IRS Issues Directive on Specified Liability Losses

This memorandum is intended to provide direction for this LMSB Tier II Issue to effectively utilize resources in the classification and examination of IRC Section 172(f) specified liability loss claims.

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. The claims identified to date have been associated with net operating loss reviews conducted by some of the top accounting firms. 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 10 taxable years preceding the loss year.

The current version of IRC § 172(f) was implemented by the Tax and Trade Relief Extension Act (TTREA) of 1998, P.L. 105-277, § 3004(a), 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:

• Product liability, or

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

Issue Tracking

Any claim cases having this issue should use the Project code 0047 and ERCS Tracking code 7942. The following are the UIL and SAIN codes to be used:

• 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

This issue is considered a Tier II issue for LMSB examiners. This issue is required to be addressed in examinations if present.

Attached are examination guidelines with audit steps to be followed to address allowable expenditures for each type of specified liability loss claims.

Product Liability -- see Attachment 1.

Land Reclamation Expenditures -- see Attachment 2.

Decommissioning of a Nuclear Power Plant or any Unit thereof -- see Attachment 3.

Dismantlement of a Drilling Platform -- see Attachment 4.

Remediation of Environmental Contamination -- see Attachment 5.

A payment under any workers compensation act within the meaning of § 461(h)(2)(C)(i) -- see Attachment 6.

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

Effect on Other Directives

This Directive does not amend or obsolete any other Directive on the subject.

Contact

If you have any questions, please contact Jody Botsford, IRC § 172(f) Technical Advisor at 626-312-5101 or Jody.N.Botsford@irs.gov , Paula Farmer, Mining Technical Advisor at 281-721-7539 or Paula.J.Farmer@irs.gov . This issue was designated as an emerging issue in Appeals on January 27, 2006. The contact person for Appeals is Joann Huerta, Appeals Technical Guidance Coordinator -- Mining, Sports & IRC 172(f) who can be reached at 954-423-7933.

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

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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:

• Caution!

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

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 200341004¹ 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)(B) 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

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 Steps

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

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. (Appellee'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)."

Audit Steps

• Examiners should review any claims for damages resulting 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).

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 1354825² 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 200322017³ 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.

Issue Name

Reclamation of Land

Introduction:

Section 172(f) provides special rules for the portion of an NOL that is identified as a specified liability loss (SLL) and as such is allowed a ten year carry back 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.

• Caution!

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.

• 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

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.

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 carry back. 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.

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

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 carry back, 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:

• Attachment 2

  • 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.)

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

Audit Steps

• 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.

Decommissioning of Nuclear Power Plant

Introduction

Section 172(f) provides special rules for the portion of an NOL that is identified as a specified liability loss (SLL) and as such is allowed a ten year carry back 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.

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 Regulation § 1.468A-1(b)(5).

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 multi-unit site, constitutes a separate nuclear power plant. Regulation § 1.468A-1(b)(4)

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. [172(f)(1)(B)(i)]

• Issue 2: What is the payment source of Decommissioning costs included as part of a SLL? Must expenditures for decommissioning be paid from the IRC § 468A fund? (Contact Utilities Tech Advisors for guidance)

• Issue 3: Do the claimed costs meet the definition of decommissioning expenditures defined by Regulation § 1.468 A-1(b)(5)?

Issue 1 -- Decommissioning Fund Payments

Audit Steps:

• Examiners should determine if the taxpayer has elected the provision of Regulation § 1.468A-7

• If the Taxpayer has elected this provision, request the required Private Letter Ruling (PLR) if it is not attached to the return. Regulation § 1.468A-3.

• 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.

• Audit Steps:

• Determine if a fund was set up for the nuclear power plant or unit being decommissioned under IRC § 468A.

• If a fund was established, the decommissioning costs being paid out of the fund the do not qualify as SLL costs.

• If a fund was established and decommissioning costs are not being paid out of the fund; request an explanation from the taxpayer.

• • There is no published guidance as to whether decommissioning costs must be paid from the IRC § 468A fund.

  • Contact Utilities Tech Advisors for guidance.

• Audit Steps:

• Are the decommissioning costs being incurred at a multi-unit 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.

• Request information documenting that cost being claimed as SLL cost meet the definition of decommissioning costs as described in the regulations.

172(f)(1)(B)(i) Any amount allowable as a deduction under this chapter (other than 468(a)(1) or 468A(a)) which is in satisfaction of a liability under a Federal or State law requiring --

• Caution!

SEC. 172. NET OPERATING LOSS DEDUCTION.

172(f)(3) SPECIAL RULES FOR NUCLEAR POWERPLANTS. -- Except as provided in regulations prescribed by the Secretary, that portion of a specified liability loss which is attributable to amounts incurred in the decommissioning of a nuclear power plant (or any unit thereof) may, for purposes of subsection (b)(1)(C), be carried back to each of the taxable years during the period --

(a) ESTABLISHMENT OF RESERVES FOR RECLAMATION AND CLOSING COSTS. --

(1) ALLOWANCE OF DEDUCTION. -- If a taxpayer elects the application of this section with respect to any mining or solid waste disposal property, the amount of any deduction for qualified reclamation or closing costs for any taxable year to which such election applies shall be equal to the current reclamation or closing costs allocable to --

(a) IN GENERAL. -- If the taxpayer elects the application of this section, there shall be allowed as a deduction for any taxable year the amount of payments made by the taxpayer to a Nuclear Decommissioning Reserve Fund (hereinafter referred to as the "Fund") during such taxable year.

Regulation § 1.468A-1. Nuclear decommissioning costs; general rules

(b) Definitions. -- The following terms are defined for purposes of section 468A and the regulations thereunder:

Regulation § 1.468A-1. Nuclear decommissioning costs; general rules (cont'd)

(5) The term "nuclear decommissioning costs" or "decommissioning costs" means all otherwise deductible expenses to be incurred in connection with the entombment, decontamination, dismantlement, removal and disposal of the structures, systems and components of a nuclear power plant that has permanently ceased the production of electric energy. Such term includes all otherwise deductible expenses to be incurred in connection with the preparation for decommissioning, such as engineering and other planning expenses, and all otherwise deductible expenses to be incurred with respect to the plant after the actual decommissioning occurs, such as physical security and radiation monitoring expenses. Such term does not include otherwise deductible expenses to be incurred in connection with the disposal of spent nuclear fuel under the Nuclear Waste Policy Act of 1982 (Pub. L. 97-425). An expense is otherwise deductible for purposes of this paragraph (b)(5) if it would be deductible under chapter 1 of the Internal Revenue Code without regard to section 280B.

Regulation § 1.468A-3. Ruling amount

(a) In general (1) Except as otherwise provided in paragraph (j) of this section, an electing taxpayer is allowed a deduction under section 468A(a) for the taxable year in which the taxpayer makes a cash payment (or is deemed to make a cash payment) to a nuclear decommissioning fund only if the taxpayer has received a schedule of ruling amounts for the nuclear decommissioning fund that includes a ruling amount for such taxable year. Except as provided in paragraph (a)(4) or (5) of this section, a schedule of ruling amounts for a nuclear decommissioning fund ("schedule of ruling amounts") is a ruling (within the meaning of paragraph (a)(2) of § 601.201) specifying the annual payments ("ruling amounts") that, over the taxable years remaining in the "funding period" as of the date the schedule first applies, will result in a projected balance of the nuclear decommissioning fund as of the last day of the funding period equal to (and in no event greater than) the "amount of decommissioning costs allocable to the fund." The projected balance of a nuclear decommissioning fund as of the last day of the funding period shall be calculated by taking into account the fair market value of the assets of the fund as of the first day of the first taxable year to which the schedule of ruling amounts applies and the estimated rate of return to be earned by the assets of the fund after payment of the estimated administrative costs and incidental expenses to be incurred by the fund (as defined in paragraph (a)(3)(ii) of § 1.468A-5), including all Federal, State and local income taxes to be incurred by the fund (the "after-tax rate of return"). See paragraph (c) of this section for a definition of funding period and paragraph (d) of this section for guidance with respect to the amount of decommissioning costs allocable to a fund.

Regulation § 1.468A-7. Manner of and time for making election

(a) In general. -- An eligible taxpayer is allowed a deduction for the taxable year in which the taxpayer makes a cash payment (or is deemed to make a cash payment) to a nuclear decommissioning fund only if the taxpayer elects the application of section 468A. A separate election is required for each nuclear decommissioning fund and for each taxable year with respect to which payments are to be deducted under section 468A. In the case of an affiliated group of corporations that join in the filing of a consolidated return for a taxable year, the common parent must make a separate election on behalf of each member whose payments to a nuclear decommissioning fund during such taxable year are to be deducted under section 468A. The election under section 468A for any taxable year is irrevocable and must be made by attaching a statement ("Election Statement") and a copy of the schedule of ruling amounts provided pursuant to the rules of § 1.468A-3 to the taxpayer's Federal income tax return (or, in the case of an affiliated group of corporations that join in the filing of a consolidated return, the consolidated return) for such taxable year. Except as otherwise provided in paragraph (b)(3) of § 1.468A-8, the return to which the Election Statement and a copy of the schedule of ruling amounts is attached must be filed on or before the time prescribed by law (including extensions) for filing the return for the taxable year with respect to which payments are to be deducted under section 468A.

(b) Required information. -- The Election Statement must include the following information:

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."

The Petroleum Industry Technical Advisor team describes dismantlement of offshore platform in their coordinated issue on estimated dismantling costs. See IRS.gov for Coordinated Issue Paper -- Dismantlement of Platforms.

• 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.

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.

• Determine the 3 year and accrual rules apply to the dismantling expenditures. "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."

Remediation of environmental contamination

Introduction:

Section 172(f) provides special rules for the portion of an NOL that is identified as a specified liability loss (SLL) and as such is allowed a ten year carry back as opposed to the two years generally allowed for NOL's. 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 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 § 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.

• Caution!

It should be noted regarding manufacturers or producers that the issuance of Revenue Ruling 2004-18, which clarifies Revenue Ruling 94-38, and the issuance of Ruling 2005-42 which confirms Rev. Rul. 2004-18, makes it clear that remediation expenses incurred for tax years ending after February 6, 2004 require such costs to be allocated to ending inventory under IRC § 263A. Revenue Rulings 2004-18 and 2005-42 make clear that certain manufacturer's remediation costs are not deductible and thus, are not specified liability losses under IRC § 172(f).

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 this three year rule is the actual environmental contamination up to three years prior to the beginning of the taxable year in which the remediation deduction is claimed.

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

• EPA or state agency reimbursements for either investigatory or remediation costs incurred by the EPA on behalf of site.

• Excavation and disposal of regulated substance found at the site.

• Containment or encapsulation costs not subject to capitalization under IRC § 263(a)

• Excavating, stockpiling, or transporting to a waste facility of contaminated soil

• Replacement or backfilling of soil

• Treatment of contaminated soil as necessary

• Treatment of contaminated water as necessary

• Future monitoring costs to assure success.

• Remediation costs for contamination that occurred less then three years before the beginning of the taxable year.

• Any and all remediation costs subject to the IRC § 263A capitalization requirements as covered by Revenue Rulings 2004-18 and 2005-42, Impacts tax years ending after February 6, 2004.

• 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 (SEP's), even if incurred on or adjacent to contaminated site.

• Any legal costs not specifically incurred in determination of the amount of remediation liability, examples of non-allowed 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.

Audit Steps

• Examiners should request;

• • A detailed break down of remediation costs and activities that the taxpayer has claimed as specified liability losses.

  • 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.

  • Notice 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.

• Examiner Review Steps

• • Reconcile the claimed costs and activities to those listed in the remediation plan.

  • Identify any potential non qualifying operating and capital costs.

  • Look for insurance reimbursements on claimed SLL expenses.

  • 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.

• 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.

Examiners should be aware that taxpayer claims for remediation 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 Federal or State environmental laws may be remediation expenses but do not meet the 3 year rule pursuant to IRC § 172(f)(1)(B)(ii)(I). For example, costs of normal monitoring and testing of facility as required by the EPA for current pollution output would not qualify as 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 of 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 pre-existing contamination are required to be capitalized to land, United Dairy Farmers, and therefore do not qualify as IRC § 172(f).

Reference -- Revenue Ruling 94-38 and addendums Rev. Rulings 2004-18 and 2005-42 Reference -- United Dairy Farmers, Inc. United States, 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 carry back, a liability shall be taken into account only if --

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

To qualify as a specified liability loss subject to the 10 year carry back, 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 specified liability loss 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, or 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 Section 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) ten year carryback.

• One taxpayer claimed that its insurance reimbursements were not taxable but rather constituted receipts from involuntary conversions under section 1033. In this scenario, the taxpayer deducted all the expenditures, but did not report the related insurance reimbursement. See TAM 200322017(Technical Advice Memorandum (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. See, e.g., IRM 4.43.1.4.18.1(3).) Although not related to an IRC § 172(f) claim, this treatment also illustrates an erroneous tax treatment of insurance proceeds.

• Another 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.

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 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 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 IRC § 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

Issue Name

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 (TTREA). Other than product liability losses, only items specifically enumerated will qualify as Specified Liability Losses (SLL's) 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 § 461(h)(2)(C)(i))."

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

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

• 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.

Examiners should be aware that taxpayer's claims for workers compensation payment expenditures qualifying for the IRC § 172(f) SLL 10 year carry-back 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. See Notice 2005-20.

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.

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.

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.

• Caution!

The regulation excerpt below indicates that workers compensation payments for production workers are required to be capitalized. Since capitalized workers compensation payments for production workers are not amounts allowable as a deduction under Section 162 or Section 165, they are not eligible for the specified liability loss ten year carryback provisions under IRC § 172(f).

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.

Sec. 1.263A-1 Uniform capitalization of costs . . .

(e) Types of costs subject to capitalization -- (1) In general. Taxpayers subject to section 263A must capitalize all direct costs and certain indirect costs properly allocable to property produced or property acquired for resale. This paragraph (e) describes the types of costs subject to section 263A.

(ii) Examples of indirect costs required to be capitalized. The following are examples of indirect costs that must be capitalized to the extent they are properly allocable to property produced or property acquired for resale:

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.

³TAM 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.