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Selecting the Appropriate Structure

Although the decision on which type of entity to use is not reducible to a formula, it may help to use a stepwise approach.

Investment vs. Business

The nature of the timber growing process is more characteristic of a business as contrasted with classical investments such as stocks and bonds. But if you have a small acreage and like to keep things as simple as possible, the investment structure may be best for you. The factors that should be considered include:

Itemize vs. above the line deduction - With the investment structure you deduct the property tax as an itemized deduction and your operating expenses as miscellaneous itemized deductions. If you do not normally itemize the business structure is preferable. If you itemize but have few, if any, non-timber miscellaneous itemized deductions, the 2-percent floor on miscellaneous itemized deductions favors a business structure.

Passive activity loss restrictions - If you want to avoid the complications of the passive activity loss restrictions, the investment structure is preferable.

Administrative burden - There is little difference in the paperwork involved in reporting an investment and a sole proprietorship business. Partnerships and corporations may involve a substantial administrative burden.

Capital gains treatment - The prevailing perception is that if you structure as a business you do not qualify for capital gains treatment on lump sum sales of timber, unless you sell with a "pay-as-cut contract." This is not necessarily true, however. Lump sum sales qualify if the timber is considered to be a capital asset, or if it is held for use in a trade or business. The confusion between "held for use in a trade or business" and "held primarily for sale to customers in the ordinary course of a trade or business" results from one of the unique aspects of timber.

In comparison with a typical manufacturing process, your timber is both the "machine" that produces the wood (annual growth) and the product itself. Cutting a tree results in a disposal of the "wood making machine" and the wood made over the life of the "machine." In the case of a normal manufacturer it's obvious when the machine used to make the product is disposed of and when the product made is disposed of. They are normally completely separate physical things.

In the case of timber the distinction must be made on the basis of whether the timber is "held for use in a trade or business" or "held primarily for sale to customers in the ordinary course of a trade or business." The following may help to clarify the difference.

Primarily held for use in a trade or business - The business has timberland holdings from which they cut timber to be processed in their mills or to produce logs sold to other mills. They rarely, if ever, sell timber on the stump to others, and if they do the gains would not qualify unless the stumpage was disposed of under a so-called pay as cut contract (Section 631(b) of the Code).

Primarily for sale to customers in the ordinary course of a trade or business - If instead of cutting timber for processing in its own mills, a company grows timber to sell on the stump to other companies, it would be holding the timber primarily for sale.

The distinction may be less obvious but is still valid in the case of a tree farmer who's not in the lumber or other timber conversion business. You can be in the business of growing timber, and when the time is right you will entertain offers to buy your timber. You haven't held yourself out to the public as being in the ongoing business of selling timber. Thus you are able to classify your tree farm as a timber business and still qualify for capital gains on lump sum sales.

Corporation vs. partnership

A factor to consider in deciding whether or not to incorporate is the total tax liability that would be incurred on income earned by the corporation after distribution to the stockholders. In most circumstances the double taxation of corporate income favors non-corporate forms of business for small enterprises receiving income from timber. Those wishing to incorporate for some other reason should consider a subchapter S election.

From a tax standpoint the S corporation and partnership tax accounting rules are similar. The corporation presents the most complicated legal situation since the requirements of state law regarding the conduct of business as a corporation must be followed. Liability protection is frequently given as a reason for incorporating. You should discuss this aspect with your legal counsel. The courts look very closely at the extent to which you and your corporation in fact constitute separate entities.

Not Sure

If you are not sure how to classify your timberland ownership, or are uncertain about how you have classified your ownership in the past click here. You will be asked a series of questions to help you determine how you should classify your timberland ownership.