Environmental Remediation Costs Ineligible for Claim-of-Right Treatment

The IRS recently ruled that the current costs of remediating environmental contamination occurring in prior tax years do not qualify for Sec. 1341 treatment.

Situation 1: N manufactures products that it sells to wholesalers and retailers. Its manufacturing process creates hazardous waste. N uses an accrual method and a calendar tax year. From the inception of its business in 1950, and until 1979, N buried hazardous waste on its land in accordance with then-applicable state, Federal and local environmental laws; it accounted for waste disposal costs as a deducible business expense under Sec. 162. In 2004, to comply with current environmental laws, N incurs expenses for all necessary services to eliminate soil and water contamination caused by the buried waste, transport the waste to a disposal facility that complies with current environmental laws and restore the land.

Situation 2: The facts are the same as in Situation 1, except that N accounted for waste disposal costs as a production cost in calculating its inventory costs for all years.

Law and Analysis

Sec. 1341 applies if: (1) the taxpayer included an item in gross income for a prior tax year(s) because it appeared that the taxpayer had an unrestricted right to the item, (2) after the close of the tax year(s) of inclusion, it is established that the taxpayer did not have an unrestricted right to the item or to a portion of the item and (3) the deduction exceeds $3,000.

Sec. 1341 ensures that the taxpayers position is not worse than it would have been had the taxpayer not included the item in gross income in the earlier year (except for the time value of money). If Sec. 1341 applies, the tax for the tax year is the lesser of the tax computed (1) with the current deduction or (2) without the deduction, less the decrease in tax for the prior tax year(s) that would have occurred had the item been excluded from gross income. The repayment must arise out of the same circumstances, terms and conditions as the original payment of the item to the taxpayer (Griffiths, 54 Fed. Cl. 198 (2002)). The fact that the repayment amount bears no relationship to the amount included in income indicates that the repayment does not arise from the same or specific circumstances, terms and conditions as the original transaction (Bailey, 756 F2d 44 (6th Cir. 1985); Uhlenbrock, 67 TC 818 (1977)).

In both Situations 1 and 2, the environmental remediation costs N incurs in 2004 do not qualify for treatment under Sec. 1341(a). N did not include an item in gross income that it is repaying or restoring in a later year. In these situations, the item of gross income for Sec. 1341(a) purposes is the proceeds received from Ns product sales from 1950 to 1979; see Rev. Rul. 72-28. During those years, N had an unrestricted right to the product sales proceeds. However, in 2004, that remains unrestricted. Ns payment of the environmental remediation costs does not restore in a later tax year any portion of the proceeds received from the original sale of Ns products from 1950 through 1979. Moreover, Ns obligation to incur the environmental remediation costs does not arise from the same or specific circumstances, terms or conditions as the original sales in those years. The amount of Ns environmental remediation costs bears no relation to the amount of sales proceeds received in 1950 to 1979. Thus, Ns payment of environmental remediation costs in 2004 is not a repayment or restoration of an item included in gross income, and the costs do not satisfy the Sec. 1341(a)(2) repayment or restoration requirement.

Deductibility

Sec. 1341 provides no right to a deduction; instead, the deduction must be allowable under another Code provision. Environmental remediation costs in-curred by reason of a production activity must be included in inventory costs; see Rev. Rul. 2004-18 (clarifying Rev. Rul. 94-38) and Regs. Sec. 1.263A-1(e)(3). Inventory costs under Sec. 263A are recovered through cost of goods sold (COGS) when the inventory is sold. COGS, or inventory costs, are not deductions, but adjustments to gross income. Thus, under Sec. 263A, Ns environmental remediation costs are inventory costs, not deductions. Further, in Situation 2, the costs are properly treated as inventory costs when incurred in 2004, because Ns 2004 environmental remediation costs would have been accounted for as inventory costs from 1950 to 1979 under Ns accounting method in those earlier years. Thus, Ns environmental remediation costs do not qualify for Sec. 1341 treatment, because they are not deductions.

Even if Ns environmental remediation costs were deductible expenses, rather than inventory costs recovered through COGS, Sec. 1341(a) would not apply to any deduction allowable for (1) an item included in gross income by reason of the sale or other disposition of the taxpayers stock in trade (or other property of a kind that would have been included in the taxpayers inventory if on hand at the close of the prior tax year) or (2) property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Ns environmental remediation costs are a consequence of the manufacture and sale of Ns products and, if not an inventory cost, would be de-ductible as an ordinary and necessary business expense of selling Ns products. Thus, in both Situations 1 and 2, the environmental remediation costs are ineligible for Sec. 1341(a) treatment.

Rev. Rul. 2004-17, IRB 2004-17, 7

Reflections: In Rev. Rul. 2004-18, the IRS clarified that environmental cleanup costs are subject to the uniform capitalization rules, even if otherwise deductible as a business expense under Sec. 162. Thus, the expenses should be included in inventory costs when allocable to inventory manufacturing. However, under a transition rule, the IRS will not challenge the treatment of such costs as deductible business expenses, rather than inventory costs, in tax years ending before Feb. 7, 2004.