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Rev. Rul. 58-266, 1958-1 CB 520

REV-RUL, Rev. Rul. 58-266, 1958-1 CB 520, (Jan. 01, 1958)

Direct expenses incurred in connection with the disposal of coal or timber subject to the provisions of section 117(k)(2) of the Internal Revenue Code of 1939 reduce the amount received for the purpose of computing gain or loss from such disposal of coal or timber. Whether any expense is a "direct expense" is a matter to be determined largely on the strength or persuasiveness of the facts of each particular case and how closely related are the activities in connection with which the expense is incurred to the disposal of the coal or timber.

Advice has been requested as to the Federal income tax treatment of expenditures which are directly attributable to the disposal of coal or timber under the provisions of section 117(k)(2) of the Internal Revenue Code of 1939.

The taxpayer in this case is a corporation which is the owner and lessor of coal lands. Substantially all of its income is derived from the disposal of coal within the purview of section 117(k)(2) of the Code. In connection with and directly attributable to the disposal of coal so as to produce the maximum income therefrom, the taxpayer expends substantial amounts for checking the lessee's records for accounting and billing purposes, for mining engineers to insure that the maximum amount of coal will be mined by modern methods, for supervisory safety measures, etc.

Section 117(k)(2) of the Code, as amended by the Revenue Act of 1951, 65 Stat. 452, 26 U. S. C. 117, provides, in part, as follows:

In the case of the disposal of timber or coal (including lignite), held for more than 6 months prior to such disposal, by the owner thereof under any form or type of contract by virtue of which the owner retains an economic interest in such timber or coal, the difference between the amount received for such timber or coal and the adjusted basis thereof shall be considered as though it were a gain or loss, as the case may be, upon the sale of such timber or coal. Such owner shall not be entitled to the allowance for percentage depletion provided for in section 114(b)(4) with respect to such coal. * * * (Italics supplied.)

The specific question, therefore, is whether the words "amount received," as used in section 117(k)(2) of the Code mean the gross amount received or whether these words are to be interpreted to mean the gross amount reduced by the direct expenses incident to the transaction.

Section 117(k)(2) of the Code was originally added to the Code by section 127(a) of the Revenue Act of 1943, C. B. 1944, 756 at 773, and, as enacted at that time, was applicable only with respect to the disposal of timber.

Senate Report No. 627, 78th Cong., First Session, C. B. 1944, 973 at 993, on the Revenue Act of 1943 states:

Your committee is of the opinion that various timber owners are seriously handicapped under the Federal income and excess profits tax laws. The law discriminates against taxpayers who dispose of timber by cutting it as compared with those who sell timber outright. The income realized from the cutting of timber is now taxed as ordinary income at full income and excess profits tax rates and not at capital gain rates. In short, if the taxpayer cuts his own timber he loses the benefit of the capital gain rate which applies when he sells the same timber outright to another. Similarly, owners who sell their timber on a so-called cutting contract under which the owner retains an economic interest in the property are held to have leased their property and are therefore not accorded under present law capital-gain treatment of any increase in value realized over the depletion basis.

It is apparent that, in the above statement, a comparison was being made of economic income from sale versus economic income from cutting or lease. The impact of income tax upon a taxpayer deriving income from cutting or lease discriminated against such taxpayer as compared with the impact of the lower capital gain rate applicable to a taxpayer deriving income from a sale.

It has been the consistent position of the Internal Revenue Service, in connection with transactions qualifying for capital gain or loss treatment, that selling expenses are treated as an offset to the selling price. I. T. 2305, C. B. V-2, 108 (1926); (Mrs.) E. A. Griffin v. Commissioner, 19 B. T. A. 1243; Therese C. Johnson v. Commissioner, 7 T. C. 465, acquiescence C. B. 1946-2, 3. Since the selling expenses in a sale of a capital asset are considered in arriving at income subject to capital gain tax, it would seem reasonable to give like consideration to direct expenses in connection with income from leases. In this way the comparison set forth in the above Committee Report would constitute a comparison of like concepts and afford a basis for a sound determination as to a finding of discrimination between similarly situated taxpayers. The fact that selling expenses may be of a recurring nature has been held not to affect their treatment as an adjustment to the selling price. General Spring Corporation v. Commissioner, Tax Court Memorandum Opinion, entered July 27, 1953.

Section 112(a) of the Code provides in general that, upon the sale or exchange of property, the entire amount of gain or loss determined under section 111 of the Code shall be recognized. Section 111 of the Code provides, in part:

(a) COMPUTATION OF GAIN OR LOSS.--The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 113(b) for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

(b) AMOUNT REALIZED.--The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.

There is no essential difference between the words "amounts received" found in section 117(k)(2) of the Code and "money received" as used in section 111. Under section 117(k)(2), since the transaction is considered as though it were a gain or loss upon the sale of such timber or coal, and under appropriate circumstances, as provided by section 117(j), gain is considered as long-term capital gain, the direct expenses incident to the transaction should constitute a reduction of the "amount received" in the same manner that selling expenses reduce the sales price.

The words "amounts received" are found in section 117(f) of the Code. Section 117(f) of the Code provides:

RETIREMENT OF BONDS, ETC.--For the purposes of this chapter, amounts received by the holder upon the retirement of bonds, debentures, notes or certificates or other evidence of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor.

The effect of this section is to convert ordinary income or loss to capital gain or loss, without any reference however to section 117(j) of the Code. Section 117(f) has been a part of the Code since its enactment in 1939.

In the case of Edward A. Atlas v. Commissioner, Tax Court Memorandum Opinion, entered January 27, 1945, two of the questions in issue were whether the taxpayer realized taxable income in 1940 when he surrendered bonds purchased at a discount and whether the gain, if any, is taxable in part as a long-term capital gain. In accordance with the provisions of section 117(f) of the Code, the court held:

We think that the surrender of the $61,000 bonds, Series M-1184, for the Fort Hubbard Apartments was the equivalent of the retirement of the bonds by the Bankers Trust Co. The gain to the petitioner upon such transaction was the difference between the cost of the bonds, $23,430.77, and the stipulated fair market value of the Fort Hubbard Apartments received, $70,000, less the fees, commissions and expenses amounting to $1,795.50, or a net gain of $44,773.73.

"The amount of the gain attributable to each period is the difference between the cost of the bonds acquired in such period and an aliquot portion of the net amount received upon surrender of the bonds, $70,000 less $1,795.50, or $68,204.50."

In the case of a corporation deriving substantially all its income from coal or timber leases, to which section 117(k)(2) of the Code is applicable, the tax relief intended by the Congress in enacting this section would be largely lost if the direct expenses attributable to the lease were not considered in arriving at the gain which would be treated as long-term capital gain. Under such circumstances, the corporation would either derive no tax benefit from these expenses, if the alternative tax under section 117(c)(1) of the Code was applicable, or it would derive no tax benefit under section 117(k)(2) if its direct expenses were so large as to make the alternative tax under section 117(c)(1) inapplicable.

On the other hand, in the case of a corporation realizing appreciable ordinary income, as well as income from section 117(k)(2) leases, if the direct expenses are not considered in arriving at the gain computed under this section, the gross profit from the lease (gross amount received less cost depletion) will be subject to a maximum tax at substantially lower long-term capital gain rates, whereas the direct expenses will in turn offset the ordinary income subject to the higher corporate normal and surtax rates. There appears to be no basis for concluding that section 117(k)(2) was intended to operate in such a manner as to favor corporations deriving both ordinary income and section 117(k)(2) income as against corporations deriving only section 117(k)(2) income.

Accordingly, it is held that direct expenses incurred in connection with the disposal of coal or timber subject to the provisions of section 117(k)(2) of the Code reduce the amount received for the purpose of computing gain or loss from such disposal of coal or timber. Whether any expense is a "direct expense" is a matter to be determined largely on the strength or persuasiveness of the facts of each particular case and how closely related are the activities in connection with which the expense is incurred to the disposal of the coal or timber.