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Letter Ruling 9826017, March 25, 1998

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

Code Sec. 1374

This letter responds to your October 1, 1996 request for rulings on the federal income tax consequences of certain timber transactions. Additional information was submitted in a letter dated November 12, 1997. The information submitted for consideration is summarized below.

Taxpayer is a domestic corporation engaged primarily in the growing and harvesting of timber and the selling of timber products such as logs. The average growth cycle of Taxpayer's timber is between 35 and 60 years or more.

In a prior year when Taxpayer was a C corporation, Taxpayer made an election under §631(a) of the Internal Revenue Code to treat the cutting of its timber as a sale or exchange of the timber cut during the year. Also in prior years, Taxpayer disposed of timber pursuant to a cutting contract entitled "Timber Sale Contract/Parcel ***** Timber Sale" (attached and hereinafter the "Old Contract"). Taxpayer has revised and replaced the Old Contract for future disposals of timber with a cutting contract entitled "Timber Sale Contract/Parcel Timber Sale" (attached and hereinafter the "Revised Contract").

Taxpayer elected S corporation status effective January 1, 1997. Taxpayer requests rulings that its income from cutting or disposing of timber during the recognition period is 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 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 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 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 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.

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 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 during that tax year. If a §631(a) election is made, gain or loss is recognized in an amount equal to the difference between the fair market value of the timber and the adjusted basis for depletion of the timber in the hands of the taxpayer.

Section 631(b) provides that in the case of disposal of timber (held for more than 1 year before disposal) by the owner under any form of contract under which the owner retains an economic interest in the timber, the difference between the amount realized from the disposal of the timber and the adjusted depletion basis of the timber disposed of shall be considered as gain or loss on the sale of the timber. The date of disposal is deemed to be the date the timber is cut, but if the owner is paid under the contract before the timber is cut, the owner may elect to treat the payment date as the disposal date.

Section 1.611-3(b)(1) of the regulations 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 taxable 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.

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.

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

Based solely on the information submitted, we rule as follows:

(1) Taxpayer's gain on cutting timber during the recognition period pursuant to §631(a) is not subject to tax under §1374 .

(2) Taxpayer's income from the sale of logs during the recognition period from timber Taxpayer cuts on its timberlands during the recognition period is not subject to tax under §1374 .

(3) Provided the period of any Old Contract or Revised Contract does not exceed two years, Taxpayer's gain on dispositions of timber under any Old Contract or Revised Contract during the recognition period pursuant to §631(b) is not 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) through (3) above. In particular, 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 any Old Contract or Revised Contract; (b) any timber disposition occurring during the recognition period under any contract or arrangement other than under any Old Contract or Revised 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) through (3) above; and (e) the validity of the §631(a) election or S corporation election.

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.

The above ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

A copy of this letter must be attached to the affected federal income tax return of each shareholder of Taxpayer during the years covered by this ruling letter.

Sincerely, Assistant Chief Counsel (Corporate), Mark S. Jennings, Acting Branch Chief, Branch 1.