Beware the tax man!
No good deed goes unpunished as environmental settlements trigger IRS scrutiny.
by George Schutzer and Ora Sheinsen
Federal and state agencies often threaten companies with lawsuits or penalties for alleged violations of environmental laws and regulations. Companies frequently settle with the agencies in the form of various types of payments and penalties, often including Supplemental Environmental Projects (SEPs), which reduce the monetary payment or penalty. SEPs are environmentally beneficial projects that a company is not otherwise required to perform, but agrees to undertake in order to settle an enforcement action.
Companies can often benefit from implementing a SEP, thereby reducing the total actual cost to the company. One benefit that many SEP participants expect is either an immediate tax deduction for expenses associated with the SEP or the ability to capitalize the cost of the expense and claim tax deductions over a period of time. As discussed in more detail below, these deductions are receiving increased scrutiny from the Internal Revenue Service (IRS).
Lately, the IRS is placing environmental settlements under increased scrutiny based on a concern that corporations are improperly deducting portions of settlements, including the costs involved in funding SEPs. While some environmental settlements are deductible as ordinary and necessary business expenses, the IRS does not allow deductions for amounts paid as a fine or similar penalty for violation of any law. In recent years, the IRS has paid more attention to whether payments made instead of penalties in environmental cases should be considered non-deductible under Section 162(f) of the Internal Revenue Code.
The IRS does not want businesses to dull the sting of a fine by getting the tax benefit of treating it as a deductible business expense. Since many federal and state environmental penalties — for example, the Federal Clean Air and Water Acts and their state analogues — are intended to be punitive, the IRS has singled out such penalties (and amounts paid in lieu of paying such penalties) under environmental regulations for particular scrutiny. In addition to disallowing deductions for amounts paid as part of punitive penalties, the IRS has determined that taxpayers cannot receive the tax benefits of including those amounts in the basis of the assets under Section 263A of the Internal Revenue Code or property under Section 1012.
In line with this reasoning, the Tax Court denied a deduction for a taxpayer’s $8 million contribution to an environmental endowment fund when the contribution was given with the understanding that a proposed criminal fine would be reduced by the same amount. In a memo issued in 2006 for a different case, the IRS concluded that a portion of the costs incurred for the performance of a beneficial environmental project (BEP) was comparable to a non-deductible fine or penalty and prohibited the taxpayer from deducting the costs of the project or including the costs in the basis of the assets produced.
Following these cases and memos, the IRS recently issued directives instructing IRS agents to audit amounts paid pursuant to settlements with the Department of Justice under the False Claims Act and the Environmental Protection Agency for SEPs and BEPs. As a result, IRS auditors are now aggressively identifying and examining the tax treatment of environmental settlement payments. One IRS directive on the subject notes that “in most cases, a portion of the proposed civil payment was reduced for agreeing to perform a SEP, experience has shown that, generally, most defendant/taxpayers deduct the entire amount of the SEP as either a Section 162 business expense or capitalize [sic] such costs with related depreciation deductions.” The directives mandate audits for SEPs in excess of $1 million.
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