Tier I Issue: Section 118 Abuse Directive #8

LMSB Control No.: LMSB-PQ-0509-130
Impacted IRM 4.51.5

June 3, 2009

This Directive provides field direction on the I.R.C. § 118 Tier I issue regarding owners or operators of petroleum underground storage tanks (UST).  The issue relates to various leaking underground storage tank state remediation cost reimbursement programs including state financial assurance funds.  This Directive addresses whether amounts received from such funds constitute taxable income under I.R.C. § 61 or nonshareholder contributions to capital excludable from income under I.R.C. § 118(a). 

Background/Strategic Importance:

In the 1980s, the Environmental Protection Agency (EPA) determined that many of the roughly 2.2 million underground storage tanks (USTs) in the United States, most of them storing petroleum, were leaking.  Many other tanks were nearing the end of their useful life expectancy and were expected to leak in the near future.  In 1986, Congress established a response program for leaking petroleum USTs through the Superfund Amendments and Reauthorization Act (P.L. 99-499), which amended Subtitle I of the Resource Conservation and Recovery Act (RCRA) to authorize the EPA and states to respond to petroleum spills and leaks.  The amendments also created the Leaking Underground Storage Tank Trust Fund to help the EPA and states cover the costs of responding to leaking USTs in cases where the UST owner or operator was unknown or incapable of cleaning up the site.  Today, the EPA and states primarily use this federal Trust Fund appropriation to oversee and enforce corrective actions performed by responsible parties.

The 1986 law further directed the EPA to establish financial responsibility requirements to ensure that UST owners and operators are able to cover the costs of taking corrective action, and compensating third parties for injuries and property damage caused by leaking tanks.  As mandated, the EPA issued regulations requiring most tank owners and operators selling petroleum products to demonstrate a minimum financial responsibility of $1 million.  Alternatively, owners and operators may rely on state assurance funds to demonstrate financial responsibility, saving them the cost of purchasing private insurance.  Unlike the Federal Trust Fund, state funds are often used to reimburse financially solvent tank owners and operators for some or all of the costs to clean leaking tank sites. 

Issue Tracking:

Any cases having this issue should use the following UIL and SAIN codes:
UIL

• Nonshareholder Contribution to Capital v. Income 61.40-00
• Basis Adjustment Under Section 362(c) 118.01-02

SAIN

• Nonshareholder Contribution to Capital v. Income
  • Primary SAIN 401    Secondary SAIN 180
• Basis Adjustment Under Section 362(c)
  • Primary SAIN 110    Secondary SAIN 186

Planning and Examination Guidance:

Issue identification:

The issue may be raised either on the original return or through claims.  Absent the filing of a claim, the issue may not be readily apparent.  Thus, an in-depth examination of a taxpayer’s Schedule M entries is required.  Specifically, book-tax differences in income and/or depreciation should be closely analyzed.

Other means of identifying the issue include any of the following:

Key words or phrases used on the tax return, such as contribution to capital, state UST or other UST reimbursements, state assurance funds or I.R.C. § 118.

A review of fixed assets for basis reductions, primarily adjustments to tax basis of land or gas station sites and/or assets claiming I.R.C. § 362(c).

A generic I.R.C. § 118 Individual Document Request (IDR) is available as a guideline to assist the field in the identification of this Issue and/or other potential I.R.C. § 118 abuses.  See Tier I Issue:  Section 118 Abuse - Guideline for a Section 118 Information Document Request. 

Planning and Examination Risk Analysis

The issue should be identified and prioritized using materiality thresholds and other considerations, such as compliance, through the risk analysis process.  If the issue is selected for examination, agents are encouraged to contact the Environmental Technical Advisor.

Audit Techniques

An audit aide to be used as a guideline for the development of the leaking UST state clean-up reimbursement issue is available as an IDR.  (See attachment.)
• A description of individual state reimbursement funds can be obtained through the EPA’s web page.  ( http://www.epa.gov/swerust1/states/fndstatus.htm )

Audit Evaluation:

Once it is determined that state clean-up reimbursements were excluded from income, examiners should identify the specific state assurance fund or funds involved, the dollar amounts received, and obtain the taxpayer’s written position paper.  In addition, an in-depth review of the correlative I.R.C. § 362(c) adjustment should be completed to determine the actual decrease in asset basis (es).  The examiner should ask the taxpayer to provide a spreadsheet(s) or other schedule(s) to identify:  (1) the amount of clean-up reimbursement, by state, that each of its subsidiaries received, and (2) the cost of assets, by state, that each of its subsidiaries added and claimed were purchased with reimbursement monies during the tax year.

LMSB Position:

The payments received from the state assurance fund, or similar clean-up reimbursements, do not constitute capital contributions under I.R.C. § 118(a), and thus they fall within the definition of gross income under I.R.C. § 61(a).
 
The Service’s position on this issue is reflected in the Coordinated Issue Paper (CIP) released February 5, 2009.  The CIP concluded that the payments were gross income under I.R.C. § 61(a), and not nonshareholder capital contributions under I.R.C. § 118(a). 

Resolution:

The field should challenge all arguments by taxpayers who attempt to exclude receipt of these reimbursement payments from gross income.  Agents must contact the Environmental Technical Advisor for additional guidance before consideration of any resolution other than full concession by the taxpayer.  

Effect on Other Guidance:

None

Contact Name and Phone Number:

David Carter, PFTG Technical Advisor Manager at 404-338-9444.
This Directive is not an official pronouncement of law and cannot be used, cited, or relied upon as such.

Attachment:
   IDR for UST

cc:   Commissioner, LMSB
        Deputy Commissioner, Operations, LMSB
        Deputy Commissioner, International, LMSB
        Division Counsel, LMSB
        Commissioner, SBSE
        Chief, Appeals
        Directors, Field Operations
        Director, Planning, Quality, Analysis & Support

Attachment to Tier I Issue: Section 118 Abuse Directive #8

Guideline for an Information Document Request (IDR) - Leaking Underground Storage Tanks and Reimbursements from State Financial Assurance or Similar Funds
This IDR seeks documents and information for the purpose of determining whether [Taxpayer] (or any of its subsidiaries or affiliates) received state reimbursements for the costs incurred in taking corrective action (clean-up), or for compensating third parties for injury or property damage caused by leaking underground petroleum tanks, that it did not report as gross income on its federal income tax returns.

For each entity (including [Taxpayer], its subsidiaries, and its affiliates) that received state reimbursements, please respond to the following requests for documents and information:

1. Describe the entity's financial and tax accounting methodologies for reporting the state reimbursements received.

2. Identify:

a. the amount of state reimbursements received each year, by state.

b. the amount included in gross income each year for tax purposes; and

c. the amount included in gross income each year for financial purposes.

3. Identify:

a. the amount of state reimbursements applied for each year, by state;

b. the amount of state reimbursements for which a letter of commitment (LOC) was issued by year’s end for each year, by state.      

4. To the extent that the entity did not report all of the state reimbursements received as gross income:

a. explain why the entity did not report these amounts as gross income (the explanation should identify the case law, statutes, and other legal authority on which the entity relied in support of its  position and explain how that authority supports its position);

b. describe how the amounts received were treated for tax purposes (the description should include a statement regarding whether the entity reduced the basis of assets in accordance with I.R.C. § 362(c));

c. identify Schedule M-1/3 entries reflecting differences between financial and tax accounting treatments;

d. provide supporting workpapers for Schedule M-1/3 entries identified in item 4.c., above;

e. to the extent the entity reduced the basis of its assets in accordance with I.R.C. § 362(c):

   i.  provide the specific fixed asset general accounts that were reduced;

   ii. identify the amount of the reduction to each general ledger account; and

  iii. describe how this reduction flowed through the tax return via the depreciation deduction.