Deducting costs that are usually capitalized

Sec. 162 authorizes a deduction for ordinary and necessary business expenses paid or incurred during the tax year in carrying on any trade or business. However, Sec. 263(a) prohibits a deduction for capital expenditures, which include the cost of acquiring, constructing, or erecting buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the tax year. Furthermore, no deduction is allowed for amounts that (1) add to the value, or substantially prolong the useful life, of the property; or (2) adapt the property to a new or different use.

Paraphrasing the Sixth Circuit in United Dairy Farmers, Inc., 267 F.3d 510 (6th Cir. 2001), if an expense fits within Sec. 263(a), that section would trump the deductibility provision of Sec. 162(a), and the expense would have to be capitalized. To be deductible, the expense must be ordinary and necessary within the meaning of Sec. 162(a) and fall outside the type of capital expenditures envisioned by Sec. 263(a). Because the Code describes what should be capitalized generally but enumerates allowable deductions specifically, “deductions are strictly construed and allowed only ‘as there is a clear provision therefor’ ” (INDOPCO, Inc., 503 U.S. 79 (1992)). This case study examines three types of expenses: environmental cleanup costs, restaurant “smallwares,” and replacement tires for qualifying vehicles.

Deducting environmental cleanup costs

Environmental cleanup costs include any costs associated with the assessment, mitigation, removal, or remediation of environmental hazards (e.g., asbestos removal and encapsulation, soil remediation, groundwater remediation, and underground tank repair and removal). An environmental cleanup project may consist of one or more related environmental cleanup activities.

The deductibility of environmental cleanup costs has evolved from a requirement to capitalize all such costs to a case-by-case determination of the expense-versus-capitalization issue. IRS pronouncements and court decisions provide the following guidelines:

Cleanup

Costs (other than costs attributable to the construction of groundwater treatment facilities) incurred to clean up land (i.e., soil remediation) and treat groundwater that becomes contaminated as a result of the manufacturer’s operations are deductible (Rev. Rul. 94-38). However, this applies only if the environmental remediation expenditures restore the contaminated property to its uncontaminated condition at the time it was acquired by the manufacturer (see IRS Letter Ruling 9541005). In Dominion Resources, Inc., 219 F.3d 359 (4th Cir. 2000), the court held that remediation costs must be capitalized where the cleanup alters the property’s character, enabling the corporation to put the property to a new use.

Asbestos removal and encapsulation

In Letter Ruling 9240004, the IRS concluded that the cost of removing asbestos had to be capitalized because it increased the property’s value. On the other hand, in Letter Ruling 9411002, the IRS allowed the taxpayer to deduct the costs of encapsulating asbestos because they did not increase the property’s value or life and, thus, were considered incidental repairs. In Cinergy Corp., 55 Fed. Cl. 489 (2003), the court held that the corporation could currently deduct (rather than capitalize) the costs of removing and encapsulating asbestos material contained within its office building’s fireproofing material because the costs (1) did not appreciably increase the building’s value but merely restored it; (2) represented only a small fraction of the building’s overall value; (3) did not substantially prolong the building’s useful life; and (4) did not adapt the building to a new or different use. However, in Norwest Corp., 108 T.C. 265 (1997), the costs to remove asbestos under a general plan of rehabilitation and renovation to improve the building had to be capitalized.

UST replacement

Costs incurred to replace underground storage tanks (USTs) used to store hazardous materials (including the costs of removing, cleaning, and disposing of the old USTs and acquiring, installing, and filling the new USTs) are deductible if the new tanks are filled with waste once, sealed indefinitely, and thereafter have no salvage value (Rev. Rul. 98-25).

Payments under an environmental indemnification agreement

In a 1999 Field Service Advice memo (FSA 199942025), the IRS concluded that if a corporation’s environmental remediation expenses were otherwise deductible, the corporation could deduct those expenses even though it was receiving reimbursement payments from another corporation under an environmental cleanup indemnification agreement.

Purchase of contaminated property

Environmental remediation costs incurred subsequent to the purchase of contaminated commercial properties must be capitalized. Because the properties were contaminated at the time of the purchase, the costs did not restore the properties to their condition at the time of the purchase. In addition, the corporation did not contaminate the properties through its normal business operations (United Dairy Farmers, Inc., 267 F.3d 510 (6th Cir. 2001)).

In Rev. Rul. 2004-18, which clarified Rev. Ruls. 94-38 and 98-25, the taxpayer owned and operated a manufacturing plant discharging hazardous waste that the taxpayer buried on portions of its land. When the taxpayer purchased the land, it was not contaminated by hazardous waste. To comply with environmental rules, the taxpayer incurred costs to remediate the soil and groundwater that had been contaminated by its hazardous waste and incurred costs to establish an appropriate system to continue monitoring the groundwater. The soil remediation and groundwater treatment restored the land to essentially the same physical condition as prior to the contamination, so the costs incurred (within the meaning of Sec. 461(h) and Regs. Sec. 1.263A-1(c)(2)(ii)) to clean up land that the taxpayer contaminated with hazardous waste by its manufacturing operations were required to be capitalized and included in inventory costs under Sec. 263A.

In Rev. Rul. 2005-42, the IRS ruled that remediation costs incurred to clean up land contaminated by the taxpayer’s manufacturing activities were properly allocable under Sec. 263A to inventory produced during the tax year the costs were incurred. The costs were required to be allocated to current-year production regardless of whether the taxpayer (1) manufactured a different inventoriable item than was produced when the contamination occurred; (2) had stopped using the contaminated site for manufacturing; or (3) incurred the costs to clean up a contaminated site separate from the manufacturing site.

Expensing restaurant smallwares

Restaurants and taverns can deduct the cost of smallwares (items used in the preparation and service of food, such as dishes, cutlery, and glassware) in the year in which the smallwares are received and used (Rev. Proc. 2002-12). The smallwares method applies to corporations engaged in the trade or business of operating a restaurant or tavern (i.e., preparing food and beverages to customer order for immediate on-premises or off-premises consumption). In addition to normal restaurants and cafeterias, it applies to caterers; mobile food servers; bars and taverns; and food or beverage services located in grocery stores, hotels and motels, amusement parks, theaters, casinos, country clubs, and similar social or recreational facilities.

Observation: A corporation that is not already engaged in the trade or business of operating a restaurant may not use the smallwares method as justification for expensing the cost of smallwares purchased before opening. Instead, the corporation can write off up to $5,000 of the startup costs under Sec. 195 and deduct the remaining amount (if any) over a 15-year (180-month) period.

Smallwares consist of the following 10 categories of items: (1) glassware and paper or plastic cups; (2) flatware and plastic utensils; (3) dinnerware (dishes) and paper or plastic plates; (4) pots and pans; (5) tabletop items; (6) bar supplies; (7) food preparation utensils and tools; (8) storage supplies; (9) service supplies; and (10) small appliances that cost $500 or less individually. Smallwares do not include collectibles or other items of significant artistic or intrinsic value, such as flatware or dinnerware made of precious metals, and antique vases or fine art for decoration purposes.

Note: The preamble to the final tangible property regulations confirmed that the final regulations (such as Regs. Sec. 1.162-3) do not supersede safe-harbor revenue procedures that permit taxpayers to treat specific property as materials and supplies. Therefore, corporations that qualify for this method are allowed to account for smallwares in the same manner as materials and supplies that are not incidental under Regs. Sec. 1.162-3. This means that the costs are deductible in the year they are consumed and used in the business. Smallwares are deemed consumed and used when they are received and are available for use. Large purchases of smallwares near year end that are stored at a warehouse or other facility other than the restaurant at which they are used are not treated as received and available for use. Such smallwares’ costs are included as inventory and expensed in the following year when used.

Example. Expensing restaurant smallwares: R, a restaurant, was incorporated on Jan. 1, 2023. It is an accrual-basis, calendar-year C corporation that will open three restaurants on June 1, 2023. Prior to opening, the corporation purchased tabletop items, bar supplies, food preparation utensils, and other items considered smallwares in the food service industry. R paid $60,000 for these items prior to opening. It estimates that it will need to purchase an additional $20,000 of replacement smallwares during 2023 and at least $30,000 per year thereafter.

The $60,000 to purchase smallwares is a startup cost under Sec. 195.

R can expense the $20,000 of smallwares costs incurred after business began when the smallwares are received and available for use. If a significant amount of smallwares are purchased at the end of 2023 and stored off-site for use in the following year, such costs are inventoried and expensed in the following year when used. The same rules apply to smallwares purchased in 2024 and later years. Since the costs of opening restaurant locations after 2023 are business expansion costs (assuming a new business entity is not created), those smallwares costs are also deductible when the smallwares are received and available for use. As a new corporation in its first year of operations, R simply begins using the smallwares method on its 2023 return (no election is required).

Expensing replacement tires

Tires for trucks, tractors, and trailers are separate assets, and tires with an average useful life greater than a year are depreciated over the class life for assets used in that specific business (Rev. Proc. 87-56). However, corporations can treat the cost of original tires as part of the vehicle and not as separate assets under the original tire capitalization method. Thus, the cost of the original tires is depreciated with the same depreciation method, recovery period, and convention as the vehicle on which the tires are first installed. The cost of replacement tires is expensed in the year they are installed on the vehicle. If adopted, this method must be used for the tires of all qualifying vehicles (Rev. Proc. 2002-27).

Qualifying vehicles are those described in assets classes 00.241 (light general-purpose trucks); 00.242 (heavy general-purpose trucks); 00.26 (tractor units for use over the road); and 00.27 (trailers and trailer-mounted containers).

Under this method, retread tires are treated as new tires. The cost of original retread tires is depreciated, and the cost of replacement retread tires is expensed in the year the tires are installed. When the safe-harbor method is not elected, the cost of a retread tire that is expected to last more than a year is depreciated as a separate asset. If the retread tire is expected to last less than a year, the cost is expensed (Chief Counsel Advice (CCA) 200252091 and CCA 200307087).

Contributor

Larry Bland Jr., CPA, is a technical editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2023 (800-431-9025; tax.thomsonreuters.com).