Solution
Sec. 263 disallows current deductions for capital expenditures. Reg. Sec. 1.263(a)-1(b) defines capital expenditures as amounts incurred to add value to or substantially prolong the life of a property. Reg. Sec. 1.162-4 states that “... incidental repairs that neither materially add value to the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition may be deducted as an expense.”

The question to be resolved is whether Seaweed’s asbestos removal and replacement program adds value or substantially prolongs the useful life of the property (capital expenditure) or merely keeps it in an ordinary efficient operating condition (current period repair expense).

In Indopco, the Supreme Court held that a corporate taxpayer was required to capitalize certain fees and other acquisition related expenses it incurred in connection with a friendly takeover by another company, where the transaction produced significant benefits to the taxpayer that extended beyond the tax year at issue. The Supreme Court stated that “... although the mere presence of an incidental future benefit —some future aspect— may not warrant capitalization, a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization.”

In LTR 9240004, on facts similar to Seaweed’s, the IRS ruled that the replacement of asbestos insulation in manufacturing equipment with something less toxic to comply with an OSHA standard is a capital expenditure. In its ruling, the IRS used the following rationale:

1. The replacement of the asbestos made the property more valuable than it had been:
a. because of the elimination of the health risk posed by the asbestos.
b. modifications to bring property into compliance with local regulations and requirements increase the resale value of the property.
c. the asbestos expenditures affect other operating efficiencies.

2. Repairs are remedies to immediate consequences. The extent and permanence of the asbestos expenditures is not a short term remedy.

3. The Supreme Court ruling in Indopco requires capitalization. The asbestos removal creates long-term benefits that are not merely incidental - they relate to the reason (health and safety concerns) for incurring the expenses.

In Rev. Rul. 94-38, the IRS concluded that the cost of cleaning up hazardous waste and treating contaminated groundwater are deductible expenses. However, the cost of constructing new groundwater facilities to extract, treat, and monitor contaminated groundwater was ruled to be a capital expenditure. The IRS determined that the clean-up costs did not extend the useful life of the land or adapt the land to a new or different use because the expenditures merely restored the land to its approximate condition before it was contaminated. That is, the IRS compared the value of the land after it was restored to the value before it was contaminated and determined that there was no increase in value due to the expenditures.

Although a private letter ruling is only binding on the taxpayer to which it is issued, it does provide insight into the service’s position on a subject. LTR 9240004 indicates that the IRS believes that asbestos removal does increase the value of property and does extend its useful life, necessitating capitalization of the costs. Rev. Rul. 94-38 indicates that the IRS believes that hazardous waste removal does not increase the value of the property, making such expenditures currently deductible.

Cinergy Corp. v. U.S., 55 Fed. Cl. 489 (2005), provides that the costs of removing and encapsulating asbestos are deductible because they did not appreciably increase the value of the property, but only restored value. Also, the costs were only a small fraction of the overall value of the building, did not prolong useful life, nor adapt to a new or different use. Thus, Seaweed may rely on Cinergy and argue that the costs are deductible because they did not appreciablya increase the value of the property and were only a small fraction of the overall fair market value of the machine.