IRS Weighs Tax Treatment of Toxic Cleanup

HOUSE and Senate conference committee members are now hashing out changes in many areas of the tax code, from the amortization of intangibles to the deduction for investment in Puerto Rico.

Looming just over the horizon is an issue that dwarfs almost all others in its potential impact on the federal budget and on American business: the tax deductibility of environmental cleanup costs.

As the Environmental Protection Agency, the Occupational Safety and Health Administration, and numerous other state and federal agencies issue more and more regulations, virtually every sector of American business will have to spend large sums of money to clean up messes and prevent environmental problems in the future. The government estimates that cleanup costs over the next 30 years will be in the $500 billion to $1 trillion range.

Until recently, companies routinely deducted the costs of cleanups as "necessary and ordinary" business expenses in the year when they were incurred. But last year the Internal Revenue Services issued two blockbuster advisories that call into question the immediate deductibility of most cleanup costs.

One ruling held that a manufacturing company could not deduct the cost of removing asbestos from a building and replacing it with different insulation. Another held that an oil pipeline company could not immediately deduct its costs for cleaning up soil contaminated by polychlorinated byphynel, a fire retardant used in the pipeline system.

In both cases, the IRS said that the environmental cleanup improved the value of the property, and hence should be "capitalized" - that is, the deduction should be spread out over the life of the property, not taken immediately. That raises cleanup costs considerably. "The effect on business is going to be enormous," says Diane Herndon, a partner in the Washington office of the accounting firm Ernst and Young. "Already the IRS has raised this issue with a lot of taxpayers."

The Big Six accounting firms have formed coalitions of clients opposed to the rulings. These coalitions have inundated the IRS and the Treasury Department with technical briefs arguing that the memoranda should be overturned. The coalitions' representatives - invariably ex-IRS employees like Ms. Herndon - have met with IRS and Treasury officials to press their case.

The companies essentially argue that the cleanups are "repairs," returning a property to its original condition, and should thereby be deducted at once, not capitalized. The IRS, on the other hand, contends that the cleanups are not "repairs" but "capital improvements."

The outpouring of protest has caused the IRS and Treasury to take a second look at the issue. Two study groups are considering issuing a "revenue ruling" in the fall to clarify the whole question. "We're pushing the pedal to the medal on this issue," says Robert Kilinskis, an accountant in Treasury's Office of Tax Policy. No matter what ruling is issued, accountants say it will dissatisfy many large corporations. They will then take their case to the courts or Congress - or both.

On Capitol Hill, staff members at the Joint Taxation Committee have been studying the question. One staff member indicates that there has been more interest in eliminating the deduction than writing it into law.

Concerns of environmentalists are sure to be a major factor should Congress decide to tackle the issue. Although companies argue the deduction is eco-friendly because it encourages businesses to clean up, Rick Hind, legislative director of the Greenpeace Toxics Campaign, counters that "deductions subsidize polluters."

Another major factor in Congress will be how analysts view the deduction's impact on the federal budget. If companies have been deducting cleanup costs all along, writing the deduction into law would, theoretically, cost nothing. But if the deduction should never have been allowed, it could be seen as costing the government billions in lost revenues. "If it's a zero-revenue estimate who can argue against it?" says Glenn Mackles, a principal at Deloitte & Touche in Washington. "But if there's a huge reven ue estimate, Congress will say we can't afford it."