Fourth Quarter 2007

The Implications of an IRS Decision on Supplemental Environmental Projects

Holland & Knight Newsletter
Nicholas William Targ | Chelsea Maclean
Parties to environmental settlements that include Supplemental Environmental Projects (SEPs) – environmentally beneficial projects voluntarily undertaken by environmental defendants in partial mitigation of penalties – should consider the tax implications before signing on the dotted line. A May 2007 Internal Revenue Service (IRS) directive concluded that amounts used to fund SEPs are not tax deductible or depreciable, given that the SEP costs are analogous to penalties. The directive also strongly implied that SEPs valued at over $1 million would be audited.

While the financial implications of the IRS directive can be managed through the settlement process, the directive has broader implications on the legality and longevity of SEPs under federal appropriations law.

Background on SEPs
Of major importance to environmental defendants, SEPs can substantially mitigate penalties, based on the cost of the SEP.

EPA has encouraged the use of SEPs for more than a decade. This past fiscal year, the EPA and environmental defendants included a total of 220 SEPs in settlements, valued at more than $76 million, according to EPA statistics. With all but two states using them as an enforcement settlement tool, SEPs have become an integrated part of the enforcement process.

The IRS decision
The May 2007 IRS directive affirmed a year-old IRS Technical Advice Memorandum holding that the portion of SEP costs used to mitigate the initially calculated penalty is analogous to a penalty, and hence is not deductible or depreciable. Further, to ensure compliance, the IRS directive requires IRS examination of all SEPs greater than $1 million. IRS Industry Director Directive on Government Settlements Directive #1, LMSB-04-0507-042 (May 30, 2007) (IRS directive); IRS Tech. Adv. Mem. 2006-29030 (Mar. 31, 2006) (IRS decision).

Both IRS decisions involved a facility with emissions in excess of those allowed under the Clean Air Act (CAA). Instead of paying a civil penalty and bringing its existing systems into compliance, the taxpayer/defendant proposed to undertake a state SEP-variant (referred to as a Beneficial Environmental Project, or BEP). Specifically, it agreed to perform a major project to convert its equipment to a design that would reduce emissions well below standards required under the CAA. The resulting emissions-reduction credits would be shared equally between the state and the facility. The state agreed to the proposal and included it in an enforceable settlement agreement.

The IRS concluded that the cost of the BEP should not be deductible because “the purpose of the civil penalty, i.e., the portion of the [BEP] imposed in the settlement of those potential penalties ... was to punish taxpayer and to deter future violations.” The IRS reasoned that if the Taxpayer had settled its civil penalty by making a cash payment to [the state], that payment would be a nondeductible fine or penalty ... The result should not change because the taxpayer settled its penalty by agreeing to incur the costs of performing a project to benefit the environment instead of incurring a direct cash payment.

The IRS directive and decision’s characterization of SEPs as comparable to a penalty implicates the nature of SEPs. If SEPs are characterized as penalties, they would be an amount “due and owing to the United States” under the Miscellaneous Receipts Act and required to be deposited into the General Treasury. 31 U.S.C. § 3302(b). Moreover, if SEPs were characterized as penalties, additional concerns would be raised under the Anti-Deficiency Act (31 U.S.C. § 1341(a)) (prohibiting agency expenditure in excess of congressional appropriations).

Implications for SEPs

Unless the issue of deductibility of SEPs is addressed when negotiating the settlement, the IRS decisions make SEPs a less attractive option. While the threat of an audit for million-dollar SEPs cannot be easily addressed – and will tend to reduce the incentives to enter into large-scale SEPs – the issue of deductibility can be treated as a negotiation factor when establishing a SEP’s value. Therefore, with proper counsel the impact of the IRS decisions on individual cases can be reduced.

Less clear is the long-term impact of the IRS decisions on the practice of SEPs more generally. If SEPs do violate federal appropriations law, a legislative remedy is needed. Whether the time is appropriate for SEP legislation is a matter left for Congress. In expressly establishing EPA’s authority to approve SEPs, Congress could pave the way for a revamped SEP policy that responds flexibly to business, environmental, and social justice priorities, while resolving regulatory uncertainty.

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