by Kent N. Schneider1 and Mark A. Williams2
I. Background Timber, for tax purposes, is considered to be the wood in standing trees available for future use by forest industries. An owner may draw income from timber in various ways: (1) the owner may cut the timber, then sell it or use it to make products for sale; (2) the owner may enter into a pay-as-cut agreement, in which the purchaser will compensate the owner only when the timber is cut; or (3) the owner may sell the standing trees for a lump sum amount, giving the purchaser the right to enter the property and cut the timber within a specified time frame.
II. Cutting the Timber — I.R.C. § 631(a) If a property owner cuts his timber, or retains someone else to cut it, he may then sell the wood. Alternatively, the owner may use the wood to make products such as furniture or crafts, which may be sold for income at a later date. In general, any gain or loss from such sale is considered ordinary gain or loss because the wood is held for sale in the ordinary course of business. 3 In contrast, an outright sale of timber qualifies for capital gains treatment.4 To remedy this inequity, Congress enacted I.R.C. § 631(a), which entitles a qualifying taxpayer to elect to treat the cutting of the timber sold or used in the taxpayer's trade or business as a sale or exchange under I.R.C. § 1231.
Although I.R.C. § 631(a) makes capital gains treatment available for timber cutting transactions, this election can have some negative consequences. First, if the transaction results in a realized loss, an I.R.C. § 631(a) election would convert this loss from an ordinary loss into a less favorably treated capital loss. Thus, the election should be avoided for dispositions at a loss. Second, since the election under I.R.C. § 631(a) treats the cutting of timber as a hypothetical sale, the taxpayer may be accelerating the recognition of income by making the election. For example, if the timber is cut in 2001 and is sold in 2002, the gain from the hypothetical sale is recognized in 2001. To prevent this gain from being taxed again when the sale actually takes place in 2002, the taxpayer's basis in the cut timber is increased to the timber's fair market value at the time of cutting in 2001. The future sale, consequently, will result in a gain or loss equaling the difference between the actual sale price and the fair market value of the timber at the time of cutting.
A. I.R.C. § 631(a) Requirements To qualify for I.R.C. § 631(a) treatment, the taxpayer must meet four requirements. If any of these requirements are not satisfied, the I.R.C. § 631(a) election is not available.
Ownership. First, the taxpayer must either own the timber, or have a contract right to cut the timber. To be considered as having a contract right to cut timber, a taxpayer who is not the timber owner must have the right to sell the cut timber on his own account or to use the timber in his trade or business.5 In contrast, the timber owner needs not possess this same right.6
Holding Period. Second, the taxpayer must have owned the timber, or possessed the contract right to cut, for more than one year before the timber is cut.7 The "holding period . . . begins on the day" after the "title passes, or on the day after which delivery of possession is made and the [purchaser assumes] the burdens and privileges of ownership," whichever occurs first.8
The timber is deemed to be cut when the amount of timber felled is first determined, rather than at the time of felling.9 This determination will be made when the cut timber is measured at a log landing, scaling station, or mill. At this point in time, the timber is deemed to be cut, since it is generally impractical to determine the quantity of timber immediately after it is felled.10 To illustrate, consider Revenue Ruling 73-267, which examined a contract right to cut on U.S. Forest Service timberland. In this ruling, the commissioner held that the timber was deemed to be cut at the time when the logs were first truck scaled by a bureau scaler, not at the later time when a Forest Service scaler determined the quantity.11 Taxpayers are required to employ a consistent scaling practice and may not shift the scaling point in order to obtain a tax advantage. For example, if stumpage values were in a state of decline, it would be to the taxpayer's advantage to have the logs scaled sooner than usual practice would dictate. However, such a shift in the scaling point is not allowed.
Purpose. Third, the timber must be cut by the taxpayer either for the purpose of selling the timber, or for using it in his trade or business (for example, in manufacturing or processing forest products). If the timber is cut for some other purpose, then it cannot be regarded as sold or exchanged under the provisions of I.R.C. § 631(a). For example, timber cut for firewood to be used in the taxpayer's own household is not considered as cut for sale or for use in the taxpayer's trade or business.12
Taxpayer Election. Finally, the taxpayer must make the election to treat the cutting of timber as a sale or exchange.13 The taxpayer must make this election by reporting the transaction pursuant to the provisions of I.R.C. §§ 631(a) and 1231 on his initial tax return for the year in which the election is made. In other words, the election cannot be made in an amended return. Furthermore, the election cannot be revoked once it is made for that taxable year. Likewise, the election is binding upon the taxpayer for all succeeding taxable years, unless the IRS allows the election to be revoked for reason of undue hardship.14 In such cases, the taxpayer who revokes a I.R.C. § 631(a) election will not be allowed to make future elections without the consent of the IRS.
B. Gain or Loss Computation Under I.R.C. § 631(a) Since a qualifying I.R.C. § 631(a) transaction is treated as a hypothetical sale, the sales price in computing the gain or loss is considered to be the fair market value of the timber on the first day of the taxable year in which it is cut. Subtracting the timber's adjusted basis from this fair market value results in the gain or loss to be recognized.
Determination of Fair Market Value. Determination of fair market value of the timber is the most difficult part of calculating the gain or loss. According to Treas. Reg. § 1.631-1(d)(2), the fair market value should be determined in light of the most reliable and accurate information available. Though this valuation is not an exact science, a reliable estimate can be made by a skillful appraiser. Several factors must be considered in estimating the fair market value of standing timber, including location, accessibility, topography, soil, drainage, species, age, size, stand density, and quality.15
Comparable timber sold at arm's length near the time and locality of the subject timber generally will provide the best evidence of the fair market value available. Rents and royalties paid for similar property also provide sound substantiation of the fair market value of timber. However, adjustments for interest and risk must be considered when translating royalties to a fair market value because, in a sale, the purchaser must pay the owner whether the timber is cut or not, thereby accepting the risk of lost timber. In a lease, however, the purchaser pays the owner as the timber is cut, meaning that the owner bears the risk of losing the timber. As a result, the purchaser will be willing to pay a higher per unit cost in a "pay-as-cut" arrangement than in an outright sale.16
III. Pay-as-Cut Agreement — I.R.C. § 631(b) If an owner enters into a pay-as-cut timber agreement, he cannot obtain capital gains treatment unless the transaction meets the requirements of I.R.C. § 631(b). If these requirements are met, however, I.R.C. § 631(b) treatment is automatic; no election is necessary. A pay-as-cut agreement differs from I.R.C. § 631(a) transactions in that the purchaser is given the right to enter the property to cut certain agreed-upon trees. The owner then will be compensated only when those trees are cut and removed from the property.
A. I.R.C. § 631(b) Requirements To qualify for capital gains treatment under I.R.C. § 631(b), four requirements must be met. If any of these requirements are not satisfied, then the pay-as-cut transaction will result in an ordinary gain or loss.
Ownership. First, the taxpayer must own or hold a contract right to cut the timber. Although this requirement is similar to the ownership requirement of I.R.C. § 631(a), there is a key difference. As previously mentioned, the actual owner of the timber can satisfy the ownership requirement of I.R.C. § 631(a) without retaining the right to cut the timber for his own account or for use in his own trade or business.17 In contrast, the regulations clearly assert that the owner (including one holding a contract right to cut) must have a right to cut the timber for sale on his own account or for use in his trade or business in order to qualify as an owner under I.R.C. § 631(b).18
Holding Period. Second, the timber must be held for the mandatory holding period of one year. The holding period requirement of I.R.C. § 631(b) is nearly identical to the I.R.C. § 631(a) requirement. The only difference, related to the ownership requirement, is that a taxpayer must have secured the right to cut the timber for his own account or use in his trade or business in order to have acquired the timber under I.R.C. § 631(b). The taxpayer's holding period begins the day after that right is acquired. All other facets of this requirement remain the same under both I.R.C. §§ 631(a) and 631(b).
Contractual Disposal. Third, a disposal of timber must be made under a contract. This condition of disposal requires that the owner relinquish cutting rights and ownership in the timber to someone else.19 If the owner cuts or is contractually obligated to cut his own timber, then the owner generally has not relinquished his cutting rights to the purchaser, and no disposal will have been made under I.R.C. § 631(b). If, on the other hand, the purchaser is obligated under contract to cut the timber, then the I.R.C. § 631(b) contractual disposal requirement is satisfied.20
Further, the contract required must be mutually binding and enforceable with respect to the sale and purchase of the standing timber.21 In other words, the contract must bind the owner to sell and the buyer to buy. Although the agreement may be made under any form or type of contract,22 such an agreement should be in writing to protect the interests of both parties. An agreement which may be terminated by either or both parties is not considered a contractual disposal since there is no real obligation for the purchaser to remove the timber involved.
Retention of Economic Interest. The fourth requirement for I.R.C. § 631(b) transactions is that the taxpayer must retain an economic interest in the timber. Basically, an economic interest is retained if the taxpayer draws income that is contingent upon the cutting of the timber.23 In other words, a taxpayer possessing an economic interest in the timber will not be paid unless the timber is cut. In addition, the owner will be paid only for that timber which is cut. If the contract states that the owner is assured of receiving a lump sum, whether or not timber is cut, then no economic interest is retained. Payments received prior to cutting may be treated as realized from the sale of timber if the contract provides that such amounts are to be applied as payment for timber subsequently cut.24
B. Gain or Loss Computation Under I.R.C. § 631(b) Once it is determined that the transaction is eligible for I.R.C. § 631(b) treatment, the gain or loss may be found by calculating the difference between the amount realized from the transaction and the adjusted basis of the timber. Expenses attributable to an I.R.C. § 631(b) timber disposal reduce the amount realized in computing the gain or loss from that transaction. These expenses include the costs of advertising, cruising, marking the timber to be cut, and scaling or measuring the timber. They also include fees paid to consulting foresters, fees paid for supervising performance under the contract, and all other expenses directly related to the disposal.25
IV. Outright Sales of Timber — I.R.C. § 1221 While I.R.C. § 631 does not apply to an outright sale of standing timber, a gain realized from such a sale may be eligible for capital gains treatment if the timber qualifies as a capital asset under I.R.C. § 1221 or as property used in the trade or business of the taxpayer under I.R.C. § 1231(b)(1).26 Under an outright sale, the owner normally will relinquish to another party, for a lump sum amount, the right to come onto the property, cut designated timber, and haul the wood away in exchange for a lump sum. Furthermore, the contract will state that the owner will be paid regardless of whether the timber is cut within the specified time frame.
If the timber meets the definition of a capital asset under I.R.C. § 1221, then an outright sale of that timber will result in capital gains treatment. This section defines a capital asset simply as "property held by the taxpayer," but lists specific exclusions from this definition. The principal exclusions are "stock in trade," inventoriable property, and "property held . . . primarily for sale to customers in the ordinary course of [the taxpayer's] trade or business."27 The other exclusions under I.R.C. § 1221 ordinarily will not come into play within the terms of an outright sale of standing timber. Even within I.R.C. § 1221(1), the primary obstacle for such a timber sale is whether the standing timber or cutting rights constitutes property held for sale to customers in the ordinary course of the taxpayer's trade or business.
Unless a client enters into substantial, frequent, and continuing timber sale transactions, the I.R.C. § 1221(1) exclusion should not pose a problem, and the sale transaction would qualify for capital gains treatment, provided the holding period requirement is satisfied. If there should be some question regarding the client's intent, however, and if he is involved in frequent timber sales, then further investigation is required. In such cases, it may be in the taxpayer's best interest to make an effort to meet the requirements of I.R.C. § 631(b) so that any question as to whether the timber is a capital asset would be moot.
Sales qualifying under I.R.C. § 1221 are generally considered to be casual sales.28 This label appears somewhat appropriate, as many taxpayers who acquire timberland do not research the future tax implications of the acquisition. As a result, these taxpayers often fail to make an allocation between land and timber at the time of acquisition, and must estimate the timber's adjusted basis years later when the timber is sold.
V. Tax Planning Implications When determining whether a transaction qualifies to be treated as a capital gain or loss, one must remember that I.R.C. §§ 631(a) and 631(b) are mutually exclusive provisions that are intended to deal with different types of timber transactions.29 To distinguish these transactions, refer to the flowchart in Figure 1 while evaluating the following examples.
Example 1. Eric owns 50 acres of timberland. If he cuts the timber himself to sell it or to make products for sale, I.R.C. § 631(a) allows Eric to treat the cutting of his timber as a capital gain. If the transaction will result in a loss, Eric may simply wait until he sells the cut timber and recognize an ordinary loss at the time of the sale.
Example 2. If Reece enters into a pay-as-cut agreement with Andrew, a buyer, then the focus should be on I.R.C. § 631(b). In this instance, Andrew will agree to pay Reece only for certain trees, and ownership of the timber will transfer when the trees are cut and removed from Reece's property. If Reece's transaction fulfills the requirements of I.R.C. § 631(b), then the gain or loss automatically must be treated as an I.R.C. § 1231 transaction and grouped with gains and losses from other I.R.C. § 1231 transactions to determine whether they will be treated as capital or ordinary gains and losses.30
Example 3. Finally, if Reece sells the timber outright to Andrew, I.R.C. § 1221 should be scrutinized. In this case, Andrew pays for and takes ownership of a designated area of timber whenever the contract specifies and will be given the right to enter the property to remove the trees. If the timber qualifies as a capital asset under I.R.C. § 1221, but does not meet the requirements of I.R.C. § 631, then Reece will recognize a capital gain or loss on the transaction.
Thus, as illustrated in this article, the Internal Revenue Code offers three different options for structuring timber dispositions. So, with careful planning, timber owners can enjoy favorable tax treatment when disposing of their timber.
Endnotes 1 Mr. Williams, an active investor in the timber industry, is a Material Services Supervisor with American Electric Power in Kingsport, TN. He received his Master of Accountancy degree from East Tennessee State University in 2000.
2 Mr. Schneider is a Professor of Accountancy at East Tennessee State University. He is a member of The Missouri Bar and The Missouri Bar's Taxation Committee. He received his J.D. from the University of Missouri-Columbia, and he is a certified public accountant.
3 I.R.C. § 1221 (2000).
4 Id.
5 Treas. Reg. § 1.631-1(b)(1) (2000).
6 Weyerhaeuser Co. v. U.S., 402 F.2d 620 (9th Cir. 1968).
7 Treas. Reg. § 1.631-1(a)(4) (2000).
8 Rev. Rul. 54-607, 1954-2 C.B. 177.
9 Treas. Reg. § 1.631-1(a)(2) (2000).
10 Rev. Rul. 58-135, 1958-1 C.B. 519.
11 Rev. Rul. 73-267, 1973-1 C.B. 306.
12 Treas. Reg. § 1.631-1(a)(4) (2000).
13 Treas. Reg. § 1.631-1(a)(1) (2000).
14 Treas. Reg. § 1.631-1(a)(3) (2000).
15 Treas. Reg. § 1.611-3(f)(1) (2000).
16 Forest Industry Audit Guidelines, § 4232.4, Subsection 217.
17 Treas. Reg. §1.631-1(b)(1) (2000).
18 Treas. Reg. § 1.631-2(e)(2) (2000).
19 Dyalwood Inc. v. U.S., 588 F.2d 467 (5th Cir. 1979).
20 Id.
21 Ah Pah Redwood Co. v. Commissioner of Internal Revenue, 251 F.2d 163 (9th Cir. 1957).
22 Treas. Reg. § 1.631-2(a)(1) (2000).
23 Dyal v. U.S., 342 F.2d 248 (5th Cir. 1965).
24 Treas. Reg. § 1.631-2(d)(1) (2000).
25 Rev. Rul. 71-334, 1971-2 C.B. 248.
26 Indian Creek Lumber Co., T.C. Memo, 1982-146.
27 I.R.C. § 1221(1) (2000).
28 Forest Industry Audit Guidelines, § 4232.4, Subsection 310.
29 Varn, Inc. v. U.S., 425 F.2d 1231 (Ct. Cl. 1970).
30 Treas. Reg. § 1.631-2(a)(2) (2000).
Volume 57 - No. 1 - January-February 2001