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In the Cinergy Corp. v. US case, the Court of Federal Claims approved a taxpayer's immediate deduction under Section 162 of the costs of asbestos removal and encapsulation in an office building. The court concluded that the costs at issue were ordinary and necessary business expenses rather than capital expenditures because the remediation costs did not substantially prolong the useful life of the taxpayer's building or adapt it to a new or different use. In addition, the changes were not part of a generalized plan of rehabilitation and renovation. The court reasoned that the abatement work was necessary to maintain the taxpayer's office building in ordinary operating condition. The court distinguished the taxpayer's abatement activities from environmental remediation expenses, which typically are capitalized over time rather than deducted immediately.
CORPORATE DEDUCTIONS
The Court of Federal Claims has approved a taxpayer's immediate deduction under IRC [sec] 162 of the costs of asbestos removal and encapsulation in an office building in Cinergy Corp. v. United States [2003-1 USTC [para]50,302 (Ct Fed Cl 2003)]. The court concluded that the costs at issue were ordinary and necessary business expenses rather than capital expenditures because the remediation costs did not substantially prolong the useful life of the taxpayer's building or adapt it to a new or different use. In addition, the changes were not part of a generalized plan of rehabilitation and renovation. The court reasoned that the abatement work was necessary to maintain the taxpayer's office building in ordinary operating condition. The court distinguished the taxpayer's abatement activities from environmental remediation expenses, which typically are capitalized over time rather than deducted immediately.
Facts
In 1972, the taxpayer constructed an addition to one of its office buildings. Three levels of the addition contained fireproofing material that consisted, in part, of asbestos fibers sprayed onto the steel structure. Environmental policies and building standards at that time did not restrict the use of such material. When the fireproofing material was originally sprayed on the structure, it was stiff and essentially encased the asbestos. In the late 1980s, however, the taxpayer discovered that the asbestos material had become friable-it was flaking off and would particularly crumble if bumped or disturbed. While air concentration samples indicated that asbestos levels were significantly below what the Occupational Safety and Health Administration viewed as hazardous, the taxpayer became concerned that maintenance personnel might be exposed to the asbestos while working around the ceilings or that the circulation of air in the office space eventually would contain hazardous levels of friable asbestos. The taxpayer decided to treat the asbestos to prevent further deterioration and to eliminate any risk of exposure.
In 1989, the taxpayer hired a company to remove or encapsulate the asbestos-containing materials present in the 1972 addition. The project took about six months to complete and included: removal and disposal of the existing drop ceiling in the basement; removal and disposal of the sprayed on fireproofing material from certain areas; removal and disposal of pipe fittings encountered during the project that contained asbestos and replacement with non-asbestos fittings; and encapsulation of some of the existing fire-proofing in the basement. The contractor was paid more than $800,000 for these services. After removal of the asbestos, a new sprinkler system was installed in the basement area to compensate for the loss of the fireproofing material and to keep the building up to local fire codes. The asbestos-abatement work was not prompted by any intent to sell the building nor was it part of a broader program to refurbish the building. The work did not extend the useful life of the 1972 addition.
Taxpayer's Return Position
The taxpayer deducted the expenses incurred to remove and encapsulate the asbestos by arguing that they were ordinary and necessary business expenses that did not add to the value or the life of the building.
IRS Challenge
The IRS disallowed the deduction and claimed that the expenses were capital in nature and therefore were not deductible immediately as ordinary and necessary business expenses.
Court Analysis and Conclusion
The court concluded that Cinergy could deduct currently, under IRC [sec] 162, the cost of removing and encapsulating asbestos material in an office building because the asbestos abatement did not appreciably increase the value and original service life of the building. The expenditures only restored value to the property that existed prior to the asbestos becoming friable. Moreover, such expenditures represented only a small fraction of the overall value of the building. The purpose of the abatement work was to arrest and correct a condition of deterioration that threatened the premature end of the building's useful life. The court compared the asbestos abatement to similar types of deductible corrective work, such as repairing leaks in iron pipes, eliminating threat of subsidence caused by water pockets under railroad tracks, and adding concrete lining to walls to prevent seepage of oil.
The court noted that an immediate deduction may be claimed for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business" [IRC [sec] 162(a)]. In contrast, IRC [sec] 263 disallows deduction for a capital expenditure, which is "[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." A capital expenditure usually is amortized and depreciated over the life of the relevant asset.
In order to qualify for a deduction under IRC [sec] 162(a), "an item must: (1) be 'paid or incurred during the taxable year,' (2) be for 'carrying on any trade or business,' (3) be an 'expense,' (4) be a 'necessary' expense, and (5) be an 'ordinary' expense." The term "necessary" imposes only the minimal requirement that the expense be "'appropriate and helpful' for 'the development of the [taxpayer's] business.'" An "ordinary" expense must be related to a transaction "of common or frequent occurrence in the type of business involved."
Distinguishing repairs that may be deducted from improvements, which must be capitalized, has spawned numerous cases and IRS regulations. The court have routinely denied deductions for amounts that: (1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) adapt property to a new or different use [Reg. [sec] 1.263(a)-1(b)]. The costs of incidental repairs, however, may be deductible if they neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition [Reg. [sec] 1.162-4]. Some courts have succinctly concluded that improvements made to "put" the particular capital asset in efficient operating condition are considered capital in nature, and must be capitalized. If, however, they were made merely to 'keep' the asset in efficient operating condition, then they are repairs and may be deducted immediately.
The court noted that the taxpayer's expenditures in question were undertaken to correct a problem-the fraying of the asbestos fire-proofing which threatened to render unserviceable the taxpayer's office building. The value and original service life of the building was not increased by the corrective work, nor was the building adapted to any new or different use. Rather, "the work simply arrested and corrected a condition of deterioration which threatened a premature end" to the service of the building.
Numerous disputes have erupted in the courts over the tax treatment of environmental cleanup costs. The courts have held that the following three elements must be satisfied for a valid deduction under IRC [sec] 162 for environmental cleanup costs:
1. The taxpayer contaminated the property in its ordinary course of business;
2. The taxpayer cleaned up the contamination to restore the property to its pre-contamination state;
3. The cleanup did not allow the taxpayer to put the property to a new use.
The taxpayer in Cinergy satisfied these requirements and is the first case to allow the immediate deduction of the costs of asbestos abatement.
Practice Pointer: A new test emerges from this case to help us determine whether the costs of asbestos abatement may be deductible currently or must be capitalized. Expenses will be deductible if the work undertaken:
* Is necessary to correct a problem or condition of deterioration that threatens a premature end to the otherwise indefinite service life of the taxpayer's property,
* Is intended to arrest the problem,
* Does not increase the value and original service life of the taxpayer's property, and
* Does not adapt the property to a new or different use.
Practice Tip. Although enacted too late to help the taxpayers in this case, the IRC [sec] 198 election is available for environmental remediation costs paid or incurred after August 5, 1997, and before Jan. 1, 2004. The IRC [sec] 198 election enables taxpayers to deduct certain environmental remediation expenses in the year paid or incurred [IRC [sec] 198]. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site, which is defined as any property:
1. Held for use in a business, for the production of income, or as inventory,
2. Certified by an appropriate state environmental agency to be located within targeted area,
3. That contains (or potentially contains) a hazardous substance that is certified by the appropriate state environmental agency.
A qualified environmental remediation expenditure is any expense that is otherwise chargeable to the capital account and which is paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site [IRC [sec] 198(c)(1)(A)]. Expenses incurred to clean up a property subject to an allowance for depreciation will not qualify for the special deduction available under IRC [sec] 198.
The IRC [sec] 198 election must be made on or before the due date (including extensions) for filing the return for the year in which the qualified expenditures are paid or incurred. Individual taxpayer must include their total Section 198 expenses on the line for "Other Expenses" on Schedule C, E, or F of their Form 1040. Taxpayer must write "Section 198 Election" on each line where they are required to itemize their expenses. Entities other than individuals, including S corporations, partnerships and trust, must include the expenses on the line for "Other Deductions," or the equivalent, on their appropriate federal tax return.
For further discussion, see FTC [para] 2203.
Copyright Aspen Publishers, Inc. Oct 2003