IRS Rules That Supplemental Environmental Project Costs Are Not Deductible Business Expenses Or Capitalized Expenditures

August 5, 2008

The tax value of Supplemental Environmental Projects (SEPs) – which are frequently used to mitigate proposed civil penalties in environmental enforcement cases – has just taken a tumble. In a coordinated issues paper effective July 3, the Internal Revenue Service’s Large and Mid-Size Business Division has concluded that the portion of the cost companies incur to perform SEPs cannot be claimed as a current business expense because they are analogous to nondeductible fines or penalties. Nor can they be capitalized and recovered as a depreciation or amortization deduction in future years. This decision has broad implications for companies that are operating under the terms of an existing federal or state environmental settlement agreement, are currently negotiating the terms of such an agreement, or are the subject of a pending enforcement proceeding.

In the last ten years, the inclusion of SEPs in environmental enforcement settlements has risen dramatically. Their popularity has been fueled to some extent by a shift in focus at EPA from collecting large fines and penalties to projects that produce environmental benefits far beyond those associated with the cost of compliance. Settlements requiring payment of a relatively modest fine or penalty, accompanied by a multi-year commitment to perform SEPs valued at millions of dollars, have become commonplace. The practice has grown to a point where SEPs are now considered a standard term in many if not most state and federal environmental settlements. Common examples of SEPs include installing state-of-the-art pollution controls to remove more pollutants than the law requires, paying for local stream improvements, funding a school bus biodiesel program, and donating property for conservation purposes. Most settlement agreements set a deadline to perform or fund a SEP. If this deadline is not met, a company must pay an additional civil penalty.

Technically, SEPs are performed voluntarily. But, in reality, there is a strong incentive to offset part of a proposed civil penalty with a SEP, i.e., to avoid the cost of trial and the risk that a court might impose a civil penalty even larger than what EPA is proposing. There can, however, be other good reasons to perform a SEP. For example, a company can sometimes receive “SEP credit” for an environmental project that it is already committed to doing. And, some SEPs – for example, an environmental auditing program or upgrading emission controls – can improve a company’s compliance status and reduce the risk of future enforcement actions. SEPs can also result in better press and community relations.

Regulators typically require the value of a SEP to be about 2 to 3 times larger than the amount of the fine or penalty being offset. But, often the parties do not specify the value of SEPs in a settlement agreement. And, sometimes they do not specify how much of the civil penalty is being offset by the SEPs. The new IRS ruling may change all of that.

Because of the position being taken by the IRS, it will now be important to specify in a settlement, or otherwise be able to distinguish, the portion of the SEP that is intended to be punitive (analogous to a fine or penalty) from the portion that is intended to be remedial, compensatory and/or beyond the value of the civil penalty. The punitive portion of the SEP will not be deductible at all. The remedial or compensatory portion may be deductible currently, or it may have to be capitalized and recovered as a depreciation or amortization expense in future years.

The conclusion of the IRS that the portion of a SEP used to offset a civil penalty cannot be deducted, is not surprising. Section 162(f) of the Internal Revenue Code supports that result. However, the conclusion that even that part of a SEP that must be capitalized cannot be deducted in the form of depreciation or amortization is not expressly supported by the Internal Revenue Code. Disallowing depreciation or amortization deductions is based upon the IRS’s interpretation of the capitalization rules in the Code, and upon its view that “public policy” should bar a taxpayer from claiming a depreciation or amortization deduction for SEP costs incurred in lieu of the payment of a fine or penalty.

But, at the same time, the IRS’ position ignores sound public policy encouraging environmental protection and resolution of disputes without litigation. The IRS’ ruling also ignores the fact that a SEP may cost 2-3 times more than the civil penalty it is off-setting. Nonetheless, according to the IRS, the entire value of the SEP is not deductible – simply because it was conducted in lieu of paying some portion of a proposed civil penalty.

Finally, the IRS ruling is flawed because it fails to acknowledge that companies often settle, even though they have not violated any environmental law – simply to avoid litigation costs and adverse publicity. The civil penalties that are typically offset by a SEP are not the result of an adjudication on the merits by a court of law. They are simply penalties proposed by EPA for alleged violations of law.

The lawyers and professional staff of the Frost Brown Todd Environmental and Tax Departments are available to consult with clients to evaluate the environmental and tax implications of proposed and existing SEPs.

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