Why update Section 631

  • Frequent ("frequent" remains undefined by the IRS) sellers of standing timber are considered to be in an "active trade or business" by the IRS and are therefore declared "dealers" of timber. If deemed a "dealer," landowners must comply with special rules in Section 631(b) of the Code in order to realize capital gains treatment once they have met the holding period requirement.
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  • Under 631(b), landowners are required to "retain an economic interest" in their standing timber until it is harvested. Under these circumstances, a hardship is created for landowners who sell timber under a contract that provides that the seller bear all the risk of loss of the timber until it is harvested.  Even when buyers default on contractual obligations to complete the harvest of specified timber, the seller is prohibited from collecting the full value of the contracted sale, and can only impose a penalty amounting to a fraction of the value of the contract.
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  • Although the timber buyer may be a large forest products company, 631(b) requires the landowner to take all the risk for harm to the timber, i.e., storms, insects, disease, fire, etc.
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  • Sales structured to meet 631(b) requirements, known as "pay-as-cut" sales, favor the buyer -- not the timber grower. When selling timber, landowners must currently choose between the most advantageous method of measuring their timber or the most favorable tax treatment.
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  • How was this illogical and unfair provision ever added to the Internal Revenue Code in the first place? The explanation lies in the evolution of the tax code over many decades. Earlier in this century, outright ("lump-sum") timber sales were associated with a "cut and run" mentality that did not promote good forest management. At that time, "pay-as-cut" sales were equated with enlightened resource management. So, in 1943, Congress passed legislation that allowed capital gains treatment for pay-as-cut sales, in an effort to provide an incentive for improved forest management.
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  • Pay-as-cut sales are no longer associated with proper timber management. Instead we have learned that such sales are likely to encourage fraud and abuse by unscrupulous timber buyers. Under the pay-as-cut method, since the seller is paid for only the timber that is harvested, there is an incentive for unscrupulous buyers to waste timber during the harvest, which disrupts management plans for sustainable forests.
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  • Also, there is an incentive for unscrupulous buyers to under-measure timber, to falsify measurements, or remove timber without measuring (scaling) it. Because of cases of fraud, the USDA Forest Service is changing to the lump-sum method.
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  • Lindy Paull, Chief of Staff of the Congressional Joint Committee on Taxation, has said that a correcting-change in 631(b) will have a negligible effect on federal revenue. The JCT calculations resulted in a "score" of zero. The scoring process was not undertaken once, but twice.
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  • A change in Section 631(b) has been supported or suggested by a number of groups for tax simplification purposes, including the Internal Revenue Service.