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Industry Specialization Program (ISP) Settlement Guidelines

POLICY, IRPO ¶180,405,
ISP SETTLEMENT GUIDELINES FOR
COMPUTATION OF TIMBER CASUALTY LOSSES

UIL No. 165.01-01: [Deductions for losses: Basis]. Back reference: Coordinated Issue Paper

May 26, 1993

STATEMENT OF ISSUES

When timber is damaged or destroyed in a qualifying casualty loss, what is the "single, identifiable property" for purposes of computing the basis limitation? Is it the marketable units of affected timber (i.e., board feet or cords) or the entire timber tract?

EXAMINATION DIVISION POSITION

The position set forth in Rev. Ruls. 66-9 and 73-51 remain the official position of the Service, notwithstanding any court case decided contrary to that position. Thus, the amount of casualty loss in the case of merchantable timber is limited to the quantity of timber rendered unfit for use multiplied by the adjusted unit basis (the depletion unit for taxpayers that claim timber depletion). In the case of young growth (also known as non-merchantable timber and immature timber growth), an acre of young growth with the associated land, in most instances should be the basis for determining the amount of the loss.

BACKGROUND

The focus of the problem with which we must deal on this issue is the definition of the term "single, identifiable property" regarding a casualty loss on timber property. As a simple example, assume that a taxpayer has a block of timber consisting of 200,000 acres of trees with a fair market value of $300,000,000 and a tax basis of $10,000,000. (See Treas. Reg. Section 1.611-3(d) for the meaning of a block). A casualty (fire, storm, etc.) occurs and destroys 20 percent of the trees in the block. The fair market value of the block after the fire is $240,000,000. The taxpayer contends that the "single, identifiable property" is the entire 200,000-acre block. Under this assumption, the casualty loss deduction would be the lower of the basis ($10,000,000) or the decrease in the fair market value of the property ($60,000,000). Thus, under this assumption, the taxpayer would deduct its entire basis in the 200,000-acre block even though 80 percent of the trees remain undamaged. The Government, of course, would argue that this position leaves the taxpayer with 80 percent of its trees undamaged and with no tax basis; therefore, the only logical definition of "single, identifiable property" is a unit which would limit the taxpayer's basis to the actual property destroyed. The Government, therefore, contends that the depletion unit should be used as the "single, identifiable property". To further illustrate the problem, if we assume that I own 100 shares of stock and 50 of those shares are stolen, it goes without saying that my basis, for purposes of the theft loss computation, would be limited to 50 percent of my basis in the stock. On the other hand, if I own an automobile and a fender is damaged, I am not required to compute the basis of only the fender for purposes of the basis limitation in a casualty loss. The basis limitation would be defined as the basis of the entire car. The difference in these two examples is the nature of the assets involved; one might think of a tract of timber as consisting of fungible units similar to shares of stock so that a per-tree allocation (or board foot) of basis would be appropriate. On the other hand, trees may be more interdependent than shares of stock similar to parts of a machine or automobile. Damage to some trees may damage others indirectly and this may suggest that the "property damaged" should be viewed as the whole tract. There are rulings and cases regarding this problem but, the area is still unsettled.

LAW AND ARGUMENT

IRC Section 165(b) states that the basis for determining the amount of the deduction under Section 165(a) is the adjusted basis provided in Section 1011 for determining the loss from the sale or other disposition of property.

Treas. Reg. Section 1.165-7(b)(1) states that the amount of loss to be taken into account for purposes of Section 165 is the lesser of either (1) the reduction in the fair market value of the property on account of the casualty, or (2) the amount of the adjusted basis prescribed in Treas. Reg. Section 1.1011-1. However, if property used in the trade or business or held for the production of income is totally destroyed and if the fair market value before the casualty is less than the taxpayer's adjusted basis in the property, the amount of the adjusted basis is treated as the amount of the loss. Treas. Reg. Section 1.165-7(b)(2)(i) states that, a loss incurred in a trade or business or in any transaction entered into for profit shall be determined under subparagraph (1) by reference to the "single, identifiable property" damaged or destroyed.

Treas. Reg. Section 1.611-3(c)(1) requires every taxpayer claiming a deduction for depletion of timber property to keep accurate ledger accounts recording the cost or other basis provided by Section 1012 of the property and the land together with subsequent capital additions and adjustments under Section 1016. Treas. Reg. Section 1.611-3(c)(2) states that, in such accounts there shall be set up separately the quantity of timber, the quantity of land, and the quantity of other resources, if any, and a proper part of the total cost or value shall be allocated to each after proper provision for immature timber growth under Treas. Reg. Section 1.611-3(d).

Treas. Reg. Section 1.611-3(d)(3) provides that the total value or total cost, as the case may be, of land and timber shall be equitably allocated to the timber and land accounts respectively, and that in cases in which immature timber growth is a factor, a reasonable portion of the total value or cost shall be allocated to such immature timber.

Rev. Rul. 66-9, 1966-1 C.B. 39, concludes that in the case of destruction of timber by a casualty, the "single, identifiable property" for purposes of Treas. Reg. Section 1.165-7(b)(2)(i) is the board foot or cord and that the amount allowable as a casualty loss deduction is limited to the adjusted basis for determining the loss from the sale or other disposition of the quantity of timber that was rendered unfit for use by the casualty. Adjusted basis on sale or other disposition of timber is determined by reference to Sections 611 and 612.

In Harper v. United States, 274 F. Supp. 809 (D. S.C. 1967) [67-2 USTC ¶9172], aff'd per curiam, 396 F.2d. 323 (4th Cir. 1968), the court accepted the Service's position that the board foot or cord of timber in merchantable trees is the "single, identifiable property" for purposes of Treas. Reg. Section 1.165-7(b)(2)(i).

In Rosenthal v. Commissioner, 48 T.C. 515 (1967) [CCH Dec. 28,533], aff'd 416 F.2d 491 (2d Cir. 1969) [69-1 USTC ¶9430], the Tax Court and the Second Circuit also agreed with the Service that a casualty loss deduction for timber destroyed is limited to the taxpayer's basis in the units of timber destroyed.

In Rev. Rul. 73-51, 1973-1 C.B. 75, the Service concluded that a taxpayer could not take a casualty loss deduction for damage to surviving merchantable trees that did not currently decrease the amount of units of timber but that might retard subsequent growth of the trees. Citing Rev. Rul. 66-9, Rosenthal and Harper, the Ruling indicates that the "single, identifiable property" destroyed is the quantity of timber rendered unfit for use by the casualty.

However, in Westvaco Corp. v. United States, 639 F.2d 700 (Ct.Cl. 1980) [81-1 USTC ¶9101], the Court of Claims disagreed with the views of the Second and Fourth Circuits and held that the block or district is the "single, identifiable property" for purposes of the adjusted basis limitation of Treas. Reg. Section 1.165-7(b)(2). The Court concluded that the manner in which basis is determined for depletion purposes, should not dictate how it is determined for casualty loss purposes and that all timber, both merchantable and nonmerchantable as stipulated in the case, in a single block or district should be seen as the "single, identifiable property" for purposes of the regulation.

The Service's position, which was accepted by the Second and Fourth Circuits, has become nearly indefensible because of its rejection by a Court of National jurisdiction in the Westvaco Corp. decision. Because the taxpayer has its choice of forum for this issue and it is apparent that any timber company, in its right mind, will choose the Claims Court as that forum, we must consider the Government victories in the Second and Fourth Circuits to be almost inconsequential.

Another case bearing on this issue, and sometimes cited by the Examination Division, is Martin Marietta, (Cls. Ct. 1983) [83-2 USTC ¶9607]. In this case, underground water flooded 9 acres of the taxpayer's 23-acre limestone quarry. The taxpayer found it economically impractical to mine the undamaged portion because the amount of usable rock was significantly reduced and the apparent uncertainty that underground water problems would continue. They therefore claimed a casualty loss based upon a loss of all the minerals in the 23 acres. The Court limited the deduction to the loss attributable to the 9 acres. The rationale for this was that no casualty had been established as to the remaining acreage; that part remained precisely as it was first acquired; all that changed was the taxpayer's knowledge of it.

Taxpayers will thus distinguish this case from Westvaco, supra., in that, the Westvaco casualty (hurricane) was not a pre-existing condition as in Martin Marietta, (existing underground water).

Examination will argue that there is nonetheless an apparent conflict in the Claims Court (formerly Court of Claims) in that, no loss was allowed for undamaged property in Martin Marietta but was allowed in Westvaco.

It seems to me then, that the guidance given by Westvaco and Marietta is that the Court may justify these apparent contrary positions by defining the single identifiable property as the area damaged. If this is so, damage caused by a hurricane, which would be more widespread in the block, would be allowed a larger basis than that by a volcano which would be more contained within the block. If the Court did adopt this posture, different results would be obtained even though the board feet of timber lost could be equal.

This position would also emphasize that if the taxpayer attempts to use the block for basis purposes, they must also use the block to determine the diminution in FMV. If the block is large, it could be argued that a small casualty loss does not affect the FMV as it may be smaller than the cruising error (the error in estimating volume in the block).

As to the issue of the definition of "single, identifiable property" then, the taxpayer has the upper hand on litigation of this issue due to its ability to choose the Claims Court as its forum. However, we must note that this issue is being re-litigated by the Weyerhaeuser Company in the Claims Court at the present time. One casualty loss issue there involves a loss caused by the Mount St. Helens eruption in 1980. Weyerhaeuser's block, or tree farm, was comprised of a total of 472,000 acres and was treated as one block for depletion purposes. Although the destruction caused by the Mount St. Helens eruption was pervasive, only 68,000 of the total 472,000 acres were affected. Using the lower of the decrease in fair market value of the 472,000 acres of trees as compared to the basis in those trees, Weyerhaeuser Company deducted, as a casualty loss, the entire basis of the 472,000 acres. The Examination Division limited the deduction to the depletion basis of the timber destroyed on the 68,000 acres of trees and Weyerhaeuser filed suit in the Claims Court. The litigation position taken by the Justice Department in the Weyerhaeuser case has been that of defining the "single, identifiable property" as a unit smaller than the block but, larger than the ISP position calling for a "single, identifiable property" based upon the board foot or the acre, in the case of young growth. The Justice Department, in the Weyerhaeuser case, is attempting to establish that the "single, identifiable property" in the Weyerhaeuser case should be the "stand". A "stand" could be defined as a contiguous group of trees which are managed as a unit, are of approximately the same age class, such that, they will be expected to be harvested as one unit, or as several units over a short time span. Most, if not all, timber companies maintain records to manage portions of the block by stand. This change to a larger unit from the board foot is not to say that the Government has abandoned its board foot definition of "single, identifiable property" but, in this case, it was necessary to develop a different litigating strategy for the Court to consider since we lost the board foot contention in Westvaco. Having observed some of the Weyerhaeuser trial (being tried in the Summer of 1992), it is my opinion that the Court was favorably impressed by the Government's new argument. The decision in this case, however, will likely not be available until the Summer of 1993. [Hoover's note: U.S. Court of Federal Claims accepted Service's use of stand as SIP, but on appeal Westvaco was held to be the precedent (use of block) that allied. Appeal to US Supreme Court by Service was rejected.]

The following are points to be made in favor of the Government's position:

* The Government has won victories in the Second and Fourth Circuit Courts wherein the Courts drew the connection between the rules pertaining to sale or other disposition of timber and the Section 165 casualty loss rules, such that, the Court accepted the Government's definition of the "single, identifiable property" as the board foot or cord.

* In Martin Marietta, supra., the Claims Court (1983) did not define the entire property as the "single identifiable property" as was done in Westvaco, Court of Claims (1980). While the Marietta case is distinguishable on the facts, comparison of the two cases points out a potential conflict in the decisions.

* The "single, identifiable unit of property damaged or destroyed" was not in the original Regulations but, was added to clean up a problem regarding the use of a percentage of basis in the computation of casualty losses. This addition was a result of the Alcoma decision, [57-1 USTC ¶9203]. In that case, the Fifth Circuit held that the taxpayer was entitled to a casualty loss reflecting the reduction in market value up to an amount equal to the adjusted basis of the entire property affected (hurricane in a citrus grove) rather than a percentage of the basis of the entire grove based upon the percentage of the grove damaged. Therefore, the intention of the insertion of "single, identifiable property" into the Regulations, was to focus on the functional unit of property to compute a casualty loss.

* The Regulations require that the taxpayer compute his casualty loss in the same manner as would be done for a sale or exchange. Timber companies sell their product by the board foot or cord as a general rule. Although timber companies do buy and sell timber by board foot and by stand, they rarely buy timber by entire blocks.

Arguments which will be made by the taxpayer are as follows:

* The taxpayer has won the "single, identifiable property" issue in Westvaco. In Westvaco, the Court refused to make the connection between Section 165 and the depletion rules under Section 611. The Court reasoned that the manner in which basis is determined for depletion purposes should not dictate how it is determined for casualty loss purposes. The Court stressed that basis for depletion purposes is derivative of Section 1011 basis, rather than vice versa, and that the Section 1011 basis is what is used for casualty loss purposes.

* The Westvaco decision's acceptance of the argument that any measurable loss to timber should be considered whether it causes total destruction or not makes sense and would bring in additional tracts for inclusion in the basis limitation. (A problem here for the taxpayer is the establishment of the loss since damage to the trees would be difficult to establish).

* The taxpayer can point to the fact that in both the Second and Fourth Circuit decisions of Harper, supra., and Rosenthal, supra., the Court pointed out that both taxpayers had declined to prove that the value of timber in the remaining tracts (those outside the total destruction area) had declined in value. Since the burden is always upon the taxpayer to establish the amount of his loss, the Court concluded that the taxpayers had failed to show any loss to the remainder of their tract. We cannot be sure of the outcome of Rosenthal and Harper if the facts had been that they had proved damage to the other portions of the affected area. However, in Westvaco, it is quite clear that the Court there accepted that the "single, identifiable property" should not be limited to merchantable units of timber destroyed but, should be extended into the entire area affected by the casualty. And the Court, in effect, described an affected unit to include the entire management unit, or "block"