ABILITY TO PAY ANALYSIS

There is no need to have it all…

Just make the most of what you have.

Rebecca Ridenour, Petroleum Tank Cleanup Section Montana Department of Environmental Quality Becky Convery, Attorney, Remediation Division Montana Department of Environmental Quality Leo J. Mullin Environmental Liability Assessment, LLC

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Montana – “Do you guys have paved streets?”

Large in landmass – 3rd largest state in the continental US (145,545 sq. mi.)

1.024 M residents

6.8 people/sq. mi.

Major industries:

Agriculture, Tourism, Mining

2013 Average Household Income:

$43,864 (41st in country; US Census)

Source: joelertola.com (accessed 9/9/15)

Why concern yourself with an O/O ability to pay (ATP)?

Past approach to ability to pay

• Used EPA guidance and methodology

• Took people’s word

• Typically started with an Enforcement action

Funding provided a transition period

Montana’s forward approach

• 2015 ATP Training w/ Leo

• New vantage point – use finances as a place to start and plan

• Cost recovery potential: A clean piece of property is worth more than a contaminated property,

even in small towns.

What I have learned

ATP is

• About the story

• The start of a discussion

• Speaking a common language

• Looking for solutions

How does this work? A business

Could be pushed too far!!!

An ATP Settlement can Reduce the amount of the claim and

Eliminate the Financial Hardship

faced with Environmental obligations

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What is the amount to be paid?

• It is a significant payment. • It requires the payment of all existing available

funds • As well as

• Future earnings for the next few years; and • money that was going to pay for new equipment or

paid to shareholders may be redirected to pay a portion of the environmental claim.

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Ability to Pay in Theory • Ability to Pay Settlements should not become

a basis for: – The inability to operate a facility properly;

– Further delay of Injunctive Relief obligations that are needed to safely maintain the facility;

– Serve as a substitute for bankruptcy;

– Ignore responses to information requests ;

– Avoid other actions needed to facilitate the cleanup, such as filing institutional controls;

– Serve as an easy way to settle a case that multiple problems.

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• Ability to pay is one of many settlement options. • Ability to pay is not significantly effected by

adjustments such as litigation risks. • Ability to pay

– is based on financial hardship; – is based on reliable information; and – is based on a mutual agreement of the parties.

• Ability to collect – Does not consider financial hardship; – is a unilateral action that may require approval of a

Court; and – directly relates to how well your office can execute a

judgment against assets.

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Ability to Pay in Theory

Helpful Guidance Documents

EPA’s Superfund Ability to Pay Guidance can be found at http://www2.epa.gov/sites/production/files/2013-09/documents/genpol-atp-rpt.pdf

Other EPA Ability to Pay Documents are referenced at http://www2.epa.gov/sites/production/files/documents/ovrview-atp-rpt.pdf

EPA’s 1986 Guidance on Determining a Violators Ability to Pay a Civil Penalty http://www2.epa.gov/sites/production/files/documents/civilpenalty-violators.pdf

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EPA’s 2015 Guidance on Evaluating a Violator’s Ability to Pay a Civil Penalty http://www2.epa.gov/sites/production/files/2015-06/documents/atp-penalty-evaluate-2015.pdf

Step one - Information Gathering •3 – 5 Years of internal or external Financial Statements • Complete copies of Federal Income Tax Returns for the last 3 – 5 years • Confirmation that none of that tax returns have been audited, amended or changed. • Copies of other financial filings that were made in the last 3 – 5 years

e.g. Loan Applications • Disclosure of all related party Transactions • Other Information that the Liable Party believes is important.

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Where do I get the questions to ask? • Most Financial Analysts have a standard set of

questions, if possible use the questions that are used by that person.

• INDIPAY has a set of standard financial questions. • A more extensive list of financial questions can be

found http://www2.epa.gov/enforcement/superfund-104e-information-request-questions-category

• When necessary, assuming permission is granted by the party, IRS records can be obtained.

• Ideally, you want one year of financial for a period of time prior to the creation of the environmental claim.

• There are other less reliable sources of information. (credit reports, Dun and Bradstreet)

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Tax Filings Type Of Entity What is filed? What Else Do You Look For?

Sole Proprietor Form 1040

With a Schedule “C”

Personal Financial State of the

Owner

General Partnership Form 1065

With K-1s

Form 1040 for each Partner

(Should have a K-1 for each partner)

Personal financial statement for

each general partner

Limited Partnership Form 1065 The Tax Return for the General

Partner (either a 1120 or 1040)

Corporation 1120 or 1120S

LLCs, LLP’s and PAs 1120, 1120S, 1065 and 1040

with a Schedule C and K-1s

Quasi-Municipal Entities,

Economic/ Industrial

Development Authorities,

City, Colleges, Hospitals

990, 1120 and financial filings for the municipality

1041 (Fiduciary Tax Returns can also be involved.)

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Comments on Tax Returns

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Pro Forma Tax Return Consolidated /Joint Tax Return

No Tax Return

IRS Forms 4506-T, 4506 and 8821

• You fill out the forms, get the party to sign them and then you mail the forms, not them.

• Form 4506-T - Request for Transcript of Tax Return • It is free. • It is fast, as long as you only want returns no older than 3

years. • It is strongly recommended that you contact the

Government Liaison Disclosure person in the IRS office you are sending the form to in advance of actually sending the form.

• Form 4506 - Request for Copy of Tax Return • It costs $50 per year, per tax return. • It takes longer, BUT it gives you all the schedules.

• Form 8821 -Tax Information Authorization • Provides access to additional IRS Information

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ABEL - Evaluates a corporation's or partnership's ability to afford compliance costs, cleanup costs or civil penalties. INDIPAY - Evaluates an individual's ability to afford compliance costs, cleanup costs or civil penalties.

Step 2.1– Computer Models (Optional)

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The computer models can be found at http://www2.epa.gov/enforcement/penalty-and-financial-models

What does ABEL do?

• Accepts data directly from tax returns submitted by:

• C and S corporations (1120 or 1120S), and

• Partnerships.

• Performs a preliminary evaluation of a firm's ability to pay a penalty or environmental costs.

• Estimates future cash flow based on past performance.

• Creates a financial profile for a company,

• But not for the general partners.

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What is INDIPAY? • INDIPAY evaluates the ability to pay of individuals.

• Screening tool.

• Requires more data than BEN or ABEL. • Why? Individual tax returns do not contain living

expenses, assets, or liabilities.

• INDIPAY presents a two-phased analysis: • Phase 1 Analysis: Optional screen to eliminate

applicants with no ability to pay.

• Phase 2 Ability to Pay Calculations: Quantifies ability to afford sought amount based on excess cash flow and debt capacity.

• INDIPAY can change the calculation to evaluate the impact on a person who is retired.

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Comments on Computer Models • Computer Models cannot evaluate the quality of the information. • Computer Models look at only a portion of the financial picture. • Computer Models may include mathematical assumptions such as probability estimates or loan qualification requirements that are not appropriate for a specific financial situation. • Errors that relate to a computer program can often be fixed by re-starting the computer. • Errors in evaluating the ability to pay of a company or a family may not be so easy to fix.

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How Does the Analysis Work?

Two step Analysis Balance Sheet + Income Statement Phase Phase

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•Balance Sheet Phase • Split assets into two groups;

• Necessary Assets • Unnecessary Assets

• Balance Sheet Phase looks for the value obtained from borrowing against or selling Unnecessary Assets •Possible additional recovery by borrowing on Necessary Assets. •The value of assets and liabilities may be adjusted to fair market value

How Does the Analysis Work?

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What are necessary Assets?

• For Individuals – Food, Clothing, Shelter

• For Businesses – The plant location, basic vehicles, reasonable replacement of equipment.

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•Income and Cash Flow Statement Phase • Revenues that are expected to be earned over the next 3 – 5 years; • Less Ordinary and Necessary Cash Expenses; = Available Income Adjustments may be made to reflect fair market values.

How Does the Analysis Work?

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For Individuals – Groceries, basic clothing,

mortgage/rent.

For Businesses – Regular costs for sales,

manufacturing and overhead.

What are ordinary and necessary expenses?

What may be beyond the definition of ordinary and necessary?

• For Individuals – Cost related to a second home, luxury automobiles, expenses of adult children.

• For Businesses – Unjustified Management Fees, Distributions or Dividends to Investors, Expenses for Luxury Items such as tickets to sporting events.

• This is a Case Specific Determination but a financial analysts can suggest ways to clarify what does not meet this definition.

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Common Issues for Ability to Pay

Situation What is the

impact?

Possible Solution

Assets that are

undervalued

Assets are worth

more than it

appears.

Increase the value to Fair

Market.

Related Party

Transactions

The Dollar amount

may not be

accurate.

Look for a way to estimate the

fair market value.

Excessive

Compensation

Profit is directed

away from the liable

party.

Identify the tasks that are

performed and find the

prevailing wage.

Uncertain Economic

Future

Little confidence

that your projection

is accurate.

Agree to a minimum payment

with an additional amount that

is based on a formula.

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Situation What is the

impact?

Possible Solution

Failure to

produce

documents

No basis for a

settlement

Explain why the

information is needed and

explain why the

production of information

is not burdensome.

Last minute

exchange of

documents

No time to

digest the

information.

Deny the claim or ask for

a delay.

Common Issues for Ability to Pay

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Situation What is the

impact?

Possible Solution

Refusal to

provide

Information

concerning

Marital Property

The analysis does

not focus on the

liable party.

Explain that without the

additional information, the

analysis may not be able to

consider the possible financial

hardship of the innocent spouse.

Consolidated

Financial Filing

The analysis does

not focus on the

liable party.

Assuming a consolidated

statement does not undervalue

the financial strength of the

liable person, accept the filings

but get agreement that the

related companies will guarantee

payment.

Common Issues for Ability to Pay

Common Issues • The company needs to make a large

payment to the Shareholders because they haven’t been compensated for several years.

• Two Responses: –1. Shareholders are paid after creditors,

not before. –2. As a result of the settlement, the

Shareholders will be able to start getting a return on their investment.

• This is a better option than losing the entire investment.

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Common Issues • A large expense is about to be made for Estate

Planning or Retirement Planning Purposes

• Two Responses:

– Heirs to an Estate receives what is left after creditors are paid. They are not paid first.

– Look at the money that has been set aside over the past few years. Given the past practice and the age of the individual, you can determine if this is a reasonable action.

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• The amount of the claim is important. • Other Equitable concerns, strength of the case, history of compliance, are not part of the ATP Analysis. • The Ability to Pay amount assumes a single payment but the case team can make adjustments when it is appropriate. • Adjustments can reduce the settlement amount but should not change the ATP Recommendation.

How Does the Analysis Work?

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Why Cost Recover? Polluter Pays Principle

Statutory Authority to Cost Recover

Section 9003(h) RCRA, 42 U.S.C. § 6991b(h)(6)(A) and § 6991b(h)(6)(E)(ii)

• Owner/operator of a UST shall be liable for the costs incurred by the state in taking corrective action to remediate a petroleum release from the UST.

• In determining the amount that should be recovered, the state shall take into consideration the ability of the owner/operator to pay corrective action costs and still maintain its basic business operations.

Section 75-11-517(3), MCA and § 75-11-307(3) • Grants MT DEQ the right to “bring

an action against a person to recover all costs for which that person is liable under this part or any other provision of state or federal law.”

• Owners/operators who seek reimbursement from the Petro Fund “may designate a person as an agent to receive the reimbursement if the owner or operator remains legally responsible for all costs and liabilities incurred as a result of the release.”

EPA Cost Recovery Guidance

• Where public funds expended, the State will pursue cost recovery

• Timely pursuit of cases/litigation increases success of cost recovery

• Prioritize cases based on cost/benefit analysis – Solvency of Responsible Party (RP)

– Cost of Cleanup

– Likelihood of Recovery

– Deterrent Value

– Opportunity Costs

Solvency of RP Mom and Pop Gas Station

vs … Big Oil

What Do You Do When an RP Says…

I don’t have any money to pay for cleanup…or

I can’t afford to pay anything toward cleanup right now…

Translation…

Ability to Pay for What?

• Typical cost to remediate a petroleum release in Montana = $150,000.00 to $200,000.00

• The state of Montana has only had 5-6 releases that exceeded $1 million in cleanup costs

• Scale your ability to pay to the projected cost of cleanup

• Owners/Operators may not have the ability to pay for the entire cleanup, but they may be able to contribute a portion of the cleanup

Ability to Pay for What? Example 1

• Total cost of cleanup projected to be $200,000.00 • Ability to pay analysis reveals owner/operator does not

have ability to pay $200,000.00 • What is the outcome with respect to ability to pay?

– Finding A: Owner/operator does not have the ability to pay $200,000.00. Cost of work will not be cost recovered, and owner/operator does not have to pay; OR

– Finding B: Owner/operator has ability to contribute $50,000.00

toward cost of cleanup. State will require owner/operator to pay $50,000.00 toward cleanup costs and the additional $150,000.00 will be paid by the State and will not be cost recovered.

The goal is NOT to put the RP out of business!

The goal is to provide incentives for owners and operators to comply with technical and financial responsibility requirements, and most importantly to clean up releases from their own tanks.

Settlement Tools

• Statutory liens – § 75-11-517, MCA, allows MT DEQ to place an automatic lien on a property for

the costs incurred to close UST

• Voluntary Liens • Judicial Liens • Mortgages • Deeds of Trust • Payment Plans • Transfer of Property to Third Party • Alternative Funding Sources

– Brownfields – MT Dept. of Natural Resources Grants – SB 96 Orphan Share – Special Legislative Funding – Leverage State Petroleum Fund

Sometimes Reviewing the RP’s Tax Information is NOT Enough

Gross Receipts vs. Cost of Goods Sold (COGS) for Gasoline

Gas Stations Make a Small Profit Margin on Gas Sales

Gross Receipts = $50.00 COGS = $48.75 Net Profit = $1.25

Higher Gas Prices = More Profit for Gas Station Owners….Right?

Higher Gas Prices = Increased Profit to Big Oil

Lower Gas Prices = Higher Net Profit for Gas Station Owners

How Do Gas Station/Convenience Stores Make Money?

What Other Info Should I Request?

• Break down of Gross Receipts vs. Costs of Goods Sold for All Merchandise Sold – Gasoline – Non-gasoline

• Documentation for Expenses • Loan Applications • Buy/Sell Agreements • Other Business Investments • Bank Account Statements • Personal Expenses (If Sole Proprietorship)

Ability to Pay in Litigation

• Liability and Damages vs. Ability to Pay – Ability to pay not a factor if liability and damages are

proven

• Determining Financial Status of RP – Sole proprietorship

• Owner/Operator may be personally liable

– Corporation • Liability protections

• Use of Expert Witness • Discovery Requests • Settlement • Credibility of RP as Witness

Lessons Learned: Cost Recovery in Montana

• In non-emergency situations, complete ability to pay early and try to reach voluntary settlement before state expends funds on cleanup

• In emergency situations, expend only those state/federal resources necessary to address the immediate threat before determining an RP’s ability to continue the cleanup

• Owners/Operators are not always honest – Trust but verify

• Half a loaf is better than none • When third-party litigation arises, cost recovery is not likely

to occur without the state joining suit • Ability to pay is an invaluable tool in pre- and post-litigation

settlement negotiations

Lessons Learned

• Unique types of entities

– Trusts

– Other parties obligated to pay

– Most common solution was sale of site property

– When possible file a lien

– Unnecessary Assets

– Excess salary

– Small increase in payments

Trusts

• A trust is a fiduciary arrangement that allows a third party, or trustee, to hold assets on behalf of a beneficiary or beneficiaries.

• Trusts are created under state law. • A written trust agreement and all amendments to the

trust should be requested. • Important elements • Grantor or Settlor • Trustee • Beneficiaries • Revocable or irrevocable

Revocable Trust

• A Revocable Trust, also known as a Revocable Trust, Living Trust or Inter Vivos Trust, is simply a type of trust that can be changed at any time.

• The down side to a revocable trust is that assets funded into the trust will still be considered your own personal assets for creditor and estate tax purposes. This means that a revocable trust offers limited or no creditor protection.

• Assets in a revocable trust may reach beneficiaries sooner than the probate process.

Irrevocable Trust • An Irrevocable Trust is a trust that generally cannot

be altered, changed, modified or revoked after its creation.

• Once a property is transferred to an Irrevocable Trust, no one, including the person who created the trust, can take the property out of the Trust.

• Income and expenses of an irrevocable trust are reported on Form 1041U.S. Income Tax Return for Estates and Trusts.

– Beneficiaries of an irrevocable trust normally report income on Schedule E.

• If a Trust is liable, you generally sue the Trustee, in the limited capacity of the Trustee.

Vacant Property • Property that is the subject of the cleanup is

often not used or underutilized.

• Significant public money is being expended to make the property safe.

• The liable party owns the property but it provides minimal income that is used to pay for the needs of the family.

• Ability to Pay classifies this as an available asset.

Vacant Property • Consider the ability to sell the property with a sharing

of net sale proceeds. • Consider reducing the real estate tax assessed value to

reflect the existing limited use. • If possible, add value to the sale by including limited

liability protection for the purchaser. • Have sampling and cleanup information available to

assist prospective purchasers when conducting due diligence (All Appropriate Inquiry)

• If possible, consider the use of trust or escrow accounts as a way to direct sale proceeds to the cleanup.

• Disburse money from protected accounts after verifying proper cleanup.

Other parties obligated to pay • Prior owner operators may have committed to cleanup

obligations under the terms of the sale agreement. (Indemnification agreements)

• Other Contractual Claims may exist that can only be exercised by the current owner. (Improper installation, insurance claims, cost recovery claims)

• Ask for complete copies of prior sale contracts. • Ask for insurance information. • Ask for law suit information. • Settlement could allow for sharing of future recoveries

or assignment of the right to future recoveries.

Unnecessary Assets Vehicles

• Elderly Individual.

• Residence has no debt.

• Stable source of income sufficient to pay for basic needs.

• Liquid Assets capable of paying for emergency expenses.

• Owns several antique vehicles.

• Recommendation sell one or two cars.

Excess salary

• Liable Party is a corporation.

• Largest expense is compensation to Officers.

• Amount of Compensation to Officers varies from year to year.

• Recommendation: Reduce compensation to reflect the fair market value of the work performed by the officer.

Year 2014 2013 2012

Gross Profit $300,000 $200,000 $250,000

Salary to Officers

$250,000 $150,000 $200,000

Net Income $ 50,000 $ 50,000 $ 50,000

Small increase in payments • Usually applies to a municipalities or non-profits.

• Approved budgets dictate expect revenues and expenses.

• Budgets, generally, include limited flexibility to pay unexpected expenses.

• Small, immaterial changes (by accounting standards), can be incurred without creating a harm.

• Small increase can create a large payment.

• Need to consider the impact on the families who pay these expenses.

Final Solutions

• Staff learned some new approaches.

• Legal Staff has more confidence on how to move forward.

• Increased use of lien authority.

• Improved template for financial questions and forms.

• Ability to move forward on these cases.

For further information

• Rebecca Ridenour 406 444-6437 rrideniur@mt.gov

• Becky Convery 406 444-6347 rconvery@mt.gov

• Leo Mullin 215 826-0462 leomullin@comcast.net