Taxing the Environment

Howard M. Shanker and Sanjay Gupta

Editors' Summary: The tax treatment of a company's environmental remediation costs is crucial to its determination of what the total cost of a remedial action actually is. Whether costs are deductible expenses that the company can offset against current income or are capital expenditures that it must depreciate over time can have a significant impact on its bottom line. This Article examines the Internal Revenue Service's (IRS') current and historic treatment of these expenditures. The Article begins by examining the distinction between deductibility and capitalization of costs. It then discusses the IRS' historic treatment of cleanup costs as capital expenditures and the current trend of allowing these costs to be deducted. Finally, it analyzes the tax treatment of related expenses, such as consulting and legal fees, as well as the treatment of funds established by potentially responsible parties to finance remedial work at multiparty hazardous-waste sites.

Howard M. Shanker, J.D., M.P.A., is an attorney in Phoenix, Arizona, specializing in environmental law. Sanjay Gupta, Ph.D., LL.B., C.P.A., is an associate professor of accountancy at the Arizona State University. The authors would like to thank W. Dustin Goldstein, Bankers Trust Company, Four Albany Street, New York, N.Y., for his input with regard to the establishment of qualified settlement funds in the Superfund context.

[27 ELR 10165]

The income tax treatment of environmental remediation and related expenditures is an essential element in determining the actual cost of any remedial alternative. The specific categorization of environmental expenditures afforded by the Internal Revenue Service (IRS) is, however, often not easily predictable. As a result, when taxation is a relevant consideration, the factors and variables discussed in this Article should, whenever possible, be taken into account before dedicating funds for environmental studies, settlement, attorneys fees, or remediation.

Specifically, this Article provides background and guidance on: (1) environmental expenditures that may be used to offset current income, (2) environmental expenditures that must be recovered through depreciation deductions over the useful lifetime of the asset; (3) the tax treatment of multiparty hazardous waste site expenditures; and (4) the tax treatment of environmental fines or penalties. This Article also traces the IRS' historic treatment of expenditures made in furtherance of environmental cleanup and discusses current trends and recent developments in the IRS' treatment of such costs.

Deduction Versus Capitalization of Environmental Costs

Environmental expenditures can generally fall into one of two categories: (1) ordinary and necessary business expenses that may be used to offset current income by the amount of the expenditure; or (2) capital expenditures that may be recovered through depreciation deductions over the useful lifetime of the asset. The distinction between costs that are deductible and those that must be capitalized is based on the principle that deductions for costs incurred should be matched with the income produced by such costs.¹

The distinction between a capital expenditure and a necessary cost of business is, however, often unclear. Indeed, the U.S. Supreme Court has recognized that the decisive distinctions between current expenses and capital expenditures "are those of degree and not of kind."² Since there is "no clear dividing line between deductible repairs and capital expenditures," courts have adopted a practical case-by-case approach in applying the principles of capitalization and deductibility to the facts before them.³

The pertinent inquiry generally turns on whether the environmental expenditure restores contaminated property to its previous condition, or whether it increases the value of the property. If the expenditure restores the property to its previous condition, the action will be considered a "repair," i.e., a deductible business expense. If, however, the value of the property is materially increased compared to its value before the condition necessitating the expenditure, the expenditure will generally be considered an "improvement" that must be capitalized.⁴

Deductible Costs of Business

Section 162 of the Internal Revenue Code generally allows a deduction for the "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."⁵ An expense is "ordinary" if it is commonly [27 ELR 10166] incurred in the taxpayer's business.⁶ An expense is "necessary" if it is appropriate or helpful in the taxpayer's business.⁷ Section 162 has been used, for example, to allow business-expense deductions for the costs of removing and disposing of waste materials produced in a taxpayer's business.⁸ Regulations interpreting § 162 allow a deduction for repair costs so long as: (1) the repair is incidental; (2) the cost of 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.⁹

Capitalized Costs

Section 263 of the Code generally prohibits deductions for capital expenditures.¹⁰ Section 263(a)(1) provides that no deduction shall be allowed for any amounts paid for new buildings or for permanent improvements or betterments made to increase the value of any property.¹¹ Section 263(a)(2) provides that no deduction shall be allowed for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance has been made in the form of a deduction for depreciation, amortization, or depletion.¹²

Applicable regulations provide that capital expenditures include amounts paid or incurred: (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment; or (2) to adapt property to a new or different use.¹³ Capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.¹⁴

The IRS historically treated cleanup costs as capital expenditures because cleanup of contaminated property, in part, increased the value of the property. The current trend, however, is for the IRS to allow an immediate deduction for cleanup costs that help restore contaminated property to its previous value but to require capitalization of expenditures made for the construction and installation of remediation equipment, such as monitoring wells and wastewater treatment facilities.

Cleanup Costs Were Historically Treated as Capital Expenditures

Historically, the IRS did not allow taxpayers to deduct environmental cleanup costs as repairs or necessary costs of business. Rather, the IRS treated such costs, pursuant to Code § 263, as permanent improvements that increased the value of the property, i.e., as capital expenditures. Indeed, the IRS treatment of environmental remedial expenditures was at odds with the U.S. Environmental Protection Agency's (EPA's) position of encouraging privately funded remedial activities.¹⁵

The IRS revised its historic position on remedial costs in a June 20, 1994 Revenue Ruling—Rev. Rul. 94-38. There were, however, three pre-1994 Technical Advice Memoranda (TAMs) that illustrate the IRS' historic requirement for capitalization.¹⁶

TAM 93-15-004 (Dec. 17, 1992)

TAM 93-15-004 addressed a situation where the taxpayer's operations had resulted in the release of polychlorinated biphenyls (PCBs). Pursuant to a consent decree with EPA and agreements with private parties, the taxpayer undertook requisite remedial action. The taxpayer capitalized certain facilities and equipment, including groundwater monitoring wells. The taxpayer treated all of the remaining costs associated with the cleanup as current expenses.

With regard to actual costs of remediation, the IRS found that: (1) the taxpayer could have instituted an ongoing program of waste identification and disposal that would have obviated the need for the extraordinary cleanup at issue;¹⁷ (2) the cleanup was part of a systematic plan involving extensive identification and/or remediation activities throughout the taxpayer's property; and (3) the taxpayer's property would be more valuable after it was cleaned of PCB residues. Thus, according to the IRS, the remediation work being performed resulted in permanent improvements that had to be capitalized.

The IRS also found that the cleanup activities were undertaken pursuant to a general plan of rehabilitation. As a general proposition, expenses incurred as part of a general plan of rehabilitation or restoration must be capitalized even though the same expense, if incurred separately, would be deductible as an ordinary and necessary business expense.¹⁸ Thus, according to the IRS,

the cleanup program is a long-term systematic program that involves systematically testing, assessing, remediating, removing and replacing extensive amounts of land. [27 ELR 10167] The cleanup operations taken in their entirety will result in permanent betterments to taxpayer's properties…. These betterments include, but are not limited to, transforming sections of contaminated land into land that is no longer contaminated, avoiding further government penalties by bringing the properties into compliance with government regulations, providing a safe environment for workers and adjoining property owners, and increasing the marketability of the properties once the level of PCBs is brought within the safety range permitted under the environmental regulations. Accordingly, the cleanup project constitutes a general plan of rehabilitation, the costs of which are required to be capitalized.¹⁹

In short, the IRS determined that all costs of remediation had to be capitalized.

The IRS also considered whether or not the taxpayer could take a deduction for attorneys fees and oversight costs. The IRS found that attorneys fees were deductible to the extent that they were incurred to defend the taxpayer's business or secure contractual rights, i.e., they did not contribute to or facilitate the environmental cleanup. More specifically, the IRS determined that the legal costs incurred in responding to the claims of EPA and state agencies to defend against claims by private third parties and to litigate insurance matters did not create or enhance an asset or produce a long-term benefit.

Oversight costs paid by the taxpayer pursuant to the consent decree were required to be capitalized. Oversight costs are generally expenditures made directly to the regulatory agency and/or its contractors as remuneration for their role in monitoring the private-party remediation. The IRS determined that such costs were incurred pursuant to the plan of rehabilitation, i.e., subject to capitalization.

TAM 92-40-004 (June 29, 1992)

In TAM 92-40-004, the IRS considered a situation where the equipment that the taxpayer corporation used in its manufacturing process was insulated with asbestos. Because of Occupational Safety and Health Administration guidelines, state mandates, and concerns about its workers' health and safety, the taxpayer implemented a program of asbestos abatement. The program involved removing the asbestos insulation from the equipment and replacing it with other insulating materials. The taxpayer took a current deduction for all costs involved in the removal and installation on two general grounds. First, pursuant to Code § 162, the taxpayer alleged that the costs incurred were incidental, because the amount involved was minor compared to the facility's overall repairs and maintenance expenses and the value of the equipment. Second, the taxpayer believed that a deduction was appropriate because the expenses neither added value nor prolonged the useful life of the equipment. Indeed, the replacement insulation neither saved energy (it was 10 percent less thermally efficient), nor contributed to any other operating efficiencies.

The IRS, however, found that the taxpayer's costs were not currently deductible repair expenses and that they had to be capitalized. The Service's main reason for requiring capitalization was that the expense of asbestos removal increased the value of the taxpayer's property by: (1) reducing or eliminating the human health risks, thereby decreasing the taxpayer's risk of liability to employees; (2) reducing or eliminating the chances of being forced to suspend operations for failure to comply with regulatory guidelines; and (3) enhancing certain operating efficiencies by eliminating the need to undertake time-consuming and expensive precautions when performing normal repairs and maintenance.

In addition, the Service found that the removal of the asbestos was a one-time expense that was not remedial in nature, but rather resulted in a permanent improvement to the property. Finally, relying on the Supreme Court's decision in INDOPCO, Inc. v. Commissioner,²⁰ the Service held that these improvements created long-term future benefits to the taxpayer that extended beyond the year in which the costs for making them were incurred. These benefits included safer working conditions, reduced risk of liability for owners and investors, and greater marketability of the taxpayer's property.

TAM 94-11-002 (Nov. 19, 1993)

The third TAM that demonstrated the IRS' historic treatment of environmental costs was promulgated in November 1993. The taxpayer in TAM 94-11-002 was in the business of selling rental warehouse space and related services. To expand its facilities, which consisted of a warehouse and a boiler house, the taxpayer sought a bank loan. To secure the loan, however, the lender required the taxpayer to remove asbestos-containing building materials in its facilities. In response to the lender's request, the taxpayer removed the boilers and tanks, which contained asbestos, from the boiler house and converted the boiler house into a garage and office space. In addition, the taxpayer rewrapped and encapsulated the damaged insulation in the warehouse. The taxpayer deducted all costs incurred in the boiler house and warehouse as ordinary business expenses under Code § 162.

The IRS found that the costs of removing the asbestos from the boiler room had to be capitalized, because the expenses permanently eliminated the health risks posed by the presence of asbestos, significantly increased the attractiveness of the property, and enabled the taxpayer to adapt the property to a new and different use. Thus, the expenses could not be viewed as incidental repair costs, but rather had to be treated as permanent improvements and betterments that are required to be capitalized under § 263.

In contrast to that determination and its determination in TAM 92-40-004, the IRS found that the expenses of encapsulating the asbestos in the warehouse constituted incidental repair costs because the effects of the encapsulation were temporary rather than permanent, and the encapsulation neither added value to the property nor enhanced its useful life. Because the issue of programmatic repairs is usually a question of fact, the IRS examined the scope of the encapsulation expenses. It ruled that they were incidental in relation to the taxpayer's overall operations and, thus, currently deductible.²¹

[27 ELR 10168]

The IRS also determined the depreciable life of the capitalized costs of asbestos removal from the boiler house, i.e., the recovery period for those costs. Because the costs constituted improvements to the taxpayer's boiler house, which would be considered "nonresidential real property," those costs had to be recovered over 31.5 years.²²

The Current Trend Is to Allow a Deduction for Environmental Cleanup Costs

Rev. Rul. 94-38

On June 20, 1994, the IRS issued Rev. Rul. 94-38,²³ which in large part reversed its position on capitalizing environmental costs. This ruling held that 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. It also held that costs allocable to constructing groundwater treatment facilities are capital expenditures.

Significantly, the IRS determined that

the appropriate test for determining whether the expenditures increase the value of property is to compare the status of the asset after the expenditure with the status of that asset before the condition arose that necessitated the expenditure (i.e., before the land was contaminated by hazardous waste).²⁴

Before this ruling, the value of property after cleanup was compared to the value of the site in its contaminated condition. Remediation increased value and was considered a capital expenditure. In Rev. Rul. 94-38, however, the IRS compared the value of the remediated property to the value of the property before it became contaminated, and viewed the cleanup costs as simply restoring the property back to its original position, i.e., remediation did not increase the property's value. Following this line of reasoning, which the Tax Court in Plainfield-Union Water Co. v. Commissioner²⁵ enunciated as "the restoration principle," the IRS was able to reverse its position and allow cleanup costs to be deducted as ordinary and necessary business expenses pursuant to Code § 162.

The Administration's Current Revenue Proposals

The U.S. Department of the Treasury has recently issued proposals aimed at expanding the scope of Rev. Rul. 94-38 for the deductibility of certain environmental cleanup expenses.²⁶ While acknowledging that the ruling has resolved some issues in the area, the Administration's proposal also admits that the ruling's scope is limited in that it only addresses cleanup costs incurred by the taxpayer who contaminated the property in the first place. The Administration believes that as a result of the uncertainty surrounding the potential legal liabilities for pollution and contamination, thousands of sites across the country have been neglected or underused.²⁷

To provide an incentive to the private sector for cleaning up these sites, particularly those located in economically distressed communities, the Administration has proposed that a current deduction be allowed for certain remediation costs paid or incurred in connection with the abatement or control of environmental contaminants at qualified sites. To qualify, a site would have to satisfy use, geographic, and contamination requirements.

The use requirement would be met if the property were used in the taxpayer's trade or business or for the production of income. The geographic requirement would be met if the property were located in: (1) any census tract that has a poverty rate of 20 percent or more; (2) any other census tract with a population under 2,000, if 75 percent or more of the tract is zoned for industrial or commercial use and the tract is contiguous to one or more census tracts with a poverty rate of 20 percent or more; (3) an area designated as a federal Empowerment Zone or Enterprise Community; or (4) an area subject to one of the 40 EPA Brownfields Pilots announced before February 1996. Sites listed on the Superfund national priority list would be excluded.

The contamination requirement would be met if hazardous substances were present or potentially present on the property. Hazardous substances would be defined by reference to §§ 101(14) and 102 of the Comprehensive Environmental Response, Compensation, and Liability Act,²⁸ subject to limitations applicable to asbestos, radon, and certain other substances released into drinking water supplies.

To claim the deduction, a taxpayer would be required to have an EPA-designated state environmental agency certify that the site satisfies the geographic and contamination requirements. Finally, unlike the cleanup expenses deductible under current law, the newly proposed deductions would be subject to recapture under Code § 1245 as ordinary income if gain were realized on disposition of the property.

Recent Developments Allow for the Deduction of Consulting and Legal Fees

Consistent with Rev. Rul. 94-38, the IRS appears to be moving toward allowing deductions for a wider range of environmentally related expenditures. The IRS recently reversed TAM 95-41-005 to allow for the deduction of consulting and legal fees associated with the proposed remediation of a site.

In TAM 95-41-005 (Sept. 27, 1995), the taxpayer owned a tract of land that was initially used for farming but later became a site for the disposal of industrial waste. The taxpayer then donated the land to the county for developing a recreational park. On discovering the contamination, however, the county ceased development of the park and conveyed the land back to the taxpayer. The land was designated a Superfund site.

Pursuant to an EPA consent order, the taxpayer incurred [27 ELR 10169] consulting expenses for performing hazardous waste studies and legal expenses for negotiating the terms of the consent order with EPA and for drafting and negotiating contracts with the consultants. Following the IRS' position in Rev. Rul. 94-38, the taxpayer currently deducted the consulting fees and legal expenses as ordinary and necessary business expenses under § 162.

The IRS, however, disallowed the deduction, claiming that Rev. Rul. 94-38 did not apply because the taxpayer acquired the land from the county in a contaminated condition. The Service specifically stated that

the revenue ruling contemplates that the taxpayer acquire the property in a clean condition, contaminate the property in the course of its everyday business operations, and incur costs to restore the property to its condition at the time the taxpayer originally acquired the property.²⁹

On January 25, 1996, the IRS issued TAM 96-27-002, which reversed TAM 95-41-005 and allowed for the current deduction of consulting and legal fees incurred in anticipation of actual remediation. The Service has conceded that the earlier ruling was made largely because of a perceived absence of proof regarding the amount and purpose for which the taxpayer sought a current deduction.³⁰ The disallowance in TAM 95-41-005 turned on the fact that in the Service's opinion the taxpayer failed to carry its burden of proof for the costs involved and, as is well known, income tax deductions are a matter of legislative grace with the onus for establishing deductibility falling squarely on the taxpayer's shoulders.³¹

In contrast to its previous position, the IRS has now concluded that the consulting and legal expenses did not add value or create an asset producing long-term benefits. Therefore, according to the IRS, these expenses should be deductible under Code § 162³² as ordinary and necessary business expenses. Moreover, a simple interim break in the ownership of property should not disallow the taxpayer from invoking the provisions of § 162. In other words, this most recent TAM indicates that the IRS may be willing to broaden the category of remedial and related activities that are considered ordinary and necessary business expenses, i.e., currently deductible expenses.

Capitalization of Remediation Equipment

As discussed previously, applicable regulations provide that capital expenditures include amounts paid or incurred: (1) to add to the value, or substantially prolong the useful life, of property, such as plant or equipment, owned by the taxpayer; or (2) to adapt property to a new or different use.³³ Capital expenditures include the cost of acquiring, constructing, or erecting buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.³⁴

Thus, the IRS has generally treated investment in remedial equipment or facilities as capital expenditures. While installation of, for example, a wastewater treatment facility that can be used in day-to-day operations might meet the above criteria for capitalization, in light of the current trend in tax treatment the IRS needs to reevaluate its treatment of facilities used only for remediation purposes.

For example, in the situation addressed by TAM 93-15-004, the IRS required capitalization for expenditures made for the installation of monitoring wells. As a practical matter, however, if the remediation itself does not increase the value of the property, installation of a monitoring well, air stripping device, or any other "fixture or equipment" that can only be used in furtherance of remediation will neither: (1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer; nor (2) adapt property to a new or different use.

In short, the IRS should reevaluate what appears to be its position on expenditures made on equipment that will be used in remediation, as opposed to equipment that can be used in operations. Only the latter adds value to the business and should be capitalized. Thus, the authors of this Article take the position that expenditures made for equipment dedicated to remediation should be deductible in the current year.

Tax Treatment of Multiparty Hazardous-Waste Sites

Environmental costs incurred at multiparty sites can often be distinguished from the environmental expenditures discussed above for two reasons: (1) potentially responsible parties (PRPs) at multiparty sites may not own the contaminated property; and (2) cleanup will often be financed by multiparty contributions to a fund. As a practical matter, the IRS has allowed payments by PRPs to be deducted as ordinary costs of business. Generally, two types of funds have emerged as industry standards for making these payments—the environmental remediation trust and the qualified settlement fund.

The IRS has recently issued a final rule specifically recognizing environmental remediation trusts, in which a portion of the trust is owned by the grantor, as distinct legal entities.³⁵ Under this rule, an environmental remediation trust is classified as a grantor trust even though it may differ significantly from the traditional trust in which trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.

An environmental remediation trust is classified as a trust because its primary purpose is environmental remediation of a waste site and not the carrying on of a profit-making business. If the remedial purpose is altered or becomes so obscured by business or investment activities that the declared remedial purpose is no longer controlling, the organization will no longer be classified as a trust.³⁶

In the context of a grantor trust, the PRP, as opposed to the trust, is the taxable entity, i.e., each contributor to the trust is treated as the owner of the portion of the trust that it contributes. Contributions to an environmental remediation trust are deducted as they are spent, as opposed to when [27 ELR 10170] the PRP makes the contribution to the trust. Moreover, the grantor, as owner of its portion of the trust, is taxed at its individual rate for any income generated by that portion of the trust, rather than at the maximum corporate rate, which would apply to a qualified settlement fund.

According to the IRS, a trust is an environmental remediation trust if

[(1)] the primary purpose of the trust is collecting and disbursing amounts for environmental remediation of an existing waste site to resolve, satisfy, mitigate, address, or prevent the liability or potential liability of persons imposed by federal, state, or local environmental laws; [(2)] all contributors to the trust have…potential liability or a reasonable expectation of liability under federal, state, or local environmental laws for environmental remediation of the waste site; and [(3)] the trust is not a qualified settlement fund within the meaning of [26 C.F.R.] § 1.468B-1(a)….³⁷

The Service has indicated that "environmental remediation" includes: (1) the costs of assessing environmental conditions; (2) remediating environmental contamination; (3) monitoring remedial activities and the release of substances; (4) preventing future releases of substances; and (5) collecting amounts from persons liable or potentially liable for the costs of these activities.³⁸

A significant consideration for many smaller entities is the IRS' recognition of the "cash-out grantor." Thus, the IRS rule provides flexibility for participants that contribute a fixed amount to the trust and are, as a result, relieved from making further contributions—even though the participant may remain potentially liable. Generally, the IRS has provided that all amounts contributed to the trust by a cash-out grantor are considered contributed for remediation, i.e., are deductible.³⁹ Moreover, the trust agreement may direct the trustee to expend amounts contributed by a cash-out grantor before expending amounts contributed by other grantors.⁴⁰ Finally, a cash-out grantor will cease to be treated as an owner of a portion of the trust when the grantor's portion is treated as fully expended.⁴¹

Many PRP groups are choosing to use a qualified settlement fund (QSF) within the meaning of 26 C.F.R. § 1.468B-1 as opposed to an environmental remediation trust. A QSF is a fund, account, or trust that: (1) is established pursuant to an order of, or is approved by, the United States, any state or political subdivision thereof, or any agency of the foregoing and is subject to the continuing jurisdiction of that governmental authority; (2) is established to resolve or satisfy one or more claims asserting liability (a) under CERCLA,⁴² (b) arising out of a tort, breach of contract, or violation of law, or (c) designated by the Commissioner in a Revenue Ruling or Revenue Procedure; and (3) is a trust under applicable state law, or is a fund, account, or trust whose assets are otherwise segregated from other assets of the transferor.⁴³

The QSF is treated as an independent taxable entity by the IRS and is subject to tax on its modified gross income for any taxable year at a rate equal to the maximum rate in effect for that year under Code § 1(e).⁴⁴ A PRP, i.e., a contributor to the QSF trust, can deduct its contribution in full immediately as an ongoing business expense. The obvious tax advantage of a QSF trust is that a contributor can take an immediate deduction for its contribution even if the actual money used for remediation will be dispersed over a number of years.

Tax Treatment of Environmental Fines and Penalties

As a general rule, fines for failure to comply with environmental requirements cannot be deducted as a business expense pursuant to Code § 162(f).⁴⁵ Section 162(f) specifically provides that no deduction shall be allowed for any fine or "similar penalty" paid to a government for the violation of any law. Applicable regulations provide that this prohibition includes amounts

(a) paid pursuant to a conviction, guilty plea or plea of nolo contendere for a felony or misdemeanor; (b) paid as a civil penalty imposed by federal, state or local law…; (c) paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (whether civil or criminal); or (d) forfeited as collateral posted in connection with a proceeding that could result in the imposition of a fine or penalty.⁴⁶

Regardless of the general guidance provided by the regulatory language, however, there are many instances where the nature of a payment is unclear. In instances where there is a question regarding the applicability of § 162(f), an analysis of the payment must be made to determine if it is more akin to a fine or penalty, or if it can be categorized as remedial, compensatory or a traditional business expense.⁴⁷

Courts have generally held that a civil penalty is similar to a fine when it is imposed to enforce the law or to punish its violation.⁴⁸ Where a civil penalty is designed to encourage compliance with the law or to compensate others for expenses connected with the violation, the penalty is not similar to a fine.⁴⁹ Where a statute has more than one purpose, the court will look to the particular purpose furthered by the payment in question.⁵⁰

[27 ELR 10171]

This analysis is especially salient in the environmental arena where more and more settlements dictate payment to a fund or environmental group, or even direct remedial action in lieu of penalties. A PRP can often opt to perform a supplemental environmental project (SEP) to offset a penalty or fine. Generally, the cost of the project is considered not to be a "fine or similar penalty" under § 162(f), but to be remedial in nature. As a result, SEPs are generally, but not always, treated the same as other environmental expenditures that can either be deducted or capitalized depending on the specific nature of the project.⁵¹

Conclusion

Before dedicating funds to environmental studies, attorneys fees, settlement, or remediation, a PRP or property owner should try to determine: (1) whether or not the expenditure, as structured, is a "fine or similar penalty" which is not deductible for tax purposes pursuant to § 162(f) of the Code; (2) whether or not the expenditure can otherwise be deducted as an ordinary and necessary business expense, or if it is a capital expenditure that must be recovered through depreciation deductions over the useful lifetime of the asset; and (3) what type of organization or fund, if any, is best suited to distribute monies. Only by making these determinations can a taxpayer ascertain the actual cost of any proposed environmental action.

1. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Rev. Rul. 94-38, 1994-1 C.B. 35, 35-36.

2. E.g., Rev. Rul. 94-38, supra note 1, at 36 (quoting Welch v. Helvering, 290 U.S. 111, 114 (1933), and Deputy v. du Pont, 308 U.S. 488, 496 (1940)).

3. E.g., Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1 (1979); Tech. Adv. Mem. 93-15-004 (Dec. 17, 1992).

4. See Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8.

5. 26 U.S.C. § 162.

6. Deputy v. du Pont, 308 U.S. 488 (1940); Peter Gray & Jeffrey Merrifield, Tax Treatment of Environmental Costs, 9 Toxics L. Rep. (BNA) 611, 612 (Nov. 2, 1994).

7. Welch v. Helvering, 290 U.S. 111 (1933).

8. See H.G. Fenton Material Co. v. Commissioner, 74 T.C. 584 (1980).

9. 26 C.F.R. § 1.162-4 (1996); see also Mark Silverman et al., IRS Remediates Environmental Cost Deduction Mess, TAX EXECUTIVE, Jan./Feb. 1996.

10. 26 U.S.C. § 263.

11. Id. § 263(a)(1).

12. Id. § 263(a)(2).

13. 26 C.F.R. § 1.263(a)-1(b) (1996).

14. Id. § 1.263(a)-2(a).

15. See generally, e.g., Howard Shanker & Laurent Hourcle, Prospective Purchaser Agreements, 25 ELR 10035 (Jan. 1995).

16. The National Office of the IRS releases TAMs weekly. TAMs resemble letter rulings in that they give the IRS' determination of an issue. Letter rulings, however, are responses to requests by taxpayers, whereas TAMs are issued by the National Office in response to questions raised by IRS field personnel during audits. TAMs, like letter rulings, may not be cited as precedents by taxpayers. 26 U.S.C. § 6110(j)(3). They do, however, explain the IRS' position on various issues. Revenue Rulings, which do have precedential value, are applicable to all taxpayers. Indeed, letter rulings or TAMs may later lead to the issuance of a Revenue Ruling.

17. According to the IRS, whether or not the taxpayer was aware that its method of disposal would require a future cleanup was not relevant. Specifically, the IRS provided that "the proper characterization of the cleanup operations as deductible repair expenses or capital expenditures depends on an analysis of the work being performed, and not on whether taxpayer was aware of the future consequences of its disposal practices." Tech. Adv. Mem. 93-15-004 (Dec. 17, 1992).

18. Id. (citing United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968)); Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir. 1959).

19. Tech. Adv. Mem. 93-15-004.

20. 503 U.S. 79, 84 (1992).

21. A current deduction for repair expenses undertaken as part of a program of improvement that is significant compared to the taxpayer's overall operations is generally not allowed. Tech. Adv. Mem. 92-40-004 (citing Mountain Fuel Supply Co. v. United States, 449 F.2d 816, 822 (10th Cir. 1971), and Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1 (1979)).

22. Section 168(e)(2)(B) of the Code defines "nonresidential real property." 26 U.S.C. § 168(e)(2)(B). Rev. Proc. 87-56 provides the class lives (useful life) of property necessary to compute depreciation allowances under § 168. Rev. Proc. 87-56, 1987-2 C.B. 674.

23. 1994-1 C.B. 35.

24. Rev. Rul. 94-38 (citing Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8).

25. 39 T.C. 333, 338 (1962).

26. U.S. DEP'T OF THE TREASURY, THE DEPARTMENT OF THE TREASURY GENERAL EXPLANATION OF THE ADMINISTRATION'S REVENUE PROPOSALS (1996).

27. See, e.g., Shanker & Hourcle, supra note 15.

28. 42 U.S.C. §§ 9601(14), 9602, ELR STAT. CERCLA §§ 101(14), 102.

29. Tech. Adv. Mem. 95-41-005 (Sept. 27, 1995).

30. Tech. Adv. Mem. 96-27-002 (Jan. 25, 1996).

31. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).

32. 26 U.S.C. § 162.

33. 26 C.F.R. § 1.263(a)-1(b) (1996).

34. Id. § 1.263(a)-2(a).

35. Environmental Settlement Funds, 61 Fed. Reg. 19189, 19191 (May 1, 1996).

36. Id.

37. Id.

38. Id.

39. Id.

40. Id.

41. Id.

42. See also 26 C.F.R. § 1.468B-1(f)(2) (defining CERCLA liability for provision of services or property).

43. Id. § 1.468B-1(a) & (c).

44. Id. § 1.468B-2(a).

45. Indeed, 2 of the 8 examples relied on by the IRS to explain § 162(f) discuss federal and state environmentally based penalties, respectively. Treas. Reg. § 1.162-21(c) (1986); see also Evan Slavitt, An Overview of the Tax Implications of Environmental Litigation, 20 ELR 10547 (Dec. 1990).

46. Treas. Reg. § 1.162-21(b). "The amount of a fine or penalty does not include legal fees and related expenses paid or incurred in the defense of a prosecution or civil action arising from a violation of the law imposing the fine or civil penalty, nor court costs." Id.

47. See Slavitt, supra note 45.

48. E.g., Southern Pacific Transp. Co. v. Commissioner, 75 T.C. 496, 643 (1980); Colt Indus., Inc. v. United States, 11 Cl. Ct. 140, 144, 17 ELR 20962, 20964 (1986), aff'd, 880 F.2d 1311, 19 ELR 21450 (Fed. Cir. 1989).

49. See supra note 48.

50. Id.; see also ENVIRONMENTAL LAW PRACTICE GUIDE: STATE AND FEDERAL LAW (Michael B. Gerrard ed., 1995).

51. Cf. Allied-Signal Inc. v. Commissioner, No. 94-7336, 25 ELR 21182 (3d Cir. Feb. 23, 1995) (court-ordered payment to environmental trust in lieu of payment to government was a nondeductible fine or penalty).