Reform §631(b) of the Internal Revenue Code to remove the requirement of a “retained economic interest” so that timber may be sold on a lump sum basis with any gains remaining eligible for capital gains tax treatment.
Background: Under the current provisions of the Internal Revenue Code there are two methods timberland owners may use to dispose of (sell) standing timber: 1) a disposition pursuant to §631(b) in which the owner retains title to the standing timber until its severance, bears the risk of physical loss until that date, and retains an economic interest in the timber because the amount received is dependent upon the volume of timber harvested; and 2) an outright, lump sum sale of standing timber pursuant to a timber deed in which the buyer takes immediate title to the timber and assumes all the risk of loss during the period from the date of the sale to time of harvest.
The first option allows the timber owner to receive capital gains treatment for gains from the sale of his or her timber. However, this method of disposition is not nearly as advantageous as the lump sum method, which allows the timber owner to conduct a sealed bid sale which ensures that the timber owner receives the highest price possible for his or her timber. The difficulty with the lump sum method is that at some point when there are repeated sales, the timber owner will be treated as holding timber for sale to customers in the ordinary course of a trade or business, resulting in ordinary income vs. capital gains tax treatment. This tax treatment difference between the disposition methods results in many timber owners having to market their timber in a disadvantageous way in order to assure capital gains tax treatment.
Rationale: At the time §631(b) was enacted, most lump sum sales qualified for capital gains tax treatment. However, lump sum sales were equated with a cut and run mentality, while pay-as-cut sales were considered good timber management. Today, lump sum sales are no longer associated with improper timber management. Sales under §631(b), however, create the opportunity for fraud and abuse by the timber buyer. Under the pay-as-cut method, there is an incentive to waste poor quality timber by purposely breaking the tree during the logging process (resulting in no payment for the timber seller), and for the timber buyer to under scale the timber or to falsify the scale tickets or to remove the timber without scaling. Even the U.S. Forest Service is changing to lump-sum sales because of several cases of fraud and conspiracy involving buyers, scalers, and even its own employees. If the U.S. Forest Service cannot police its buyers and employees, surely non-industrial, private forest landowners should not be required to monitor the timber buyer’s conduct in order to ensure the most favorable tax treatment. Good forest management practices, not tax law, should determine the type of timber sale contract.
Reform of §631(b) is important to non-industrial private forest landowners because it will improve the economic viability of their forest investments. This in turn will benefit the entire forest products industry and the U.S. economy, which are dependent on timber production.
The environment will benefit because healthy forests require investment, and economic attractiveness is a prerequisite for investment.