automobile Association28 and IRC Section 1341, it may prove to be a better tax strategy for the seller to reduce the sale price in the year of sale in exchange for a release from and assumption by the buyer of all environmental remediation liability. At least the seller will then have a closed transaction in the year of sale and will not be subject to later remediation costs and possible changes in tax rates.
Even if the parties agree on a price reduction in exchange for a release from or assumption by the buyer of environmental liability, sellers must be aware that they may still have continuing liability to remediate environmental damage under CERCLA.29 Under Section 107(a), a past owner or operator of a site remains a potentially responsible party (PRP) with obligations to remediate or reimburse others for the cost of remediation of an environmentally impacted site. This means that a seller remains potentially liable as a PRP for the entire cleanup costs of the site even if it no longer owns the property and even if the buyer has released the seller from any claims.30
If the buyer assumes liability for environmental matters, or later settles potential liability for environmental deficiencies that were either unknown or unquantified at the time of sale or pays for environmental remediation, how will the buyer and the seller treat a later payment of the remediation costs by the buyer? It appears the buyer will be entitled to expense or capital treatment based on the customary rules of IRC Sections 162(a) and 263. It further appears that pursuant to Revenue Ruling 95-74,31 the seller will not be charged with income on an imputed increased sales price due to the buyer's remediation.
The facts involved in Revenue Ruling 95-74 were complicated and involved a tax-free incorporation. In this case, a parent corporation formed a subsidiary and contributed a plant with environmental problems to the subsidiary in exchange for the subsidiary's stock and assumption by the subsidiary of all liabilities, including the environmental liability, of the plant. Two years later, the subsidiary undertook groundwater and soil remediation of the plant site. The IRS concluded that the subsidiary's assumption of the contingent environmental remediation obligation was not a liability assumed by the subsidiary that exceeded the parent corporation's adjusted basis of the property and therefore would not invalidate the tax-free incorporation. The IRS also concluded that the assumed contingent liabilities were not to be treated as money received by the parent corporation when determining its basis in the stock of the subsidiary. Further, when the subsidiary later undertook the environmental remediation, the IRS concluded that the costs for the remediation would be capitalized or expensed based on the work done. The parent was not charged with having received income in the year the work was undertaken.
The holding in Revenue 95-74 follows prior authorities that declared that a seller is not required to take into account relief from a contingent liability in the year of sale.32 Further, a buyer who assumes contingent liabilities cannot add contingent liabilities to the tax basis of its acquired property.33 Only later-when, as, and if the buyer pays the contingent liability-can the buyer take a deduction or increase its basis.34
The tax treatment of environmental remediation costs also remains murky in a landlord-tenant relationship. Although expenditures for repairs or improvements are usually made by, and are deductible or capitalizable by, owners, lessees who agree to make repairs can deduct expenditures made pursuant to a lease.35 Further, a tenant who undertakes improvements to the leased property can capitalize the costs.36 Accordingly, if a tenant causes or suffers an environmental discharge and remediates it during the period of its tenancy, it would appear that the tenant should be able to either expense the cost of remediation or capitalize the cost and depreciate it.
On the other hand, the costs of the remediation should not be considered as income received by the landlord, because the remediation only puts the landlord in the same condition as if the environmental discharge had never occurred. Further, Section 109 specifically provides that improvements made by a tenant during the term of a lease cannot be imputed as income to the landlord at the termination of the lease.
The terms of a lease may allocate to the tenant responsibility for the remediation of any contamination that exists at the beginning of the lease term. In that case, the cost of remediation may be treated either as additional rent that is deductible by the tenant or as a capitalized cost to be recovered by the tenant over the life of the lease.37 Despite the provisions of Section 109, some authorities have charged the landlord with a receipt of rent revenue for improvements that the lease requires the tenant to undertake when the tenant accepted this requirement in lieu of the payment of rent.38
Landlords may also be forced to remediate contamination caused or suffered by tenants who may no longer occupy the premises or who have disappeared. Although the landlord is improving property that has been damaged by another party, the landlord should still be entitled to apply normal expense or capitalization criteria when determining the tax treatment of the remediation cost.39
On the other hand, when tenants are required to remediate a property years after a lease has expired (either as a PRP or under a contractual obligation) the landlord clearly receives a benefit. However, it is unclear whether that benefit falls under the provisions of Section 109. If it does not, it is possible that the landlord could be charged with ordinary income in the year the remediation is undertaken. After all, the property has been improved at no cost to the landlord.
The tenant's tax treatment of the costs is also unclear. The tenant would not seem to fall under the rationale established in Arrowsmith40 or the reach of IRC Section 1341, since the tenant has not received income in any prior year. The tenant would like to be able to take a deduction for rent or ordinary business expenses years after the lease has expired. However, as the tenant is no longer in occupancy of the premises, it is simply satisfying a liability imposed upon it by law. No authority addresses the tenant's tax treatment of such costs.
The issue of the tax treatment of environmental remediation costs remains uncertain. Practitioners must be aware of this uncertainty and be prepared to explain the various risks that clients must assume when they decide-or are forced-to undertake an environmental remediation or when their clients are buying, selling, or leasing properties.
1 I.R.C. §263(a)(1).
2 I.R.C. §263(a)(2).
3 Treas. Reg. §1.162-4.
4 Indopco v. Commissioner, 503 U.S. 79 (1992). The holding in Indopco, which related to the deductibility of takeover expenses, was so broad, that the I.R.S. felt compelled to issue Rev. Rul. 94-12, 1994-1CB 36, to reassure taxpayers that incidental repairs to real property could still be expensed.
5 Appeal of Illinois Merchants Trust Co., 4 B.T.A. 103 (1926).
6 Midland Empire Packing Co.v. Commissioner, 14 T.C. 635 (1950).
7 Levy v. Commissioner, 212 F. 2d 552 (5th Cir. 1954).
8 Adam L. Croff v. Commissioner, 16 T.C.M. 721 (1957).
9 Rev. Rul. 98-25, 1998-19 I.R.B. 4.
10 Rev. Rul. 94-38, 1994-1 C.B. 35.
11 Norwest Corp. v. Commissioner, 108 T.C. 265 (1997).
12 Indopco v. Commissioner, 503 U.S. 79 (1992). But see Plainfield Union Water Co. v. Commissioner, 39 T.C. 333 (1962), an earlier case that held that cleaning out contaminated material in the pipes of a water company and relining of the pipes with cement was deductible.
13 Dominion Resources, Inc. v. United States, 99-1 U.S.T.C. 50,369 (D.C. Va. 1999).
14 Rev. Rul. 94-38, supra note 10.
15 Walling Estate v. Commissioner, 67-1 U.S.T.C. 9238 (3d Cir. 1967).
16 Rev. Proc. 98-17, 1998-5 I.R.B. 4.
17 Edward A. Saccone v. Commissioner, 39 T.C.M. 616 (1979). This loss from termite damage, for example, is not a casualty loss. See Rev. Rul. 63-232, 1963-2 C.B. 97.
18 Treas. Reg. 1.165-1(d)(2).
19 Teitelbaum v. Commissioner, 294 F. 2d 541 (7th Cir. 1961).
20 Hotel Sulgrave v. Commissioner, 21 T.C. 619 (1954).
21 See also Blue Creek Coal v. Commissioner, 48 T.C.M. 1504 (1984); Woolrich Woolen Mills v. United States, 289 F. 2d 444 (3rd Cir. 1961); Glenn A. Noble v. Commissioner, 70 T.C. 916 (1978); Swig Inv. Co. v. United States, 78 A.F.T.R. 2d 96-6705 (1996).
22 United States v. Monsanto, 858 F. 2d 160 (4th Cir. 1988).
23 See Treas. Reg. §1.162.21(c)(2).
24 American Automobile Assoc. v. United States, 367 U.S. 687 (1961).
25 Schlude v. Commissioner, 372 U.S. 128 (1963).
26 But see Artnell v. Commissioner, 68-2 T.C. 9593 (7th Cir. 1968), a case in which the court allowed the Chicago White Sox to defer advance season ticket sales to the year in which games were played.
27 Arrowsmith v. Commissioner, 344 U.S. 6 (1952).
28 American Automobile Assoc., 367 U.S. 687.
29 Comprehensive Environmental Response and Liability Act, 42 U.S.C. §§9601 et seq.
30 Any remediation payments by a PRP seller in a later year would seem to fall within the purview of Arrowsmith, 344 U.S. 6, and IRC §1341.
31 Rev. Rul. 95-74, 95-2 C.B. 36.
32 Freitas v. Commissioner, 25 T.C.M. 545 (1966).
33 Pacific Transp. v. Commissioner, 483 F. 2d 209 (9th Cir. 1973); Columbus & Greenville Ry. Co. v. Commissioner, 42 T.C. 834 (1964).
34 Long v. Commissioner, 71 T.C. 1 (1978), rev'd on other grounds, 81-2 T.C. §9668. See also Treas. Reg. 1.461-1, which requires the taxpayer to meet three tests before taking the contingent liability into account: 1) all events must have occurred to establish the fact of liability, 2) the amount of the liability must be determinable with reasonable accuracy, and 3) economic performance must have occurred.
35 Rose v. Haverty Furniture Co., 15 F. 2d 345 (5th Cir. 1926).
36 Rev. Rul. 62-8, 1962-1 C.B. 31.
37 Your Health Club v. Commissioner, 4 T.C. 385 (1944).
38 Treas. Reg. 1.109-1; Boston Fish Market Corp. v. Commissioner, 57 T.C. 884 (1972); Sirbo Holdings, Inc. v. Commissioner, 509 F. 2d 1220 (2nd Cir. 1975).
39 D. Howard v. Commissioner, 19 B.T.A. 865 (1930).
40 Arrowsmith v. Commissioner, 344 U.S. 6 (1952).
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