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Section 630, Depletion Problems

Internal Revenue Manual
Specialized Industry Guidelines - Timber
Section 630, Depletion Problems
Last amended: 8-4-1981

Depletion Problems

(1) Timber acquired under cutting contracts should be carried in separate accounts. Timber acquired under the usual form of cutting contract is paid for as it is cut at pre-determined rates. Ordinarily, the quantity of timber paid for should equal the quantity of timber cut. If there is a difference, it may have been created for tax purposes. As previously mentioned, by overstating the quantities cut, a taxpayer can increase capital gains and decrease ordinary income. Or, by overstating the quantity and cost of the timber acquired under a cutting contract, capital gains can be reduced. Taxpayers who cut timber acquired under cutting contracts with price escalation provisions--such as U.S. Forest Service contracts in the West--may claim timber cost for the year at the rate that applied under the contract on the first day of the taxable year. The argument for this is that under IRC 631(a) the true measure of gain can only be derived by tying both cost and value to the same day, that is, the first day of the taxable year. This position is erroneous since Regulations 1.1012-1(a) and 1.631-1(a) provide that the basis of property is its cost. The actual cost is the amount paid for such property. In a rising market, taxpayers claiming an estimated cost will have excessive capital gains.

(2) Section 1-611-3(d)(5), I.T. Regs. (1954) provides that for good and substantial reasons satisfactory to the District Director, or as required by the District Director on audit, the timber or land accounts may be readjusted by dividing individual accounts, by combining two or more accounts, or by dividing and recombining accounts. Some of the reasons mentioned for dividing or combining timber accounts are tree species, scattered tracts, and accessibility. As a practical matter, examiners will find that different taxpayers divide their timber accounts to fit their own particular situations. There will usually be reasonable justification for the particular accounting classification used. If the taxpayer is consistent from year to year and the classifications are reasonable, the examiner can usually consider the accounts used as acceptable. Examiners should be concerned when taxpayers divide or combine their timber accounts in a manner that is inconsistent with their usual method, or if no consistent practices are followed. The following illustration shows how inequities might be created:
The Smith Corporation has several tracts of timber scattered throughout Oregon and Washington. It has consistently maintained separate timber accounts for each individual tract. In the examination of the Corporation's 1976 return, the examiner discovers that this pattern has been broken. Three of the Oregon timber tracts are combined into a single account (designated as Tracts A, B and C). Upon further investigation, the examiner learns that Tract A and B were logged during 1976. Tract C is a considerable distance from the taxpayer's mill and it seems unlikely that it will be logged within the next few years. For Tracts A, B and C, depletion of $336,000 has been claimed on the 1976 tax return. The taxpayer is unable to give a good business reason for the change, other than for a tax benefit. Accordingly, the examiner recommends that each tract be depleted separately, as in prior years.

(3) The recomputation of the depletion allowance results in a decrease of $136,000. The examiner's computations appear in Exhibit 600-1.