Chapter 3 - Income Taxation of Timber Operations - Hardwood Timber Industry
TIMBER INCOME
The timber industry in the northeastern United States experienced a substantial resurgence in the late 1980's and early 1990's and is anticipated to continue to grow at a rapid pace. Data from this project and available historical examination data indicate that there are instances of sales of standing timber, logs and timber products for cash or checks payable to nominees for the purpose of tax avoidance or evasion. Further, numerous self-employed timber operators operate strictly on a cash basis, including payments to their employees, and frequently do not file applicable federal returns.
Within, Parkersburg District's Timber Compliance 2000 Project, a significant compliance problem was identified in two areas. It was established that over 40% of identified timber industry entities failed to file an income tax return. Of the entities that did file, over 30% appeared to report less than their total gross income. It was the opinion of the team that many instances of this noncompliance was due to lax record keeping and failure to meet reporting requirements of the Internal Revenue Service.
Companies in the business of buying and selling timber, logs and pulpwood, etc. accomplish this in many different ways. For example, a company may purchase timber from landowners. The company then may hire contractors to cut the timber and deliver the logs. In some instances, the company will pay the landowner for the timber cut by the contractors and will pay the contractor for cutting the timber. In other cases, the company will pay the contractors for both the timber and the cutting. Standing timber is usually purchased in one of three ways: 1) outright purchase of the land and related timber, 2) purchase at a specified rate per unit of timber actually cut (pay-as-cut), or 3) purchase for a set total amount or lump sum. The company may also purchase logs from independent contractors rather than from landowners.
When the company pays the owner of standing timber at a specified rate for each unit of timber actually cut under a pay-as-cut contract, the payment for that timber is a royalty and it must be reported on Form 1099-S unless the recipient is a corporation. See Ann. 90-129, 1990-48 I.R.B. 10. When a company purchases standing timber for a lump sum, the transaction is considered a real estate transaction and no reporting is required because that transaction is excluded from the real estate reporting requirements.
The purchase of logs for a lump sum is not a royalty arrangement, and need not be reported because they are payments for merchandise under Treas. Reg. 1.6041-3(d). The payments to contractors for a total amount that covers the purchase of timber and the service of cutting are also excludable from reporting as the payment of a bill for merchandise. Finally, payment to independent contractors for cutting timber is compensation for services performed, and payments of $600 or more must be reported on Form 1099-MISC in the nonemployee compensation box.
The Timber Compliance 2000 Team recommended that the information reporting requirements for the timer industry be expanded to cover all significant transactions or circumstances within the industry. This expansion would encourage companies to maintain better records and to report all income received.
When gross income is established, the gain or loss on the sale or other disposition of timber is determined by reducing the amount received for the timber by the cost or other basis of the timber and any expenses incurred in making the sale. See below:
SALE PROCEEDS
-COST OR BASIS
-SALES EXPENSESNET GAIN (LOSS)
TIMBER EXPENSES
The basic rule is that ordinary and necessary expenditures associated with the production of timber held with the intention of making a profit can be recovered in three basic ways:
1. Capitalized expenditures are entered into a capital account for recovery through depreciation, amortization, depletion or other means.
2. Operating expenses generally are deductible from gross income for the tax year in which the expenditure occurs.
3. Selling Expenses associated with a timber disposal are used to offset the amount received.
CAPITAL EXPENDITURES
Capital expenditures are costs incurred for acquisition of property (or property rights) or permanent improvements that increase the value of property already owned. Capital expenditures must be capitalized. It is necessary to examine accounts to ensure proper recording of original cost, amounts recovered, and additions for improvements.
Assets placed in the land account include the land itself, nondepreciable improvements, and depreciable land improvements. The value placed in this account may result from purchase, gift, inheritance, etc.
At the time of acquisition, the total cost is allocated among the assets included in the purchase. The proportion allocable to land itself is the portion of the total acquisition cost attributable to the bare land. Land cannot be depreciated or depleted. Its value can only be recovered when it is disposed of by sale, exchange, etc.
Nondepreciable land improvements are primarily earthwork amelioration's of a permanent character such as clearing for and constructing roadbeds of permanent roads, land leveling, and impoundment's. Like the land itself, these amounts generally can only be recovered when the. land is disposed of. Depreciable land improvements include bridges, culverts, graveling, fences, firebreaks, etc. These types of improvement costs are recoverable through depreciation.
There are two basic types of logging truck roads for tax purposes --
permanent and temporary. Permanent roads, sometimes called long-term, are
those with an undeterminable useful life to the taxpayer. They are
intended not only for timber harvesting, but for general management
activities, including fire control. A temporary or timber access logging
road, by contrast, is constructed solely to remove certain timber and is
then
abandoned.
The tax status of permanent roads is clear. Construction costs of the nondepreciable portions must be capitalized and are not recoverable unless the road is sold or abandoned (for adequate reason). The parts that must be replaced from time to time are depreciable. These include such items as bridges, trestles, fences, culverts and surfacing. Their costs are recoverable through depreciation. Depreciation is allowable whether or not the road is used in a year. Finally, maintenance costs not related to basic construction are deductible as business expenses in the year incurred.
The tax treatment of permanent logging truck roads differs somewhat if, rather than owning the land and timber to which the road is associated, the taxpayer only has the right to timber by means of a long-term lease or cutting contract. In such a case, if a taxpayer builds a permanent road that is to become the property of the landowner at the end of the agreement, the taxpayer may recover the depreciable portions of the road in the normal manner. On termination of the agreement, any remaining basis with respect to the depreciable portion would be recoverable in that year. For the nondepreciable portion of the road, an aliquot part may be taken as a business deduction over the life of the agreement. If, for some reason, the road does not revert to the landowner at the end of the agreement, the taxpayer continues to recover any depreciable basis in the normal manner.
The costs of temporary logging truck roads are recoverable through depreciation. Under the modified accelerated cost recovery system (MACRS), the costs are recoverable over 15 years as a land improvement, Asset Class 00.3 in Rev. Proc. 87-56, 1987-2 C.B. 674, clarified and modified by Rev. Proc., 88-22, 1988-1 C.B. 785, or by a unit-of-production method. Under the unit-of-production method, recovery of cost occurs in proportion to the removal of the volume of timber for which the road was constructed.
According to Rev. Rul. 68-281, 1968-1 C.B. 22, the total costs of a temporary road, including the costs of clearing, grubbing, rough cut and fill grading, are recoverable. The IRM states in part that:
"If the life of a temporary road depends on the logging of a certain quantity of timber, the unit-of-production method of depreciation is perhaps the most logical means of apportioning costs to operations.,,
Rev. Ruling 88-99, 1988-2 C.B. 33, further clarified Rev. Rul. 68-281 to indicate that any road regardless of its physical attributes, must have a useful life to the taxpayer that is determinable in order for depreciation to be available.
When a timber tract is purchased, a reasonable part of the total cost is allocable to the timber, that is, stumpage or recoverable wood. This allocation is based on the relative value of the timber to the total value of the assets acquired. This cost is recovered by the taxpayer through allowable basis if the timber is disposed of on the stump or depletion if cut by the owner.
If the value of the young growth is significant, a portion of the purchase cost should be allocated to it also, based on its relative value at the time of acquisition. When the young growth trees become merchantable the volume and basis of the timber in these trees are transferred to the ',merchantable" timber account.
The Plantation sub-accounts are used to record the costs associated with reforestation or forestation by natural or. artificial means, such as planting or seeding. All costs associated with regeneration are included, e.g., site preparation (tree girdling, brush or stump removal, land leveling, and conditioning), seed or seedling, prorated cost of equipment used, and Paid labor. Up to $10,000 of qualified expenditures may be transferred to a reforestation amortization account and amortized over an 84-month period, per IRC 194.
Assets placed in the equipment account include the cost of durable equipment such as a sawmill, trucks, tractors, power saws, etc. Subaccounts are normally used by larger companies. The cost of any major repairs or reconstruction that materially increases the value or prolongs the life' of these items is added to the equipment account.
OPERATING EXPENSES
Operating expenses are broad classes of costs which can be defined as all those which are not capital costs and are not associated with the disposal of an asset. The ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business may be deducted per IRC 162. In addition, an individual may deduct ordinary and necessary expenses for the production or collection of income or for the management, conservation, or maintenance of property held for the production of income per IRC 212. The following items are some types of deductible operating expenses:
1. Tools of short life or small cost including axes, handsaws, sledges, wedges, etc.
2. Maintenance costs including incidental repairs of trucks, tractors, and other mechanical equipment.
3. Salaries or other compensation for services rendered by others, such as hired labor, fees for consulting foresters, lawyers, accountants, etc., provided these expenditures are not directly related to any activity, such as timberland purchases, reforestation projects, or timber sales. These expenses would be capital in nature if so related.
4. Taxes such as property, yield, severance, sales, gasoline, and license fees for business vehicles Federal income tax, estate, inheritance and gift taxes, and Special assessments for local benefits are not deductible.
5. Interest payments on bank loans and other short-term credit, and long-term indebtedness such as mortgages. Note: Individual personal interest is not deductible.
6. Premiums for fire, windstorm, theft, or other insurance, such as public liability and workmen's compensation are deductible.
7. Travel expenses while away from home on business may be deductible under certain circumstances.
8. Rent or other payments for land, equipment, or other business property in which the taxpayer has no equity.
SELLING EXPENSES
All costs associated with a specific timber sale are sale expenses. These costs are recovered by deducting them from the proceeds of the sale. The following is a listing of items which are considered directly attributable to a disposal of timber per Rev. Rul. 71-334, 1971-2 C.B. 248.
1. Advertising the timber for disposal.
2. Cruising to determine the quantity and quality of timber to be disposed of.
3. Marking or otherwise designating the timber for cutting.
4. Marking seed trees to be retained
5. Scaling, measuring, or otherwise determining the quantity of timber cut.
6. Fees paid to consulting foresters, selling agents, and others for service directly related to timber disposal.
7. Supervising or checking performance under the contract.
8. Other items directly attributable to the disposal.
ESTABLISHING COST OR BASIS
The basis (book value) of timber should be established at the time it is acquired. This is needed to calculate the depletion unit used to determine the taxable gain (loss) when timber is sold on the stump, cut, or disposed of involuntarily, such as by a casualty or condemnation.
Real estate is usually acquired for a lump-sum amount, even though more than one asset is included. In order to recover the portion of the basis attributable to any one asset, such as timber, a separate basis must be established for that asset. In the case of timber, this most often means separating the amount paid for the land from the amount paid for the timber.
The allocation of basis between assets should be based on the Proportion of the fair market value (FMV) of the asset to the total FMV of the property acquired. This requires estimating the FMVs of each of the assets individually. Note: In some cases, the sum of the FMV of the individual assets will be greater than FMV of the combined assets. The taxpayer is expected to make a "reasonable effort" to estimate the fair market values. What is reasonable for five acres of low grade timber may be an estimate based on readily available information, such as published price reports. This approach would be unreasonable for a larger tract and/or higher-value timber,, in which case an appraisal by an experienced forester would be appropriate.
FMV is the price at which an asset would change hands between an unrelated willing buyer and an unrelated willing seller. Sales of similar property (comparables) on or about the valuation date are the best indicators of FMV. If a tract contains a mix of high value and low value species of merchantable size, consideration should be given to establishing separate cost basis for each type of timber. This will allow the taxpayer to more clearly match income and expenses on disposition of any timber.
The procedure used to allocate the available basis between assets is the same no matter how the property is acquired. However, the total basis available for allocation will depend on how the property was acquired. The basis of purchased property is the amount paid to the seller, plus any additional costs incurred in the process of acquiring property. The purchase price may have been in the form of cash, other property, or a combination of both. Additional acquisition costs include amounts paid for attorney's fees, surveying, a timber cruise, real estate taxes owed by seller, and any other costs directly associated with the acquisition.
In a perfect world, the appropriate time to establish a separate cost basis for timber is when the property is acquired. However, we don't live in a perfect world. It may be necessary to establish a basis at a later time. This can be done if the necessary information as of the date of acquisition is available. Taxpayers who acquired timber several decades ago and have not previously established a separate basis, may find the cost of doing so now exceeds the benefits. This is a determination that should be made on a case by case basis, however. The larger the tract and/or the more valuable the timber, the further back in time it would pay to go to establish available basis.
The information needed is exactly the same as that needed if the allocation was made at the time of acquisition. In order to estimate the FMV of the timber at the time of acquisition, it is necessary to estimate the volume and type of timber that was present on the land at that time.
The taxpayer is required to estimate, with respect to each separate timber account established, the total units (board feet, cords, or other units) of timber reasonably known, or on good evidence, believed to have existed on the date of acquisition of the property. If records do not exist to readily do this, forest measuring techniques can literally reverse the grow of the current forest back to the date of acquisition. This is a task a professional forester will need to perform. The forester will consider factors such as growth period, weather, insects, forest fires, etc.
After the volume by type has been estimated, the FMV of this timber on the date of acquisition must be estimated. The best available evidence of timber values on this date must be used. Ideally, the price actually paid for timber similar in character and quality in the location of the subject property on or near the valuation date should be used. Consulting foresters or timber buyers with records dating back to that time period may be good sources of this data. Otherwise, published price reports may be used to. develop acceptable estimates if the average prices are adjusted to reflect differences between averages and the particular location and timber in question.
In addition to the FMV of the assets as of the date of acquisition, it is also necessary to determine the volume of timber disposed of, if any, since the acquisition. This is because the basis must-be reduced by the basis allowable for any previous sales, even if the basis was not claimed on the tax return for the year of the sale.
EXAMPLES
Example l
Mr. and Mrs. A. Dell purchased a tract of rural land. The land was purchased primarily as an investment. The tract produces income from several sources. The pasture and barn are rented to a local farmer and the house is rented to a local family. In addition, the woodlands include many prime stands of mixed hardwoods.
The 120 acre tract was purchased for $135,000. The costs associated with the purchase include the purchase price and fees paid to professionals for services rendered. See below.
| Purchase price of farm | $135,000 |
| Lawyer fee - title search | $ 420 |
| Surveyor fee | $1,200 |
| Consulting forester fee for cruising & valuing timberland | $800 |
| .Misc. selling expenses | $380 |
| Total Cost or Basis | $137,800 |
In addition, this cost would have to be allocated among all assets acquired. This allocation would require the assistance of experts. See below.
| ASSET DESCRIPTION | FMV OF ASSET | % OF FMV | COST BASIS |
| House Per realty company estimate | $12,00 | 6.62 | $9,122.36 |
| Barn - Per realty Company estimate | 8,000 | 4.42 | 6,090.76 |
| Fences - estimated by Mr. Dell | 1,400 | .77 | 1,061.06 |
| Timberland, 90 acres @ $120/ acre per realty co. estimate | 10,800 | 5.96 | 8,212.88 |
| Pasture land, 29 acres @ $800/ acre per realty co. estimate |
23,200 | 12.81 | 17,652.18 |
| Home land, 1 acre @ $1600 per realty co. estimate | 1,600 | .88 | 1,212.64 |
| Merchantable timber 12 MBF/ acre @ $110/MBF per Cons. Forester | 118,800 | 65.56 | 90,341.68 |
| Young growth timber @ $60/ acre per Cons. Forester | 5,400 | 2.98 | 4,106.44 |
| Totals | $181,200 | 100.00 | 137,800.00 |
Example 2
Continuing with Example 1, assume that the Dells sell all the merchantable timber on the 90 acres in the same year that they purchased it. The contract price is $110 per MBF and the volume estimate of 12 MBF per acre is used. The net gain from the sale would be:
| Gross Income: | |
| 90 acres x $110/MBF x 12 MBF | $118,800 |
| Allowable basis (cost basis): | ($ 90,342) |
| Sales expenses | ($ 5,940) |
| NET GAIN | $22,518 |
The computation of the net gain in Example 2 was simplified by the assumption that all of the merchantable timber was sold at the same time and in the year it was purchased. This made it possible to reduce the sale proceeds by the entire cost basis of the timber. If only a portion of the timber is sold, only a similar portion of the cost basis written off against a particular sale or other disposal of timber is determined by multiplying the number of units (volume) sold by the depletion unit. See Example 3 below.
Example 3
Referring to Example 1 again, assume the Dells sell 450 MBF in year 1, instead of all the timber as was assumed in Example 2. The depletion unit for the timber is $83-.65 per MBF, obtained by dividing $90,342 by 1,080 MBF. The contract price is $110 per MBF. Selling expenses total = $3,500. The net gain from the sale would be:
| Gross Income: | |
| 450 MBF x $110/MBF | $49,500 |
| Allowable basis: | |
| 450 MBF x $83.65/MBF | ($37,643) |
| Sales Expenses | ($ 3,500) |
| NET GAIN | $ 8,357 |
As shown in Example 3, the depletion unit is the cost per unit of volume. It is obtained by dividing the basis of the timber by the volume of timber.
The situation becomes more complicated if a year or more elapses between the purchase and the sale of the timber. It is necessary to adjust the volume of timber for growth. It also is necessary to adjust the cost basis if any costs were capitalized during the period or a portion of the basis recovered.
The initial volume entered in the timber account should be the estimated total volume that the tract would produce on the date of acquisition if all the timber was cut and utilized in accordance with the standards of utilization prevailing in the region at the time.
The timber account must be adjusted as needed to reflect the following charges:
1. Volume of additional timber purchased or otherwise acquired during the period
2. Transfer from young growth or plantation accounts to the merchantable timber account the volume that becomes merchantable during that period.
3. Volume gained through growth since last adjustment
4. Volume removed through sale or other disposition, or lost due to natural or other causes.
Timber companies would generally make annual adjustments for growth. However, owners of small holdings who have infrequent timber transactions would generally make these adjustments only for a year in which they cut, sell, or otherwise dispose of timber. The easiest way for small producers to account for
timber growth may be to simply recruise the entire timber tract. This can be accomplished most easily at the same time timber is marked or otherwise designated for sale.
Any additions or reductions to the basis which have occurred since the last adjustment should be reflected in the account before the depletion unit is calculated. The volume and cost basis used to calculate the depletion unit for a given year must be the adjusted volume and adjusted cost basis. The adjustments should be made to reflect the actual volume available for harvest and the unrecovered cost basis as of the end of the year (before depletion or other reduction of basis) for which the depletion unit is calculated.
Example 4
Referring to Example 3, assume that the Dells sell 900 MBF in the tenth year. During the period since the initial purchase the following transactions have occurred:
1. A timber stand improvement was made at a net cost of $60 per acre, which was capitalized.
2. A 20-acre tract containing 300 MBF of timber was purchased for $30,000. The timber accounted for 2/3 of the purchase price or $20,000, and it was added to the timber account previously established.
3. The merchantable timber had an average net growth of 350 bf per acre per year.
4. The young growth reached merchantable size. Its average net growth was 350 bf per acre per year.
BASIS ANALYSIS
| ORIGINAL COST - YEAR 1 | $90,342 |
| TIMBER SALE - YEAR 1 | ($37,643) |
| TSI 90 ACRES @ $60/ACRE | $ 5,400 |
| PURCHASE -JONES TRACT | $20,000 |
| TRANSFER FROM YOUNG GROWTH | $ 4,106 |
| ADJUSTED BASIS | $82,205 |
VOLUME ANALYSIS
| ORIGINAL VOLUME - YEAR 1 | 1,080 MBF |
| TIMBER SALE - YEAR 1 | ( 450) MBF |
| PURCHASE - JONES TRACT | 300 MBF |
| TRANSFER FROM YOUNG GROWTH | 315 MBF |
| GROWTH | 315 MBF |
| ADJUSTED VOLUME | 1,560 MBF |
If the contract price for the sale is $145 per MBF and selling expenses are $8,000, the net gain would be computed in the following way:
GAIN COMPUTATION
| Gross Income: 900 MBF x $145/MBF |
$130,500 |
| Allowable basis: $82,205 adj. basis/1,560 MBF = $52.70 900 MBF x $52.70/MBF |
($47,430) |
| Selling expenses | ($ 8,000) |
| NET GAIN | $75,070 |
If, instead of selling the timber, the owner cuts the timber, producing logs, and sells the logs, the depletion allowance is calculated in exactly the same manner as the allowable basis. Although depletion occurs when the timber is cut, the depletion is not allowable until the logs are sold or otherwise disposed of. No depiction allowance can be claimed for timber cut for personal use, such as home firewood, and basis for depletion should be reduced by the cost attributable to the personal use timber.
The tax treatment of a disposal of standing timber held for more than 1 year depends on the primary purpose for which the timber is held and the manner in which the timber is disposed of.
1. If a taxpayer holds timber for investment and it is a capital asset in the hands of the owner per IRC 1221, a sale of the timber will produce long-term capital gains or losses
2. If the timber is held for the use in the taxpayer's trade or business it is IRC 1231 property, a sale of which will produce gains or losses that are netted with other IRC 1231 gains and losses. If this netting results in a net gain, these timber gains or losses are treated as a long-term capital gains or losses. However, if there is a net IRC 1231 loss, the timber gains and losses are treated as ordinary income or losses.
3. If the timber id held primarily for sale to customers in the ordinary course of a trade or business, a sale of the timber will result in ordinary income or losses.
4. Regardless of the reason for which timber is held, a disposal of it with a retained economic interest under IRC 631(b) is treated as a disposal of IRC 1231 property, the gains or losses from which are netted with other IRC 1231 gains and losses per item 2.
5. If the taxpayer cuts its timber, all income therefrom is ordinary income unless the taxpayer elects under IRC 631(a) to treat the cutting as a sale or exchange of the timber cut. If IRC 631(a) is elected, the difference between the adjusted basis of the timber cut and its fair market value on the first day of the tax year it is treated as IRC 1231 gains or losses, which are netted per item 2. Subsequent income or loss from the cut timber is ordinary income or loss.