Deducting Environmental Cleanup Costs

BY CHARLES J. REICHERT

TAX CASE

Environmental remediation costs can be deductible trade or business expenses under IRC section 162. However, under IRC section 263, businesses must capitalize expenditures that increase a property’s value or its useful life or adapt it to a different use. The tax treatment of specific remediation costs is determined by the facts and circumstances of the situation.

In 1989 United Dairy Farmers, Inc., purchased two stores with soil contaminated by leakage from underground gasoline storage tanks. While neither seller operated gas stations, United Dairy was aware of the leakage at each property’s closing date. The company spent $259,980 cleaning the soil and deducted the amount on its 1993 corporate tax return. The IRS argued the amounts represented capital expenditures under section 263. In 2000 the Southern District Court of Ohio agreed with the IRS. In 2001 United Dairy appealed the decision to the Sixth Circuit Court of Appeals.

Result. For the IRS. United Dairy, citing Plainfield-Union v. Commissioner, 39 TC 333 and revenue ruling 94-38, argued the expenditures were deductible under section 162 because the remediation only restored the value to the property that existed before the soil contamination. In Plainfield-Union the court had allowed a current deduction for the taxpayer’s costs to restore water mains to their condition before the addition of acidic water impaired the water flow. In revenue ruling 94-38, a company was allowed to deduct cleanup costs for groundwater contamination due to hazardous waste discharge that had been part of its manufacturing process over a number of years. Both rulings had applied a test that compared the property’s status after the remediating expenditure to its status before the condition that caused the expenditure. United Dairy argued it should be allowed a current deduction for its $259,980 expenditure since it restored the property to the same condition before the gasoline leakage—the event that had caused the expenditure.

The Sixth Circuit disagreed. It refused to extend the reasoning of these rulings to taxpayers that purchased contaminated property. Such an extension, according to the court, was inconsistent with Dominion Resources, Inc., 2000-2 USTC 50,633. In the Sixth Circuit’s opinion, Dominion and the two cases it relied on, Jones v. Commissioner, 57-1 USTC 9517, and Jones v. United States, 68-1 USTC 9192, established the principle that “when a taxpayer improves property defects that were present when the taxpayer acquired the property, the remediation of those defects are capital in nature.”

The Sixth Circuit enumerated a three-pronged test taxpayers must satisfy to currently deduct environmental cleanup costs:

The taxpayer contaminated the property by its business operations.

The taxpayer returned the property to its previous clean condition.

The cleanup did not permit the taxpayer to use the property in a new way.

The court concluded that since United Dairy did not satisfy the first test, it must capitalize its cleanup costs.

IRC section 198, which allows taxpayers to elect to currently deduct certain environmental cleanup costs, has eliminated some of the uncertainty surrounding this issue. If the taxpayer does not make this election, it must follow the Sixth Circuit’s three-pronged test.

United Dairy Farmers, Inc. v. United States, 2001-2 USTC 50,680.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

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