New Ruling on Treatment of Environmental Cleanup Costs

By Charles E. Price and Leonard G. Weld

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Revenue Ruling 94-38

Revenue Ruling 94-38 identifies a very specific fact situation: An accrual basis taxpayer purchased uncontaminated land. The taxpayer’s manufacturing operations discharged hazardous waste that was buried on the property. In order to comply with federal, state, and local requirements, the taxpayer removed the contaminated soil and groundwater, backfilled the land with uncontaminated soil, and constructed groundwater treatment facilities (wells, pipes, pumps, and equipment to monitor and treat groundwater). This soil remediation and water treatment would restore the land to the same condition that existed when the taxpayer purchased the property.

IRC section 263(a)(1) denies the deduction of amounts paid for new buildings or for improvements or betterments made to increase the value of any property. Section 263(a)(2) prohibits deduction of amounts spent to restore property when cost recovery is or has been allowed. Revenue Ruling 94-38 then cites Indopco [503 U.S. 79 (1992)] and the importance of considering “the extent to which the expenditure will produce significant future benefits.” To determine whether expenditures increase the value of property, the ruling cites the Plainfield Union [Plainfield Union Water Co. v. Comm’r, 39 TC 333 (1962)] test, wherein the status of the asset after the expenditure is compared with the status of the asset before the condition necessitating the expenditure arose.

The ruling states that the soil remediation and groundwater treatment do not improve the land or provide significant future benefits, but simply restore the land and water to the original, uncontaminated state. Because no cost recovery is allowed for land, the restoration does not conflict with the prohibition of IRC section 263(a)(2). These expenditures are ordinary and necessary business expenses under IRC section 162. On the other hand, the treatment facilities and equipment constructed by the taxpayer have a useful life that extends substantially beyond the taxable year, and thus must be capitalized.

Revenue Ruling 98-25

In Revenue Ruling 98-25, a corporate accrual-basis taxpayer operated a manufacturing facility that had produced waste by-products in the course of business operations. This waste was placed in steel underground storage tanks and buried on the taxpayer’s land. To comply with federal, state, and local environmental laws, the taxpayer incurred costs to remove the old steel underground storage tanks, drained the waste from the old tanks, and transferred the waste to new composite material tanks. These new tanks were buried in the same holes. The old steel tanks were cleaned and transported to an appropriate disposal facility.

The new tanks would remain filled with the same waste indefinitely. Once the tanks are filled and sealed, they have no salvage value and no remaining useful life. These new tanks are distinguished from the water treatment facilities in Revenue Ruling 94-38 because the tanks have no useful life beyond the current year.

The ruling states that “the costs of acquiring and installing the new tanks are not capital expenditures, but are ordinary and necessary business expenses deductible under IRC section 162. Furthermore, the costs of removing, cleaning, and disposing of the old tanks, [as well as the] filling and on-going monitoring of the new tanks[,] are deductible as business expenses under section 162.”

Revenue Ruling 2004-18

The fact pattern in Revenue Ruling 2004-18 is very specific and reminiscent of Revenue Ruling 94-38. An accrual-basis corporate taxpayer owns and operates a manufacturing plant that produces property that is inventory. Manufacturing operations discharge hazardous waste. In the past, this waste was buried on the taxpayer’s previously uncontaminated land. In order to comply with federal, state, and local environmental requirements, the taxpayer incurs costs to remediate the soil and groundwater that had been contaminated. The taxpayer also establishes a system to monitor the groundwater to ensure that all of the hazardous waste is removed. Soil remediation and groundwater treatment restores the land to essentially the same physical condition that existed prior to contamination. The taxpayer continues to operate the plant in the same manner, except that hazardous waste is now disposed of in compliance with environmental requirements.

Next, the ruling reviews the holdings of Rulings 94-38 and 98-25 and concludes that remediation and monitoring costs are ordinary and necessary expenses under section 162. New analysis begins at this point with the introduction of section 263A, which requires the taxpayer to capitalize the direct costs of inventory and the inventory’s proper share of those indirect costs—part or all of which are allocable to inventory.

Although the remediation costs are deductible under section 162, additional examination will reveal whether or not these expenses must be included as inventory costs. As with labor, taxes, and rent, currently deductible business expenses may still be included in the cost of inventory under section 263A.

Treasury regulations section 1.263A-1(e)(3)(i) states that a taxpayer “must capitalize all indirect costs properly allocable to property produced or property acquired for resale. Indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities” [emphasis added].

Analysis of Revenue Ruling 2004-18

The crux of the issue is whether environmental cleanup costs are properly allocable to inventory. There is no doubt that some indirect costs must be allocated to inventory. Even costs that may normally be deductible under IRC section 162 (e.g., supplies, repair or maintenance of machines, production supervisory salaries) should be allocated to inventory because they are “incurred by reason of the performance of production or resale activities.”

If one accepts the proposition that there is a link between current production of hazardous waste (as a manufacturing by-product) and inventory, then disposal costs of current waste might be properly allocable to inventory by reason of the performance of production activities.

The issue addressed in these rulings, however, concerns hazardous waste buried in prior periods. Remediation costs of this period are associated with the disposal of waste, not the production of inventory. Whether the waste is in the soil or in underground storage tanks, the waste was created and buried in prior periods. There must be a compelling argument presented to justify the position that these costs are properly allocable to inventory. The existence of a production process is not sufficient. Even Treasury Regulations section 1.263A-1(e)(3)(i) recognizes that not all indirect costs are allocable to production or resale activities. Treasury Regulations section 1.263A-1(e)(3) states that costs might be properly allocable to “both production and resale activities as well as to other activities that are not subject to section 263A.” Revenue Ruling 2004-18 does not provide any reasoning or justification to support its contention that remediation costs are properly allocable to inventory.

Revenue Ruling 2004-18 states that the current cost of cleaning contamination from prior periods is properly allocable to inventory under IRC section 263A. Applying the analysis above, however, there is no logical or reasonable link between current cleanup costs associated with the disposal of waste from a prior period and the current production of inventory.