Industry Director's Directive #3 on Specified Liability Losses IRC 172(f) Status Changed to Monitoring

April 12, 2010

LMSB-04-0210-009
Impacted IRM 4.51.2

Effective immediately, the status of the specified liability loss issue is changed from active to monitoring.  In monitoring status, the specified liability loss issue can be resolved by examiners applying existing guidance without the extensive coordination required for issues in active status.  Attachment 3, decommissioning of a nuclear power plant or any unit thereof, has been revised to include audit steps for two identified issues.  The remaining attachments referenced below are active links and have not changed from IDD #2 which was released June 19, 2009.

Background/Strategic Importance:

In early 2005, LMSB and SBSE became aware of an increased number of claims for refund using the provisions of IRC § 172(f).  The claims were generated as informal claims on examination, formal filings of Form 1120X, Amended U.S. Corporation Income Tax Returns, or formal filings of Form 1139, Corporation Application for Tentative Refund.  In the case of specified liability losses incurred for taxable years beginning after December 31, 1990, IRC § 172(b)(1)(C) provides an exception to the general carryback period.  Under this exception, the normal two-year carryback period is replaced with a 10-year carryback period.  As a result, the portion of a net operating loss that qualifies as a specified liability loss may be carried back to each of the ten taxable years preceding the loss year.

The current version of IRC § 172(f) was implemented by section 3004(a) of the Tax and Trade Relief Extension Act (TTREA) of 1998, Pub. L. No. 105-277, and applies to net operating losses arising in tax years ending after October 21, 1998.

The 1998 amendment to IRC § 172(f) substantially narrowed the scope of expenditures eligible for the 10-year carryback and now applies to only a limited class of losses.  The purpose of this amendment was to lessen the controversy as to the proper interpretation of the specified liability loss provisions by providing a definitive list of eligible items.

Thus, effective for losses incurred in tax years ending after October 21, 1998, specified liability losses are defined to include the following categories:

1. Deductible product liability amounts or expenses incurred in investigating or settling a product liability;
2. Deductible expenses incurred in satisfaction of Federal or State laws in connection with:
   a) Reclamation of land,
   b) Decommissioning of a nuclear power plant,
   c) Dismantlement of a drilling platform
   d) Remediation of environmental contamination, or
   e) Payments under a workers compensation act.

The first category of specified liability losses includes certain losses attributable to product liability.  See IRC § 172(f)(1)(A).  This encompasses any amount allowable as a business expense deduction under IRC § 162 or a loss deduction under IRC § 165 that is attributable to:

• Product liability, or
• Expenses incurred in investigating, opposing, or settling claims against the taxpayer on account of product liability.

The second category of specified liability losses consists of certain deferred liability losses described in IRC § 172(f)(1)(B).  Expenditures falling under this provision must meet the following requirements:

1. The amount is allowable as an income tax deduction for an amount paid in satisfaction of a liability under a federal or state law requiring:

   a) The reclamation of land;
   b) The decommissioning of a nuclear power plant or any unit thereof;
   c) The dismantlement of a drilling platform;
   d) The remediation of environmental contamination; or
   e) A payment under any workers compensation act within the meaning of IRC § 461(h)(2)(C)(i).

2. The act or failure to act giving rise to the liability occurs at least three years before the beginning of the taxable year;
3. The taxpayer used the accrual method of accounting throughout the period or periods during which the act or failure to act giving rise to the liability occurred; and
4. The amount is not allowable as a deduction under IRC § 468(a)(1) [election regarding certain mining and solid waste reclamation and closing costs] or IRC § 468A [election regarding certain payments made to a Nuclear Decommissioning Reserve Fund].

The nature of the issues identified to date relate to whether or not the claimed expenditures are indeed qualified specified liability losses under IRC § 172.  This analysis includes:

1. Whether the incurred costs are allowable deductions, as opposed to capital expenditures, and
2. Whether or not the costs were incurred in satisfaction of a Federal or State law requiring the expenditure, as opposed to company policy or other mandate and
3. Whether or not the act or failure to act that gave rise to the liability occurred at  least three years prior to the beginning of the taxable year in which the amount is allowable as a deduction, as opposed to a normal current business operating expense.

This issue was designated by NRC as an emerging issue for LMSB and SBSE on June 23, 2005.  NRC established an Emerging Issue Team to determine the impact of these claims and to develop examination guidance for consistency in issue resolutions.

Issue Tracking:

• Project Code 0047
• Tracking Code 7942

Failure to Substantiate:

• UIL Code 172.05-00
• SAIN 529-01, Second Tier SAIN 350

Product Liability:

• UIL Code 172.06-00
• SAIN 529-01, Second Tier SAIN 351

Deferred Statutory or Tort Liability Losses:

• UIL Code 172.07-00
• SAIN 529-01, Second Tier SAIN 352

Planning and Examination Guidance:

As a Tier II issue, this issue is required to be addressed in examinations if present.

Attachment 1 – Product Liability
Attachment 2 – Land Reclamation Expenditures
Attachment 3 – Decommissioning of a Nuclear Power Plant or any Unit thereof (Revised)
Attachment 4 – Dismantlement of a Drilling Platform
Attachment 5 - Remediation of Environmental Contamination
Attachment 6 - A payment under any workers compensation act within the meaning of IRC § 461(h)(2)(C)(i)

It is recommended that examiners make inquiries as to any insurance reimbursements received associated with the expenditures claimed as a specified liability loss.

If you have any questions, contact the IRC § 172(f) Technical Advisor or Mining Technical Advisor.

This LMSB Directive is not an official pronouncement of the law and cannot be used, cited, or relied upon as such.

cc:      Commissioner, LMSB
           Deputy Commissioner, Operations, LMSB
           Deputy Commissioner, International, LMSB
           Director, Planning, Quality, Analysis & Support, LMSB
           Director, Research & Workload Identification, LMSB
           Division Counsel, LMSB
           Chief, Appeals
           Commissioner, SBSE
           www.irs.gov

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Attachment 1 - Product Liability

Introduction

IRC §172(b)(1)(C) requires a taxpayer with a specified liability loss to carry this loss back for 10 years rather than the usual two-year net operating loss (NOL) carryback period.  The taxpayer can make an election under IRC §172(f)(6) to irrevocably relinquish the 10-year carryback period.  The term “specified liability loss” is defined in IRC §172(f)(1).

IRC §172(f)(1)(A) provides that a specified liability loss includes an amount allowable as a deduction under IRC §§162 or 165 which is attributable to product liability or to expenses incurred in investigating, settling or opposing claims against the taxpayer on account of product liability.

IRC §172(f)(2) limits the amount of the specified liability loss to the amount of the NOL for the year.  To the extent the NOL exceeds the specified liability loss, any excess is then carried back 2 years following the regular NOL carryback rules

IRC §172(f)(4) defines a product liability as:

(A) liability of the taxpayer for damages on account of physical injury or emotional harm to individuals, or damage to or loss of the use of property, on account of any defect in any product which is manufactured, leased, or sold by the taxpayer, but only if

(B) such injury, harm, or damage arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.

Product liability losses do not include injuries to employees while manufacturing the product, or injuries or damages sustained while delivering, installing or testing the product for the customer.  Product liability losses do not include normal costs of repairs and maintenance or warranty items or liabilities incurred as a result of services performed by the taxpayer. 

Note that while the statute expressly includes expenses incurred in investigating, settling, and opposing claims in defining product liability losses, it does not repeat these expenses in the definitions of the other five permitted categories of specified liability losses listed in IRC §172(f)(1)(B).

The additional requirements for specified liability loss treatment contained in IRC §172(f)(1)(B)(ii) do not apply to product liability expenses.  Thus, for product liability losses only, the taxpayer need not have been on the accrual method of accounting for the entire period and the liability need not arise from an act which occurs at least 3 years before the beginning of the loss year.

Some potential product liability loss issues examiners need to be aware of include the following:

• Issue 1: Differences between product liability and other specified liability losses
• Issue 2: Damages vs. product replacement/warranty expenses
• Issue 3: Damages prior to completing delivery do not qualify
• Issue 4: Proper treatment of insurance reimbursements
• Issue 5: Prejudgment and post-judgment interest do not qualify

For more information contact the IRC Section 172(f) Technical Advisor.

Issue 1: Differences between product liability and other specified liability losses

Although now included within the same Code section, the greatest similarity between product liability losses and the other permitted forms of specified liability losses are that both have a special 10-year carryback provision.  Product liability losses and their special carryback rules were enacted first and carry far fewer restrictions than other specified liability losses.  While there are Regulations for product liability losses, there are none for the other forms of specified liability losses.

Congress first enlarged the carryback period for NOLs attributable to product liability (product liability losses) in the Revenue Act of 1978. This enactment constituted part of a congressional response to a perceived business crisis arising from product liability claims, including an inability to obtain product liability insurance at reasonable prices. Congress provided a larger carryback period for product liability losses because product liabilities tend to be large and sporadic. The expanded carryback period reduces the likelihood that a large product liability loss will exceed taxable income during the carryback period. Staff of the Joint Committee on Taxation, 95th Cong., General Explanation of the Revenue Act of 1978, 232 (Comm. Print 1979). Taxpayers receiving tax refunds attributable to the larger carryback period could also use those funds to pay product liability claims. 124 Cong. Rec. 34,733 (1978).

The definition of what constitutes a product liability varies among the states and has changed over time.  Regulation §1.172-13(b)(2)(iii) clarifies that the federal tax definition of product liability controls rather than state law when it comes to IRC §172(f).  TAM 200341004[1]  involved a taxpayer’s claim of product liability treatment for defective fasteners it manufactured.  The amounts included both cash payments to customers and accounts receivable write-offs.  The taxpayer could not trace the manufacturing deficiencies to particular production lots and thus had to test and repair (rework) a substantial quantity of fasteners.  Some of the taxpayer’s customers stopped paying for items already shipped to them claiming that testing and other costs exceeded any amount they owed the taxpayer.  Some customers asserted claims for additional inventory carrying costs since they could not sell these defective fasteners.  Other customers claimed “cover” charges since they had to find a replacement supplier for the fasteners at a higher than contracted for cost.  The damages at issue did not involve actual personal injury or physical property damage.  The TAM provides considerable discussion about how product liability is defined for tax purposes and concludes that the taxpayer’s damages do not qualify for the 10-year carryback.

Regulation §1.172-13(b)(2)(i) largely echoes the definition of product liability provided in the statute. The regulations further provide, however, that a taxpayer's liability for damage done to other property or for harm done to persons that is attributable to a defective product may be product liability regardless of whether the claim sounds in tort or contract.  The damages must result from physical injury or emotional harm to individuals, or damage to or loss of the use of property, on account of a defect in the product manufactured, leased, or sold by the taxpayer.  The damages must occur after the taxpayer has relinquished possession of the product.

This concept is illustrated by Regulation §1.172-13(b)(3) Example (1) where a heating equipment manufacturer sells a boiler to a customer.  If the boiler explodes and injures the customer after the boiler was fully installed and turned over to the customer, payment for the customer’s physical injuries qualifies as product liability.

Product liability losses are not subject to the 3-year rule applicable to other types of specified liability losses under IRC §172(f)(1)(B)(ii)(I).

Specified liability losses for the 5 items specifically enumerated in IRC §172(f)(1)(B)(i) only include amounts “in satisfaction of” the otherwise qualifying liability.  Product liability losses, by definition under IRC §172(f)(1)(A)(ii), also include the expenses incurred to investigate, settle or oppose product liability claims against the taxpayer. 

This is not an unlimited license however to include all items, no matter how remotely connected.  Regulation §1.172-13(b)(1)(ii) (flush language) provides, “Indirect corporate expense, or overhead, is not to be allocated to product liability claims so as to become a product liability loss.”

Regulation §1.172-13(b)(2)(ii) specifically excludes liability incurred as a result of services performed by the taxpayer from the definition of product liability.  Where both a product and services are integral parts of the transaction, product liability cannot occur until after the taxpayer has relinquished possession of the product.  The service based exclusion is illustrated by Regulation §1.172-13(b)(3) Example (3) where a medical association is sued for the malpractice of one of its doctors.  This service based damage payment does not qualify as product liability.

Regulation §1.172-13(b)(2)(iv) and (v) cover the basic rule that amounts paid for insurance against product liability are not paid on account of product liability and the limited exceptions.

Audit Steps

• Examiners should request a detailed break down of product liability amounts claimed in order to determine if the items are included within the definition of product liability expenses.  Verify that all the requirements and exclusions have been met.
• Product liability expenses Uniform Issue List (UIL) Code 172.06-00 refers to product liability issues and UIL 172.07-00 refers to other specified liability losses

Issue 2: Damages vs. product replacement/warranty expenses

Regulation §1.172-13(b)(2)(ii) provides that the term "product liability" does not include liabilities arising under warranty theories relating to repair or replacement of the property that are essentially contract liabilities.  “For example, costs incurred by a taxpayer in repairing or replacing defective products under the terms of a warranty, express or implied, are not product liability losses.”

Agents have encountered situations where the taxpayer manufactures small appliances such as toasters.  When the product does not work, the taxpayer replaces the appliance or refunds the customer’s purchase price.  The taxpayer then includes these costs in the 10-year carryback computation.  This is not correct.  If the defective product caught fire and damaged the customer’s house, the amounts paid for the customer’s damages would qualify while the cost of replacing the defective item would not.

Taxpayers often attempt to claim the cost of product or safety equipment recalls (both voluntary and involuntary) as product liability expenses even though the products caused no harm or injury.  When the taxpayer produces and sells a product it is, at the very least, implicit that the product is in proper operating condition and will perform the job for which it is sold.  If the product is defective and the taxpayer must incur costs to recall and replace the product, these costs are nothing more than liabilities arising under a warranty theory, essentially a contract liability.  They do not qualify as product liability expenses or losses.

Regulation §1.172-13(b)(3) Example (2) illustrates this point.  If the manufacturer of heating equipment sells a boiler to a customer and the boiler explodes after it has been installed and turned over to the customer, while the cost of damage or injury caused by the boiler qualifies as a product liability loss, the cost to replace or repair the boiler does not.

Audit Step

• Differentiate between costs incurred for damages or injury caused by the defective product and those for repairing or replacing the defective product.

Issue 3: Damages prior to completing delivery do not qualify

IRC §172(f)(4)(B) limits product liability to injury, harm or damage which “arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.”

Regulation §1.172-13(b)(3) contains examples which illustrate this principle.  In Example (4), the retailer of communications equipment is in the process of installing the equipment for the customer when the unit catches on fire.  Because the retailer had not relinquished control of the equipment, amounts paid to the customer for damage to the customer’s property are not payments on account of product liability.  Had the retailer finished the installation and relinquished control to the customer, the damages would have constituted payments on account of product liability as illustrated by Example (5).  Similarly, if the equipment later catches on fire during a subsequent service visit by the retailer, the amounts paid for customer property damages qualify as product liability expenses as shown by Example (6).

Regulation §1.172-13(b)(3) Example (7) deals with a computer manufacturer who sells a computer to the customer.  The manufacturer also has employees who periodically service the computer after the initial delivery, installation, servicing and testing have been completed.  If the computer catches fire during one of these subsequent service calls, amounts paid for property damage to the customer’s office and physical injury to the customer are considered product liability payments

IRS vs. Harvard Secured Creditors Liquidation Trust, 96 A.F.T.R.2d ¶ 6409 (D.N.J. 2005), dealt with settlement payments relating to defective aircraft parts manufactured by a Harvard division.  The District Court held that Harvard’s product liability losses do not qualify as specified liability losses under IRC §172(f)(4).

The District Court looked to Black’s Law Dictionary 963 (8th ed. 2004) for the definition of “loss”:  “failure to maintain possession of a thing”.  The court stated:

There is no dispute that the intended use of the lock-nuts was inventory for resale by Harvard’s customers.  It follows that the loss of such use, under the definition of loss cited above, could not have occurred.  Loss contemplates possession followed by the failure to maintain possession.  Harvard’s customers did not have possession of lock-nuts fit for resale at any point; they merely had possession of defective lock-nuts that were unfit for resale. Consequently, Harvard's customers could not have lost the use of the property for its intended purpose where they did not possess usable lock-nuts in the first place.

The District Court also addressed the requirement that the taxpayer must have relinquished possession of the product:

In the instant case, the defect that gave rise to Harvard's liability arose during the manufacturing of the lock-nuts, as Harvard's own brief admits. (Apelles's Br. at 5). Since the damage to the property clearly occurred before Harvard relinquished possession of the product, the damage to the lock-nuts is excepted from the statutory definition of product liability as stated in 26 U.S.C. section 172(f)(4).

Id.  Examiners may wish to check on the Service's current view as to the applicability of this case to a given set of facts before citing to it.

Audit Steps

• Examiners should review any claims for damages resulting in injury, harm, or damage due to defective products to ensure that the taxpayer had completed all the necessary steps to deliver, install, initially service and test the equipment and relinquish control to the customer before the defective product malfunctioned.  For large projects this may involve inspecting all the contracts and any necessary sign-offs on building or other permits.  Details can also be found in the court documents or complaints filed against the taxpayer alleging liability for damages.
• Be sure to examine any product liability insurance policies or other coverage the taxpayer maintains to determine if the taxpayer was reimbursed for the damage expenditures.  Such insurance should be both included in income and offset against the related damage payments for purposes of IRC §172(f).

Issue 4: Proper treatment of insurance reimbursements

This is an area where we have encountered significant differences in treatment by taxpayers.  Some taxpayers have failed to report the insurance reimbursements, either on an as received basis or by accrual even though the taxpayer has a reasonable prospect of recovery.  These taxpayers have instead deducted the expense payments and treated them as eligible for a 10-year carryback.  See FSA 1992 WL 1354825 [2] which concluded, based upon its facts, that even though a contested liability is paid, a deduction may not be accrued “because under these facts a right to reimbursement existed which was virtually certain to be paid.  Such a right to reimbursement precludes a section 162 trade or business deduction.”

Other taxpayers, while reporting the insurance reimbursements in income, have failed to offset the insurance reimbursements against the related expenditures before computing the 10-year carryback amount.  The typical taxpayer position in support of this treatment is that only IRC §165 contains the language “and not compensated for by insurance or otherwise” while these expenditures are deducted under IRC §162.

One taxpayer, in the environmental remediation area, contended that insurance settlement payments received under third-party Commercial General Liability policies were monies received due to an involuntary conversion under IRC §1033(a)(2).  TAM 200322017[3]  concluded that insurance settlement payments received by the taxpayer in this scenario were monies received for indemnification with respect to tort liability and not monies received due to an involuntary conversion.

Two Chief Counsel Advice memoranda addressed the treatment of a mixture of SLLs and of product liability expenses.  Under the particular facts, CCA200725031[4] , concerning a manufacturer taxpayer, concludes:

(1) A taxpayer may not claim a section 165 loss deduction to the extent the taxpayer has a claim for reimbursement for which there is a reasonable prospect of recovery.  A taxpayer may not claim a section 162 business expense deduction to the extent the taxpayer has a right to reimbursement, even if the right is not certain or is subject to a contingency.  The standards "reasonable prospect of recovery" under section 165 and "right to reimbursement" under section 162 are highly factual.  Whether a taxpayer claims a deduction for an expense under section 165 or section 162, the deduction should be denied if, based on the facts and circumstances, the taxpayer has insurance coverage that appears to provide a right to reimbursement and there is no indication that an exception to coverage applies.

(2) A SLL expense must be allowed as a deduction for the taxable year in order to generate a SLL for that year.

(3) The taxpayer generally must include the amount of reimbursement for prior year SLL expenses in gross income in the taxable year of reimbursement pursuant to the tax benefit rule.  To be eligible to generate a SLL, section 172(f)(1) simply requires an item to qualify as a SLL expense and to be deductible (under section 162 or section 165 for product liability expenses) for the taxable year.  Neither section 172(f) nor the regulations thereunder provide any authority to net recoveries of SLL expenses deducted in prior taxable years against unrelated SLL expenses for the current taxable year in determining SLL deductions for the current taxable year.

(4) Deductions for legal and other fees incurred in connection with resolving issues that do not bear on Taxpayer's product liability to third party claimants but relate only to Taxpayer's claims against its insurers do not qualify as product liability deductions.

CCA 200730020[5] , in addition to echoing some conclusions of the other CCA, holds as follows:

(2) A product liability expense must be allowed as a deduction for the taxable year under section 162 or 165 in order to generate a SLL in that year.

(3) The taxpayer generally must include the amount of reimbursement for prior year product liability expenses in gross income in the taxable year of reimbursement pursuant to the tax benefit rule.  To be eligible to generate a SLL, section 172(f)(1) simply requires an item to qualify as a product liability expense and to be deductible under section 162 or section 165 for the taxable year.  Neither section 172(f) nor the regulations thereunder provide any authority to net recoveries of product liability expenses deducted in prior taxable years against product liability expenses for the current taxable year in determining product liability deductions for the current taxable year.

Issue 5:  Prejudgment and post-judgment interest do not qualify

Concerning prejudgment and post-judgment interest that a taxpayer pays on product liability losses, CCA 200836025[6]  concluded:

1. Prejudgment interest is not deductible under section 163 since it is not interest on indebtedness; however, prejudgment interest stemming from product liability is an ordinary and necessary business expense deductible under section 162 and post-judgment interest relating to product liability is deductible under either section 162 or section 163.
2. Prejudgment and/or post-judgment interest on product liability claims does not qualify as product liability damages within the meaning of section 172(f)(4) and thus is not eligible for the 10-year carryback provided in section 172(b)(1)(C).

For more information contact the IRC Section 172(f) Technical Advisor.

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Attachment 2 - Reclamation of Land

Introduction

Section 172(f) provides special rules for the portion of a net operating loss (NOL) that is identified as a specified liability loss (SLL) and as such is allowed a 10-year carryback as opposed to the two years generally allowed for NOLs. Section 172(f) was amended in 1998 to restrict the types of expenses that qualify as SLLs and therefore now only applies to a narrow set of liabilities.

IRC §172(f)(1) now requires that, for an amount to qualify as an SLL, it must be "in satisfaction of a liability under a Federal or State law requiring—(I) the reclamation of land, (II) the decommissioning of a nuclear power plant (or any unit thereof), (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers compensation act (within the meaning of §461(h)(2)(C)(i)).”

All U.S. mining operations are required to undertake reclamation and have detailed reclamation plans that must be approved by government officials before mining begins. Reclamation bonds may be required of the mining companies to ensure a successful completion of the process and may have detailed cost information. Although underground mines may not have as much surface disruption as a surface mine, they do have reclamation requirements for stabilizing tailings (waste), ponds, removing surface facilities and reclaiming disturbed areas when mining is completed.
The Surface Mining Control and Reclamation Act of 1977 (SMCRA) is a federal law requiring the reclamation of coal mines in the United States. This law is only applicable to coal mines. For non-coal mine or quarry reclamation, individual states will have separate laws for general restoration requirements and or specific restoration requirements which are dependent upon the type of mineral products produced in the state.

Expenditures incurred for the reclamation of land at mining operations qualify as specified liability losses. IRC §172(f)(1)(B)(i)(I).

Reclamation may include the following activities:

• dismantlement of surface facilities
• contouring and grading of land;
• the placement of subsoil and topsoil or an approved substitute on the graded area;
• reseeding with native vegetation, crops and/or trees; and
• future monitoring to assure success.

There are some potential issues regarding reclamation SLLs that examiners need to be aware of and include the following:

Issue 1: Qualified reclamation versus current operating or capital expenditures
Issue 2: Reclamation deductions claimed under IRC §468 do not qualify as SLLs
Issue 3: Reclamation of land disturbed within 3 years of the taxable year
Issue 4: When Depreciation may qualify as an SLL

Issue 1: Qualified reclamation versus current operating or capital expenditures

Examiners should be aware that taxpayer claims for reclamation deductions as a qualified specified liability loss subject to IRC §172(f) may include non qualified expenditures for current operating and capital costs.

Current operating costs to maintain compliance with permits or Federal or State mining laws may not be qualified reclamation or may not meet the 3 year rule pursuant to IRC §172(f)(1)(B)(ii)(I). For example, costs of extraction of a mineral product from the ground are not reclamation costs to restore land disturbed from the extraction process. However some concurrent backfilling (with material from the current extraction process) of land disturbed 3 years prior to the taxable year may be qualified reclamation for purposes of IRC §172(f). Similarly, costs of maintaining permit compliance such as spraying water on roads to minimize dust are not qualified reclamation, even though the roads were built more than 3 years prior to the taxable year and will be subject to removal and reclamation in the future.

Taxpayer claims for reclamation deductions may also include nonqualified capital costs. For example, current operating permits and reclamation plans may require the construction of sediment or tailings (waste) disposal impoundments. These impoundments, when filled to capacity, will be required to be sealed, closed and reclaimed. The construction of these impoundments are capital costs subject to IRC §263(a) and as such are not currently deductible nor subject to IRC §172(f), even though the impoundments themselves will be reclaimed in the future.

Audit Steps

• Examiners should request a detailed break down of reclamation costs and activities that the taxpayer has claimed as specified liability losses.
  Reference - Initial Pro Forma IDR for Issue Development
• Examiners should also request the taxpayer’s mining and reclamation plans and maps which would be filed with State or Federal authorities as part of the taxpayer’s mining permit application.
• Note that the taxpayer will also be required to file annual reclamation activity reports with the State or Federal permitting agency. Request these annual reports and conduct the following analysis:
• Reconcile the claimed costs and activities to those listed in the reclamation plan.   
• Identify any potential non-qualifying operating and capital costs.
• Identify land disturbance dates from the mining plan and compare it with the current reclamation activities.

Issue 2: Reclamation deductions claimed under IRC §468 do not qualify as SLLs

Examiners should be aware that taxpayer deductions for reclamation claimed pursuant to IRC §468 do not qualify as specified liability losses subject to IRC §172(f).

IRC §468 is an elective provision that allows taxpayers to accrue and deduct mine reclamation and solid waste disposal property closing costs in advance of the economic performance rules under IRC §461.

Election to deduct reclamation costs under IRC §468 is mutually exclusive to qualification as a specified liability loss for purposes of the 10-year carryback. IRC §172(f)(1)(B)(i).

Audit Steps

• Examiners should ascertain whether the taxpayer has an IRC §468 election in place. There are no treasury regulations for IRC §468 and therefore the specific method of election is not always apparent.
• Review the tax return for election statements.
• Specifically ask the taxpayer if an election has been made in a prior year. Sometimes taxpayers will simply accrue reclamation for tax purposes which may be considered a deemed election under IRC §468.
• Although there may be a Schedule M adjustment for reclamation, financial accruals for reclamation will be different from the tax accrual for reclamation due to the interest provisions of IRC §468. Do not mistake this Schedule M as a reversal of financial accruals.
• Take issue with any IRC §172(f) claims where a deduction for reclamation has been claimed under IRC §468.

Issue 3: Reclamation of Land Disturbed within 3 years of the taxable year

For purposes of the 10-year carryback, a liability shall be taken into account only if:

1. The act (or failure to act) giving rise to such liability occurs at least 3 years before the beginning of the taxable year, IRC §172(f)(1)(B)(ii)(I), and
2. The taxpayer used an accrual method of accounting throughout the period or periods during which such act (or failure to act) occurred, IRC §172(f)(1)(B)(ii)(II).

Nearly all mining operations are governed by either Federal or State laws requiring reclamation of the land subsequent to mining. All coal mines are governed by the Surface Mining Control and Reclamation Act of 1977, (SMCRA), a Federal law. Other non coal minerals reclamation will be governed by individual state laws and vary in the degree or amount of reclamation required by state and by mineral type produced within the state. For example, a sand and gravel quarry may have different reclamation requirements from a phosphate rock mining operation within the same state. Both the sand and gravel and phosphate mine reclamation may be different from any coal mine reclamation required under federal law.

In many instances, state regulations for reclamation will specifically identify the time period between when the land is disturbed from mineral extraction and when reclamation must begin and when reclamation must be completed.

To qualify as a specified liability loss subject to the 10-year carryback, any qualified reclamation of land must address a reclamation liability that occurred at least 3 years prior to the beginning of the taxable period in which the costs were incurred. The act of disturbing the land for mineral production is the act that establishes the reclamation liability.

Audit Steps

• The examiner should identify and understand the Federal or State law that establishes the taxpayer’s reclamation liability.
• Examiners should also request the taxpayer’s mining and reclamation plans and maps which would be filed with State or Federal authorities as part of the taxpayer’s mining permit application.
• Note that the taxpayer will also be required to file annual reclamation activity reports with the State or Federal permitting agency. Request these annual reports and conduct the following analysis:
• Request copies of the Federal or State laws requiring the extent of reclamation. These laws can also be accessed using internet research for any particular state.
• Review the timing requirements for the commencement and completion of reclamation.
• Ensure that reclamation costs claimed as a qualified specified liability loss meet the 3 year rule by comparing reclamation costs incurred to areas disturbed by mining. (Use reclamation reports, reclamation maps and mining maps requested to compare costs incurred to areas disturbed and reclaimed.)

When Depreciation may qualify as an SLL

While liabilities arising under federal or state law may constitute a portion of the depreciable basis of an asset, depreciation deductions arising from the liability giving rise to the depreciable basis of a depreciable asset are not included as part of the specified liability loss solely because the source of that portion of the basis arises from a federal or state liability.

Depreciation deductions may be allowable with respect to liabilities (including reclamation) satisfied through the use of the depreciable asset. For example, depreciation on a bulldozer used to contour or grade land may be included as part of the specified liability loss.

Liabilities arising under federal or state law may be treated as part of the cost basis of property if the liabilities are properly chargeable to a capital account. For example, IRC §164(a) requires sales taxes imposed on the purchase of equipment used in a taxpayer’s trade or business to be capitalized into the cost basis of the equipment.

If an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3 years before the beginning of that taxable year, some taxpayers have asserted that any portion of the NOL generated by depreciation deductions for the portion of the property’s depreciable basis attributable to the capitalized sales tax constitutes a pre-1998 IRC §172(f)(1)(B) specified liability loss irrespective of how the property is used. Likewise, taxpayers may be required to place certain equipment into service to comply with requirements of federal or state law, for example, clean water standards. Some of these taxpayers have asserted that if the equipment was acquired by the taxpayer at least 3 years prior to the beginning of the taxable year, the portion of any NOL generated for the taxable year by depreciation deductions attributable to the equipment qualifies as a former IRS §172(f)(1)(B) specified liability loss. The Service disagrees with both of these assertions.

IRC §167(a) allows a depreciation deduction only for property that is either used in a trade or business or held for the production of income. Whether a depreciation deduction is allowable “with respect to” a liability depends upon the property’s actual use. For example, if a taxpayer uses equipment to satisfy an environmental cleanup liability imposed by federal law, the portion of the equipment’s depreciation allocable to satisfying the environmental cleanup liability is allowable with respect to the environmental cleanup liability. If the environmental cleanup liability arose as a result of a chemical spill that occurred at least 3 years before the beginning of the taxable year and the environmental cleanup liability is otherwise deductible, the depreciation deductions may generate a specified liability loss. However, if a taxpayer uses equipment to satisfy environmental cleanup liabilities that arise during the same taxable year the depreciation deductions are allowable, for example, by preventing the discharge of pollutants resulting from manufacturing activities during the current taxable year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy the 3-year act or failure to act requirement of former IRC §172(f)(1)(B)(i), irrespective of when the taxpayer placed the cleanup equipment in service.

Reference: IRS Notice 2005-20, 2005-1 C.B. 635.

Audit Step

• Examiners should review any claims for depreciation as a qualified specified liability loss and ensure that the depreciation is related to capital assets used in satisfying a liability as opposed to a deduction claimed with respect to the liability giving rise to depreciable basis of a depreciable asset.

For more information contact the Mining Technical Advisors.

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Attachment 3 - Decommissioning of Nuclear Power Plant

Introduction

IRC § 172(f)(1) now requires that an amount be "in satisfaction of a liability under a Federal or State law requiring—(I) the reclamation of land, (II) the decommissioning of a nuclear power plant (or any unit thereof), (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers compensation act (within the meaning of IRC § 461(h)(2)(C)(i)).

In general, expenditures incurred for the decommissioning of a nuclear power plant (or any unit thereof) qualify as a specified liability loss (SLL) for purposes of IRC § 172(f).

Nuclear decommissioning costs are defined in Treas. Reg. § 1.468A-1T(b)(6).

Unlike other SLLs which must be carried back 10 years, nuclear decommissioning costs may be carried back to the year the plant was placed in service; IRC § 172(f)(3). 

Be aware that for purposes of determining whether a unit has been decommissioned, each unit located at a multiunit site, constitutes a separate nuclear power plant. Treas. Reg. § 1.468A-1T(b)(5)

While the amounts allowable as a deduction under IRC § 468A(a) for payments to a Nuclear Decommissioning Reserve Fund are not part of a "specified liability loss," IRC § 172(f)(1)(B)(i), nuclear decommissioning costs paid with assets from either the Fund, or from other sources, qualify as a "specified liability loss."  CCA 200835031.[7]

There are some potential issues that examiners need to be aware of and include the following:

• Issue 1: Payments into an IRC § 468A fund do not qualify as SLLs. [IRC § 172(f)(1)(B)(i)]
• Issue 2: Do the claimed costs meet the definition of decommissioning expenditures defined by Treas. Reg. § 1.468 A-1T(b)(6)?

Issue 1 – Payments into an IRC § 468A fund do not qualify as SLLs

Audit Steps:

• Examiners should determine if the taxpayer has elected the provision of Treas. Reg. § 1.468A-7T  
• If the Taxpayer has elected this provision, request the required Private Letter Ruling (PLR) if it is not attached to the return. Treas. Reg. § 1.468A-3T.
• Verify payment compliance with the PLR:
  • Examiners should also verify the existence of a financial reserve for nuclear decommissioning. 
  • Check for current year increases to the reserve.
  • If there are current year increases, the examiner should review Schedule M’s adjustments to determine the tax treatment of the fund payment.
  • Ensure that payments into the fund are not included in computing a Specified Liability Loss.

Issue 2 - Do the claimed costs meet the definition of decommissioning expenditures defined by Treas. Reg. § 1.468A-1T(b)(6)?

Audit Steps:

• Are the decommissioning costs being incurred at a multiunit nuclear power plant site?
  • Has the entire site been permanently been shut down or in the process of being shut down?
  • If not, determine if one of the units has been or is in the process of being permanently shut down and ensure the costs being claimed as SLL costs relate to that specific unit.
    • Costs associated with the assets acquired to store spent nuclear fuel assemblies removed from a unit and the monitoring of the spent fuel may qualify as decommissioning costs under Treas. Reg. § 1.468A-1T(b)(6)
• Request information documenting that cost being claimed as SLL cost meet the definition of decommissioning costs as described in the regulations.

For more information contact the IRC Section 172(f) Technical Advisor and the Utility Technical Advisors.

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Attachment 4 - Dismantlement of Drilling Platforms

Introduction

IRC §172(f)(1) provides ” The term ’specified liability loss‘ means the sum of the following amounts to the extent taken into account in computing the net operating loss for the taxable year.”

IRC §172(f)(1)(B)(i) states, “Any amount allowable as a deduction under this chapter (other than section 468(a)(1) or 468A(a)) which is in satisfaction of a liability under a Federal or State law requiring --- (I) the reclamation of land; (II) the decommissioning of a nuclear power plant, (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers compensation act within the meaning of section 461(h)(2)(C)(i).”

IRC §172(f)(1)(B)(ii) provides additional conditions on allowable deductions. “A liability shall be taken into account under this subparagraph only if — (I) the act (or failure to act) giving rise to such liability occurs at least 3 years before the beginning of the taxable year, and (II) the taxpayer used an accrual method of accounting throughout the period or periods during which such act (or failure to act) occurred.”
IRC §172(f)(2) provides a “Limitation – The amount of the specified liability loss for any taxable year shall not exceed the amount of the net operating loss for such taxable year.”

Preceding those sections, IRC §172(b)(1)(C), concerning specified liability losses, states, “In the case of a taxpayer which has a specified liability loss (as defined in subsection (f)) for a taxable year, such specified liability loss shall be a net operating loss carry back to each of the 10 taxable years preceding the taxable year of such loss.”

Dismantlement of offshore platforms arises as specified liability loss based on the manner in which such drilling rights are obtained.  Accrual basis taxpayers acquire long term mineral leases for the production of oil and gas. Offshore oil and gas leases typically have durations of 20 years or more. Easements are generally negotiated for oil and gas pipeline right-of-ways. The terms of the leases or land easements contain a contractual obligation to remove the platforms and well fixtures upon abandonment of the wells or termination of the leases. The pipeline must be removed when it is no longer used (i.e., after the last barrel of oil has moved through the pipeline) or upon termination of the easement.

The Petroleum Industry Technical Advisor Team provides general guidance on issues involving drilling platforms because of their involvement with the oil and gas industry.

Audit Steps

• Examine the expenditures included within the specified liability loss related to the dismantlement of the drilling platforms to insure current period costs are excluded.
• Determine if taxpayer accrued and deducted estimated dismantling and removal costs, either as an improper method of accounting or pursuant to a pre 1984 Appeals coordinated settlement position.
• Determine if the dismantlement was triggered by storm damage and whether there is any potential insurance reimbursement.
• Determine if the claimed dismantlement of the platform is in satisfaction of a liability under a Federal or State law.

For more information contact the Petroleum Technical Advisors.

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Attachment 5 – Remediation of Environmental Contamination

Introduction

IRC § 172(f) provides special rules for the portion of a net operating loss (NOL) that is identified as a specified liability loss (SLL) and as such is allowed a 10-year carryback, as opposed to the two years generally allowed for NOLs. IRC § 172(f) was amended in 1998 to restrict the types of expenses that qualify as SLLs and therefore now only applies to a narrow set of liabilities.

IRC § 172(f)(1) now requires that an amount be "in satisfaction of a liability under a Federal or State law requiring—(I) the reclamation of land, (II) the decommissioning of a nuclear power plant (or any unit thereof), (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers’ compensation act (within the meaning of IRC § 461(h)(2)(C)(i)).
All individuals and businesses living or operating within the United States, its commonwealths, possessions and boundaries are subject to US Environmental Laws and Regulations as administered by the US Environmental Protection Agency (EPA). In addition, individual state agencies may be charged with the administration and enforcement of both federal and state environmental laws and regulations.   States may, under their own discretion, put in place laws or regulations that exceed such federal standards.  Environmental statutes regulate the necessity, level and timing of the remediation (clean up) of environmental contamination.

Areas for close review include: 

• The US and State environmental statutes have provisions covering a wide range of environmental laws and regulations, including, but not limited to, current compliance requirements, enforcement and remediation.  The environmental statutes further provide for criminal and civil monetary penalties for failure to comply with related provisions.  Additionally, under environmental enforcement provisions, the EPA, state environmental agencies, Department of Justice and State Attorney General offices have the ability to mitigate some or all monetary penalties in exchange for the violator to voluntarily incur costs for a supplemental (beneficial) environmental project (SEP / BEP).  Current compliance requirements, capital projects, SEPs, BEPs, or similar activities performed or paid in lieu of paying some or all of a penalty, as well as clearly identified penalty payments, are not qualified environmental remediation expenses. Therefore, such costs are not eligible as an SLL under IRC § 172(f)(1)(B)(i)(IV).
  
• Environmental remediation costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its production activities are subject to Revenue Rulings 2004-18 and 2005-42.  For tax years ending after February 6, 2004, Rev. Rul. 2004-18 and 2005-42 treat environmental remediation costs as indirect costs of production, subject to capitalization under IRC § 263A.  Therefore, costs incurred (within the meaning of IRC § 461(h) and Treas. Reg. § 1.263A-1(c)(2)(ii)) to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste by the operation of the taxpayer's manufacturing plant must be included in inventory costs under IRC § 263A.
  
  IRC § 172(f)(1)(B) permits the inclusion of "[a]ny amount allowable as a deduction" that otherwise qualifies as an SLL. Thus, since environmental remediation costs that are allocated to inventory under IRC § 263A and recovered through cost of goods sold are taken into account in computing taxable income, they constitute SLLs to the extent they are taken into account in computing a net operating loss for the taxable year.  IRC § 172(f)(1) requires that amounts must be “taken into account in computing the net operating loss for the taxable year.”  Environmental remediation costs that are allocated to inventory under IRC § 263A are taken into account in computing the net operating loss for the taxable year, but only to the extent they are included in cost of goods sold for that year.  Environmental remediation costs allocated to inventory that remains on hand at the end of the taxable year (ending inventory) are not “taken into account in computing the net operating loss for the taxable year.”  Those costs may be treated as SLLs for the year that they are actually recovered through cost of goods sold, rather than the year in which they are incurred, so long as the taxpayer incurs a net operating loss for that year.  It is the taxpayer’s responsibility to keep sufficient records as required by IRC § 6001 of the Code to document the portion of any future year’s cost of goods sold that constitutes an SLL. 
  
  In the event that environmental remediation costs that a taxpayer incurred in a prior tax year are included in the cost of goods sold for a later tax year, but the taxpayer does not incur an NOL for that later tax year, then the environmental remediation costs do not qualify as an SLL because they are not part of an NOL for that year.  Likewise, qualifying environmental remediation costs incurred during a tax year in which a taxpayer does not incur an NOL can nonetheless qualify as an SLL in a later tax year in which those costs are included in the cost of goods sold for that later tax year, and the taxpayer incurs an NOL.

IRC § 172(f)(1)(B)(ii)(I) requires the act or failure to act to have occurred at least three years prior to the beginning of the taxable year in which the remediation liability is claimed.  The triggering event for the application of this three year rule is that the actual environmental contamination must occur up to three years prior to the beginning of the taxable year in which liability for the activities undertaken to remediate the contamination is incurred, within the meaning of Treas. Reg. § 1.446-1(c)(1)(ii).

Remediation costs eligible for IRC § 172(f) treatment may include the following:

• Environmental site investigatory costs:
  • Preparation of Investigation report
  • Preparation of response action plan
• Preparation of site for cleanup
• Reimbursements of the EPA or state agency for either investigatory or remediation costs incurred by them concerning the site
• Excavation and disposal of regulated substances found at the site
• Containment or encapsulation costs not subject to capitalization under IRC § 263(a)
• Excavating, stockpiling, or transporting contaminated soil to a waste facility
• Replacement or backfilling of soil
• Treatment of contaminated soil as necessary
• Treatment of contaminated water as necessary
• Monitoring costs to assure success
• Remediation costs allocated to inventory under IRC § 263A and in the year recovered through cost of goods sold, but only to the extent they are included in the current year NOL.

Remediation costs under IRC § 172(f) does not include the following:

• Remediation costs for contamination that occurred less than three years before the beginning of the taxable year
• Environmental remediation costs allocated to inventory that remains on hand at the end of the taxable year (ending inventory)
• Current compliance costs
• Remediation costs on assets acquired with pre-existing contamination
• EPA or state agency fines or penalties
• Any voluntary environmental projects, including supplemental (beneficial) environmental projects (SEPs / BEPs), even if incurred on or adjacent to the contaminated site
• Generally, legal costs are not considered environmental remediation expenses for purposes of IRC § 172(f).

Examples of excluded legal costs:

• Legal costs incurred to negotiate EPA consent decrees
• Legal costs incurred to defend against civil or criminal charges for violation of environmental laws or regulations
• Legal Costs incurred to defend against third party liability claims

• Any capital expenditure subject to IRC § 263(a) , including construction of ground water treatment facilities, wells, pipes, pumps or other equipment put in place to monitor or treat the soil or water

Remediation of environmental contamination

Audit Steps

• Examiners should request:
  • A detailed break down of remediation costs and activities that the taxpayer has claimed as SLLs
  • A complete copy of any and all notices of environmental violations issued by federal or state environmental agencies
  • A complete copy of any consent or similar agreements entered into by federal or state environmental agencies
  • Notices of lawsuits or litigation regarding third party claims surrounding environmental contamination
  • Complete copies of insurance reimbursement claims submitted by taxpayer surrounding environmental contamination
  • Complete insurance settlement agreements regarding environmental contamination
  • Examiners should also request the taxpayer’s site investigation report and remediation action plan
  • For manufacturers, request, where appropriate, the following records:
    • Documents showing the type and quantity of goods manufactured at the site of contamination during the year of remediation
    • Inventory records showing both the inventory method employed for such goods (e.g., FIFO, LIFO), and the computation of both the cost of goods sold and the ending inventory for such goods
    • Where SLLs contain amounts that had been included in the inventory balances carried forward into that tax year, substantiation of the qualification of such expenditures as SLLs during the year incurred (i.e., 3-year time period from contamination to start of tax year when cost incurred)
    • Proof of NOL in tax year for which SLL claimed
  • Examiner Review Steps
    • Reconcile the claimed costs and activities to those listed in the remediation plan.
    • Identify any potential nonqualifying operating and capital costs
    • Identify any remediation costs that are included in inventory at the end of the year
    • Look for insurance reimbursements on claimed SLL expenses
    • Examiners should review any claims for depreciation as a qualified SLL and ensure that the depreciation is related to capital assets used in satisfying a liability as opposed to a deduction claimed with respect to the liability giving rise to depreciable basis of a depreciable asset.

Examiners need to be aware of the following potential issues regarding environmental remediation SLLs:

• Issue 1: Qualified remediation versus current operating or capital expenditures
• Issue 2: Contamination of site within 3 years of the taxable year
• Issue 3: Insurance reimbursement
• Issue 4: When Depreciation may qualify as an SLL

Issue 1: Qualified remediation versus current operating or capital expenditures

Examiners should be aware that taxpayer claims for remediation deductions as a qualified SLL subject to IRC § 172(f) may include nonqualified expenditures for current operating and capital costs.

Current operating costs to maintain compliance with Federal or State environmental laws may be remediation expenses but do not meet the three-year rule pursuant to IRC § 172(f)(1)(B)(ii)(I).  For example, costs of normal monitoring and testing of a facility as required by the EPA for current pollution output would not qualify as an IRC § 172(f) remediation expense.  However monitoring costs related to environmental contamination eligible under the three-year rule will qualify.  Similarly, costs of maintaining permit compliance, such as obtaining or purchasing emission credits, are not qualified remediation.

Taxpayer claims for remediation deductions may also include nonqualified capital costs.  For example, current pollution operating permits may require the construction of monitoring wells or slurry containment walls. The construction of these assets are capital costs subject to IRC § 263(a) and as such are not currently deductible nor subject to IRC § 172(f). Taxpayer claims for remediation may also include costs to remediate assets that were acquired with pre-existing contamination.  Clean up costs of such preexisting contamination are required to be capitalized to land, see United Dairy Farmers, Inc. v. United States, 107 F. Supp. 2d 937, 943 (S.D. Ohio 2000), and therefore do not qualify for IRC § 172(f) treatment.

Reference – Rev. Ruls. 94-38, 2004-18 and 2005-42.

Reference – United Dairy Farmers, Inc., 107 F. Supp. 2d 937 (S.D.Ohio 2000) , aff’d, 267 F.3d 510 (6th Cir. 2001).

Issue 2: Remediation of site contaminated within 3 years of the taxable year

For purposes of the 10-year carryback, a liability shall be taken into account only if —

1. The act (or failure to act) giving rise to such liability occurs at least 3 years before the beginning of the taxable year, IRC § 172(f)(1)(B)(ii)(I), and
2. The taxpayer used an accrual method of accounting throughout the period or periods during which such act (or failure to act) occurred, IRC § 172(f)(1)(B)(ii)(II).

Pollution and contamination can be the result of many years of production at such site and may be continuing at a site while remediation efforts are occurring. As a result, some remediation costs are for contamination that occurred less than 3 years before the beginning of the taxable year at issue.

In many instances, EPA site evaluations as well as remediation plans will clearly identify costs needed to remediate contamination as being at least 3 years old.  Specific identification of contaminants can at times be readily identified in site reports. At other times, although rare, contamination more than 3 years old and less than three years old can be commingled, making it difficult to determine costs associated with remediation for contamination greater than three years old.  Although the taxpayer has the burden to verify or break out costs eligible for IRC § 172(f), examiners should evaluate all facts and ascertain the reasonableness of any allocation of such costs.

To qualify as an SLL subject to the 10-year carryback, any qualified remediation expense must address a contamination liability that occurred at least 3 years prior to the beginning of the taxable period in which the costs were incurred.

Issue 3:  Treatment of insurance reimbursements for remediation expenses.

Examiners should be aware that taxpayer claims for remediation deductions as a qualified SLL subject to IRC § 172(f) may include expenses for which it has or will be reimbursed.  Insurance reimbursement surrounding environmental contamination can be received from either a property and casualty insurer or pursuant to a commercial general liability policy.  Care should be taken as to treatment of both the reporting of such reimbursement as well as the netting of insurance claims against claimed IRC § 172(f) expenses.

(See examples below)

• Taxpayer treated the insurance reimbursements on a cash basis and reported them in income in the year of receipt, irrespective of the period during which the related IRC § 172(f) expenditures that the insurance served to reimburse were deducted.  To the extent that the insurance reimbursements were determinable in the year of the related expenditures, this overstated the IRC § 172(f) 10-year carryback.  
• Taxpayer claimed that its insurance reimbursements from a commercial general liability policy were not taxable but rather constituted receipts from involuntary conversions under IRC § 1033.  In this scenario, the taxpayer deducted all the expenditures, but did not report the related insurance reimbursement.  While such recoveries are based upon the facts surrounding the payments, the origin of the claim doctrine should prevent insurance claims on commercial general liability policies from being treated as proceeds from involuntary conversions, as the basis of that type of insurance reimbursement is generally based upon damages to third-parties.  See, generally, Kieselbach v. Commissioner, 317 U.S. 399 (1943), and Tiefenbrunn v. Commissioner, 74 T.C. 1566 (1980).  Although not related to an IRC § 172(f) claim, this treatment also illustrates an erroneous tax treatment of insurance proceeds.
• Taxpayer had received an insurance settlement based on environmental claims filed with its insurer.  The settlement was recorded in the books as goodwill and no adjustment was made to include the settlement in taxable income or reduce the related expense before carryback.  The taxpayer maintained that the insurance settlement was recovery of basis and, therefore, not taxable. Since the proceeds are includible as income under IRC § 61, this position is an erroneous tax treatment of insurance proceeds.

Issue 4:  When Depreciation may qualify as an SLL

While liabilities arising under Federal or State law may constitute a portion of the depreciable basis of an asset, depreciation deductions arising from the liability giving rise to the depreciable basis of a depreciable asset are not included as part of the SLL solely because the source of that portion of the basis arises from a Federal or State liability.

Depreciation deductions may be allowable with respect to liabilities (including remediation) satisfied through the use of the depreciable asset.  For example, depreciation on a bulldozer used to remove contaminated soil may be included as part of the SLL.

Liabilities arising under Federal or State law may be treated as part of the cost basis of property if the liabilities are properly chargeable to a capital account.  For example, IRC § 164(a) requires sales taxes imposed on the purchase of equipment used in a taxpayer’s trade or business to be capitalized into the cost basis of the equipment.  If an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3 years before the beginning of that taxable year, some taxpayers have asserted that any portion of the NOL generated by depreciation deductions for the portion of the property’s depreciable basis attributable to the capitalized sales tax constitutes a pre-1998 IRC § 172(f)(1)(B) SLL, irrespective of how the property is used.  Likewise, taxpayers may be required to place certain equipment into service to comply with requirements of Federal or State law, such as clean water standards.  Some of these taxpayers have asserted that if the equipment was acquired by the taxpayer at least 3 years prior to the beginning of the taxable year, the portion of any NOL generated for the taxable year by depreciation deductions attributable to the equipment qualifies as a former IRC § 172(f)(1)(B) SLL.  The Service disagrees with both of these assertions.

IRC § 167(a) allows a depreciation deduction only for property that is either used in a trade or business or held for the production of income.  Whether a depreciation deduction is allowable “with respect to” a liability depends upon the property’s actual use.  For example, if a taxpayer uses equipment to satisfy an environmental cleanup liability imposed by federal law, the portion of the equipment’s depreciation allocable to satisfying the environmental cleanup liability is allowable with respect to the environmental cleanup liability.  If the environmental cleanup liability arose as a result of a chemical spill that occurred at least 3 years before the beginning of the taxable year and the environmental cleanup liability is otherwise deductible, the depreciation deductions may generate a SLL.  However, if a taxpayer uses equipment to satisfy environmental cleanup liabilities that arise during the same taxable year that the depreciation deductions are allowable, for example, by preventing the discharge of pollutants resulting from manufacturing activities during the current taxable year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy the 3-year act or failure to act requirement of pre-1998 IRC § 172(f)(1)(B)(i), irrespective of when the taxpayer placed the cleanup equipment in service.

Reference: IRS Notice 2005-20, 2005-1 C.B. 635

For more information contact the Environmental Technical Advisor.

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Attachment 6 – Payments under a Workers Compensation Act

Introduction

IRC § 172(f) was modified by §3004(a) of the Tax and Trade Relief Extension Act of 1998.  Other than product liability losses, only items specifically enumerated will qualify as Specified Liability Losses (SLLs) for net operating losses arising in tax years ending after October 21, 1998.  The statute retained the 3-year rule and the requirement for using an accrual method of accounting.

IRC § 172(f)(1) now requires that an amount be "in satisfaction of a liability under a Federal or State law requiring—(I) the reclamation of land, (II) the decommissioning of a nuclear power plant (or any unit thereof), (III) the dismantlement of a drilling platform, (IV) the remediation of environmental contamination, or (V) a payment under any workers compensation act (within the meaning of IRC § 461(h)(2)(C)(i)).”

IRC § 461(h)(2)(C)(i) references the following:

IRC § 461(h) Certain Liabilities Not Incurred Before Economic Performance.–

(1) In general.--For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.
(2) Time when economic performance occurs.--Except as provided in regulations prescribed by the Secretary, the time when economic performance occurs shall be determined under the following principles:

(C) Workers compensation and tort liabilities of the taxpayer.--If the liability of the taxpayer requires a payment to another person and --
(i) arises under any workers compensation act, or
(ii) arises out of any tort, economic performance occurs as the payments to such person are made. Subparagraphs (A) and (B) shall not apply to any liability described in the preceding sentence.

In Harvard Secured Creditors Liquidation Trust v. IRS, 2007 WL 1651144 (D. N.J., June 4, 2007), the U.S. District Court reversed a prior Bankruptcy Court case.  The bankruptcy court had held that retrospective adjustments a company paid on its workers’ compensation policies were deductible losses for IRC 172(f) tax treatment, but that administrative expenses did not qualify as specified liability losses.  The U.S. District Court reversed the part of the decision concerning the administrative expenses, and allowed the debtor-taxpayer to include the administrative expenses it paid to be treated as part of the price paid for the workers compensation insurance, qualifying as specified liability losses.
 
Audit experience with this tax law area has identified some potential issues that examiners need to be aware of and include the following:

• Issue 1: Black Lung Federal Excise Tax Payments do not qualify.
• Issue 2: Insurance premiums do not qualify.
• Issue 3: Self-insurance must meet the accrual and 3-year rules.
• Issue 4: Workers compensation costs that are allocated to inventory under IRC § 263A and recovered through cost of goods sold constitute specified liability losses to the extent they are taken into account in computing a net operating loss for the taxable year and meet all the other requirements.

Issue 1:

Black Lung Federal Excise Tax Payments do not qualify.         

Examiners should be aware that taxpayer’s claims for workers compensation payment expenditures qualifying for the IRC § 172(f) SLL 10-year carryback tax treatment may include non-qualifying payments to the Black Lung Disability Trust Fund.

The Federal Coal Mine Health and Safety Act of 1969, 83 Stat. 792, recognized for the first time in Federal legislation the inadequacy of compensation to miners totally disabled by pneumoconiosis (black lung) and to the miners’ families.  The Act, as amended by the Black Lung Benefits Revenue Act of 1977, Pub. L. No. 95-227, provides two separate and distinct programs in dividing the financial responsibility between the Federal government and the coal industry.  Under this two-part structure, the Federal government assumed the cost of the backlog of claims that had accumulated over decades, while the industry assumed the burden of paying new claims.   Black lung disease is caused by inhaling coal dust for prolonged periods of time, usually at least 10 years.

IRC § 4121 imposes an excise tax on domestically produced coal. The taxes collected on the sales of coal are deposited to the Black Lung Disability Trust Fund to finance payments of black lung benefits to afflicted miners.  Producers of coal in the United States are liable for the tax upon the first sale or use of the coal.  Using a Federal Tax Deposit form, the taxpayer should make semi-monthly deposits based on the incurred liability.  In addition, excise taxes are reported on the quarterly filed Form 720 (Quarterly Federal Excise Tax Return).

Some taxpayers have tried to make the nexus that their excise tax payments into this fund are in the nature of a workers compensation benefit.  However, the Service’s position is that these required payments are excise taxes; thus not qualifying for SLL tax treatment.

Audit Steps

• Examiners should request a detailed explanation from the Taxpayer as to the make-up of any workers compensation payments on IRC § 172(f) SLL claims.
• Examiners should also ask if any of the payments claimed as a qualifying SLL expenditure were made to the Black Lung Disability Trust Fund and/or filed on the quarterly filed Form 720 (Quarterly Federal Excise Tax Return).
• Examiners should ascertain from the Taxpayer the Federal or State law, which required such workers compensation payments for any of the claimed SLL expenditures.
• Ensure that the Taxpayer is using the accrual method of accounting per IRC § 172(f)(1)(B)(ii)(II) and that the 3 year rule under IRC § 172(f)(1)(B)(ii)(I) is met.

Issue 2:

Insurance premiums do not qualify.

Examiners should be aware that some taxpayers have also included their payments for health insurance premiums as qualifying for IRC § 172(f) SLL tax treatment under “worker’s compensation ”   These would not qualify for SLL treatment because of the IRC § 172(f)(1)(B)(i) requirement that any amount allowable as a deduction must be made in satisfaction of a liability under a Federal or State law.   Health insurance by an employer for the employees is not mandated by a federal or state law.  

Audit Steps

• Examiners should request a detailed explanation from the Taxpayer as to the make-up of any worker’s compensation payments on IRC § 172(f) SLL claims.
• Examiners should ascertain from the Taxpayer the Federal or State law which required such worker’s compensation payments for any of the claimed SLL expenditures.
• Ensure that the Taxpayer is using the accrual method of accounting per IRC § 172(f)(1)(B)(ii)(II) and that the 3 year rule under IRC § 172(f)(1)(B)(ii)(I) is met.

Issue 3:

Self-insurance must meet the accrual and the 3 year rules.

Situations may occur when the self-insured employer decides to pay individual employees’ cost from sustained job-related injuries.  In other situations, the self-insured employer may have coverage up to a certain limit and will incur a qualifying expenditure only when they have to make payments in excess of their coverage limit on specific incidents.  Both of these situations are common occurrences for self-insured employers. 

Audit Steps

• Examiners should request a detailed explanation from the Taxpayer as to the make-up of any workers compensation payments on IRC §172(f) SLL claims.
• The examiner should make sure that the Taxpayer is using the accrual method of accounting per IRC § 172(f)(1)(B)(ii)(II) and that the 3 year rule under IRC § 172(f)(1)(B)(ii)(I) is met.

Issue 4:

Workers compensation costs that are allocated to inventory under IRC § 263A and recovered through cost of goods sold constitute specified liability losses to the extent they are taken into account in computing a net operating loss for the taxable year and meet all the other requirements. 

The regulation excerpt below indicates that workers compensation payments for production workers are required to be capitalized.  Since it is likely that a significant portion of a manufacturer’s workers compensation payments would relate to production workers, agents should look closely at this area.

IRC § 263A(a) provides that the direct costs and indirect costs properly allocable to property that is inventory in the hands of the taxpayer shall be included in inventory costs.

Section 1.263A-1(a)(3)(ii) of the Income Tax Regulations requires a manufacturer of inventory to include in inventory costs (1) all direct costs of producing the inventory, and (2) the inventory’s allocable share of indirect costs.  Treas. Reg. § 1.263A-1(e)(3)(i) provides that indirect costs are properly allocable to produced inventory when the costs directly benefit or are incurred by reason of the performance of production activities.  Examples of indirect costs that must be allocated to inventory include cost recovery, production facility repair and maintenance costs, and scrap and spoilage costs, such as waste removal costs. See Treas. Reg. § 1.263A-1(e)(3)(ii)(I), (O), and (Q).

Treas. Reg. § 1.263A-1(c)(2)(i) provides that any cost which (but for IRC § 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under IRC § 263A and the regulations thereunder. 
Treas. Reg. § 1.263A-1(c)(2)(ii) provides that the amount of any cost required to be included in inventory under IRC § 263A may not be included in inventory before the taxable year during which the amount is incurred, within the meaning of Treas. Reg. § 1.446-1(c)(1)(ii). 

Under IRC § 461(h), in determining whether an accrual method taxpayer has incurred an amount for any item during the taxable year, the all events test shall not be treated as met any earlier than when economic performance occurs.

Treas. Reg. § 1.263A-1(e)(3)(ii)(D) defines "employee benefit expenses" to include "all other employee benefit expenses [not described in § 1.263A-1(e)(3)(ii)(C)] to the extent such expenses are otherwise allowable as deductions under chapter 1 of the Internal Revenue Code . . . includ[ing] worker's compensation."

A Chief Counsel Advice Memorandum, released 12/19/2008 and cited on the IRS.gov website as AM 2008-012[8], states that IRC § 172(f) applies to certain costs included in inventory under IRC § 263A.  

AM 2008-012 states that workers compensation costs that are allocated as indirect costs of production under IRC § 263A and recovered through cost of goods sold constitute specified liability losses for the taxable year in which they are taken into account in computing a net operating loss.  Depending on the taxpayer's sale of goods and its inventory accounting method, a portion of these amounts may be included in cost of goods sold in the year in which the costs were incurred, and that portion of the costs is taken into account in computing gross income for that taxable year.  The remainder of these costs is included in ending inventory and will be taken into account in computing gross income when that inventory is sold or, more precisely, when the cost of the inventory is included in cost of goods sold under the taxpayer’s method of accounting.

Workers compensation payments that are allocated to inventory under IRC § 263A are taken into account in computing the net operating loss for the taxable year only to the extent they are included in cost of goods sold for that year.  Environmental remediation costs and workers compensation payments allocated to inventory that remain on hand at the end of the taxable year (ending inventory) are not “taken into account in computing the net operating loss for the taxable year.”  Those costs may be treated as specified liability losses for the year that they are actually recovered through cost of goods sold, assuming the taxpayer has a net operating loss for that year.  It is the taxpayer’s responsibility to keep sufficient records as required by IRC § 6001 to document the portion of any future year’s cost of goods sold that constitutes a specified liability loss.

As an example of the allocations required, assume that in taxable year 20X1, Manufacturer’s gross receipts are $20x and cost of goods sold (CGS) is $15x.  Manufacturer incurs $10x of workers compensation costs (w.c.costs), $2x of which is properly allocable to CGS (and is included in the $15x CGS amount above) and the remaining $8x of which is properly allocable to ending inventory.  In addition, Manufacturer incurs $25x of ordinary and necessary business expenses deductible under § 162(a), none of which constitutes a specified liability loss.  Manufacturer’s net operating loss (NOL) of $20x and specified liability loss of $2x are computed as follows:

NOL Computation for 20X1

The $8x of workers compensation costs that is included in ending inventory for 20X1 will be included in the subsequent taxable year’s beginning inventory.  This $8x will generate a specified liability loss in the taxable year in which the cost of that inventory is included in Manufacturer’s cost of goods sold, provided Manufacturer has a net operating loss in that taxable year. 

Audit Steps

• Examiners should request a detailed explanation from the Taxpayer as to the make-up of any workers compensation payments on IRC § 172(f) SLL claims.
• The examiner should make sure that the Taxpayer is using the accrual method of accounting per IRC § 172(f)(1)(B)(ii)(II) and that the 3 year rule under IRC § 172(f)(1)(B)(ii)(I) is met.
• Examiners should request a detailed allocation breakdown of any capitalized workers compensation expenditures to ensure that only the amount included in the Cost of Goods Sold for that tax year is allowed as a specified liability loss amount.

For more information contact the IRC Section 172(f) Technical Advisor and the Mining Technical Advisors.

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Footnotes:

1. Technical Advice Memorandum (TAM) 143949-01, TAM 200341004 (Oct. 10, 2003), discusses the manner in which product liability is defined for tax purposes.  Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs.  See, e.g., IRM 4.43.1.4.18.1(3). Top
2. Field Service Advisory Memorandum (FSA) 1027A, 1992 WL 1354825 (1992), discusses the applicable law and potential taxpayer positions regarding this issue.  Do not cite this FSA as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs. Top
3. TAM 200322017 (Feb. 13, 2003), discusses the applicable law surrounding the treatment of insurance settlement payments and the nonapplicability of IRC §1033.  Do not cite this TAM as precedent per IRC §6110(k)(3), as the disclaimer at the end of this memorandum directs. Top
4. IRS CCA 200725031 (May 27, 2007), discusses the tax treatment of certain SLL expenses (including product liability claims) that are reimbursable by insurance or otherwise.  Pursuant to IRC § 6110(k)(3), this document is not to be cited or otherwise relied on as precedent. Top
5. IRS CCA 200730020 (Apr. 27, 2007), discusses the tax treatment of certain expenses of product liability claims that are reimbursable by insurance or otherwise.  Pursuant to IRC § 6110(k)(3), this document is not to be cited or otherwise relied on as precedent. Top
6. Pursuant to IRC § 6110(k)(3), IRS CCA 200836035 (May 20, 2008), is not to be cited or otherwise relied on as precedent. Top
7. IRS CCA 200835031 (July 16, 2008), discusses the tax treatment of decommissioning expenses that are derived from the reserve funds or otherwise.  Pursuant to IRC § 6110(k)(3), this document is not to be cited or otherwise relied on as precedent. Top
8. As set forth in that memorandum, the CCA may not be used or cited as precedent, pursuant to IRC § 6110(k)(3). Top