Letter Ruling 9825018, March 19, 1998
Uniform Issue List Information:
UIL No. 1374.00-00
Tax imposed on built-in gains
Code Sec. 1374
This letter responds to your November 5, 1997 request for rulings on certain federal income tax consequences of a proposed transaction. The information submitted in that letter and in later correspondence is summarized below.
Taxpayer, the parent of an affiliated group of corporations that files a consolidated federal income tax return, is engaged in the business of growing timber, cutting the timber, and selling the logs produced therefrom to third parties. Taxpayer currently has approximately a shareholders, after application of §1361(c) of the Internal Revenue Code.
The company's primary timber tract is the A property, which is a b acre tract on which the company has c years remaining on a d-year lease. The Taxpayer's timber reserves consist of e and f trees, which have average growth cycles of g and h years, respectively.
Taxpayer generates timber revenues primarily from two activities: (1) selling processed logs under yearly contracts with lumber mills, and (2) selling processed logs on the open market. Taxpayer has also entered into a long-term contract with B with respect to logs from its A property for a minimum of i cords of pulpwood per year. The majority of Taxpayer's revenue from this arrangement is derived from the sale of processed pulpwood logs to B. A portion, however, is derived from the sale of timber that B cuts and removes from the A property, for stumpage value.
Pursuant to this contract, Taxpayer identifies the timber that B has the right to cut and remove from the A property. Taxpayer subsequently receives payments based on the quantity of timber actually cut and removed by B, as determined subsequent to the time of actual cutting. Because payment for the timber is dependent on the actual quantity of timber cut, Taxpayer retains an economic interest in the timber. The minimum yearly volume of pulpwood under this long-term arrangement was executed by Taxpayer and a predecessor of B approximately j years ago. Taxpayer and B mutually agree on an annual basis the portion of the pulpwood timber to be cut and delivered by Taxpayer, and the portion to be cut and removed from the property by B.
Taxpayer intends to make an S corporation election for its taxable year beginning January 1, 1999. Prior to electing S corporation status, Taxpayer intends to reduce the number of its shareholders, through redemptions or sales among its existing shareholders, in order to become eligible to elect S corporation status. It also may make Qualified Subchapter S Subsidiary elections for some, or all, of its subsidiaries. Taxpayer will also make an election under §631(a) to treat the cutting of its timber as a sale or exchange of that timber.
Taxpayer requests rulings that certain income categories after it becomes an S corporation are not subject to tax under §1374 .
Section 1374 imposes a corporate-level tax on an S corporation's net recognized built-in gain during the 10-year recognition period 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 tax year is generally its taxable income for the year computed as if it was a C corporation, but taking into account only items treated as recognized built-in gain or recognized built-in loss.
Section 1.1374-4(a) provides that §1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction that is treated as a sale or exchange for federal income tax purposes.
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 on 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 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 converts to 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 did not hold the oil it sold for $75,000, it held only a working interest in an oil and gas property.
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.
An election under §631(a) specifically allows a taxpayer to treat the cutting of timber (for sale or use in the taxpayer's trade or business) as a sale or exchange of such timber cut during the year. The §631(a) gain or loss calculation equals the difference between the fair market value of the timber and its adjusted basis for depletion.
Section 631(b) provides that if an owner disposes of timber held for more than 1 year under any form or type of contract by virtue of which the owner retains an economic interest in the timber, the income from the disposal shall be considered gain or loss on a sale of timber. On the sale, the taxpayer generally recognizes capital gain or ordinary loss under §1231 in an amount equal to the difference between the amount realized for the timber and the timber's adjusted basis for depletion. The date of disposal is deemed to be the date such timber is cut, or at the election of the taxpayer, the date payment is contractually made if such date is earlier than the date of cutting.
A timber contract under which the owner retains an economic interest is one in which payment for the timber is dependent on the actual quantity of timber cut. See Rev. Rul. 61-56 , 1961-1 C.B. 243.
Section 631(a) provides an election under which the cutting of timber by a taxpayer who owns or has a contract right to cut the timber is treated as a sale or exchange of the timber in the tax year the timber is cut, provided the timber or the contract right to cut the timber is held for more than 1 year, and irrespective of whether the timber or the products produced therefrom are sold in the tax year the timber is cut.
Section 1.611-3(b)(1) provides that the depletion of timber generally takes place at the time timber is cut. To the extent that depletion is allowable in a particular year but the products of the cut timber are not sold during the year, the depletion allowable is included as an item of cost in the closing inventory of the timber products for the year.
Based solely on the information submitted and provided Taxpayer makes a valid S corporation election, we rule as follows:
(1) Taxpayer's income from the disposition of logs during the recognition period from timber Taxpayer cuts on its timberlands during the recognition period is not subject to tax under §1374 .
(2) Taxpayer's gain under §631(a) on cutting timber during the recognition period is not subject to tax under §1374 .
(3) Taxpayer's income recognized pursuant to the deemed sale of timber under §631(b) pursuant to the arrangement with B will not be subject to tax under §1374 .
No opinion is expressed about the tax treatment of the proposed transaction under other provisions of the Code and regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the proposed transaction that are not specifically covered by the above rulings. In particular, no opinion is expressed about the tax consequences under §1374 of income categories other than the income categories described in the above rulings.
The above rulings are directed only to the taxpayer who requested them. Section 6110(j)(3) provides that they may not be used or cited as precedent.
A copy of this letter must be attached to the federal income tax returns of each taxpayer involved for the taxable years in which the proposed transaction is consummated.
Pursuant to the powers of attorney on file in this office, copies of this letter have been sent to the taxpayer's authorized representatives.
Sincerely yours, Assistant Chief Counsel (Corporate), Charles M. Whedbee, Senior Technical Reviewer, Branch 5.