Christmas Tree Production

In General

Christmas tree growing because of the nature of the activity, usually constitutes a business rather than an investment. Therefore, Section 631 of the Internal Revenue Code is particularly relevant. Section 631(a) includes the provisions that: "For purposes of this subsection and subsection (b), the term 'timber' includes evergreen trees which are more than 6 years old at the time severed from the roots and are sold for ornamental purposes." This generally precludes capital gains treatment for producers of Southern yellow pine Christmas trees.

It is important to keep in mind that the procedures set forth in Section 631(a) and (b) were written for traditional timber production activities, and applying them to Christmas tree production requires close attention to details.

Operating and Management Expenses

The general rule with respect to establishment costs is that all such costs, including replanting, are capital expenditures and must be capitalized to a plantation account. This applies to Christmas trees, just as it does to other timber, whether you use the cash or accrual method of accounting. This also includes any costs incurred after the year of planting to assure the establishment of the stand. In addition, the expense associated with any activity which permanently improves the value of the property must be capitalized.

Reforestation Amortization

Trees planted for ornamental purposes, such as for sale as Christmas trees, do not qualify for the reforestation amortization deduction. Instead planting costs are capitalized to the plantation account for recovery as the trees are harvested.

The rules for deducting timber related operating expenses and carrying charges apply to Christmas tree production if the trees in question are more than 6 years old when cut or or sold. Since Christmas tree growing is almost always a business, the favorable rules for deducting business costs are applicable however, the passive loss rules are also applicable to you or anyone else with an ownership interest in the Christmas tree farm. Only those who materially participate in the business can deduct current expenses against non-Christmas tree income, unless the other income is passive in nature.

Shearing and pruning costs

Until 1971 the IRS held that the pruning and shearing costs of trees grown for the Christmas tree market represented capital expenditures under Section 263(a) of the Code. However the IRS was overruled in two court cases and in 1971 decided to follow the rulings in these cases. Revenue Ruling 71-228, 1971-1 C.B. 78, provides that the costs incurred in taxable years ending after May 24, 1971, for shearing and pruning of trees grown for the Christmas tree market are deductible business expenses.

Claiming Capital Gains Treatment

It is theoretically possible for an occasional producer of Christmas trees who sells on the stump to qualify for capital gains treatment under Section 1221. This would only be the case if the trees were not being held primarily for sale to customers in the ordinary course of a trade or business. Since even the casual choose-and-cut grower will need to advertise and otherwise hold themselves out as being in the business, you should not rely on Section 1221 treatment.

If capital gains treatment is desired you should use the provisions of Section 631(b) for sales of standing trees. Whether or not the trees are being held primarily for sale, if you cut the trees yourself or contract with someone to cut them for you, the provisions of Section 631(a) must be elected to receive capital gains treatment on the stumpage value of the trees cut.

Choose-and -cut: The choose-and-cut method of operation presents some unique problems. In Revenue Ruling 77-229 the IRS held that the sales in a choose-and-cut operation were of cut timber because the buyer obtained no interest in the timber until he actually cut one or more trees. As such, Section 631(a) would need to be used. Although it is possible to establish on-site sales procedures to meet the qualifications of Section 631(b), it may be more trouble than it's worth. For example the buyer would have to go into the stand, select the tree to be cut, agree to buy it (usually by paying for it) and then cut it.

Section 631(a) will apply to most producers, particularly those selling cut trees on the wholesale market. The tax calculation is fairly straight forward however, difficulty may arise in determining the fair market value of the trees on January 1 of the sale year. Valuations acceptable to the IRS can be made if the following guidelines are observed:

a) Prices of comparable quantities and qualities of trees in sales made in the area at or near the valuation date,
b) Legitimate offers to buy and sell,
c) Valuations made for other purposes, for example, estate and gift tax settlements,
d) Conversion back calculation predicted upon growth in the period intervening between valuation and sale.

The specific requirements are contained in Section 1.631-1(d)(2), Income Tax Regs.:

(2) The fair market value of the timber as of the first day of the taxable year in which such timber is cut shall be determined, subject to approval or revision by the district director upon examination of the taxpayer's return. This estimate is made by the taxpayer in light of the most reliable and accurate information available with reference to the condition of the property as it existed at that date, regardless of all subsequent changes, such as changes in surrounding circumstances, methods of exploitation, degree of utilization, etc. The value sought will be the selling price, assuming a transfer between a willing seller and a willing buyer as of that particular day. Due consideration will be given to the factors and the principles involved in the determination of the fair market value of timber as described in the regulations under Section 611.

The value that is to be used is the taxpayer's best estimate of what the trees could be sold for on the first day of the tax year based on their condition on that date. If someone were to purchase Christmas trees on January 1, it is reasonable to assume that they would look at their value at the time of cutting to determine their offering price. The buyer would in, essence, be buying Christmas tree futures. The IRS has adopted the applicability of this concept to Christmas tree valuation and recommends a procedure that is based on the value per foot of height.

An important court case provides guidance on the pricing of trees in January. The finding in Schudel vs. Commissioner [33 CCH Tax Ct. Mem. 1155, 1975; P-H Tax Ct. Mem. - 74,262 (1974)] dealt with the determination of the fair market value of Christmas trees for filing under Section 631(a).

Christmas Tree Organizations: