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The "Lump Sum" Fix

Tree Farmer Magazine: January/February 2001 - Volume 20, No. 1

You face many hard questions as a taxpaying tree farmer. One of the more troublesome is how to qualify for capital gains treatment on timber sales if you operate as a business. You''ve probably heard that you won't qualify if you sell "lump sum." This refers to selling for a fixed amount specified in the contract. You get to keep this amount regardless of how the timber cuts out, if it's damaged before logging starts, or even if it's never cut at all.

By way of explanation of a somewhat obscure law let's look at the distinction between assets used in a trade or business, and assets held primarily for sale to customers in the ordinary course of a trade or business. After learning this stuff you'll really be able to converse with your CPA. I'll start with an analogy.

Consider a cow-calf farming operation. The farmer keeps mature cows to breed and produce calves. Each year he sells the calves and keep the cows as long as they are producing. The income from the sale of the calves is ordinary income. But, if he sells a cow he would report the income as a capital gain from the disposal of an asset used in your trade or business. It's the calves that are held primarily for sale.

The distinction between assets used in a business and those held primarily for sale is straight forward for most businesses. But for the timber business it most certainly isn't. In fact, a given tree is both the asset used in the business and at some point becomes the asset that is sold. It's both the cow and the calf.

For a solution to the problem, I refer you to Section 631(b) of the Internal Revenue Code. Actually, it's an artificial construct created in the 1940's to solve a problem that no longer exists. Until Congress chooses to simplify our lives, we're stuck with the provisions.

So, if you are concerned that the IRS might disqualify capital gains on a lump sum sale the solution is to dispose of your timber using a pay-as-cut contract. The trick is to write the contract to reduce your financial risk. The risk results from having to depend on the buyer to determine the volume cut from your land. But there are ways to reduce the risk associated with depending on the buyer and/or logger to fairly and accurately determine the volume harvested.

An easy way is to require a before-and-after cruise in the contract. For a selective cut you or your forester would mark the trees to be harvested and estimate their volume. The contract would also need to specify a price per unit. The amount you're owned is the volume cut times the unit price.

You can receive payment for all the timber in advance of actual cutting as long as the contract also calls for you or your forester to cruise the timber after the harvest is completed, and requires an adjustment in the payment if the buyer cuts more or less than was marked.

If more is cut, then the buyer owes you an additional payment based on the additional volume times the unit price in the contract. If the buyer cuts less than was marked, then you need to refund the amount determined by the volume of undercut and the unit price in the contract. This provision needs to be in the contract even if it's highly unlikely that an adjustment will be needed.

If you are making a regeneration cut then you and the buyer should agree on the volume available on the designated acreage and the unit price. The contract must require payment based on this volume and the unit price. You can receive this amount before cutting starts. But the contract must call for you or your consultant to inspect the acreage after the harvest to determine if there was an undercut. If so, then you owe the buyer a payment based on the volume undercut times the unit price in the contract. In most cases you'll want to have a penalty specified if an undercut occurs. This penalty would be ordinary income, but it would offset in whole or in part any payback required under the contract.

I can't emphasize enough the need to have these provisions specified in your contract. Lawyers specializing in timber matters are familiar with these kinds of contracts. They can write them to meet the needs of both you and the buyer.

The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)