• Home
• Federal Income Taxes
• State Tax Laws
• Estate Planning
• Publications
• Professional Research
  • Master Index
  • Case Law
  • Revenue Rulings
  • Private Letter Rulings
  • Regulations
  • Internal Revenue Code
  • Public Laws
  • Research Process
• Tax Workshops/Education
• Tax Policy
• Links

Letter Ruling 9802005, September 30, 1997

Uniform Issue List Information:
UIL No. 1374.00-00
Tax imposed on built-in gains

Code Sec. 1374

This letter responds to your May 7, 1997 request for rulings on certain federal income tax consequences of a proposed transaction. The information submitted in support of your request is summarized below.

Taxpayer, previously a C corporation, grows, harvests, and disposes of several types of timber. Effective Date 1, Taxpayer elected to become an S corporation under §1362(a) of the Internal Revenue Code and to treat its only subsidiary as a qualified subchapter S subsidiary under §1361(b)(3) (the "Elections"). On Date 1, Taxpayer owned and held certain real property containing timber (the "Timber"). Taxpayer has continuously owned and held the Timber for at least the last a years and has the right to cut the Timber for sale on its own account or for use in its trade or business.

Following the Elections and during the recognition period as defined in §1374(d)(7) , Taxpayer proposes to dispose of Timber to unrelated parties pursuant to a contract entitled "Warranty Timber Deed" (attached and hereinafter the "Contract"). In addition to dispositions under the Contract, during the recognition period Taxpayer will cut and sell a small amount of Timber directly to unrelated parties.

The Contract provides for the disposal of all marked merchantable pine and/or hardwood Timber located within a specified area to one interested in cutting the Timber. The contract price for the Timber is broken down into specified price-per-unit amounts for the specific types and grades of Timber available for cutting. At the time the Contract is signed, the grantee will pay a deposit to Taxpayer. The Timber cut each week will be scaled after the cutting and the grantee will make weekly payments for all Timber cut in the previous week. Title to the Timber will pass to the grantee only upon severance, and Taxpayer will retain all risk of loss prior to severance. The Contract will terminate on a specified date, and ownership of all Timber left uncut at the termination of the Contract will revert to Taxpayer. A penalty of one-third of the Contract value of any such uncut Timber will be paid to Taxpayer. The original deposit will be applied toward any such amounts or, if no amounts are left owing, will be refunded to the grantee.

Taxpayer asks whether the income received during the recognition period from the above-described dispositions will be subject to tax under §1374 .

Section 1374 imposes a corporate-level tax on an S corporation's net recognized built-in gain during the recognition period (generally 10 years) following (a) a C corporation's conversion to S corporation status (§1374(a) ), or (b) an S corporation's acquisition of C corporation assets in a carryover basis transaction (§1374(d)(8) ).

Section 1374(d)(2) provides that an S corporation's net recognized built-in gain for any taxable year is generally its taxable income for the year computed as if it were a C corporation, but taking into account only items treated as recognized built-in gain or recognized built-in loss.

Section 1374(d)(3) provides that recognized built-in gain includes any gain recognized on the disposition of an asset during the recognition period, except to the extent the S corporation shows that (a) it did not hold the asset as of the beginning of the first taxable year for which it was an S corporation (the "Conversion Date"), or (b) the gain recognized was greater than the excess of the asset's fair market value over its adjusted basis on the Conversion Date.

Section 1.1374-4(a) of the Federal Income Tax Regulations provides that §1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction treated as a sale or exchange for federal tax purposes.

Section 1374(d)(6) provides that if the adjusted basis of any asset is determined (in whole or in part) by reference to the adjusted basis of any other asset held by the S corporation on the Conversion Date, the asset is treated as held by the S corporation on the Conversion Date, and any determination under §1374(d)(3) with respect to that asset is made by reference to the fair market value and adjusted basis of the other asset on the Conversion Date.

In Example 1 of §1.1374-4(a)(3) , X is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, X owns a working interest in an oil and gas property on which production of oil has not yet begun, and the fair market value of the working interest exceeds X's adjusted basis in the working interest by $200,000. During the recognition period, X produces and sells oil from the working interest and includes $75,000 in income on the sale. X's $75,000 of income is not recognized built-in gain because on the Conversion Date X held only a working interest in the oil and gas property and not the oil it sold.

In Example 2 of §1.1374-4(a)(3) , Y is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, Y owns a royalty interest in an oil and gas property, and the fair market value of the royalty interest exceeds Y's adjusted basis in the royalty interest by $100,000. During the recognition period, Y sells the royalty interest and recognizes a gain of $75,000 on the sale. Y's $75,000 gain is recognized built-in gain because Y held the royalty interest on the Conversion Date.

Section 631(b) provides that if a taxpayer disposes of timber held for more than a requisite period under any form or type of contract in which the taxpayer retains an economic interest in the timber, the income from the disposal is considered gain or loss on a sale of timber. The date of disposal of the timber is deemed to be the date the timber is cut, but if payment is made to the owner under the contract before the timber is cut the owner may elect to treat the date of payment as the date of disposal. The taxpayer generally recognizes capital gain on the sale under §1231 in an amount equal to the difference between the amount realized for the timber and the timber's adjusted depletion basis. See §1231(b)(2) .

Under §1.631-2(d)(1) , payments received in advance of cutting pursuant to a §631(b) contract are treated as realized from the sale of timber if the contract of disposal provides that the amounts are to be applied as payment for timber subsequently cut.

Neither §631(b) nor the regulations thereunder give guidance on what constitutes a retained economic interest. Section 1.611-1(b)(1) , however, provides than an economic interest is possessed when a taxpayer has acquired by investment any interest in standing timber and secures, by any form of legal relationship, income derived from the severance of the timber, to which the taxpayer must look for a return of capital. In other words, an owner retains an economic interest under a timber cutting contract if the amount of the payment for the timber depends solely on the actual quantity of timber cut.

The Contract is a pay-as-cut contract, under which all proceeds paid to Taxpayer are payments for Timber actually cut. Taxpayer retains title and risk of loss until severance of the Timber, and all uncut Timber reverts to Taxpayer at the close of the Contract period. Taxpayer is the owner of the Timber, as the term "owner" is defined in §1.631-2(e)(2) , and has held the Timber for the requisite period under §631(b) . Consequently, provided the period of any Contract does not exceed two years, Taxpayer will retain an economic interest in the Timber disposed of under that Contract such that §631(b) will apply.

Based solely on the information submitted and authority set forth above, we rule as follows:

(1) Provided the period of any Contract does not exceed two years, Taxpayer's income recognized under that Contract on dispositions of Timber during the recognition period will not be subject to tax under §1374 .

(2) Taxpayer's income from the sale of logs during the recognition period from Timber Taxpayer cuts during the recognition period will not be subject to tax under §1374 .

We express no opinion about the federal income tax treatment of the above-described dispositions under any other section of the Code or regulations, or the tax treatment of any conditions existing at the time of, or effects resulting from, the above-described dispositions that are not specifically covered by rulings (1) and (2) above. Specifically, we express no opinion concerning the federal income tax treatment of (a) the character of income derived from any Timber disposition or from any payment under the Contract, (b) any Timber disposition occurring during the recognition period under any contract or arrangement other than the Contract, (c) any sale of logs cut before, rather than during, the recognition period, (d) income categories under §1374 other than those described in rulings (1) and (2) above, and (e) the validity of the Elections.

The rulings in this letter are based on the facts and representations submitted under penalties of perjury in support of the request. Verification of that information may be required as part of the audit process.

This ruling letter has no effect on any earlier documents and is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

The taxpayers involved must attach a copy of this letter to their federal income tax returns for each recognition period year in which an above-described disposition occurs.

Pursuant to a power of attorney on file in this office, a copy of this letter is being sent to your authorized representative.

Sincerely, Assistant Chief Counsel (Corporate), Robert T. Hawkes, Assistant Branch Chief, Branch 4.