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Sub-Section 217, Value Evidence

Internal Revenue Manual
Specialized Industry Guidelines - Timber
Sub-Section 217, Value Evidence
Last amended: 8-4-1981

Value Evidence

(1) The price paid in an arms-length transaction, on or near the critical valuation date, for the timber being appraised would provide the best evidence of its value. Such evidence will not be available for IRC 631(a) purposes, however, because of the holding period requirement.

(2) This does not mean, however, that the cost of the timber to the taxpayer could not be a good indication of its value for purposes of IRC 631(a). Suppose, for example, that a taxpayer bought a tract of timber, after arm's-length negotiations, on December 31, 1975 and cut it in 1977. Other factors being equal, the value of that timber on January 1, 1977 should be what it cost plus or minus an adjustment to reflect only noticeable change in the timber market between January 1, 1976 and January 1, 1977.

(3) Sales of similar timber at arm's-length at about the same time and in the vicinity of the subject will ordinarily produce the best evidence of value. As a rule, the amount that comparable property changes hands for on the market at about the critical valuation date is the best evidence of market value available.

(4) Other than actual sales of similar property, rents and royalties paid for similar property provide valid market value evidence. When using timber royalty payments as value evidence, it is essential that the distinction between a timber lease and a timber sale be clearly understood.

(5) In a timber lease, the lessee is given the right for a specified time to cut certain timber, with the obligation to pay a timber royalty to the landowner based on the number of units actually cut. Royalties are paid only for timber when, as, and if cut. In the timber business, the timber royalty is usually called a stumpage payment; the royalty rate is called the stumpage rate.

(6) By contrast, a sale of timber is the transfer of cutting rights for a specified period of time for a stated lump-sum consideration that must be paid whether the timber is cut or not. Payment may be made in cash on the date sold, or the payments may be deferred. The important point, however, is that payment is not contingent on the cutting.

(7) In order to reflect sale value, royalty rates must be discounted to show present worth. This may be illustrated by the example of a typical two year pay-as-cut arrangement for the disposal by an owner of 24,000 units of timber with royalty payments made monthly at $10 per unit for the timber actually cut during the month. If we assume a uniform rate of cutting and payment by the lessee, payments of $10,000 per month for 24 months would be made. The sum of the payments would be $240,000. However, to say that such a transaction indicates a FMV of $240,000 for the timber on the date of the contract inception would quite obviously be ignoring the discounting principle as well as any other advantages such a transaction gives to the lessee. If we consider the rate for the use of money alone, the present value (on the contract date) of the $240,000 in the example, at 8% per annum, would be approximately $220,800. Thus, the sale value per unit indicated by the timber lease in this example is no more than $9.20, rather than the $10.00 royalty rate.

(8) The present worth of the future royalty payments would, without further adjustment, be a reasonable representation of the equivalent selling price, if the transaction was simply a deferred payment sale--that is, if the lessee were obligated to make all the monthly payments regardless of the quantity of timber actually cut. But, as we have pointed out, a timber lease is not the same as a deferred payment sale, either in form or substance. In a sale, either cash or deferred payment, the grantee must bear the risk of timber loss. In a lease, such risk is retained and borne by the lessor-owner. It is obvious, therefore, that in converting royalties to a sale value, adjustments for both interest and risk must be given careful consideration. In a lease, the purchaser (lessee) can afford a higher timber unit cost rate than in a sale, whereas the seller (lessor) can demand a higher unit price to compensate for the deferral of income and the risks of timber loss and wasteful logging inherent in a lease.

(9) Another form of valid stumpage value evidence is the margin between cost of production and the price realized for timber products. The so called conversion return approach utilizes this relationship. In simplified form, the conversion return approach holds that the fair royalty rate (stumpage rate) is equal to the average selling price of the first marketable product (i.e., logs, cordwood, or chips) less the average cost of production and the margin for profit and risk. The conversion return approach must often be relied upon where evidence derived from comparable sales or leases is not persuasive.

(10) Taxpayers have the burden of supporting the fair market values claimed. It is generally to their advantage to claim the highest possible value. For this reason, they may be prone to put great emphasis on evidence pointing to high values and little emphasis on evidence that may indicate the opposite. The Income Tax Regulations, however, require that any and all facts that have a bearing on market value be given due consideration (section 1.611-3(f) of the regulations).

(11) Pulpmills generally pay much less for wood than the sawmills and plywood mills do. This is true because pulpmills can profitably use logs that are too small or too crooked for profitable conversion to lumber or plywood. The highest quality southern pine trees generally yield material demanded by the pole and piling plants. The volume of wood used in the pole and piling market is, however, small when compared to the demands of the pulpmills and sawmills.

(12) Because timber suitable for use by sawmills, plywood mills, and the pole and piling market is so much more valuable than timber suitable only for pulpwood, taxpayers who cut large quantities of timber for use in their pulpmills, frequently claim sawtimber and poletimber values for a substantial portion of the timber used as pulpwood.

(13) It is reasonable to believe that a pulp manufacturer would cut and use some of its sawtimber for pulpwood in an emergency situation to avoid shutting down the mill for lack of wood. But it is not reasonable to believe that a manufacturer would consistently and from year to year cut very substantial quantities of its sawtimber for pulpwood use.

(14) United States Forest Service timber sales are frequently used, especially in the west, for transaction evidence. The most widely used sales contract used by the Forest Service is of the type designated as Contract Form 2400-6, Timber Sale Contract. This form of contract, although called a timber sale contract, does not provide for a sale of timber, but rather a lease of timber. It requires payment for the timber at specified rates only when, as, and if the timber is cut. Also, the bid price (royalty rate) is in most instances subject to quarterly adjustment, in harmony with a wholesale commodity price index during the term of the contract. The contract may be from 2 to 10 years duration.

(15) When using Forest Service transactions as value evidence, the high bid most often includes certain road costs that do not become part of the price paid for timber. The statistical high bid excludes such road costs and should, therefore, be used as the price bid on the timber. See Rev. Rul. 71-354, 1971-2 C.B. 246.

(16) Payments anticipated under Forest Service timber transactions must be reduced to their cash equivalent before they can be logically considered to represent the selling price of the timber included under a particular Forest Service sale.

(17) Also, it is important to remember that under Contract Form 2400-6, the Forest Service, rather than the purchaser, bears the risks of timber loss. This is a valuable provision to the purchaser and must be taken into account when reducing anticipated payments to a cash equivalent, or present value.

(18) In general, Forest Service sales under Contract Form 2400-6 and other sales under similar contracts, are so dissimilar to outright sales of timber that they should not be relied upon as the only source of value evidence. Where there are no more comparable transactions to use, the appraiser should rely more heavily on other kinds of evidence, such as the conversion return approach to stumpage value.

(19) In the West, sawmills often include the scale of so-called cull logs in the quantity of timber cut. Fair market values must take into account the fact that the value of cull logs is much less than the grade logs. If the logs were scaled by a Log Scaling Bureau or by the U.S. Forest Service, the cull log scale will be segregated in the scaling reports. Otherwise, the extent of cull log activity may be determined by checking the taxpayer's records of cull log sales.

(20) The agent should also be alert to the fact that under some circumstances a low fair market value would reduce the tax liability. An example follows:

(a) Corporation X reported the following on its 1960 income tax return. The capital gains from cutting timber equaled $1,000,000. Ordinary income equaled $100,000. The tax (at ordinary rates) was $521,500 and the tax (by the alternative method) was $341,500.

(b) The evidence indicated that the taxpayer had underestimated the fair market value of the timber cut. The agent's more objective computation produced the following results. Capital gains from cutting timber equaled $1,500,000. Ordinary loss totaled $400,000. The tax (at ordinary rates) was equal to $521,500 and the tax (by the alternative method) equaled $450,000.