Chapter 2 - Timber Casualty Loss Audit Techniques Guide
Publication Date: April 2011
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
2. Determining Audit Scope and Depth
A. Pre-Audit Analysis: Return Review
Timber casualty losses may be reported in a variety of ways on a Federal Income Tax Return, depending upon the taxpayer’s accounting practices, sophistication, and desire to disclose or conceal the loss. During the opening interview, the examiner will have the opportunity to ask about casualty losses, and determine where and how such losses have been reported. Otherwise, examiners should review the return, looking in several places for a possible casualty loss deduction.
Form 4684 - Casualties and Thefts
Ideally, a casualty loss deduction will be reported on Form 4684, under Section B, for property used in a trade or business or for income production.
Part 1
Examiners should note how the taxpayer has identified the timber property affected by the casualty. Has the property been identified as a single tract or has the taxpayer aggregated several tracts and selected the entire depletion block as the unit of property? In general, the larger the property unit, the greater the potential for a valuation issue.
Examiners should look for indications of the type of casualty affecting the timber. This may be described in Part 1, Section B, of Form 4684 or it may be included in a separate statement, or on line 14 of Part II of Form T. Certain types of timber casualty events have greater potential for widespread destruction, such as fire damage or hurricanes, whereas other types of casualties, such as ice storms, may result in partial damage. The widespread nature, severity, and timing of the casualty will have an impact on the techniques used by the taxpayer to estimate the loss. Partial damage claims are generally more of an audit concern because more judgment is involved in estimating the loss.
Examiners should carefully look at lines 27 and 28 of Form 4684, to see how the taxpayer reported the Fair Market Value (FMV) before and after the casualty, and compare those figures with the adjusted basis. If no figures have been reported for FMV, or if the FMV has diminished significantly, the examiner should include valuation as a significant component in the audit plan.
Form 4797
The examiner should also review Form 4797-Part I to see whether there are any indications that the taxpayer has conducted a salvage of the damaged timber. Salvage sales may result in gains or losses. Typically, the taxpayer may elect to defer any gains under §1033 by attaching an appropriate statement.
The examiner should review Form 4797 - Part II (Line 14) to see whether any losses are reported from casualties. The examiner should be able to reconcile the total casualty loss from Form 4684 to the Form 4797.
Form T - Part II
Form T (Forest Activities Schedule) should be filed whenever a taxpayer makes a claim for a depletion deduction. If a form T has not been filed it should be requested through the IDR process. In examining Form T, examiners should review line 14 of Part II of Form T, which is the place to report timber casualty losses.
Examiners should determine the cause of the loss, to ensure that it constitutes an allowable casualty loss. Losses from disease or insects do not qualify as casualty losses. Losses from fire, storm, hurricane, theft, and wind would qualify as casualties.
The examiner should note whether any reductions to the loss amount were reported for insurance or other recoveries. Generally, timber property is not covered by property and casualty insurance, but the taxpayer may have received proceeds from a Federal or State Disaster Relief fund, or other third party. The examiner should obtain an explanation of how the taxpayer determined their total loss from the casualty. If the explanation is vague, missing or unclear, it may be an indication that the taxpayer did not maintain records or did not document its procedures to estimate the volume lost, or the value of the loss.
Basis verification is discussed in Chapter 4 with a discussion of the examination issues associated with basis recovery in a casualty loss situation.
Schedule M-1/Schedule M-3
In some instances, a taxpayer will not disclose or report a timber casualty loss on the forms described above. The loss may be “buried” as an “other deduction” or similar line item on the return.
However, since there is often a book/tax difference in the basis of timber, a Schedule M-1 adjustment (or a Schedule M-3 adjustment for a corporation with assets of $10 million or more) may provide an indication that a casualty loss has been claimed. The examiner should review the Schedule M-1/M-3 adjustments, including the detailed statement for Schedule M-1/M-3 to see whether there are any indications of a casualty loss.
If a casualty loss indication exists on Schedule M-1/M-3, but is not reported else where, the examiner should inquire where and how the loss is reflected in the return, and why it was reported that way. This may often be an indication of a potential issue.
Cost of Sales
Similar to the instances where a casualty loss is buried in “other deductions”, a taxpayer may report a timber casualty loss as a component of Cost of Goods Sold. This may have been done to avoid having to disclose information about the casualty loss, to avoid having to “net” the casualty loss with other ordinary gains and losses on Form 4797, or other reasons. As described above, the examiner should inquire about the reason for the unusual reporting, and be aware that it could indicate a potential issue.
Materiality Considerations
The examination of a timber casualty loss frequently involves a considerable amount of time because of :
• the complexity of the issues that could be involved
• the need to inspect the affected property
• the potential for a valuation issue
• the possible lack of detailed records that document how the loss was determined
• other factors
In many cases, the issue will need to be referred to an IRS Forester, and in some cases, an outside appraiser may be needed. Because the examination of this issue tends to be time and resource intensive, it is important to consider materiality and compliance risk when developing the audit plan.
Determining the scope and depth of examination for casualty losses will depend upon the materiality of the loss, but could also be impacted by other considerations, including:
1. History of the Taxpayer with Respect to the Issue
Is there a greater compliance risk because of issues in past examinations? Does the taxpayer have a history of aggressiveness in estimating or valuing casualty losses? Were there substantiation issues? How were prior issues resolved?
Although historic compliance does not guarantee current compliance, this is a factor to be considered in planning the audit procedures that will be used.
2. Strength of Taxpayer’s Internal Record Keeping and Reporting Procedures
Depending on a taxpayer’s compliance history, examiners may often rely upon some of the taxpayer’s internal records and reports, rather than independently verifying each component in the determination of the loss. Such reliance may be appropriate for taxpayers with strong internal record keeping and reporting procedures, including the use of automated forest inventory systems, stated policies and procedures for contemporaneous record keeping, stated policies and procedures for minimizing and reporting losses to management, detailed field manuals providing procedures for foresters on the ground, in the areas of sampling, measurement, and quantifying losses.
3. Full and Adequate Appraisal of Property Before and After the Casualty
In some instances, the appraisal may be so well done and documented, that few additional audit procedures will be necessary. If the taxpayer maintains excellent records and can easily demonstrate adequate basis, a quality appraisal may eliminate the need for many field procedures.
4. Large geographic loss, with obvious large loss in value, but deduction limited to minimal basis in the block.
There could be instances where the adjusted basis in the depletion block has already been reduced because of previous year casualties, and there is minimal remaining basis to absorb the current year casualty loss. If the current casualty loss is much larger than the available basis, then the compliance risk associated with the loss deduction is obviously significantly reduced.
However, the mere fact that the loss has been limited to adjusted basis does not mean that there is no valuation issue, since the loss may actually be limited by diminution in value if an inappropriate valuation determination was made. The examiner should be aware that the valuation diminution may be greatly overstated, perhaps as much as 50% based on examination experience since the publication of Revenue Ruling 99-56, 1999-2 C.B. 676. Thus, the examiner should make a determination of the compliance risk, considering the potential for valuation overstatement. If the remaining basis is still the limiting factor for the claimed loss, then the examination procedures may be limited to basis verification and some limited volume verification procedures.
C. Referrals to IRS Foresters
After evaluating the materiality of the claimed loss, as well as the appropriate scope of the examination, an examiner should consider the need for an IRS forester’s assistance. In general, for any loss that is material, and that involves timber valuation as a significant component, a Forester referral should be made.
The examination of timber casualty losses frequently involves many judgments about forest conditions, timber markets, appropriate methods of cost and value estimation, appropriate methods of volume estimation, as well as knowledge of the field forestry records and operational procedures. The examiner must also have an understanding of timber terminology and timber management practices in the geographical region where the loss occurred. The IRS foresters have expertise in all of these areas, as well as specific examination experience with the timber casualty loss issue, and should be utilized as part of a quality examination. The forester’s involvement will also reduce examination time and burden on the taxpayer due to the efficiency gains which accrue from expertise and experience. In addition, a forester’s involvement ensures greater consistency of treatment across the industry, because of their training and involvement with the Forest Products Technical Advisors.
In situations where a Forester referral is not accepted or cannot be made due to lack of forester availability or geographical considerations, an examiner should still consider contacting an IRS forester or the Forest Products Technical Advisors, for consultation.