Wilmington Trust Co v. United States

WILMINGTON TRUST CO. v. UNITED STATES
79-2 U.S.T.C. ¶ 9707 45 AFTR2d 80-301 (Ct, Cl, 11-14-79)
(Timber issue only)

CAPITAL v. EXPENSE
· Generally
· Ad valorem taxes
· Attorney's fees
· Direct expenses of disposal
· Land management expenses
· Operating expenses
· Rent
· Selling expenses

In this case, the Court of Claims responds to the recommendation of Trial Judge Miller in Wilmington Trust Co. v. United States (see immediately preceding case) and Trial Judge Browne in McMullan v. United States

The facts of Wilmington Trust are as described on page 179 of this volume. The facts of McMullan are described in Volume 15. In brief, McMullan involved taxpayers who jointly owned land which produced income from oil, gas, coal and timber. The income from the timber, about 80 percent of the total, was received from cutting contracts and was treated by the taxpayers as capital gain under Section 631(b) of the Internal Revenue Code. All of the taxpayers' costs of managing the land, including expenses directly related to the sale of the timber under the cutting contracts (i.e., a disposal of timber with a retained economic interest) were treated as ordinary and necessary business expenses and deducted by the taxpayers from ordinary income. The Internal Revenue Service disagreed with the taxpayers' deduction of the expenses directly related to the acquisition, negotiation and management of the timber cutting contracts, contending that these expenses (salaries of foresters for marking timber, legal fees for drafting contracts, etc.) were capital expenditures rather than deductible expenses and as such should be treated for tax purposes as an offset against the taxpayers' capital gains on the timber disposals.

Held: For the taxpayers. The decision in the Union Bag case is controlling in the Court of Claims and thus is precedent in that court for the rule that the direct expenses of disposals of timber may be deducted as ordinary and necessary business expenses and thus do not have to be offset against the capital gains from the disposals. The Court found that the facts of Union Bag were strikingly similar to those of McMullan and Wilmington Trust in that the forest management expenses relating to the sale of the timber comprised only a nominal and incidental portion of the total forest management expenses.

The Court concluded that its decision would be the same regardless of whether the receipts under the cutting contracts were capital gains because of Section 631(b) or because of Section 1221 of the Code.

FRIEDMAN, Chief Judge, delivered the opinion of the court: These three consolidated federal income tax refund suits present two separate issues: (1) whether certain expenses the taxpayers incurred in connection With their timber operations, the gain on which is capital gain, were ordinary business expenses and hence deductible from taxpayers' ordinary income (as taxpayers contend), or were part of the cost of selling the timber and therefore deductible only from the capital gains (as the government argues); (2) whether, under the doctrine of equitable recoupment, the government could offset against refunds due to the taxpayers for overpayment of income taxes the reduction in estate taxes that the taxpayers previously had made to reflect the estate's prior payment of the refunded income taxes, in a situation where the statute of limitations would bar the direct assessment of such additional taxes against the estate. We answer both questions in favor of the taxpayers. ¹

I. A. Wilmington Trust and Schutt (Nos. 50-73 and 51-73). ²

1. During the taxable years involved, 1964-70, the taxpayers, W. Sam Carpenter, III and C. Porter Schutt, were partners in Wilmon Timberlands ("Wilmon"). ³ The firm owned and managed from 35,700 to 45,000 acres of timberland in Alabama, which it held for investment purposes. Findings 20, 21. Except in 1970, when it conducted its own logging operations, Wilmon entered into contracts for cutting and removal of timber on and from its land. Findings 21, 22.

During the years involved, Wilmon had between nine and 11 full-time employees. The partnership had a manager, a forester, an officer manager, forest workers, and two employees who maintained roads and bridges. In 1970 the partnership employed seven or eight additional men in connection with its own logging operations. Finding 23.

The manager operated the timberlands so as to obtain continuous growth through natural stand regeneration. This requires that the timber cut in any year not exceed the annual growth, Wilmon makes regular studies of the growth and volume of the timber, and on that basis selects the areas most suitable for cutting, which range from 500 to 2,000 acres. The cutting is done at a rate which, on the average, enables the entire tract to be cut in a I0-year cycle. Finding 24.

When the area for cutting is selected, an effort is made to maintain the best stock for future growth, cutting, and natural reseeding. Trees are designated for cutting on the basis of whether their growth has been or is likely to be slowed and whether their removal will aid the growth of younger trees of good stock. Trees that are cut include those that have reached maturity, that have been damaged, that are defective, and that overshadow and dominate less mature trees and retard their growth by depriving them of sun, air, and nutrients. Finding 24.

In effectuating natural stand regeneration, Wilmon's timber crews perform various tasks. They make timber growth studies and insect damage surveys, and control insect infestations by cutting infected trees. They repaint all boundary lines every 5 years to prevent encroachments. They trap and attempt to control beaver, which otherwise build dams which back up water and kill trees. They practice fire control and extinguish fires. They maintain roads and bridges, They mark trees for cutting where growth is slowing, to provide spacing necessary to enhance recent growth and to obtain revenue. Finding 25.

In cutting and selling timber, Wilmon first designated the trees to be cut. The partnership manager negotiates all cutting contracts by showing the available timber to three or four prospective buyers and agreeing upon a price; negotiation of a contract takes approximately 30 minutes. During several of the years involved, Wilmon operated under a single long-term contract with a sawmill company, so that little additional negotiation was required, Finding 26(a), (b).

A typical cutting period lasts 3 or 4 months a year. During that time Wilmon undertakes "contract supervision," which includes weekly or biweekly field checks to ascertain that all merchantable logs were removed, that minimum damage was done to the remaining trees, and that only marked trees are cut. This requires "from a halfday every week or two weeks." Finding 26(c), Wilmon's forester testified that the contract supervision was "not done to assist the cutter" but was "done for our benefit."

After the contract logger has cut and moved the timber to the sawmill, the timber is "scaled" there to determine the amount of the selling price. Wilmon employed a part-time scaler during the cutting season, who did the scaling on all timber other than plywood, which was scaled by the plywood buyer's employees. Finding 26(d). At oral argument the plaintiffs, in effect, conceded that their expenses for their scaler were sales expenses of the timber sales and deductible as capital rather than as ordinary expense, but stated that the amount involved is de minimis. Except for the scaler, Wilmon has not hired anyone specifically in connection with the sale of timber or any additional employees for that purpose. Finding 27.

All of Wilmon's sales "conformed to the practice of good forestry and silviculture," Finding 28.

2. In their income tax returns the plaintiffs reported all of their land and wood management expenses as deductions from ordinary income. The Commissioner ruled that a portion of those expenses was sales expense that could be offset only against the capital gain of the sale of timber and not against ordinary income, and assessed deficiencies.

Trial Judge Miller held that the expenditures taxpayers made in connection with their timber operations were capital and not ordinary expenses.

B. McMullan (No. 130-76).

1. During the years involved, 1969-71, the taxpayers, Mr. McMullan and his wife, ⁴ owned half and leased the other half of land in West Virginia and North Carolina. Land was held for investment purposes. The land's primary source of income was timber sales, although it also generated income from oil, gas, and coal. Findings 7, 8, 9.

Mr. McMullan sought to manage the timber on the "perpetual yield theory, cutting no more than annual growth in order to enhance the value of the property as a long-term productive asset, and in the course of management on that basis timber was sold." He did no scientific research to determine the average annual growth in board-feet, however, but merely made a rough estimate of such quantity based on a working knowledge of the land. Finding 10. The timber was managed so as to improve the stand, rather than merely to maintain the status quo, "by marking the timber to be sold, and by requiring the timber cutters to girdle certain undesirable trees marked by the forester in order to kill such cull trees that were hindering other growth in the vicinity." Finding 11. Marking of trees was unnecessary to sell timber but was necessary for "sale and cull in order to be assured of improving the quality and quantity of the stand of timber on the leased lands." Finding 12.

During the years involved, McMullan entered into at least 16 contracts for the cutting and sale of timber on the property. Finding 18. Timber was sold on a yearly basis, and from October 1970 through 1971 timber was cut at all times. Two contractors maintained sawmills on the property. Finding 19.

McMullan incurred various expenses in connection with the "management and operation" of the land. The major item was "forestry'' expenses, which represented salaries of the foresters, who marked the trees that were the subject of the timber sales contracts; one of them also checked performance under those agreements. Findings 14, 15, 16, 17. Other expenses included those for frequent trips McMullan made from his home to the property, on some of which he negotiated timber cutting contracts and timber sales (finding 21); amounts spent for repainting boundary lines and marking timber (finding 24); and for legal fees (findings 22, 23). Although "part" of the expenses "were directly related to the sale or disposition of timber," the record "does not show sufficient detail to indicate what portions of the total management expenses were so related.'' Finding 26.

2. In their federal income tax returns for the years involved, the taxpayers reported the income from the !and as capital gain, and all the expenses incurred in the management and operation of the land were deducted from ordinary income. The Commissioner disallowed some of those deductions, asserting that the portion of the expenses attributable to the timber operations was to be offset against the capital gain on the timber sales rather than treated as a deduction from ordinary income.

Trial Judge Browne upheld the taxpayers' position. He ruled that they properly had offset all the expenses incurred in connection with the timber operations against the ordinary income on the sale of the timber,

II. A. In section 631(b) of the Internal Revenue Code of 1954, Congress provided that gain upon the disposal by the owner of timber that was held for more than 6 months, under a contract by which the owner retained an economic interest in the timber, is to be treated as capital gain. The provision was designed to give an owner of timber who sells it under cutting contracts the same favorable capital gain treatment as an owner who sells the timber outright. See S. Rep. No. 627, 78th Cong., 1st Sess. 25-26 (1943), dealing with section 117(k) of the 1939 Code, the predecessor of section 631.

Generally, "costs incurred in the . . . disposition of a capital asset are to be treated as capital expenditures," which are not deductible as business expenses but are "added to the basis of the capital asset with respect to which they are incurred and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is sold." Woodward v. Commissioner [70-1 USTC ¶ 9348], 397 U.S. 572, 574-75 (1970). In section 63 l(b) Congress provided that the gain on the sale of timber under the cutting contracts there covered "shall be considered as though it were a gain.., on the sale of such timber." The question is whether, in providing that such gain be treated as capital, Congress also intended to treat the expenses incurred in connection with the timber operations as capital.

In Union Bag-Camp Paper Corp. v. United States [64-1 USTC ¶ 9122], 163 Ct. Cl. 525, 325 F. 2d 730 (1963), the full court (then consisting of five judges) considered the question and, adopting the opinion of the trial commissioner, unanimously held that the expenses were ordinary deductible business expenses. The facts of that case are strikingly similar to those here. Union Bag entered into contracts for the cutting and selling of timber on lands it leased. It treated all of its expenses in connection with its timber operations as ordinary business expenses and deducted them from ordinary income. The Commissioner disallowed 5 percent of Union Bag's "total general expenses for land management on the ground that such five percent of management expense was properly attributable to the cost of entering into and supervising certain cutting contracts . . . and should be charged against the gain realized by plaintiff from such contracts." Id. at 534, 325 F. 2d at 734-35. In rejecting the Commissioner's action, the court stated in id. at 545, 325 F. 2d at 741-42: ⁵

The record shows that during 1949 plaintiff's employees did spend a small part of their time negotiating sales prices for cutting contracts, designating areas to be cut, marking certain trees to be left standing, making casual checks as to quantities of timber cut, and occasionally inspecting the areas involved after cutting had been completed (Finding 26, infra.) The record further shows, however, that the foregoing activities were only incidental to overall forest management activities? and that, even the complete elimination of the contract activities would have affected total management expenses merely in nominal amounts. Nonetheless, defendant contends that under Towanda Textiles. Inc. v. United States [60-1 USTC ¶ 9258, 149 Ct. Cl 123 (1960) and Rev, Rul. 58-266, 1958-1 C. B. 520, some portion of the management expense must have been selling expense directly attributable to the entering into the supervising of the cutting contracts and therefore should be offset from the gain realized under those contracts rather than deducted from ordinary income. In support of its estimate that such selling expense amounted to five percent of the total cutting contract receipts, defendant merely asserts that the Commissioner's determination in this regard must be accepted absent proof to the contrary by the taxpayer. However, as stated above, the record before this court is persuasive that the contract activities of plaintiff's employees were only incidental to their forest management duties and at best had but nominal effect on plaintiff's payroll and other management expenses. In no sense do the expenses at issue here resemble the direct and substantial expenses involved in Towanda Textiles, lnc ......

The court then went on to state that, even accepting arguendo the Commissioner's estimate that 5 percent of the management expenses were properly attributable to the cutting contracts, "in any event.., selling expenses, such as those involved here, are properly deductible from gross income and are not required to be restricted to an offset against contract proceeds." Id. at 546, 325 F. 2d at 742, It concluded that the Code provisions "contain nothing which on any normal reading would prohibit the deduction by a timber dealer from income of his ordinary and necessary expenses incurred in the growing or selling of his timber, or which would require him to offset such expenses against capital gains realized on timber sales or disposals." Id. at 547, 325 F. 2d at 743.

The government contends that this second branch of the Union Bag decision, which it labels dictum, was incorrect and should be overruled, We find it unnecessary to reach that question, however, since we conclude that the first branch of Union Bag, which the government explicitly stated it is not asking us to overrule, controls these cases.

Here, as in Union Bag, "the contract activities of plaintiff's employees were only incidental to their forest management duties and at best had but nominal effect on plaintiff's payroll and other management expenses" and were not "direct and substantial." In the cases before us. as shown above, the taxpayers conducted their timber operations primarily to maintain and improve the timber. Most of the work their employees did would have been necessary to accomplish those objectives without regard to selling the timber. Although the timber sales generated substantial income, they, too, were an integral and essential part of maintaining and improving the quality and number of the trees.

There are relatively minor variations between the operations in Union Bag and those in Wilmington Trust and McMullan, and between those in the latter two cases. But the basic operations in the three cases were the same. Whatever minor differences may exist do not justify different treatment of the cases before u s and Union Bag,

In Wilmington Trust, the parties stipulated that "[i]n the event that the plaintiffs are incorrect in their basic contention that all land management and woods management expenses are ordinary deductions and not 'direct selling expenses, the proper amounts to be treated as 'direct selling expenses' are as follows: .... "The stipulation then specified dollar amounts for each of the years 1964 to 1970, which ranged from 12.9 percent to 28.7 percent of the total expenses. On the basis of these stipulated percentages, Trial Judge Miller distinguished Union Bag. He stated:

The expenses at issue here were from 12.9 to 28.7 percent of the management expenses in the various years from 1964 through I970. They were derived from a specific allocation of the portion of each activity or expenditure deemed directly related to the sales. Thus, they were recognizable and hardly nominal.

The plaintiffs object to this use of the stipulation on the ground that by its terms "its use is permitted only in the event that plaintiff's contention is found to be incorrect, not to prove that contention incorrect." Plaintiffs' objection is well taken. The stipulation provided only that if the plaintiffs' contention that all the expenses were deductible from ordinary income were rejected, then a specified percentage of those expenses would be treated as the cost of selling the timber. In view of plaintiffs' contention that their case is indistinguishable from and is controlled by Union Bag, the percentage of expenses they stipulated could be treated as direct selling expenses if their argument on Union Bag were rejected cannot be relied upon to show that the percentage of expenses attributable to the selling of the timber was sufficiently higher in this case than in Union Bag to make the latter inapplicable. In other words, we decide the applicability of the first ground of decision in Union Bag without regard to the stipulation.

B. In McMullan, but not in Wilmington Trust, the government argues that, with one exception, section 631(b) does not cover the contracts under which the plaintiffs disposed of their timber. This argument is based on the requirement in section 631(b) that the disposals of timber take place under a contract "by virtue of which [the] owner retains an economic interest in [the] timber." A retained economic interest exists when a taxpayer acquires an interest in standing timber by investment and looks to "income derived from the.., severance of the timber.., for a return of his capital; Treas. Reg. § 1.611-1(b)(1). The income generated by the cutting contracts must be totally contingent upon the actual severance of the timber for section 63 l(b) to apply. See, e.g., Superior Pine Products Co. v. United States [73-1 USTC ¶ 9348], 201 Ct. Cl. 455, cert. denied, 414 U.S. 857 (1973); Boeing v. United States, 121 Ct. C1, 9, [51-2 USTC ¶ 9411], 98 F. Supp. 581 (1951); Dyal v. United States [65-1 USTC ¶ 9285], 342 F. 2d 248 (5th Cir. 1965); Estate of Lawton v. Commissioner [Dec. 23,795], 33 T. C. 47 (1959).

The government states that the timber contracts it has seen (covering approximately 40 percent of the receipts at issue), the payments were to be made prior to Cutting and were based on the timber marked as available to be cut and not on the amount actually cut. Such an arrangement would not satisfy the requirement in section 631(b) of a retained economic interest. Cf. Union Bag, supra, 163 Ct. Cl. at 543, 325 F. 2d at 740 ("it is clear that plaintiff retained the required 'economic interest' since the payments under the cutting contracts were based upon actual units of timber cut and were payable only as timber was cut").

Trial Judge Browne made no findings on whether these contracts provided for a retained economic interest, and the plaintiffs do not appear to have offered proof that the contracts did so,

Although recognizing that the income from the dispositions of timber under these contracts was properly reported as capital gain even if section 631(b) does not cover the contracts, ⁶ the defendant contends that, if the section does not apply, forest management expenses related to these dispositions were capital expenditures and not deductible from ordinary income. We find it unnecessary to decide whether section 631(b) covers these contracts. Even if it does not, the gain on the sale of the McMullan timber was capital under section 1221 of the Code (see note 6 supra). We have determined that the forest management expenses related to the sale of the timber comprised only a nominal and incidental portion of the total forest management expenses and that under Union Bag all of the latter expenses for that reason are deductible as ordinary rather than as capital expenses. This is so whether the receipts under the cutting contracts were capital gains because of section 631(b) or because of section 1221 of the Code.

Accepting arguendo the defendant's view of the nature of these timber dispositions, there is no reasonable basis for distinguishing, for federal tax purposes, the forest management expenses in Wilmington Trust and Union Bag from those in McMullan. In both cases before us, the plaintiffs held the land for investment purposes, deriving their income from sales of timber, In both, the land was managed according to modern perpetual yield theories, to improve or at least maintain the timber stand. In both, only a nominal portion of the expenses was attributable to the selling of the timber. The only significant distinction between the operating methods in these two cases is the different basis of payment for the timber. This difference has no relationship to the proper tax treatment of the timber management expenses.

The policy considerations noted in Union Bag that favor deduction of these expenses from income, such as encouragement of "desirable conservation practices" and minimization of extraordinary accounting burdens (163 Ct. Cl. at 549 & n. 28, 325 F. 2d at 744 & n. 28), are no less applicable in McMullan than in Wilmington Trust and Union Bag, despite the different methods of payment. In each case the cutting and selling of timber, whether or not the seller had a retained economic interest, had as a major purpose the culling of some trees to encourage growth of the rest. There is no reason to give the McMullan plaintiffs less favorable tax treatment from that given the virtually identical operations in Union Bag and in Wilmington Trust, just because the income was capital gain by virtue of section 1221 rather than section 63 l(b).

The plaintiffs are entitled to deduct from ordinary income the expenses of their timber operations. The government is not entitled to offset against the income tax refunds due the plaintiffs the reduction in estate taxes the plaintiffs previously paid that would reflect the estates' prior payment of the refunded income taxes. The cases are remanded to the Trial Division to determine the amount of recovery pursuant to Rule 131(c).

1 We adopt the findings of the trial judges in both cases. The findings are not printed, however, since the pertinent portions are set forth in this opinion.

2 The facts related to the equitable recoupment issue in both cases are set forth in our discussion of that issue in part III, infra.

3 The wives of these two persons are parties only because they filed joint returns with their husbands. We use the term "taxpayers,' to refer only to the husbands. During this litigation Mr. Carpenter died, and the Wilmington Trust Company as executor was substituted as a plaintiff.

4 Harry McMullan died in 1973, and Mrs. McMullan, with whom he filed joint returns for the years involved, appears here both as his executrix and individually.

5 The court found that "[i]n the development and regeneration of its timberlands · . . plaintiff.., relied largely on (a) natural reseeding, and (b) the so-called 'seed tree method, by which in any cutting or thinning of any particular tract of land, selected trees (chosen on the basis of quality, height and crown size) are left standing to provide natural reseeding in the surrounding area." Finding 13, 163 Ct. Cl. at 558-59.

6 This result is dictated by the trial judge's finding that the plaintiff's lands "were held for investment purposes" and that ,'the primary source of income from the property was timber." Finding 9. In such a situation, the general rule that income from an investment is capital gain applies. See Scott v. United States [62-2 USTC ¶ 9617], 158 Ct. Cl. 434. 305 F. 2d 460 (1962); Boeing, supra.