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Cash Method Landfill Business Can Currently Deduct Estimated Future Cleanup Costs

(Parker Tax Publishing August 2017)

The Tax Court held that an S corporation that operated a landfill and used the cash method of accounting was permitted to elect under Code Sec. 468 to currently deduct estimated reclamation, closure and post closure costs. The court also determined that the term "taxpayer" as used in Code Sec. 468 includes cash method taxpayers and was not limited to taxpayers using the accrual method. Gregory v. Comm'r, 149 T.C. No. 2 (2017).

Bob and Kay Gregory incorporated their landfill business, Texas Disposal Systems Landfill, Inc. (TDSL) as a cash method S corporation in 1988. The landfill occupied approximately 700 acres near Austin, Texas and processed between 2000 and 3000 tons of solid waste per day. Due to the high costs to clean up and restore a landfill site after it closes, the Texas Commission on Environmental Quality required waste disposal companies to keep a standby letter of credit. By the end of 2009, TDSL's letter of credit amounted to over $2 million. On its 2008 tax return, TDSL deducted approximately $100,000 for estimated cleanup costs, and took a slightly smaller deduction for cleanup costs on its 2009 return. The deductions were based on estimates by a professional engineering service hired by TDSL.

The IRS issued notices of deficiency for the Gregorys' 2008 and 2009 tax years in April 2013 disallowing the deductions because TDSL is a cash method taxpayer. The IRS argued that a taxpayer as that term is used in Code Sec. 468 means a taxpayer who uses the accrual method. It therefore determined that TDSL was not entitled to the deductions and the Gregorys' income for those years was substantially higher. The Gregorys filed a Tax Court petition to challenge the notices.

Code Sec. 468 permits a taxpayer to make an election with respect to mining or waste disposal property to deduct qualified reclamation or closing costs for a tax year equal in an amount to the current reclamation or closing costs allocable to that year. The IRS acknowledged that Code Sec. 468 by its terms does not limit the election to accrual method taxpayers. However, the IRS asserted statutory interpretation, legislative history, and policy grounds for why the election should be limited to accrual method taxpayers.

The IRS's textual arguments included the assertion that Code Sec. 461, which lists several exceptions to the rule that a cash method taxpayer must make a payment before taking a deduction, does not include Code Sec. 468 as one of the exceptions. The IRS also argued that Code Sec. 468 uses the term "incurred," a term which usually refers to an expense that is deductible under the accrual method. The IRS cited a case in which a district court described Code Sec. 468 as allowing landfill operators who use the accrual method to deduct cleanup costs before they are incurred. The IRS further asserted that the language in Code Sec. 468 was similar to that in Code Sec. 468A, and since Code Sec. 468A applies only to accrual method taxpayers, Code Sec. 468 must as well.

Next, the IRS argued that the legislative history of Code Sec. 468 showed Congress's intent to limit Code Sec. 468 to accrual method taxpayers. The IRS reasoned that Code Sec. 468 was enacted simultaneously with Code Sec. 461(h), which provides that cleanup costs accrue when they can be estimated with reasonable accuracy. Code Sec. 461(h) also added the economic performance requirement to the test for whether a liability was incurred by an accrual method taxpayer. This legislative history, according to the IRS, showed that Congress passed Code Sec. 461(h) to ensure that accrual method taxpayers take deductions only when they economically incur expenses, and Code Sec. 468 was intended as an exception to this general rule for reclamation and closing costs. According to the IRS, this showed that Congress had accrual taxpayers in mind when it enacted Code Sec. 468. The IRS also put forth a policy argument that permitting cash basis taxpayers to make a Code Sec. 468 election would lead to both a current deduction for cleanup expenses and a double deduction for those same expenses later when cleanup begins.

The Tax Court held that the Code Sec. 468 election is not limited to accrual method taxpayers. Rejecting the IRS's textual arguments, the court began by noting that although the term "taxpayer" is not a defined term in Code Sec. 468, a default definition is provided in Code Sec. 7701(a). The court reasoned that the default definition does not distinguish entities that use the accrual method from those that use the cash method, but only looks to whether the person (which includes a corporation like TDSL) is subject to any internal revenue tax. TDSL, an S corporation, was required to pay social security and unemployment taxes, so it qualified as a taxpayer under the default definition. Further, the court found nothing in Code Sec. 468 that was manifestly incompatible with the Code Sec. 7701(a) definition of a taxpayer. The court also reasoned that when Code Sec. 468 was drafted, Congress could have said "accrual method taxpayer" but chose not to do so. Thus, "taxpayer" as used in Code Sec. 468 was unambiguous, and the IRS's textual arguments for limiting the definition to an accrual method taxpayer failed.

Next, the Tax Court considered and rejected the IRS's legislative history and policy arguments. The court noted that in 1982, Congress considered several bills that would have allowed both cash and accrual method taxpayers to deduct estimated cleanup costs for surface mining before the work was actually performed. A bill from that year used the term "accrual reclamation expenses" but would have also applied to cash method taxpayers. When the 1982 statute was enacted in 1984, the phrase "accrual reclamation expenses" was replaced by "qualified reclamation expenses" and "qualified closing costs." Thus, according to the Tax Court, the unfinished 1982 legislation aimed to help both cash and accrual method taxpayers, and it was reasonable to infer that the enacted 1984 statute was a way of achieving the same end. Finally, the court found that the IRS's policy concern regarding double deductions for the same expenses was not realistic because if a taxpayer elects to claim deductions under Code Sec. 468, its liability is computed under that section, and it gets no deduction for current cleanup expenses until it exhausts its accumulated reserve for those costs.

Observation: In a concurring opinion, five judges agreed with the result but were convinced that the legislative history showed Congress's intent for Code Sec. 468 to apply only to accrual method taxpayers. According to the concurring opinion, the Tax Court was bound by the language of the statute, and the IRS could issue regulations if it believed that Code Sec. 468 contained a statutory gap that needed to be filled.

For a discussion of the cash method of accounting, see Parker Tax ¶241,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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