Under Sec. 263A, a taxpayer has to capitalize all direct and certain indirect costs properly allocable to the production of real or tangible personal property. In Rev. Rul. 2004-18, the taxpayer incurred costs currently for soil and groundwater remediation for contamination from hazardous waste disposal in prior years. The IRS concluded that the costs incurred for environmental cleanup were indirectly related to the taxpayers production activities and had to be capitalized into inventory under Sec. 263A.

Rev. Rul. 94-38 used to be considered the general authority on how to treat environmental remediation costs. In that ruling, the IRS determined that costs incurred to clean up contaminated land and to treat groundwater were not capitalizable, because they did not extend the propertys useful life. The taxpayer had buried hazardous waste generated by its manufacturing operations on property it owned. In a subsequent year, to comply with stricter environmental requirements, the taxpayer began remediation of the contaminated soil and groundwater. The costs incurred for the environmental cleanup were considered current deductions, not capitalizable under Sec. 263.

Rev. Rul. 2004-18 also cited Rev. Rul. 98-25 to support the conclusion that environmental cleanup costs may be deductible as ordinary and necessary business expenses. The general issue in Rev. Rul. 98-25 was the deductibility of costs to replace underground storage tanks (USTs) used to store waste generated by the taxpayers production activities. The IRS concluded that the costs of removing, cleaning, and disposing of the old USTs, and filling and on-going monitoring of the new USTs are deductible as business expenses under section 162.

The IRSs premise in Rev. Rul. 2004-18 for capitalizing the environmental cleanup costs is that both prior rulings dealt only with the capitalization of items under Sec. 263(a) and did not address the Sec. 263A inventory capitalization rules. Its basic argument was that the costs must first be determined to be deductible as ordinary and necessary business expenses. Second, it must be determined whether the costs are properly allocable to a taxpayers production activities. This is illustrated in the ruling by analogizing to repair costs incurred in the production process. The ruling states, once repair costs are determined to be deductible under 162, a taxpayer with inventories must still apply the rules of 263A to determine whether the repair costs must be included in inventory.

One question left unanswered is whether the Service would have reached a different result had the taxpayer no longer used the property in its operations, but continued to incur environmental cleanup costs. A strong argument for deducting these costs under Sec. 162 would appear to exist, because there was no longer an indirect association with the taxpayers production activities. As stated in Rev. Rul. 94-38, on the treatment of such environmental costs, [t]hese results are applicable whether the taxpayer plans to continue in its manufacturing operations that discharge the hazardous waste or to discontinue those manufacturing operations and hold the land in an idle state. Rev. Rul. 98-25 reached the same conclusion on the taxpayers continued activities.

Under a transition rule, Rev. Rul. 2004-18 allows taxpayers to treat environmental cleanup costs as deductible expenses under Sec. 162, not subject to capitalization under Sec. 263A, for tax years ending before Feb. 7, 2004. A taxpayer using a method that does not comply with Rev. Rul. 2004-18 must file for a change in accounting method, using the Rev. Proc. 2002-9 automatic change procedures for the first tax year ending after Feb. 5, 2004. The taxpayer may implement this change using Sec. 481(a) general principles or under a cut-off method.