The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 3, October 2000, Panel Publishers, New York, NY.


By Robert W. Wood

Occasionally we at The M&A Tax Report have covered the question of environmental costs including asbestos removal and various other types of environmental remediation expenses. We all know what businesses developers, and just about everybody else, will want to do with such expenses: deduct them! They are usually large expenses, given the special safety considerations that go into remediation. (After all, those moon suits must be uncomfortable!) A couple of recent pieces of authority, one case, and one Field Service Advice suggest that there is still substantial concern about these expenses.

The case involved United Dairy Farmers, Inc et al v. United States, No. C-1-97-1043 (Southern District of Ohio May 23, 2000), Tax Analysts Doc. No. 2000-17988, 2000 TNT 128-41, in which the U.S. District court held that a corporation could not deduct environmental remediation costs, abandonment losses, and accounting fees. The court held that they should have been capitalized. United Dairy Farmers (the "Company"), was as S corporation that purchased sixty 7-11 convenience stores from Southland Corporation, and later one additional store. Unfortunately, it was later discovered that one of the stores had operated a retail gasoline station and had soil contamination due to leakage from underground tanks. This resulted in a number of expenses. Plus, the Company had to pay for engineering studies related to its manufacturing plant. None of these studies were used or implemented.

In the midst of all these expenses, the Company (which previously had been a C corporation), made an S election, incurring fees paid to Ernst & Young in the analysis and implementation of that election. The Company deducted the expenses for remediation of the soil and the accounting fees as ordinary and necessary business expenses. The Company also deducted the price of the studies as abandonment losses under Section 165.

The IRS issued its Notice of Final S Corporation Administrative Adjustment, and needless to say, the taxpayer disagreed. When the matter went to district court, the court had little difficulty finding that the remediation costs had to be capitalized. After all, said the court, the remediation increased the value of the newly purchased property, rather than merely restoring it. The court also found the accounting expenses were corporate reorganization expenses that must be capitalized.

As far as the costs related to the new site visibility studies were concerned, the court found these were part of an integrated plan to build a distribution center, and therefore must be capitalized. Interestingly, the court apparently did not care that none of these studies were ever used.

Asbestos Removal

To the stream of asbestos removal authority, we can add a recent Field Service Advice, No. 200035021, Tax Analysts Doc. No. 2000-2261, 2000 TNT 172-47. The IRS here concluded that the removal of asbestos to inspect or repair production plants or machinery is not deductible and therefore must be capitalized. The taxpayer involved was an electric utility which owned and routinely inspected and repaired production plants and machinery. Part of the inspection and repair frequently included asbestos insolation removal.

The Field Service Advice explains if the retirement and removal of a depreciable asset occurs in connection with the installation or production of a replacement asset, the costs incurred in removing the retired assets are not required to be capitalized as part of the cost of the replacement asset. On the other hand, if the utility does not create the asbestos as a separate depreciable asset, but instead treats it as part of the production, plant and machinery with which it is associated (and as part of the capitalized cost of those assets), then the removal for inspection or repair may not be deducted. In this case, the removal to inspect or repair was considered not deductible as a business expense and was instead subject to capitalization.


The deduct vs. capitalize dichotomy can also be present where there is an indemnity agreement — as there often is in acquisitions.

The question in Letter Ruling 9942025 was whether a corporation could deduct certain environmental cleanup costs even though those costs were subject to indemnification under an agreement to sell the corporation's stock. The indemnity agreement (and the overall stock sale agreement) were made in a prior year. The IRS nevertheless ruled that the corporation could deduct the costs. The target corporation was formed as a subsidiary to facilitate the sale of assets in a refining, marketing and transportation business. The environmental damage that saddled those assets was vast and difficult to assess, so the parties agreed to make the transfer free and clear of both present and future liabilities. The facts involve numerous later transfers of the target's stock through stock purchase agreements, as well as various other inter-corporate transactions that included transfers of liability under the initial indemnity agreement connected with the sale of the target's assets.

After a few years, the target began to incur environmental cleanup costs on some of its properties. It was fully responsible under the law regardless of whether it could seek indemnification. In fact, the target eventually brought a lawsuit against two other companies and, under a settlement agreement, the target received a lump sum payment, a specified amount to be received in three future years, and an agreement to share certain future environmental cleanup costs.

The target did not include any of the indemnity payments it received in gross income, but rather treated the most capital contributions. Its assertion was that these payments related back to the initial stock purchase, and merely reduced the basis of the target's stock. The target also deducted all environmental cleanup costs incurred during the years in question, including those for which it received indemnity payments. The company claimed that the environmental cleanup costs were paid out of capital contributions.

Environmental Remediation and Asbestos Removal: More INDOPCO Trash? (Part One), Vol. 9, No. 3, The M&A Tax Report (October 2000), p. 7.