Be Audit Ready - 2008 End-of-Year Review
Tree Farmer Magazine: November/December 2008 - Volume 27 No. 6
There are several significant timber tax issues that have not been definitively settled by the IRS's rule-making process or by court cases. you may need to work with your tax preparer to conduct your year-end analysis. If you do, be certain they are familiar with the benefits available to Tree Farmers, even if this means "educating" them yourself. the IRS;s audit program is focused on upper-income returns, those with more than $1 million of gross income, and pass through entities such as partnerships and S corporations. This includes limited liability companies, since most elect to be taxed as partnerships. A little less than two out of 100 returns in these categories are audited. Only one out of 500 returns reporting $25,000 or less gross income are audited.
Should these odd change how aggressive your are in making decisions about return entries related to your Tree Farm activities? I'd say, yes, in some cases. Many Tree Farmers don't take advantage of the incentives provided by Congress because of the amount of interpretation required in applying the provisions to their factual circumstances. Those of us in the timber tax education business do our best to explain the law as we understand it and hoe it applies to a range of circumstances, but ultimately the person signing the return - you - has to be comfortable with what's on it.
Profit Motive & Potential
The first requirement an auditor will look at is the profitability of your Tree Farm. There are two aspects to profitability. Profit potential is based on the productivity of your timber and other products, and their current and expected future values. It also includes the expected increase in the value of the land used for your Tree Farm. Unless you're speculating on the land, the increase in land value can be added to the increase in the value of the timber to get the total potential income for a given year. profit motive focuses on how you balance your expenses against the income potential. Here's how I like to make the point.
If during the last several years the value of your land and timber has increased by say, $10,000 per year on average, but your average operating expenses per year are significantly more than this, then it's hard to argue that you're working to balance your expected income and expenses in order to eventually have an overall profit. If you keep estimates of expected income and records of your costs, it's possible to make a case for having a profit motive. But a larger percentage of Tree Farmers don't keep records on the value of their land and timber. Cost records are easier to maintain. If you are audited and can't discuss with the revenue agent the balance between your expected income and expenses, it will be very hard to convince them that you are operating your Tree Farm to eventually make a profit. Profit motive is required for the deduction of operating expenses for both investment and business activities.
Business or Investment
IRS auditors also question Tree Farmers about whether their activity is a business or an investment. In the worst case, they will take the position that it's a hobby. The basic treatment of what is deductible is the same in all three cases, but the benefit you receive is different. If it's an investment, you must itemize to deduct property taxes, and except for qualified reforestation expenses, investment expenses only help to the extent you itemize and your miscellaneous itemized deductions exceed two percent of your adjusted gross income. There is not hard-and-fast rule on what constitutes a business. The criterion most often used is the regularity and frequency of activities. If your Tree Farm is a hobby, property taxes are an itemized deduction, and qualified reforestation expenses are adjustments to gross income. All other expenses are miscellaneous itemized deductions, but only up to the amount of income received for the year from the hobby.
Year-end Decisions
Reviewing your tax situation before the end of the year means making a rough calculation of your tax liability assuming various adjustments to your income and deductions to minimize your 2008 tax liability. To be reportable on your 2008 tax return, you need to constructively receive the income or make the payments by December 31. This assumes you're a cash-basis calendar year tax payer. You may be able to time withdrawals from IRA accounts and sales of assets, including timber. On the expense side, reforestation projects and management activities may be flexible. Remember that you can deduct up to $10,000 per year for each of your qualified timber properties (QTP). If you will be spending more than $10,000 per QTP and don't want to amortize the amount over the cap, consider spreading the project over more than one year. Also consider scheduling receipt of discretionary ordinary income in years when you incur reforestation costs. If your activity is an investment and your end-of-year assessment shows that some of your expenses won't reduce your taxes because you will take the standard deduction, consider electing to treat these expenses as carrying charges. This means adding them to the basis of your timber, thereby increasing the depletion allowance when you dispose of the timber.
Know Your Tax Bracket
There is a good chance that ordinary and capital gains tax rates will increase starting in 2011. Until then, if you can keep your taxable income below the upper limit for the 15 percent ordinary income tax bracket, your capital gains rate will be 0 percent. Although the tax rates stay the same through 2010 the tax brackets are adjusted for inflation. After 2010, the lowest capital gains rate will be 10 percent, applicable to those in the lowest ordinary tax bracket of 15 percent. In a higher bracket, the capital gains rate will be 20 percent.
Keep Your Records Audit Ready
Always keep your records "audit ready." Make journal entries to accompany your receipts. Explain what the expense was and its purpose. Explain how the expense is related to the income potential of your Tree Farm. This is especially important if you live on your Tree Farm. For many expenses, it's necessary to differentiate between personal and household use and those directly related to the production of income. Develop a procedure for allocating costs between these two categories.
Treatment of Specific Expenses
How an expense is treated depends on both the nature of the expense and what it is used for. If your activity is a business, you'll also be faced with the passive-loss rules. The IRS recently announced that if you change how you combine more than one activity to determine your material participation, this change must be reported to the IRS
Property Taxes - Regardless of what you do on your Tree Farm, property taxes are deductible, assuming you itemize. If your Tree Farm is for personal use, hobby, or an investment and it's to your advantage to itemize, you report the tax as an itemized deduction with the tax on improvements.If you Tree Farm is a business, the property tax paid on the forestland and improvements used strictly for business purposes is deducted with your other business expenses. If your Tree Farm is a mix of personal use and investment or business use, you'll need to allocate among these uses.
Operating Expense - Other expenses are deductible only if they directly affect potential income and are not capital in nature. If you report as an investor and itemize, make certain to include as many other miscellaneous itemized deductions as possible to get over the two percent of adjusted gross income limit. Of course this doesn't matter for reforestation expenses, since they are adjustments to gross income if you file as an investor.
Capital Expenses - The costs of major assets you acquire are capital expenses recovered over time or when you dispose of the asset. Capital accounts are needed to determine the gain or loss when assets are disposed of, and to determine casualty and non-casualty business losses. Don't forget to make an allocation between personal and for-profit use of assets. You'll also want to update capital accounts for any improvements made this year. Also, remember to take advantage of the step-up basis when a spouse dies and the property is owned jointly.
Reforestation Costs - If you reforested land this year, make certain the details of the project are in your records. Unless your circumstances are unusual, you'll want to take the $10,000 per QTP deduction discussed above. Expenditures above $10,000 for each QTP are amortized. File an attachment to your return giving the details of each project. Don't forget to go back to the amortization schedules for reforestation expenditures in prior years. Your total amortization business deduction - or adjustment to gross income if you report as an investor - is the sum of the amortization for this year and previous years. Also, remember that trusts don't qualify for the deduction, but estates do. Both trusts and estates qualify for the amortization deduction, which is not capped.
One of the major unsettled issues is how to determine how many QTPs you have, i.e., how many $10,000 deduction you can take in a year. It's very clear that a given taxpayer can have more than one QTP. The broadest interpretation is that each reforestation project is a separate QTP. Apparently the IRS is waiting to see how taxpayers are defining what constitutes a QTP in practice, and will initiate a ruling project based on this information and any court ruling on this issue.
Timber Sales
If you sell timber this year, make certain your records are complete. File a copy of sales contracts. If you have not established the basis for the timber, contact a consulting forester who handles basis determinations. If you have a basis established, you'll need to update the accounts. This requires an estimate of the total volume of timber as of 2008, not just the volume you sold, so you can calculate the depletion unit. Your depletion allowance is the depletion unit times the number of units sold. Don't forget to add your sales expenses to the depletion allowance when completing Form 4797 or Schedule D. Except in very unusual circumstances, proceeds from the sale of standing timber will qualify for long-term capital gains treatment. Long-term means held more than 12 months before selling it if you purchased your Tree Farm. Long-term treatment applies as soon as you take title if you inherited your Tree Farm. If you operate as a business, it is no longer necessary to use a pay-as-cut contract to qualify for capital gains, but the gain or loss is still reported on Form 4797, not Schedule D. Also, remember that having a basis for your timber is not required for capital gains treatment. Timber income is reported in the year actually received, even if you defer payments from the year of the sale solely for tax purposes.