In a surprising decision, Revenue Ruling 2004-18 has "clarified" Revenue Ruling 94-38 and Revenue Ruling 98-25 by specifying that previously deductible environmental cleanup costs must be capitalized as indirect costs of inventory in accordance with IRC section 263A. This new classification of cleanup costs will have negative consequences for taxpayers, and the decision requires greater scrutiny.
Revenue Ruling 94-38
Revenue Ruling 94-38 identifies a very specifie 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)(l) 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 9438 then cites lndopco [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 [Plainfleld 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. …