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Industry Director Directive on IRC Section 172(f) Specified Liability Losses - Attachment 5

Issue Name
Remediation of environmental contamination

Introduction:

Section 172(f) provides special rules for the portion of an NOL that is identified as a specified liability loss (SLL) and as such is allowed a ten year carry back as opposed to the two years generally allowed for NOL’s. Section 172(f) was amended in 1998 to restrict the types of expenses that qualify as SLLs and therefore now only applies to a narrow set of liabilities.

IRC §172(f)(1) now requires that an amount be "in satisfaction of a liability under a Federal or State law requiring—(I) the reclamation of land, (II) the decommissioning of a nuclear power plant (or any unit thereof), (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers compensation act (within the meaning of §461(h)(2)(C)(i)).

All individuals and businesses living or operating within the United States, its commonwealths, possessions and boundaries are subject to US Environmental Laws and Regulations as administered by the US Environmental Protection Agency (EPA). In addition individual state agencies may be charged with the administration and enforcement of both federal and state environmental laws and regulations.   States may under their own discretion put in place laws or regulations that exceed such federal standards.  Environmental statutes regulate the necessity; level and timing of the remediation (clean up) of environmental contamination.

▲ Caution!

The US and State environmental statutes have provisions covering a wide range of environmental laws and regulations, including but not limited to current compliance requirements,  enforcement and remediation.  The environmental statues further provide for criminal and civil cash penalties for failure to comply with its related provisions.  Additionally under environmental enforcement provisions the EPA and environmental State agencies have the unique ability to mitigate (without litigation) some cash penalty in exchange for the violator to voluntarily incur costs for a supplemental (beneficial) environmental project (SEP).  Current compliance requirements, capital projects, SEPs and penalties are not qualified environmental remediation expenses therefore such costs are not eligible as a specified liability loss under IRC §172(f)(i)(B)(IV).
 
It should be noted regarding manufacturers or producers that the issuance of Revenue Ruling 2004-18, which clarifies Revenue Ruling 94-38, and the issuance of Ruling 2005-42 which confirms Rev. Rul. 2004-18, makes it clear that remediation expenses incurred for tax years ending after February 6, 2004 require such costs to be allocated to ending inventory under IRC §263A.  Revenue Rulings 2004-18 and 2005-42 make clear that certain manufacturer’s remediation costs are not deductible and thus, are not specified liability losses under IRC §172(f).

IRC §172(f)(1)(b)(ii)(I) requires the act or failure to act to have occurred at least three years prior to the beginning of the taxable year in which the remediation  liability is claimed.  The triggering event for this three year rule is the actual environmental contamination up to three years prior to the beginning of the taxable year in which the remediation deduction is claimed. 

Remediation costs eligible for IRC §172(f) treatment may include the following:

  • Environmental site investigatory costs:
    • Preparation of Investigation report
    • Preparation of response action plan
  • Preparation of site for cleanup
  • EPA or state agency reimbursements for either investigatory or remediation costs incurred by the EPA on behalf of site.
  • Excavation and disposal of regulated substance found at the site.
  • Containment or encapsulation costs not subject to capitalization under IRC §263(a)
  • Excavating, stockpiling, or transporting to a waste facility of contaminated soil
  • Replacement or backfilling of soil
  • Treatment of contaminated soil as necessary
  • Treatment of contaminated water as necessary
  • Future monitoring costs to assure success.

Remediation costs under IRC §172(f) does not include the following:

  • Remediation costs for contamination that occurred less then three years before the beginning of the taxable year.
  • Any and all remediation costs subject to the IRC §263A capitalization requirements as covered by Revenue Rulings 2004-18 and 2005-42, Impacts tax years ending  after February 6, 2004.
  • Current compliance costs
  • Remediation costs on assets acquired with pre-existing contamination
  • EPA or state agency fines or penalties
  • Any voluntary environmental projects including supplemental (beneficial) environmental projects (SEP’s), even if incurred on or adjacent to contaminated site.
  • Any legal costs not specifically incurred in determination of the amount of remediation liability, examples of non-allowed legal costs:
    • Legal costs incurred to negotiate EPA consent decrees
    • Legal costs incurred to defend against civil or criminal charges for violation of environmental laws or regulations
    • Legal Costs incurred to defend against third party liability claims
  • Any capital expenditure subject to IRC §263(a) , including construction of ground water treatment facilities, wells, pipes, pumps or other equipment put in place to monitor or treat the soil or water.  

Remediation of environmental contamination
Audit Steps

  • Examiners should request;
    • A detailed break down of remediation costs and activities that the taxpayer has claimed as specified liability losses.
    • A complete copy of any and all notices of environmental violations issued by federal or state environmental agencies.
    • A complete copy of any consent or similar agreements entered into by federal or state environmental agencies.
    • Notice of lawsuits or litigation regarding third party claims surrounding environmental contamination.
    • Complete copies of insurance reimbursement claims submitted by taxpayer surrounding environmental contamination.
    • Complete insurance settlement agreements regarding environmental contamination.
    • Examiners should also request the taxpayer’s site investigation report and remediation action plan.
  • Examiner Review Steps
    • Reconcile the claimed costs and activities to those listed in the remediation plan.
    • Identify any potential non qualifying operating and capital costs.
    • Look for insurance reimbursements on claimed SLL expenses. 
    • Examiners should review any claims for depreciation as a qualified specified liability loss and ensure that the depreciation is related to capital assets used in satisfying a liability as opposed to a deduction claimed with respect to the liability giving rise to depreciable basis of a depreciable asset.

There are some potential issues regarding environmental remediation SLL’s that examiners need to be aware of and include the following:

  • Issue 1: Qualified remediation versus current operating or capital expenditures.
  • Issue 2: Contamination of site within 3 years of the taxable year
  • Issue 3: Insurance reimbursement
  • Issue 4: When Depreciation may qualify as an SLL.

Issue 1: Qualified remediation versus current operating or capital expenditures

Examiners should be aware that taxpayer claims for remediation deductions as a qualified specified liability loss subject to IRC §172(f) may include non qualified expenditures for current operating and capital costs. 

Current operating costs to maintain compliance with  Federal or State environmental  laws may be remediation expenses but do not meet the 3 year rule pursuant to IRC §172(f)(1)(B)(ii)(I).  For example, costs of normal monitoring and testing of facility as required by the EPA for current pollution output would not qualify as IRC §172(f) remediation expense.  However monitoring costs related to environmental contamination eligible under the three year rule will qualify.  Similarly, costs of maintaining permit compliance such as obtaining or purchasing of emission credits are not qualified remediation.

Taxpayer claims for remediation deductions may also include nonqualified capital costs.  For example, current pollution operating permits may require the construction of monitoring wells or slurry containment walls. The construction of these assets are capital costs subject to IRC §263(a) and as such are not currently deductible nor subject to IRC §172(f). 

Taxpayer claims for remediation may also include costs to remediate assets that were acquired with pre-existing contamination.  Clean up costs of such preexisting contamination are required to be capitalized to land, United Dairy Farmers, and therefore do not qualify as IRC §172(f).

Reference – Revenue Ruling 94-38 and addendums Rev. Rulings 2004-18 and 2005-42
Reference – United Dairy Farmers, Inc. United States, 107 F. Supp. 2d 937 (S.D.Ohio 2000)  aff’d, 267 F.3d 510 (6th Cir. 2001).

Issue 2: Remediation of site contaminated within 3 years of the taxable year

For purposes of the 10 year carry back, a liability shall be taken into account only if —

  1. The act (or failure to act) giving rise to such liability occurs at least 3 years before the beginning of the taxable year, IRC §172(f)(1)(B)(ii)(I), and
  2. The taxpayer used an accrual method of accounting throughout the period or periods during which such act (or failure to act) occurred, IRC §172(f)(1)(B)(ii)(II).

Pollution and contamination can be the result of many years of production at such site and may be continuing at a site while remediation efforts are occurring. As a result some remediation costs are for contamination that occurred less then 3 years before the beginning of the taxable year.

In many instances, EPA site evaluations as well as remediation plans will clearly identify costs needed to remediate contamination at least 3 years old.  Specific identification of contaminants can at times be readily identified in site reports. Other times although rare contamination more then 3 years old or less then three years can be commingled making it difficult to determine costs associated with remediation for contamination greater then three years old.   Although the taxpayer has the burden to verify or break out costs eligible for Section 172(f) examiners should evaluated all facts and ascertain reasonableness to any allocation of such costs.

To qualify as a specified liability loss subject to the 10 year carry back, any qualified remediation expense must address a contamination liability that occurred at least 3 years prior to the beginning of the taxable period in which the costs were incurred. 

Issue 3:  Treatment of insurance reimbursements for remediation expenses.

Examiners should be aware that taxpayer claims for remediation deductions as a qualified specified liability loss subject to IRC §172(f) may include expenses for which it has or will be reimbursed.  Insurance reimbursement surrounding environmental contamination can be received from either a property and casualty, or a Commercial General Liability policy.  Care should be taken as to treatment of both the reporting of such reimbursement as well as the netting of insurance claims against claimed Section 172(f) expenses.

(See examples below)

  • Taxpayer treated the insurance reimbursements on a cash basis and reported them in income in the year of receipt, irrespective of the period during which the related IRC §172(f) expenditures that the insurance served to reimburse were deducted.  To the extent that the insurance reimbursements were determinable in the year of the related expenditures, this overstated the IRC §172(f) ten year carryback.  
  • One taxpayer claimed that its insurance reimbursements were not taxable but rather constituted receipts from involuntary conversions under section 1033.  In this scenario, the taxpayer deducted all the expenditures, but did not report the related insurance reimbursement.  See TAM 200322017(Technical Advice Memorandum (TAM) 200322017 (Feb. 13, 2003), discusses the applicable law surrounding the treatment of insurance settlement payments and the nonapplicability of IRC §1033..  Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.  See, e.g., IRM 4.43.1.4.18.1(3).)  Although not related to an IRC §172(f) claim, this treatment also illustrates an erroneous tax treatment of insurance proceeds. 
  • Another taxpayer had received an insurance settlement based on environmental claims filed with its insurer.  The settlement was recorded in the books as goodwill and no adjustment was made to include the settlement in taxable income or reduce the related expense before carryback.  The taxpayer maintained that the insurance settlement was recovery of basis and, therefore, not taxable. 

Issue 4:  When Depreciation may qualify as an SLL

While liabilities arising under federal or state law may constitute a portion of the depreciable basis of an asset, depreciation deductions arising from the liability giving rise to the depreciable basis of a depreciable asset are not included as part of the specified liability loss solely because the source of that portion of the basis arises from a federal or state liability.

Depreciation deductions may be allowable with respect to liabilities (including remediation) satisfied through the use of the depreciable asset.  For example, depreciation on a bulldozer used to remove contaminated soil may be included as part of the specified liability loss.

Liabilities arising under federal or state law may be treated as part of the cost basis of property if the liabilities are properly chargeable to a capital account.  For example, IRC §164(a) requires sales taxes imposed on the purchase of equipment used in a taxpayer’s trade or business to be capitalized into the cost basis of the equipment. If an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3 years before the beginning of that taxable year, some taxpayers have asserted that any portion of the NOL generated by depreciation deductions for the portion of the property’s depreciable basis attributable to the capitalized sales tax constitutes a pre-1998 IRC §172(f)(1)(B) specified liability loss irrespective of how the property is used.  Likewise, taxpayers may be required to place certain equipment into service to comply with requirements of federal or state law, for example, clean water standards.  Some of these taxpayers have asserted that if the equipment was acquired by the taxpayer at least 3 years prior to the beginning of the taxable year, the portion of any NOL generated for the taxable year by depreciation deductions attributable to the equipment qualifies as a former IRC §172(f)(1)(B) specified liability loss.  The Service disagrees with both of these assertions.

IRC §167(a) allows a depreciation deduction only for property that is either used in a trade or business or held for the production of income.  Whether a depreciation deduction is allowable “with respect to” a liability depends upon the property’s actual use.  For example, if a taxpayer uses equipment to satisfy an environmental cleanup liability imposed by federal law, the portion of the equipment’s depreciation allocable to satisfying the environmental cleanup liability is allowable with respect to the environmental cleanup liability.  If the environmental cleanup liability arose as a result of a chemical spill that occurred at least 3 years before the beginning of the taxable year and the environmental cleanup liability is otherwise deductible, the depreciation deductions may generate a specified liability loss.  However, if a taxpayer uses equipment to satisfy environmental cleanup liabilities that arise during the same taxable year the depreciation deductions are allowable, for example, by preventing the discharge of pollutants resulting from manufacturing activities during the current taxable year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy the 3-year act or failure to act requirement of former IRC §172(f)(1)(B)(i), irrespective of when the taxpayer placed the cleanup equipment in service.

Reference: IRS Notice 2005-20

Page Last Reviewed or Updated: 11-Feb-2014