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ISP Settlement Guidelines for Capitalizing Reforestation Costs

Capital Expenditures (Deductible v. Not Deductible): Allocation Between Capital Expenditure and Expense
Back reference: Decoordinated Issue Paper

May 21, 1993

STATEMENT OF ISSUE

Should portions of the salaries of foresters engaged in the planning and supervision of reforestation be capitalized?

EXAMINATION DIVISION POSITION

The taxpayer should use a reasonable method to allocate the forester salaries attributable to reforestation and capitalize these amounts as part of its reforestation costs.

BACKGROUND FACTS

It has long been established that the cost of establishing a stand of timber is a capital cost recoverable through depletion. For example, the cost of preparing the soil for planting, the cost of seedlings, and the actual cost of planting, are routinely accepted as capital costs. These particular costs are spelled out by example in rulings dealing with reforestation costs and have been accepted by the Courts in several cases as such. The cases and the ruling examples, however, do not specifically name the applicable portion of foresters' salaries related to planning and supervision of reforestation efforts. Many taxpayers recognized the need to allocate supervision costs to the planting activity, however, some did not. The Examination Division adopted the coordinated issue primarily to insure consistent treatment among taxpayers. Historically, forest regeneration primarily involved mechanical site preparation and planting or natural regeneration with seed trees. The Examination Division focused only on actual or easily identifiable preparation and planting costs and ignored pre-planting costs (planning and supervision) and post-planting costs (fertilization, herbicides, etc.). As timber companies have become more sophisticated in reforestation efforts, these pre- and post-planting costs have increased and Examination is now seeing these costs as significant enough to raise the issue as to their capitalization.

For example, taxpayers employ foresters to manage all aspects of their forest properties, including the reforestation of cutover timberland. In this respect, the forester determines the extent of any preparation of the site for replanting (such as brush removal and preparation of the seedlings beds), decides on the type of tree species to plant, orders the seedlings, and arranges for the company crews to perform the planting. The preparation for and supervision of these operations are significant responsibilities of the forester.

LAW AND ARGUMENT

Section 446(a) of the Internal Revenue Code provides that taxable income must be computed under the method of accounting on the basis of which the taxpayer regularly computes income in keeping its books. Expenditures made during the year must be properly classified as either capital (where the item has a life extending beyond the end of the taxable year) or expense as provided by Section 1.446-1(a)(4)(ii) of the Income Tax Regulations.

Section 461(a) of the Code provides that the amount of any deduction or credit allowed must be for the tax year that is proper under the method of accounting used in computing taxable income. If any expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the tax year, that expenditure may not be deductible, or may be deductible only in part, for the tax year in which made or incurred as provided by Section 1.461-1 of the Regulations.

Section 162(a) of the Code generally allows as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including a reasonable allowance for salaries.

Section 261 of the Code provides that in computing taxable income no deduction is allowed in respect to the items specified in Part IX, which includes Section 263.

Section 263(a) of the Code disallows, with exceptions that are not pertinent in the present case, any deduction for amounts paid out for permanent improvements or betterments made to increase the value of any property or estate.

Section 1.263(a)-1(a) of the Regulations provides that, except as otherwise provided in Chapter 1 of the Code, no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property.

Section 611 of the Code allows as a deduction in computing taxable income a reasonable allowance for depletion of timber. The reasonable allowance is to be made under prescribed Regulations.

Section 1.611-3(a) of the Regulations provides that with respect to capital invested in timber that is recoverable through depletion allowances, the capital remaining in any year is the basis provided by Section 612 of the Code and its Regulations. It also provides that amounts paid or incurred in connection with the planting of timber are to be capitalized and recoverable through depletion allowances. Such amounts include, for example, expenditures for the preparation of the timber site for planting and the cost of seedlings.

Revenue Ruling 75-467, 1975-2 C.B. 93, holds that generally, direct costs incurred in connection with reforestation are capital expenditures. Examples of these costs include amounts paid or incurred for (a) preparation of the site; (b) seedlings; and (c) labor and tools, including depreciation of equipment used in reforestation.

Amounts paid or incurred for reforestation are capitalized because they are for the creation of a stand of timber, an asset that will yield income in the future. The deduction for these should be taken when income is received from the timber. See, Commissioner v. Idaho Power Co., 418 U.S. 1 (1974), 1974-2 C.B. 85 [74-2 USTC ¶9521], in which the Supreme Court concluded that Section 263(a) of the Code required that the amounts of depreciation allocable to transportation equipment used by the taxpayer for self-constructing capital facilities must be capitalized and recovered over the lives of the self-constructed assets. The Court reasoned that the deductions allowable under Section 162 through 196 are subject to the general capitalization rule of Section 263(a).

Thus, the statutory and regulatory scheme of tax accounting for stands of timber would indicate that any expenditure to establish or enhance the growing timber would be a capital item recoverable through depletion. Rulings and cases however, have dealt only with the actual planting costs because that was the focus of IRS activities in the past due to insignificant pre- and post-planting costs. Although there are no cases dealing specifically with this issue for reforestation costs, other cases dealing with capitalization of costs into assets with a life beyond the taxable year indicate that the Courts would conclude that a forester's salary, related to establishment of a timber stand, should be a capital cost recoverable through depletion. See, e.g., Adolph-Coors Company v. Commissioner, 60 T.C. 368 (1973) [CCH Dec. 32,003], aff'd 519 F.2d 1280 (10th Cir. 1975) [75-2 USTC ¶9605], cert. denied, 423 U.S. 1087 (1976). Idaho Power Company, supra.