rr-04-17.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 1341.BComputation of Tax Where Taxpayer Restores Substantial Amount Held
Under Claim of Right

26 CFR 1.1341-1: Restoration of amounts received or accrued under claim of right.
(Also ' 263A.)

Rev. Rul. 2004-17

ISSUES

Do amounts paid or incurred in the current taxable year to remediate
environmental contamination that occurred in prior taxable years qualify for treatment
under ' 1341 of the Internal Revenue Code?

FACTS

Situation 1

N manufactures products that it sells to wholesalers and retailers. N=s
manufacturing process creates hazardous waste. N uses an accrual method of
accounting and the calendar taxable year. From the inception of its business in 1950
until 1979, N buried the hazardous waste on land that it owned in accordance with then
applicable state, federal, and local environmental laws. N accounted for waste disposal
costs as a deducible expense under § 162.

Significantly stricter state, federal, and local hazardous waste disposal laws were
enacted in later years. In 2004, in order to comply with current environmental laws, N
incurs expenses for all necessary services to eliminate soil and water contamination
caused by the buried waste, transport the waste to a waste disposal facility that
complies with current environmental laws, and restore the land.

Situation 2

The facts are the same as in Situation 1 except that N accounted for waste
disposal costs as a production cost in calculating its inventory costs for all years.

LAW AND ANALYSIS

Section 1341 applies if: (1) the taxpayer included an item in gross income for a
prior taxable year (or years) because it appeared that the taxpayer had an unrestricted
right to the item, (2) a deduction is allowable to the taxpayer for the taxable year

2
because it was established after the close of the taxable year (or years) of inclusion that
the taxpayer did not have an unrestricted right to the item or to a portion of the item, and
(3) the amount of the deduction exceeds $3,000. Section 1341(a)(1) - (3).

If ' 1341 applies, the chapter 1 tax for the taxable year equals the lesser of: (1)
the tax for the taxable year computed with the current deduction, or (2) the tax for the
taxable year computed without the deduction, less the decrease in tax for the prior
taxable year (or years) that would have occurred if the item or portion thereof had been
excluded from gross income in the prior taxable year (or years). Section 1341(a)(4) and
(5). Section 1341 ensures that the taxpayer=s position is not worse than the position the
taxpayer would have been in if the taxpayer had not included the item or portion thereof
in gross income in the earlier year (except for the time value of money).

Section 1.1341-1(a)(1) of the Income Tax Regulations provides that ' 1341
applies if the taxpayer is entitled to a deduction of more than $3,000 because of the
restoration to another of an item that was included in the taxpayer=s gross income for a
prior taxable year (or years) under a claim of right.

Under the claim of right doctrine, a taxpayer that receives an amount under a
claim of right without restriction on disposition must include the amount in gross income
in the taxable year received, notwithstanding that the taxpayer=s right to retain the
amount received may be uncertain and the taxpayer subsequently may be required to
restore the amount to the rightful owner. North American Oil Consol. v. Burnet, 286
U.S. 417, 424 (1932).

In United States v. Lewis, 340 U.S. 590 (1951), the Supreme Court concluded
that a taxpayer who was required under the claim of right doctrine to include a bonus in
income in the taxable year received, and who had to repay part of the bonus in a later
year, could not amend his tax return for the earlier year. The taxpayer=s only remedy
was to deduct the amount repaid in the taxable year in which the taxpayer restored it to
the payor. The Court followed the principle that income is properly reported under the
claim of right doctrine in the year received, consistent with a tax system based on
annual rather than transactional accounting. See Burnet v. Sanford & Brooks Co., 282
U.S. 359, 364, 365 (1931).

The application of the claim of right doctrine may result in an inequity when,
because of changes in tax rates or other circumstances, the tax increase resulting from
the income inclusion in the earlier year exceeds the tax decrease that results from the
deduction in the later year. Congress enacted ' 1341 to ameliorate this inequity in
cases such as Lewis, in which a taxpayer receives an amount that it is required in a
later taxable year to restore or repay to another claimant. See S. Rep. No. 1622, 83d
Cong. 2d Sess. 118 (1954) (AUnder present law if a taxpayer is obligated to repay
amounts which he had received in a prior year and included in income because it
appeared that he had an unrestricted right to such amounts, he may take a deduction in

3
the year of restitution@) (emphasis added); H.R. Rep. No. 1337, 83d Cong. 2d Sess. 86
(1954) (same).

Section 1341(a)(2) requires that it be established after the close of the taxable
year or years that the taxpayer did not have an unrestricted right to the item of gross
income or portion thereof. To satisfy this test the taxpayer must repay or restore the
item or portion of the item to another claimant. Section 1.1341-1(a)(1); see also
Chernin v. United States, 149 F.3d 805 (8
th
Cir. 1998) (relying on a Alegislative history
[that] is replete with references to repayment, restoration, and restitution@); S. Rep. No.
1622, 83d Cong. 2d Sess. at 118; H.R. Rep. No. 1337, 83d Cong. 2d Sess. at 86.

For purposes of ' 1341, to restore an item included in income, the repayment
must arise out of the same circumstances, terms, and conditions as the original
payment of the item to the taxpayer. Griffiths v. United States, 54 Fed. Cl. 198 (2002).
The fact that the amount of the repayment bears no relationship to the amount included
in income indicates that the repayment does not arise from the same or specific
circumstances, terms, and conditions as the original transaction. Bailey v.
Commissioner, 756 F.2d 44 (6
th
Cir. 1985); Uhlenbrock v. Commissioner, 67 T.C. 818
(1977).

In both Situation 1 and Situation 2, the environmental remediation costs N incurs
in 2004 do not qualify for treatment under § 1341(a). N did not include an item in gross
income that N is repaying or restoring in a later year. In these situations, the item of
gross income for purposes of ' 1341(a) is the proceeds received from the sale of N=s
products from 1950 to 1979. See Rev. Rul. 72-28, 1972-1 C.B. 269. During 1950 to
1979, N had an unrestricted right to the proceeds received from the sale of N=s products
during those years. In 2004, N=s right to the sales proceeds received during 1950 to
1979 remains unrestricted. N=s payment of the environmental remediation costs does
not restore in a later taxable year any portion of the proceeds received from the original
sale of N=s products in 1950 through 1979. Moreover, N>s obligation to incur the
environmental remediation costs does not arise from the same or specific
circumstances, terms, or conditions as the original sale of N=s products in 1950 to 1979.
The amount of N=s environmental remediation costs bears no relation to the amount of
proceeds received from the sale of N=s products in 1950 to 1979. Accordingly, N=s
payment of environmental remediation costs in 2004 is not a repayment or restoration of
an item included in gross income. N=s environmental remediation costs do not satisfy
the repayment or restoration requirement of ' 1341(a)(2).

Section 1341(a)(2) also requires, as a prerequisite to ' 1341 treatment, that a
deduction must be allowable to the taxpayer for the repayment or restoration of the item
included in income. Section 1341 itself provides no right to a deduction. Instead, the
deduction must be allowable under another provision of the Code. Section 1.1341-
1(a)(1); Wood v. United States, 863 F.2d 417, 420 (5
th
Cir. 1989); MidAmerican Energy
Co. v. Commissioner, 114 T.C. 570, 583( 2000), aff
=d, 271 F.3d 740 (8
th
Cir. 2001).

4

Inventory costs under ' 263A are recovered through cost of goods sold when the
inventory is sold. Section 1.263A-1(c)(4). Costs of goods sold, or inventory costs, are
not deductions but are properly treated as adjustments to gross income. Section 1.61-
3(a). Environmental remediation costs incurred by reason of a production activity must
be included in inventory costs. See Rev. Rul. 2004-18, 2004-8 I.R.B. (clarifying Rev.
Rul. 94-38, 1994-1 C.B. 35); ' 1.263A-1(e)(3). Thus, under ' 263A, N=s environmental
remediation costs are inventory costs, not deductions. Furthermore, in Situation 2,
because the environmental remediation costs N incurs in 2004 would have been
accounted for under N=s method of accounting as inventory costs in 1950 through 1979
if incurred in those earlier years, the costs are properly treated as inventory costs under
N=s method of accounting when incurred in 2004. Therefore, N=s environmental
remediation costs do not qualify for treatment under ' 1341 because the costs are
inventory costs and do not satisfy the deduction requirement of § 1341(a)(2).

Section 1341(b)(2) provides that ' 1341(a) does not apply to any deduction
allowable with respect to an item included in gross income by reason of the sale or
other disposition of the taxpayer=s stock in trade (or other property of a kind that would
have been included in the taxpayer=s inventory if on hand at the close of the prior
taxable year) or property held by the taxpayer primarily for sale to customers in the
ordinary course of its trade or business. Thus, even if N=s environmental remediation
costs constituted deductible expenses rather than inventory costs recovered through
cost of goods sold, ' 1341(a) would not apply. N=s environmental remediation costs are
a consequence of the manufacture and sale of N=s products and, if not an inventory
cost, would be deductible as an ordinary and necessary business expense of selling N=s
products. Accordingly, in both Situations 1 and 2, the environmental remediation costs
would be allowable with respect to an item that is included in gross income by reason of
the sale of N=s products and would not be eligible for ' 1341(a) treatment by reason of '
1341(b)(2).

HOLDING

Amounts paid or incurred in the current taxable year to remediate environmental
contamination that occurred in prior taxable years do not qualify for treatment under
' 1341.

DRAFTING INFORMATION

The principal author of this revenue ruling is Forest Boone of the Office of
Associate Chief Counsel (Income Tax & Accounting). For further information regarding
this revenue ruling, contact Mr. Boone at 202-622-4960 (not a toll-free call).