ISP Settlement Guidelines for Expenditures for Replanting Forest Plantations that Fail

Allowance of deduction for depletion (Deductible v. Not deductible): Timber--General].
Back reference: Decoordinated Issue Paper

May 20, 1993

STATEMENT OF ISSUES

Whether the costs of replanting areas where the initial planting was unsuccessful and the poor survival rate of planted tree seedlings was not due to a casualty should be:

  1. Allowed as an ordinary and necessary business expense under Section 162;
  2. Allowed as a loss under Section 165(a); or
  3. Treated as a capital expenditure under Regs. Section 1.611-3(a) in a manner identical to the original planting costs.

EXAMINATION DIVISION POSITION

All planting costs, including replanting costs, should be capitalized in accordance with Regulation Section 1.611-3(a). This position is also contained in Rev. Rul. 81-2, 1981-1 C.B. 10. Replanting costs arising due to a "casualty" must also be capitalized, however, a casualty loss deduction on the original planting would be allowable in the year of the loss, (not year of the replanting).

BACKGROUND

A typical fact pattern regarding this issue would be as follows. A timber company owns forested lands which it manages for continuous production of timber. After harvesting mature timber, the taxpayer reforests the land by planting, say, 600 new trees per acre with the hope of having 300 well-spaced survivors. If less than 300 seedlings survive, the reforestation is unsatisfactory and the understocked portion of the area is "replanted" to the desired stocking level. Some taxpayers claim the new "replanting" costs as a Section 162 ordinary and necessary business expense or as a Section 165(a) loss. Others may claim the basis of the trees lost as an ordinary deduction under Section 165. The Examination Division contends the new replanting costs are a capital expenditure just as the failed reforestation costs were under Regulations Section 1.611-3(a).

The taxpayer may contend that a casualty loss is allowable under 165. The Examination position and this Appeals position does not consider whether a deduction for the failed trees is allowable as a casualty loss. That question is purely factual and should be decided by the Appeals Officer based upon the facts of each case. (Revenue Ruling 90-61 dealing with loss of seedlings due to abnormal drought or Rev. Rul. 87-59, death of trees due to insects, may be of some help in deciding a factual casualty loss issue. Both of the rulings involved unusual and unexpected losses for which deductions were allowable).

LAW AND ARGUMENT

Section 165(a) of the Code provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

Treas. Reg. Section 1.165-1(b) provides that, to be allowable as a loss under Section 165(a) of the Code, a loss must be fixed by identifiable events. Only a bona fide loss is allowable. Substance, not mere form, shall govern in determining a deductible loss.

Section 611(a) of the Code provides that, in the case of timber, there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion and for depreciation of improvements.

Treas. Reg. Section 1.611-3(a) provides that amounts paid or incurred in connection with the planting of timber shall be capitalized and are recoverable through depletion allowances.

In Rev. Rul. 75-467, 1975-2 C.B. 93, the Service took the position that the direct costs of reforestation are capital expenditures recoverable through the depletion allowance. The theory underlying capitalization of planting and reforestation costs is that such costs are incurred in creating an asset, a stand of timber, that will yield income in the future, and that the deduction of such costs should be in the future when the stand becomes merchantable and the timber is grouped with other timber for depletion purposes.

The Courts, which have addressed the issue of reforestation after harvest, have agreed with the Service's position (1.611-3(a) and Revenue Ruling 75-467) that these costs are capital items; Chapman & Dewey Lumber, CA-6, [66-1 USTC ¶9385]; W.A. Belcher, DC, [60-2 USTC ¶9733]; and T.R. Johnson, 62 TCM 46.

There are no cases, however, dealing with "replanting" after the failure of an initial reforestation attempt.

G.C.M. 38377 takes the position that no deductible loss results on account of the failed seedlings and that amounts expended to replant are capitalized and recovered through depletion. The stated facts are that the failure of the seedlings was not due to a casualty. The memorandum reasons that to be deductible under Section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events. Treas. Reg. Section 1.165-1(b). The transaction involved is the growing of timber and the death of the seedlings was not the close of the transaction since the taxpayer replanted the understocked portions of the tract continuing the enterprise of growing timber. Thus, it is concluded, no loss is deductible under Section 165(a).

Revenue Ruling 81-2 did not allow a Section 165 loss for the basis of failed seedlings. Although not made clear in Revenue Ruling 81-2, a subsequent ruling, 90-61, clarified that the 165 deduction was not allowable where the replanting was normal or contemplated as part of the cost of establishing the stand of trees.

In Revenue Ruling 90-61, a greater than normally anticipated failure of planted tree seedlings because of an abnormal drought resulted in a deductible loss under Section 165.