DEDUCTIBILITY OF ENVIRONMENTAL CLEANUP COSTS

By Robert A. Solomon and Allen E.F. Rozansky
Solomon Blum Heymann & Stich LLP

In the United States, the question of whether expenses incurred in environmental cleanup were tax deductible was not clear . . . until now. The Taxpayer Relief Act of 1997 (the "Taxpayer Relief Act"), signed into law by President Clinton this past summer, provides a clear line for determining whether environmental remediation expenditures are currently deductible, at least for now.

Prior to the Taxpayer Relief Act, the determination of whether environmental cleanup costs were deductible was unclear. The general rule was that costs of environmental cleanup must be capitalized, except in certain circumstances. In Revenue Ruling 94-38, the Internal Revenue Service ("IRS") tried to clarify the matter. In this ruling, the costs of remediation of contaminated soil and groundwater were determined to be currently deductible. However, the IRS also held that the costs of constructing a groundwater treatment plant to prevent future contamination of groundwater were not currently deductible, but rather had to be capitalized by the company and deducted over the useful life of the plant. The IRS reasoned that the remediation of the soil and groundwater, unlike the new water treatment plant, merely returned the soil and groundwater to the way they were prior to contamination and did not increase the value of the property. Thus, the IRS confirmed the general rule set forth by various courts that costs of environmental cleanup must be capitalized, if such costs produce significant future benefits or increase the value of the taxpayer's property.

This rule, unfortunately, was extremely vague and applied only to the specific facts presented. It provided little guidance to practitioners as to when certain environmental cleanup costs should be currently deducted rather than capitalized.

The United States Congress, acknowledging the ambiguity left by Revenue Ruling 94-38, included a provision in the Taxpayer Relief Act adding a new Section 198 of the Internal Revenue Code. Section 198 provides a clearer line for determining the deductibility of certain environmental cleanup costs by allowing a taxpayer to elect to currently deduct "qualified environmental remediation expenditures" paid or incurred after August 5, 1997 and on or before December 31, 2000. If the taxpayer fails to make such an election, the costs will be deemed to be capital expenditures.

Section 198 defines the term "qualified environmental remediation expenditures" as those costs which would otherwise be capitalized and which are paid or incurred in connection with the abatement or control of "hazardous substances" at a "qualified contaminated site." "Hazardous substances" are those defined as such in the Comprehensive Environmental Response, Compensation, and Liability At of 1980, including, in general, toxic pollutants and hazardous chemical wastes, as well as asbestos and similar substances within buildings, certain natural substances (including radon), and other substances released into drinking water due to deterioration through ordinary use. "Qualified contaminated sites" are those areas (1) that are held by the taxpayer for use in a trade or business, for the production of income, or as a stock in trade or inventory, (2) that are within a "targeted area," and (3) at or on which there has been a release (or threat of a release) or disposal of any hazardous substance. "Targeted areas" include (1) any population census tract with a poverty rate of at least 20%, a population census tract with a population of less than 2,000 (with certain restrictions), (3) any empowerment zone or enterprise community and (4) any site announced before February 1, 1997 as being part of the brownfield pilot project of the EPA. It should be noted that sites on or proposed to be on the National Priorities List, a list of specific contaminated sites issued by the President annually, are not included in the definition of "target areas." Thus, the deductibility of expenses incurred in the cleanup of such sites will be determined by the case law in existence prior to the Taxpayer Relief Act.

If a taxpayer elects to currently deduct under Section 198 environmental cleanup costs, the amount of the deduction will be "recaptured" as ordinary income upon the sale or other disposition of the property rather than being taxed at the more favorable capital gains rates. Therefore, each cleanup situation must be analyzed by the taxpayer to ascertain the preferred result (current deduction and higher eventual tax vs. capitalizing and lower eventual tax).

As a result of Section 198, Congress has provided limited, temporary relief for taxpayers in the area of environmental cleanup costs. Unfortunately, whether this relief is expanded, or extended past the current December 31, 2000 sunset date, will probably not be determined in the immediate future.