Earth Tones, Inc. was a wholly owned subsidiary of Cutlinger Corporation. Several years ago, Earth Tones acquired numerous oil leases and began exploration activities to determine their suitability for commercial exploitation. The tests were negative. But during the time Earth Tones owned the land, environmental damage resulted in that required expenditures of about $30 million to reverse.

These activities cause the value of the Earth Tone stock to fall to zero. Cutlinger found a buyer for the Earth Tone shares, however. Courtney Kent purchased the stock for $100,000, but she refused to assume the obligation for the environmental damage. Those obligations were spun off into a new wholly owned Cutlinger subsidiary, Western Gold Inc. and the sale was completed. Cutlinger claimed a $20 million long-term capital loss on its return for the year of the sale of the Earth Tones stock.

Western Gold was more successful in purchasing and developing productive oil and natural gas wells, including some shale fields, where it is conducting highly profitable fracking operations. Western, flush with cash, paid the outstanding $30 million obligation of Cutlinger to carry out the environmental remediation.

Cutlinger filed consolidated Federal income tax returns with both Earth Tones and Western Gold. The $30 million Western Gold deduction for the environmental cleanup reduced Cutlinger?s consolidated taxable income for group in the year of payment.

On audit, the IRS disallowed the entire remediation deduction. Mary Ellen Rogers, tax director of Cutlinger, wants your analysis of the situation. Write a letter to her addressing the IRS?S position. Cutlinger?s corporate offices are at 1101 Office Strip Lane, Suite 3, Hudson, OH 44237.

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