Publications > Internal Revenue Service > Market Segment Specialization Program > Hardwood Timber Industry
Chapter 2 - Compliance and Audit Issues
METHODOLOGY/RETURN ANALYSIS
All aspects of the hardwood timber industry have been analyzed. From this analysis, market segments were measured for levels of compliance and possible common tax problem areas. In addition, input was sought from other districts with significant hardwood timber based upon their own compliance efforts and historical examination data.
Data was gathered from selected third party sources including sawmills and concentration yards for the years 1989 through 1992 to evaluate compliance problems in the timber industry. Information was compiled in a data base and refined for further evaluation. This information gathering was done to supplement current and historical compliance data.
During the classification and examination processes, audit issues were identified which appeared to be common with this industry. The following are some of the most common areas identified:
1. There were large numbers of non-filers.
2. Operators attempt to avoid employment tax liabilities and workers compensation premiums by paying wages in cash, classifying all payments to workers as subcontractor payments, and failing to file employment tax returns.
3. Operators are underreporting income. Internal control is poor and this leads to under reportng of income earned. In addition, poor accounting records lead to both unreported income and unsubstantiated expenses. Some operators contend that they lack the expertise necessary to maintain proper books and records.
4. Returns are being prepared by preparers with little understanding of the timber industry. This leads to many returns being Filed without a Form T being included.
Various technical issues were also identified and will be discussed in specific areas later within this guide.
FOREST ACTIVITIES SCHEDULE (FORM T)
Record keeping and certain procedures related to timber account management are essential components of the entire timber taxation process. The federal tax form that guides most timber taxation and procedures is Federal Tax Form T (Timber). If a taxpayer claims a deduction for depletion of timber or for depreciation of plant and other improvements related to timber accounts, or elects under IRC 631(a) to treat the cutting of timber as a sale or exchange; the taxpayer must complete and attach Form T to the income tax return. Generally, Form T should be filed when a taxpayer sells or cuts standing timber or is involved in other timber transactions. The Forest Activities Schedules provide a convenient format for forest industry record keeping. It is organized into nine major sections or "schedules."
Schedule A - Maps
Schedule A Consists of maps of a taxpayer's timber properties. Although filing maps with the income tax return is optional, the maps must be available upon examination of the return. The maps should include taxpayer's name, tax year, and other details such as timber cutting contracts acquired separately from the land, forest lands acquired, timber sold or otherwise disposed of under cutting contracts, etc.
Schedule B - Acquisitions
Acquisitions of timber, timber-cutting contracts, or forest land should be detailed in Schedule B. This schedule provides a format for recording costs associated with such acquisitions and for allocating total purchase costs to appropriate capital assets. For purchased forest property, the total amount to be allocated is the actual cost including legal fees, etc.; for inherited property, the estate's value is allocated to assets.
The asset categories included in Schedule B are forested land, other unimproved land, improved land, timber, premerchantable timber, improvements, and mineral rights. The cost is allocated to the respective accounts according to the relative values of the assets at the time the property was acquired. A forester can be helpful in establishing relative values and determining allocations.
The premerchantable timber account should consist of subaccounts for young growth (naturally occurring trees of premerchantable size) and plantations (trees planted or seeded). Plantation accounts are generally referred to as deferred reforestation accounts. Each of the timber accounts should include entries reflecting a unit of measure (such as board feet for merchantable timber and acres for premerchantable timber) and value. A reasonable amount of the basis should be allocated to the premerchantable subaccounts if they contribute to the overall value of the property. The quantity and value of all merchantable timber at the time of acquisition should be entered into the timber account. To verify the taxpayer's basis, review the taxpayer's documentation which should include items such as property maps, timber cruise information, forester's appraisal, etc.
Schedule C - Profit or Loss from Land and Timber Sales
Schedule C provides for recording and reporting all dispositions of timber or forest land. The gain or loss from a sale or exchange of timber is equal to the proceeds reduced by the adjusted basis of the asset and by any expenses directly related to the transaction.
Generally, a taxpayer disposes of timber through one of three methods; a lump-sum sale, a disposal with a retained economic interest, or cutting. A lump-sum sale of timber is the outright sale (Usually by means of a timber deed or sale contract) of standing timber for a fixed total amount agreed to in advance. The income produced by sale generally is capital gains if the timber is held for investment, IRC 1231 gain if the timber is held for use in the taxpayer's trade or business, and ordinary income if the timber is held for sale to customers.
A disposal of timber with a retained economic interest is the disposal of timber under any form or type of contract that requires payment at a specified rate for each unit of timber actually cut and measured. This type of transaction often is called a pay-as-cut contract. The income produced by a disposal with a retained economic interest is treated under IRC 631(b) as IRC 1231 gain or loss from the sale of the timber, regardless of the reason for which the timber is held.
The cutting of standing timber (felling) is part of the process by which standing timber is made into logs or other products that are sold. Proceeds from this process will result in ordinary income, unless an IRC 631(a) election is in effect. An IRC 631(a) election treats the cutting of qualifying timber for use in the taxpayer's trade or business as though the standing timber was sold, resulting in IRC 1231 gain or loss.
Whether timber income is active, passive or portfolio, income depends on the reason for holding the timber and whether the taxpayer materially participates in a trade or business involving the timber.
Exhibit 7 illustrates the important steps in calculating basis and determining the income from a sale of timber. The values shown in the tables reflect the transactions discussed in the following example:
A taxpayer purchased a 40-acre tract of timberland 11 years ago. The value attributable to the 200 thousand board feet (MBF) of timber on that land totaled $10,000. That works out to be $50 per MBF. An additional 10 acres of adjoining forest land with 50 MBF of timber was purchased 5 years later, with $3,750 attributable to the timber. From forest inventory data collected by a professional forester, timber growth on the properties from date of purchase through last year was estimated to be 50 MBF, resulting in standing timber volume of 300 MBF. The basis in this timber was $13,750. Therefore the depletion unit rate was $45.83 per MBF ($13,750/300 MBF).
Let's say the timber is grown another year and the taxpayer disposes of 100 MBF on a pay-as-cut basis. As a result of the additional year's growth, the depletion unit rate is reduced to $44.35 ($13,750/310 MBF). The taxpayer receives $200 per MBF. In addition, a consulting forester was utilized in the sale, for which the taxpayer paid a 15% commission. The taxpayer also incurred another $500 of direct sale-related expenses. The gross receipts of $20,000 are reduced by the adjusted basis of $4,435 and the costs of sale of $3,500, netting the landowner a $12,065 profit.
The particulars of the transaction are reported on Schedule C of Form T and transferred to Part I of Form 4797, Sale of Business Property. If Form 4797 shows a net gain, it is reported as long-term capital gain in Part II of Schedule D (Form 1040).
Schedule D - Losses
If during the tax year, the taxpayer had losses from fire, wind, etc., a deduction for these losses may be claimed on the taxpayer's income tax returns. Therefore it is necessary for these losses to be documented in reference to the nature and amount of the loss on Schedule D of Form T. See Rev. Rul. 87-59, 1987-2 C.B. 59 for discussion of losses from an epidemic of attack of Southern Pine Beatles.
Schedule E Reforestation and Timber Stand Improvement
Schedule E provides for reporting expenses for reforestation and timber stand activities during the tax year. The taxpayer should have on file all the detailed information reflecting items that are required to be capitalized and items elected to be capitalized. Expenses to be reported on this schedule are expenses such as for supplies, labor, overhead, transportation, tools, etc.
Deferred reforestation subaccounts should reflect capital expenses incurred in connection with establishing timber stands by planting, seeding, or natural regeneration. Establishment costs include money spent to prepare the site for planting or seeding, costs of seedlings or seed, costs of mechanical or chemical conditioning of the site, cost of small tools, and costs of labor associated with those treatments.
Annually, a taxpayer may claim a 10% investment tax credit on up to $10,000 of qualified reforestation expenditures, including costs of site preparation, seeds, seedlings, labor and tools. The site must be at least one acre, be located in the U.S., and be capable of commercial timber production. On qualified expenditures of $10,000, the taxpayer may reduce federal income taxes owed by $1,000. In addition, up to $10,000 per year of capitalized reforestation costs may be amortized over an 84-month period. This will allow $1,428 in amortization deductions each year, except for the first and last year when half this amount is allowable. However, if both the investment tax credit and amortization are applied, the amortization allowance is reduced to an amount equal to the qualified reforestation expenditures minus one-half of the tax credit. For example, if a taxpayer has $10,000 of qualified costs and claims a $1,000 credit; then the amount available for amortization would be $10,000 - ($1,000/2) = $9,500. The reforestation credit is claimed on Form 3468, and the reforestation amortization is claimed on Form 4562.
Schedule F - Capital Returnable Through Depletion
Schedule F is used for recording changes in a timber account during a tax year and determining the basis recoverable on timber dispositions. In general, this schedule is used to reflect growth of timber, harvest activities or other disposals, acquisitions, losses, transfers of timber from other accounts, changes in standards of utilization, and anything else that will affect the volume or basis of timber (wood available and suitable for exploitation and use by the forest industries) in the account. It is a record of activities involving the timber account. The unit rate returnable through depletion, or basis of sales or losses, is computed based on the volume and basis of timber that were available during the year, not just that available at the beginning of the year.
The IRC 631(a) election is made on Schedule F, which election treats the cutting of timber as a sale or exchange of the timber cut. Under this election, the taxpayer must determine the fair market value of timber cut during the year. This schedule details information the taxpayer must provide in connection with the fair market value determination.
Schedule G - Land Ownership
Changes in the land account, due to acquisition or disposal, are reported on Schedule G. Assets that are placed in the land account include the land itself and non-depreciable land improvements. Non-depreciable land improvements include earthwork assets of a permanent character, either acquired with the property or constructed later. Examples are roadbeds of permanent roads, land leveling, etc. The basis of such assets like that of the land itself can only be recovered when the taxpayer sells or otherwise disposes of the land.
Schedule H Road Construction
Schedule I - Drainage Structures
Schedules H and I are for reporting activities related to the construction of roads and water level control devices such as ditches and canals.
EXAMINATION TECHNIQUES
An examiner should begin by considering all pre-audit techniques set forth in IRM 4231, Audit Technique Handbook for Internal Revenue Agents. In addition, IRM 4232.4, Techniques Handbook for Specialized Industries Timber, can also be reviewed. Although the forestry information in IRM 4232.4 is dated, the principles in the handbook are still applicable.
When an examiner is assigned a hardwood timber return and the case file does not contain an IRP transcript, one should be ordered as soon as possible. Most timber operators, truckers, sawmills, etc. have several sources of income. Some of these may be verified through the use of an IRP transcript. However, do not use the IRP document as your only source since it is most likely that the document is partially complete at best.
Income is the issue which is the most difficult to develop and verify. A lack of sufficient record keeping within the timber industry is the major contributor to this problem. Operators compute their income in several different ways. The most common methods used are: 1) The operator deposits all proceeds received into a bank account (either business or personal). It is then assumed that all income is deposited. Normally it is difficult to verify sources of deposits under this method. 2) The operator totals income amounts on all Forms 1099 received and reports this amount as income. Under this method, it is surmised that all income is subject to 1099 filing and that all relevant 1099s were filed. We know this is not the case. Quite to the contrary, very few 1099s are required to be or are filed. 3) The operator maintains a cash receipts journal supported by bank deposits identifying the deposit source. This is better control particularly if the taxpayer maintains a double entry set of books. 4) Some operators estimate their income based upon their current financial condition and prior years estimates. This tends to be the least accurate of the methods discussed.
Most timber operators are small operations conducted in a small geographic area. Many are family operations lacking essential elements of internal control. Lack of internal control and poor record keeping create opportunities for taxpayers to underreport income. These situations leave little or no audit trail.
As in most cases, the examiner's initial interview will help in determining income sources and in evaluating internal control. The majority of questions asked in reference to income will be similar to those used in other examinations. Therefore, this guide will not repeat them. However, be sure to inquire as to timber job sites and points of sale. Normally these will be in close proximity to each other.
When determining if any income has been unreported, an examiner should first look to the books and records of the taxpayer to identify income that is reported. In addition, during the initial interview the examiner should obtain the taxpayer's listing of customers for whom they worked during the examination year. The examiner should also consider examining the taxpayer's duplicate deposit slips to identify income sources. This works well if the taxpayer is depositing income and is normally paid by check.
After identifying income that the operator has reported, the examiner must probe for unreported income. The examiner should consider contacting the taxpayer's known customers as well as other sawmills and concentration yards within the area. For the most part, because of transportation cost factors and customer needs, an operator will use several different customers (sawmills, concentration yards, etc), but they usually will be within close, proximity to the operator's job sites.
And another important income identification resource is the use of other third party contacts. For example:
1. Land/Timber seller's income can be identified through:
a. Courthouse records of timber deeds
b. Real property tax receipts
c. Logger or broker purchase records
d. Timber cruise job orders
e. Federal or State Forest Services
2. Loggers/Timber operators income can be identified through:
a. Courthouse records of timber deeds
b. Real property tax receipts
c. Sawmill or concentration yard purchase records
d. Timber cruiser job orders
e. Federal or State Forest Services and IRP
f. Timber severance taxes where applicable
3. Trucker's income can be identified through
a. Related timber purchases on a per job basis
b. Verification of the trucker's drivers, cutters and skidders, and income arrangements
c. IRP
4. Sawmills and concentration yards income can be identified through:
a. Verification of the trucker's drivers, cutters, and skidders income arrangements
b. IRP
c. Customer purchase records
d. Federal or State Forest Services
After income sources have been developed, it is necessary to contact these sources to request that documentation pertaining to the taxpayer under examination. For the most part, these sources are very cooperative in providing documentation such as invoices, canceled checks, contracts, etc. The examiner should use diligence in gathering this data to gather all relevant data because in many cases the source records-may be incomplete. For example, it is not uncommon for these records to have a name and an amount and no other data. This makes it very difficult to identify the payee, even if they were paid by check (checks may be cashed rather than deposited). In many cases, it may take a combination of third party contacts to identify income not reported. If the third party does not comply with the examiner's request, the examiner and his/her manager should decide if a summons should be sent to the third party.
Most timber sellers, operators, sawmills, concentration yards, etc. maintain their own books and records. When they have their tax return prepared by a return preparer, they normally will provide the preparer with a list of their income and expenses. As mentioned previously, most of these operations have limited internal controls. Therefore, the probability of error is great. For example, many times there will be missing or unavailable invoices or other documentation to support expense deductions.
Standard audit techniques maybe used to examine expenses. (IRM 4231) Many examiners fail to properly consider the cost of goods sold (COGS) during their examinations. However, in the timber industry, COGS is usually the second largest dollar volume item on a tax return next to gross income.
COGS can easily be used to cover a multitude of incorrectly treated expenditures. The IRM requires minimal inventory checks, but the examiner may want to extend probes further. Techniques are found in IRM 4231, Section 4(10)2. Inventory and COGS are unique areas within the timber industry.
The other types of expenses a timber industry taxpayer can deduct are very similar to those of any other business. Differences do exist but for the most part these expenses are expenditures necessary to produce income. Some of the most common areas of high noncompliance are:
1. Personal expenses are often paid out of business accounts but still deducted on the taxpayer's return.
2. Expenses are overstated with no supporting documentation. Timber industry taxpayers frequently deal in cash and fail to keep applicable receipts.
COMPLIANCE 2000 OPPORTUNITIES
The West Virginia Timber Industry Prototype became a Compliance 2000 Project in 1992 as a result of an Information Gathering Project (IGP) to determine if timber sales were being properly reported. Because of such widespread noncompliance within the timber industry, it was believed that traditional enforcement methods would have limited success in improving the overall compliance level without the use of substantial resources. At the same time, the West Virginia Department of Tax and Revenue (WVDTR) was conducting a similar project. These similar goals and objectives contributed to a joint Compliance 2000 approach. The Joint Timber Compliance Team also utilized the West Virginia Forestry Division in improving compliance in the timber industry.
Data was gathered from selected third party sources, including sawmills and concentration yards. This information was compiled in a data base and refined for further evaluation to determine the compliance problems in the timber industry.
The project increased awareness and cooperation with both internal and external customers (taxpayers). This project indicated a need for assistance to taxpayers who want to voluntarily comply in tax filing and that the service should aggressively pursue those who do not comply. A comparison of the initial and final baseline measurements showed a substantial improvement in all four areas measured: percentage of nonfilers, percentage of inaccurate returns file, percentage of returns not timely filed, and Percentage of returns not fully paid.
The team developed strategies to increase the level of compliance within the timber industry. Market segment taxpayers and both external and internal stakeholders in West Virginia were reached through the use of short-term strategies focusing on education.
Through the use of mass media, almost 100% of the taxpayer population may be reached with messages to bring about compliance in the timber industry. Efforts in this project illustrate the range of techniques that can be used to educate and inform taxpayers. Major strategies included:
1. Posters and flyers were distributed to IRS and State tax offices, forestry department offices and over 500 sawmills and concentration yards. The objective of this strategy was to publicize the free tax assistance being offered to timber operators.
2. Workshops were conducted at states and federal agencies, timber associations, and tax practitioner and CPA chapter meetings. These presentations were held to educate timber industry taxpayers concerning the requirements of filing tax returns and of maintaining adequate records.
3. Media coverage was utilized focusing on timber industry participation in the district's Nonfiler Program "Opportunity Get Right." Through media releases, taxpayers received information on responsibilities to file tax returns and to maintain adequate records. In addition, taxpayers were informed on hoe to obtain assistance from both IRS and WVDTR.
4. A Timber Telephone Hotline was established and staffed by team members to provide specialized assistance. This service was publicized in many of the other strategies.
5. A series of four Letters of Inquiry were used to contact known logger underreporters and nonfilers. The first letter was informal and nonthreatening and offered federal and state tax assistance to all known timber-related individuals. The second letter contacted a sample of timber-related taxpayers who had not filed federal income tax returns. The third letter contacted a sample of timber-related taxpayers who had filed federal income tax returns, but may not have reported all gross receipts. Finally, letter four was sent under the signature of the District Director to all taxpayers who had not responded to the issuance of either letter two or three. With the issuance of the series of letters, many taxpayers came into compliance by voluntarily filing returns and amending returns. However, not all taxpayers voluntarily complied and traditional enforcement efforts were used on chronic noncompliers.
6. Recordkeeping requirements were issued to all sawmills and concentration yards in the district. Essentially, this letter requires that the name, address, identification number, and legible signature be maintained on file for all purchases of timber or logs.
7. Letters of congratulations were sent to all entities registering in West Virginia as a licensed logger. This letter welcomed the taxpayer into the timber industry, offered tax assistance, and provided a tax reference guide.