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Rev. Rul. 62-81 1, 1962-1 CB 153

REV-RUL, Meaning of terms., Rev. Rul. 62-81 1, 1962-1 CB 153, (Jan. 01, 1962)

SECTION 1221.--CAPITAL ASSET DEFINED

26 CFR 1.1221-1: Meaning of terms.
(Also Section 631, 1231; 1.631-2, 1.1231-1.)

The owner of a tract of timber land entered into a contract with a paper company whereby the latter was granted, for a term of 60 years, the right to grow timber and to cut timber growing and to be grown on the tract. The company is obligated to make payments in each year of the term of the contract. The obligation to pay is not contingent upon the quantities of timber which are cut. At the time of execution of the contract, there was a stand of timber upon the tract having a known fair market value. Held, the transaction is not a "disposal" of timber under section 631(b) of the Internal Revenue Code of 1954. Payments equal to the fair market value of the timber existing at the execution of the contract constitute proceeds of sale of timber. Any gain included in the above amount is capital gain provided the conditions described in sections 1221 or 1231 of the Code are met. Any excess of such payments over the fair market value of the timber existing at the execution of the contract is ordinary income.

Advice has been requested as to the manner in which the owner of timber land, who enters into a long-term contract, under the circumstances described below, should treat the income therefrom for Federal income tax purposes.

The contract entered into between the owner of the timber land and a paper company is to extend for 60 years. The contract provides that for the stated term the owner agrees to "sell" and the company to "buy" all timber growing and to be grown upon the tract. The paper company, during the first ten years of the contract, must pay for and may cut 4M cords of wood per year, and during the next ten years must pay for and may cut 8M cords of wood per year. During the succeeding 40 years, timber cruises are to be made at specified intervals and quantities of annual growth of timber are to be estimated. Over this period of 40 years, the company must make annual payment for 8M cords or the quantity of estimated annual growth, whichever is greater, but cutting in any year may not exceed the estimated annual growth. However, with respect to the entire contract term, timber permitted to be cut, which is not cut in any year, may be cut in any of the succeeding twelve years, but not later than the expiration date of the contract, provided the quantity permitted to be cut in the later year is first cut.

The contract payment is at the rate of 3X dollars per cord, subject to periodic adjustment to reflect changes in the Wholesale Commodity Price Index of all commodities from that prevailing at the execution of the contract, but in no event shall the adjusted payment be at a rate of less than 2X dollars per cord.

The company is required, at its own expense, at all times during the term of the contract, to manage and operate the land and timber thereon in accordance with good forestry practices in such manner that the average annual growth of timber shall not be less than the amount of timber cut and removed or otherwise utilized annually. The contract provides for the assumption by the company of ad valorem taxes, the use by the company of existing improvements, the right to construct additional improvements, and the right of the company to the full beneficial possession of the surface to an extent not detrimental to timber growth.

Title to the timber was to pass to the purchaser as cut. In the event of fire beyond a specified magnitude, the permissible annual cut could, at the seller's option, be reduced in proportion to the acreage affected, but purchaser was obligated to continue paying under the original schedule. In the event performance of any part of the agreement was prevented by specified factors beyond the control of the parties (including infestation of timber but not including fire) purchaser's obligation to pay was to be reduced in proportion to the extent and duration of such factors.

The fair market value of the timber existing at the date of the contract (merchantable timber of cutting size and smaller young growth of appraisable value) exceeds the landowner's adjusted basis for such timber.

Capital gain treatment of any portion of the landowner's receipts under the contract would be available to the landowner only to the extent that the transaction constituted either (1) a "sale" of timber, within the purview of sections 1221 or 1231 of the Internal Revenue Code of 1954, or (2) a "disposal" of timber within the purview of section 631(b). If the timber is held by the landowner "primarily for sale to customers in the ordinary course of trade or business," the provisions of sections 1221 or 1231 are not applicable. However, the fact that the timber is so held does not preclude the application of section 631(b). Ah Pah Redwood Company v. Commissioner, 251 Fed. (2d) 163 (1957); and Rev. Rul. 57-90, C.B. 1957-1, 199.

A "disposal of timber," to qualify under section 631(b), must be under a contract by virtue of which the owner retains an economic interest in such timber. An essential condition is that recovery of the capital investment of the owner must be conditioned upon severance of the timber. Estate of James M. Lawton v. Commissioner, 33 T.C. 47 (1959). See also section 1.611-1(b)(1) of the Income Tax Regulations; Joe S. Ray v. Commissioner, 32 T.C. 1244 (1959), affirmed 283 Fed. (2d) 337 (1960); and Rev. Rul. 56-542, C.B. 1956-2, 327.

The fact that the original unit price is subject to periodic adjustment for changes in the Wholesale Commodity Price Index of all commodities does not give the landowner a retained economic interest in the timber. The provision merely assures the landowner a return which will reflect changes in the general purchasing value of the dollar.

The possibility of a reduction of the purchaser's obligation to pay, to the extent that performance is prevented by specified factors other than fire does not create a retained economic interest in the timber; despite such possibility, the landowner still looks to payments which are not conditioned upon the severance of timber for the recovery of his investment.

By the contract the landowner is to be paid stipulated amounts which are not conditioned on the quantities of timber which the paper company cuts. The landowner is assured of a fixed return, and the paper company is committed to a fixed obligation, neither of which is dependent upon, or governed by, the time or degree of severance of the timber. Thus, the landowner does not posses a "retained economic interest" in the timber. Accordingly, the transaction is not a "disposal" of timber under section 631(b) of the Code.

The contract, however, accomplishes a "sale" of the timber existing at the time of its execution. The contract shifts to the paper company the significant benefits and burdens incident to beneficial ownership of the timber during its term. The retention by the landowner of legal title to the timber until cut is merely a security device.

The agreement can accomplish a "sale" only of timber existing at the date of the contract since only timber in existence can be the subject of a present sale. See Williston on Sales (Rev'd Ed.), sections 62 and 258.

The landowner has parted with all control of the timber and of the land itself so far as it pertains to timber growth; growth occurring during the time of the contract is attributable to the possession and management of the property by the paper company. This would apply both to the subsequent growth of trees existing at the making of the contract and to timber grown in its entirety during the contract term. Payments under the contract not attributable to timber existing at the execution of the contract are not proceeds of sale of timber by the landowner but are consideration for the use of the land by the paper company and, therefore, constitute ordinary income. Estate of James M. Lawton.

Accordingly, payments under the contract equal to the fair market value of the timber existing at the execution of the contract constitute proceeds of sale of timber. Any gain included in the above amount is capital gain, provided the conditions specified in section 1221 or 1231 of the Code are met. Any excess of such payments over the fair market value of the timber existing at the execution of the contract is ordinary income.