Federal, State, and Local Tax Incentives for Environmental Remediation Costs

Federal, state, and local governments offer numerous tax incentives to promote the cleanup of environmentally contaminated properties. This item provides a high-level overview of the most common incentives that are offered and a brief update of the federal rules regarding the expensing of environmental remediation costs.

Federal Tax Incentives

The primary federal tax incentive—available since August 5, 1997—has been to allow the expensing of environmental (or “brownfield”) remediation costs that would normally have to be capitalized (Sec. 198). However, these rules recently expired and do not apply to costs incurred after December 31, 2007. As a result, unless Congress extends the expiration date or makes Sec. 198 permanent, these costs will have to be capitalized under Sec. 263(a).

With the expensing option no longer available for costs paid or incurred after December 31, 2007, taxpayers will now have to more closely analyze their environmental remediation costs to determine whether there are still some costs that can be expensed under Sec. 162. In making this determination, these expenditures will now be subject to the same expensing/capitalization rules as other expenditures. Also, even if these expenditures are allowed to be currently expensed under Sec. 162, they might still have to be included in inventory under the uniform capitalization rules of Sec. 263A (Rev. Rul. 2004-18).

A number of federal cases and rulings have shed some light on whether environmental remediation costs are currently deductible or have to be capitalized. In the absence of Sec. 198, these should be reviewed in order to determine the appropriate treatment of costs. (See Rev. Rul. 94-38; Rev. Rul. 2004-18; Plainfield-Union Water, 39 TC 333 (1962).)

Prospects for extension: Although several bills were introduced in 2007 that would make the Sec. 198 brownfields tax incentive permanent, none of these bills has been considered by the House Ways and Means Committee. The president’s fiscal year 2009 budget proposal also includes a provision to permanently extend the expensing of brownfield remediation costs.

State Tax Incentives

Many states provide tax and nontax incentives to encourage brownfield and environmental cleanup. The most common types of tax incentives include:

• Current expensing of capitalizable remediation costs;
• Income tax credits;
• Property tax abatements and exemptions; and
• Tax incremental financing.

Environmental Remediation Cost Expensing

Almost all states that have a tax based on income (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not have a tax based on income) use federal taxable income as the starting point for determining state taxable income. The two exceptions are Arkansas and Minnesota, which use their own set of rules. However, even these two states make reference to federal taxable income in their determination of state taxable income. The states will then make modifications to federal taxable income to arrive at state taxable income before apportionment.

California and New Hampshire are two states that modify federal taxable income with respect to Sec. 198. California allows expensing similar to Sec. 198 under its own set of rules but allows only the expensing of costs incurred on or before December 31, 2003 (CA Rev. & Tax. Code §24369.4). Other states that conform to the Code as of a date before the extension of Sec. 198 through 2007 may allow remediation costs to be expensed, but their effective date may not match the federal date.

Practice tip: Taxpayers need to determine how their states treat environmental remediation costs. This will become even more critical if Sec. 198 is not extended.

Income Tax Credits

Many states (including Colorado, Florida, Indiana, Kentucky, Louisiana, Massachusetts, Michigan, Mississippi, Missouri, New York, South Carolina, and Wisconsin) provide some form of income tax credit for brownfield and environmental remediation. The amount of the credit is usually equal to a percentage of the remediation costs up to a designated amount. Some states allow only a nonresponsible party to claim the credit. In almost all states the taxpayer must obtain approval from the appropriate government agency before undertaking the remediation.

State and Local Property Tax Abatements and Exemptions

States and some municipalities (including Connecticut, Georgia, Idaho, Indiana, Maryland, Missouri, New Jersey, South Carolina, Texas, and Virginia) also provide for property tax abatements and exemptions for cleaning up contaminated property. The amount of the exemption or abatement is often equal to a percentage of the increase in the property’s value as a result of the remediation.

The exemption or abatement is usually allowed for a limited number of years. For example, Idaho allows a seven-year property tax abatement equal to 50% of the increase in the property’s value as a result of the remediation (ID Code §63-602BB). Maryland allows a 50%–70%, 5- or 10-year property tax credit (MD Code Tax-Prop. §9-229). In most cases, the incentive applies only to real property, but in a few states, including Indiana (IN Code §6-1.1-42-23) and Ohio (OH Rev. Code §5709.65), personal property used at the remediated site might also qualify.

Some states, such as Indiana, Massachusetts, and Wisconsin, provide for the forgiveness of delinquent property taxes to any purchaser of the property who agrees to remediate it (IN Code §6-1.1-45.5; MA Gen. Laws Ch. 59A; and WI Stat. §75.105).

Taxpayers almost always have to enter into an agreement with the appropriate state or local government or agency before undertaking the remediation.

Tax Incremental Financing

States and their municipalities also use tax incremental financing (TIF) to help finance the development of brownfields. When TIF is used, the state or municipality provides financing to a developer or business to help clean up a site. The financing is typically provided in one of two ways:

• By borrowing funds and then providing those funds to the developer or business at the beginning of the project to help cover environmental remediation costs. The municipality will then pay off the debt service with the increased property tax generated by the remediated property.
• By having the developer or business use its own funds to pay for the environmental remediation costs. Typically, the funds will be treated as a loan from the developer or business to the municipality. The municipality then pays the debt service with the increased property tax generated by the remediated property. The municipality’s obligation under the loan is usually limited to the tax increment generated by the project.

The latter structure reduces the financial risk to the municipality if the project does not generate enough incremental tax revenue to pay off the loan to the developer or business.

Some states have TIF rules that specifically apply to environmental remediation projects; others have TIF rules that allow remediation costs to be included in projects where environmental remediation represents just a portion of the overall project development cost. The taxpayer will be required to enter into an agreement with a state or local government or agency in order to obtain TIF incentives.

Summary

It is possible that Sec. 198 will not be extended, and for federal tax purposes taxpayers will no longer be able to expense capitalizable environmental remediation costs incurred after December 31, 2007. As a result, taxpayers will need to determine whether some of these costs are deductible under Sec. 162 or whether they will need to be included in inventory under Sec. 263A. The same determination will need to be made at the state level.

There are other tax incentives available, primarily at the state and local levels, to help developers and businesses clean up brownfields and other contaminated properties. In most cases these incentives are not available unless the taxpayer enters into an agreement with the appropriate government agency. Thus, advance planning is required to take full advantage of these incentives.

From Thomas J. Alberte, CPA, MBA, MST, Milwaukee, WI

In December 2007, the IRS issued Technical Advice Memorandum (TAM) 200749013, providing guidance on the treatment of costs related to investigating various corporate restructuring transactions that ultimately were not consummated. Specifically, the TAM addresses whether these costs are deductible as ordinary and necessary business expenses under Sec. 162(a), are deductible losses under Sec. 165, or must be capitalized under Sec. 263(a).

Costs incurred while investigating and pursuing mutually exclusive proposed business restructurings (meaning that only one restructuring transaction can be completed) must be capitalized as part of the completed transaction costs. If part of the mutually exclusive proposal is abandoned, no abandonment loss under Sec. 165 is recognized unless the entire proposal is abandoned (United Dairy Farmers, Inc., 267 F3d 510 (6th Cir. 2001)). Alternatively, restructuring costs incurred in investigating and pursuing nonmutually exclusive potential business restructurings, otherwise capitalized under Sec. 263(a), are deductible under Sec. 165 when each proposed transaction is abandoned (Rev. Rul. 73-580). 

The TAM was written in response to a taxpayer engaged in one primary and two lesser businesses that restructured its business in order to refocus its efforts on its core activities. Before restructuring, the taxpayer investigated several options, including (1) maintaining the status quo, (2) a leveraged recapitalization or a full recapitalization with a spin-off of the lesser business divisions, and (3) divestiture of the lesser business divisions, including a targeted stock offering or an initial public offering (IPO) with a split-off or spin-off. The taxpayer’s board of directors quickly eliminated the first two alternatives and then shortly thereafter eliminated the consideration of a spin-off or targeted stock offering. The only restructuring option remaining was an IPO split-off, and the board soon approved this alternative. Subsequently, the taxpayer formed a subsidiary and contributed to the subsidiary its lesser business divisions. The IPO of the subsidiary was soon completed. The taxpayer abandoned the split-off of the subsidiary because it would not maximize shareholder value but later completed a spin-off of the subsidiary.

The IRS field personnel maintained that the taxpayer intended to enter into one restructuring transaction; thus, all of the transactions considered were mutually exclusive and the associated costs should be capitalized under Sec. 263(a). The taxpayer disagreed and claimed that the different restructuring transactions were not mutually exclusive. Therefore, according to the taxpayer, all of the costs associated with the abandoned transactions were deductible under Sec. 165. Furthermore, the taxpayer claimed that all of the investigatory costs incurred when deciding whether or not to enter into a restructuring transaction were amortizable under Rev. Rul. 99-23, relating to start-up expenditures under Sec. 195.

The IRS National Office concluded that the taxpayer’s first option of maintaining the status quo was mutually exclusive but that not much of the cost at issue was attributable to that option. The Service further concluded that the second and third alternatives were not mutually exclusive. Because the board eliminated the second option, the associated costs were deductible under Sec. 165. Regarding the third option, the Service concluded that a spin-off and a split-off are very similar transactions. Therefore, all costs incurred by the taxpayer from day one of the restructuring proposal related to the IPO, spin-off, or split-off must be capitalized as part of the restructuring that was completed. The Service also rejected the taxpayer’s claim that the investigatory costs were amortizable as start-up expenditures under Rev. Rul. 99-23 because the ruling pertains only to acquisitions of new businesses and not the division of existing businesses.

The TAM serves as a reminder that it is important to identify the costs associated with potential business restructuring transactions and to determine whether the transactions considered are or are not mutually exclusive in order to determine whether the costs of abandoned transactions are deductible or must be capitalized.

From Jessica M. Staley, CPA, MSA, Dallas, TX