Southern Pacific Transportation Co. v. Commissioner

This issue presents the following question for our consideration: Whether timber expenses incurred by petitioner are expenses of management deductible as ordinary and necessary business expenses under section 162 or whether they are expenses directly related to cutting contracts under section 631(b); and, if the latter, whether such expenses are applied as a reduction of capital gain under the contracts (as reported by petitioner) or as a reduction of petitioner's ordinary income.

Findings of Fact

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

Among the assets of the predecessor Southern-Pacific Company received by the former Southern Pacific Company in the 1947 rein-corporation was all of the outstanding stock of the Southern Pacific Land Company (SPLC).

SPLC has been incorporated under the laws of the State of California on February 1, 1912. In 1912 and in 1930, various predecessors ² of petitioner transferred real property to SPLC. This real property consisted principally of what the companies called "outlying" acreage, i.e., alternate sections of land adjacent to railroad rights-of-way. Much of the land was located in the timber country of northern California and bore timber. During the years at issue (1959, 1960, and 1961), all of the real property held by SPLC was located within the State of California.

From the outset (and continuing through the years at issue), the SPLC lands were managed by the Land Department of the predecessor Southern Pacific Company and, subsequently, by the Land Department of the former Southern Pacific Company.

Between the years 1916 and 1949, the Land Department was actively engaged in a program of trying to dispose of the acreage owned by SPLC and other land-grant properties under the jurisdiction of the department, including timberlands. During this period the Land Department did not permit any timber cutting on the lands under its jurisdiction, and between 1916 and 1949, no cutting leases were executed. Even buyers were not permitted to enter upon the land to cut timber until the contracts were paid in full.

During the period 1912 to 1949, SPLC transferred substantial outlying timberland acreage to outsiders. In 1949, SPLC withdrew from the practice of actively selling its timber holdings, and thereafter, except for isolated accommodation transactions, transfers of outlying timber acreage were made by SPLC only to governmental authorities (Federal, state, or local) or to utilities, under threat of condemnation.

The decision by the Land Department to withdraw the SPLC properties from sale (and also certain lands of the former Southern Pacific Company) was made to permit a study of whether such sales should continue Or whether a land management program should be commenced.

A preliminary study in 1949 determined that the SPLC timber holdings would benefit by a management program, In 1951, SPLC adopted such a program with respect to its timberlands in Northern California which called for limited cutting of timber on a sustained yield basis. Under this method, old and mature trees are permitted to be cut on a given section of land, but only to the extent they will be replaced by new trees.

The 1951 management Program was undertaken to conserve timber, to increase the productivity of the land, to generate income for SPLC from timber sales, and, indirectly to generate freight revenues for the former Southern Pacific Company. In order to implement this program, the Land Department employed photogrammetrists to conduct a timber survey and hired additional graduate foresters and experienced woodsmen.

During 1952, a further study was undertaken to determine the volume of timber on the SPLC lands and to estimate the allowable annual cut on a sustained yield basis. The study determined that it would take 30 years to achieve removal of all of the old and mature trees, and it was estimated that 64 million board feet could be cut each year (and would be replaced each year).

SPLC adopted this program of cutting timber on a sustained yield basis, and continued it through 1959, 1960, and 1961.

Annual timber sales were negotiated for the disposition of the allowable cut (i.e., 64 million board feet per year). These sales resulted in an annual harvesting program which was designed to average the calculated sustained production of the forest properties. The only reasons for exceeding allowable cut were fire damage, storm damage, insect damage, and other miscellaneous causes.

During the years at issue, SPLC held approximately 1,900,000 acres of outlying land in California. Of this land, over 700,000 acres were in the timber country of northern California. This timber acreage had been held essentially intact since 1949. Over half of the acreage was considered to contain merchantable timber of excellent to marginal quality.

During the years at issue, SPLC was operating in its first 30-year cutting cycle, in which over mature trees and trees in danger of death from insects and disease were to be cut. This 30-year period was established because the United States Forest Service was operating under a 30-year development program. Because of the checkerboard ownership pattern, ³ it was essential for road-planning purposes that SPLC cooperate with the Forest Service.

While the primary purpose of the timber program was the production of income, there were several long-term benefits that accrued from the annual harvesting activity. The harvesting served to regenerate the forest by stimulating growth in the remaining timber stand and it improved the general health of the stand by eliminating trees that were over mature, dying, and subject to insect attack. Fire hazard was reduced by the removal of dead trees.

During 1959, 1960, and 1961, a timber sale was commenced in the following manner: Discussions would be held between the chief forester and the district foresters regarding the most appropriate places to have a sale of timber. Relying on the district foresters' field knowledge of the property and information available from SPLC files, certain locations for timber sales were designated. Thereafter formal "assignment" letters were sent out to the district directors designating the areas within their districts where cutting contracts should be obtained.

Typically, in a year prior to entering into a contract of sale with a purchaser, SPLC's headquarters offices in San Francisco would have sent one or more "assignment" letters to its pertinent district, asking the district personnel to cruise and appraise timber on acreage described in the letter according to section, township, and range. This involved reconnaissance, line running, marking, cruising, and appraising, and the results of this activity were rendered in written reports referred to as "timber sale offerings." These written reports served as the basis for offering specific timber in specific areas and specific prices to customers. ⁴

The field reconnaissance conducted by the district personnel was rather extensive. They would go through an area for the purpose of gaining a general impression of the character of the timber, the topography, the roads, the stand conditions, the status of the section corners and the accessibility of the timber. Aside from its primary purpose of providing information relative to a sale, a reconnaissance also gave the district forester a knowledge of conditions in the area that would affect its future management, Following the field reconnaissance was line running, involving the surveying of boundary lines. No contracts entered into during the years in issue involved a requirement that the purchaser survey the boundaries of the sales area.

SPLC maintained maps for each township showing land ownership and survey information from SPLC sources and from outside sources like the United States Forest Service. Other maps showed what areas had been logged and remained to be logged. As a survey was made in preparation for timber sales, the year of the survey and the points determined by the survey were marked on the township maps.

The timber sale contracts described the land on which timber was to be cut by subdivision, section, township, and range. If property lines were not readily ascertainable from prior surveys, it was necessary at times for SPLC employees to perform extensive surveying to delineate the property boundaries involved in the contracts in order to avoid cutting timber upon adjacent lands. This involved locating the corner points of the original survey on the ground and either running lines between the corners or, where a sale involved an area well within a section, flagging a temporary cutting line. In addition to their use in a sales context, line running surveys were also useful in preventing trespass upon SPLC lands, in the granting of easements, and in the establishment of the number of productive acres available for purposes of management.

After the survey, the district forester and his assistant would go into the area in which the timber was to be offered for sale and mark with a paint stripe each tree that was to be cut. This marking was a time-consuming process, and it was limited only to those areas where there was a sale in the immediate offing. SPLC chose to be specific about the individual trees it would allow to be cut in order to prevent indiscriminate cutting by purchasers and to assure that the trees left after the cutting would be suitable for future sales of timber. Marking also gave the foresters control over the forest stand that would remain after logging for management purposes.

Thereafter, an employee would perform a timber cruise (i.e., an on-site examination of timberland) to determine the quantity and quality of the timber to be sold, From an examination of the number, size, species, and quality of the trees to be cut, he estimated the volume of timber on the tract to be cut. The information obtained from a timber cruise was included in a written report.

The report of the timber cruiser generally included data on the volume of trees by species and on the volume of trees anticipated to remain after the sale. It included a map showing existing and proposed roads, and it contained a description of the condition of the boundary references. Also generally contained in the report was information regarding (1) the quality and character of the timber by species, including defects and breakage, (2) the average number of logs per tree, including average diameters, (3) the fire damage to the timber, (4) the status of reproduction in the area, (5) the status of site and soil improvements, (6) the potential inclusion of other SPLC lands in the logging unit, (7) the nature of occupancy on the !and, (8) the status of water and minerals, and (9) the potential of the area for recreational use.

On most occasions, a cruise was conducted primarily to gain data pertinent to a sale of timber, although the acquisition of this data produced information which was useful in managing the !and. On some occasions, cruises were conducted solely for the purpose of reporting on everything within a given section of land. Such cruises, unrelated to timber sales, produced data that was used primarily for management purposes and the cost of such cruises is not included in the amounts in issue.

Appraising the timber to be cut was the final step of a district forester in response to the "assignment" letter. He calculated the sales prices by grade, using the Forest Service printed statement of price recovery and overrun percentages. The appraisal was very similar to that which the Forest Service used. ⁵

The district forester forwarded the foregoing information (including the report of the timber cruiser) with his letter of transmittal outlining his plan for the sale to the headquarters office. This information was used to prepare a sales offering.

While appraisals were prepared primarily as part of the contract process, they had incidental uses outside of a sales context. They were used to establish the value of timber at the time of a discovered trespass in collecting from the trespasser. They were used in connection with land condemnation cases. They were used in property tax matters.

Following the cruise and appraisal, the headquarters office would make a proposal to a purchaser. If the proposal was accepted, the contract would be prepared and would be submitted to the purchaser for signature. It would then be submitted to the SPLC board of directors and to the executive committee of the former Southern Pacific Company for approval. A copy of the contract was then forwarded to the district forester. He had the responsibility to see that its terms were complied with.

During the years at issue, employees of the Land Department and SPLC tried to negotiate the cutting contracts for a 1-year term but very often made them for a 2-year term (but never more than 2 years). Under extraordinary circumstances, a contract would be extended for another logging season. The usual purchasers of timber were operators who had established mills along the railroad and who, in prior years, had been customers for the purchase of timberland.

After the contract had been executed and the purchaser began cutting timber, employees scaled (i.e., measured the quantity of) the cut timber, determined the volume cut, and transmitted the log scale books and log scale journal sheets to the headquarters office. The hours spent scaling were reported when it was necessary to make a computation to determine if the purchaser was to pay the cost of the scaling.

Scaling records have value apart from their principal use in billing the purchaser. They are used in adjusting property tax records, in updating inventories, in checking on the efficiency and the quality of the cruise, and in checking on the efficiency of personnel.

The foresters exercised a great deal of control over the felling of timber by purchasers in order to prevent damage to the remaining stand in both the felling and yarding operations. Yarding is the process of moving fallen logs to the roadside. To control damage caused by yarding, the foresters would locate the skid trails of the hauling machinery and determine whether there was damage to the reserve stand, to young growth, or to the soil. If such damage existed, discussions would be held with the operator of the logging operation for the purpose of minimizing the damage.

After felling and yarding were completed, the purchaser was required to cut water bars or ditches across the skid trails to prevent erosion. In addition, slash disposal by the purchaser (i.e., the cutting of damaged young trees) was required in order to prevent insect buildup and to reduce the fire hazard.

During the years at issue, the forestry activities of reconnaissance tine running, marking, cruising, appraising, scaling, and inspection were engaged in primarily because of timber sales arising under the cutting contracts in question. While to some extent a portion of these activities served long-term management goals in addition to their immediate sales-related purpose, the forestry work, to a very substantial degree, would not have been required were it not for an actual or potential contract for sale of timber. The fulfillment of management goals was frequently fortuitous, an incidental benefit which flowed from activities that were necessary for preparing or carrying out specific sales contracts. Essentially, the above-de-scribed forestry activities were occasioned by and necessitated by the timber sales, and most of the forestry work at issue fulfilled only sales-related goals. Only a small portion of these activities was totally unrelated to the cutting contracts and served solely a management purpose.

It is stipulated that the SPLC timber sale contracts are predominantly cutting contracts to which section 631(b), I.R.C. 1954, applies. (This section is discussed in our opinion, infra.) The issue presently under discussion involves only such stumpage sale cutting contracts. ⁶

In the consolidated income tax returns filed by the former Southern Pacific Company and its affiliates for 1959, 1960, and 1961, SPLC reported the following amounts as timber "expenses of sale":

Year	Amount
1959	$133,487.89
1960	261,888.24
1961	68,524.61

The foregoing amounts include both (1) expenses incident to sales under cutting contracts to which section 631(b) applies, and (2) expenses not within the scope of section 631(b) (e.g., amounts paid to contractors to log timber for SPLC's own account, and costs of Christmas tree sales). The latter expenses are stipulated by the parties to be within the purview of section 631(a) and to be deductible as ordinary and necessary business expenses. The present issue involves a controversy only as to the expenses attributable to timber sales qualifying for treatment under section 631(b). The expenses attributed to section 63 l(a) and section 631(b) during the years at issue are as follows:

Year	Amount attributable to sec. 631(a) sales	Expenditures in controversy attributable to sec. 631(a) sales
1959	$ 67,969.47	$ 65,518.42
1960	237,231,96	24,656.28
1961	35,066.84	33,457.77

The gains from the sales under the cutting contracts at issue were reported as section 631 (b) capital gains on the tax returns, and the expenses incident to such sales were offset against these gains. ⁷

In the consolidated returns for the years at issue, SPLC reported the following as (1) total quantity of timber sold, expressed in thousands of board feet, (2) gross receipts from total timber sales, and (3) total quantity of timber sold under contracts qualifying for section 631(b) treatment, expressed in thousands of board feet:

Year	(1) Total Quantity	(2) Gross Receipts	(3) Sec. 631(a) Quantity
1959	90,683	$1,878,720.06	89,000.50
1960	31,181	877,217.16	47,181.18
1961	66,636	1,313,448.61	66,191.00

The amounts set out above under the heading "Expenditures in Controversy Attributable to Sec. 631(b) Sales" are stipulated by the parties to be the amounts at issue herein. To compute these amounts, the total quantity of timber (expressed in thousands of board feet) sold during 1959, 1960, and 1961 under section 63I(b) contracts was multiplied by a figure representing average cost (per thousand board feet of timber) during each year. The average cost figures which were used for the years at issue are as follows:

Year	Average cost per thousand board feet
1959	$0.71
1960	0.50
1961	0.50

The average cost for 1959 ($0.71 per thousand board feet of timber) was derived by totaling the daily salaries of the employees engaged in activities relating to the section 631(b) timber sales and by multiplying that figure by the estimated total days these employees spent engaged in the activities of cruising, appraising, marking, scaling, and inspection. The figure thus obtained was divided by the total quantity of board feet of timber scaled during 1959, In this manner, a cost of $0.71 per thousand board feet cut was calculated for that year ^{. 8}

The average cost for 1960 and 1961'($0.50 per thousand board feet of timber) was derived from the I959 computation above, except that work days relating to the inspection function were eliminated from the calculation ^{. 9}

The petition filed in this case claims, inter alia, an overpayment of tax due to "Commissioner' s failure to allow claims for deduction of costs of cruising, marking, and other expenses in connection with timber." In this regard, the petition states:

(1) For each of the taxable years ended December 31, 1959, 1960 and 1961, Southern Pacific Land Company incurred expenses in cruising and marking timber and other activity pertaining to its standing timber.

(2) In the consolidated returns for the taxable years ended December 3I, 1959, 1960 and 1961, Southern Pacific Land Company inadvertently treated the foregoing as expenses incident to sale of timber pursuant to cutting contracts and offset them against section 631(b) capital gains.

(3) On audit certain adjustments were made, but the Commissioner's agents erroneously continued to treat amounts of $65,518.42, $24,656,28, and $33,457.77 as such sales expenses to be offset against section 631(b) capital gains for the taxable years ended December 31, 1959, 1960 and 1961, respectively.

(4) The Commissioner has failed to allow claims by Southern Pacific Land Company for deduction of the foregoing amounts as ordinary and necessary business expenses for the taxable years ended December 31, 1959, 1960 and 1961.

Opinion

During the years 1959, 1960, and 1961, petitioner ¹⁰ received proceeds of sales under cutting contracts falling within the purview of section 631(b). That section, in the circumstances therein specified, provides for capital gains treatment of the proceeds from the disposal of timber of certain cutting contracts with a retained economic interest. ¹¹ See sec. 1.631-2(a)(2), Income Tax Regs. Also during 1959, 1960, and 1961, petitioner incurred expenses in the form of salaries for forestry work performed by its employees.

As a general rule, "ordinary and necessary expenses" of a taxpayer's business are deductible under section 162. However, even if related to a business, such expenses are treated as capital expenditures when they are incurred in the acquisition or disposition of a capital asset. Capital expenditures "are added to the basis of the capital asset with respect to which they are incurred, and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is sold." Woodward v. Commissioner [70-1 ustc ¶ 9348], 397 U.S. 572, 574-575 (1970).

Thus, if the forestry expenses at issue in the present case were incurred in connection With a timber transaction described in section 631(b) ¹² the provisions of section 162 will not apply. Instead, the expenses will be viewed either as additions to basis ¹³ or as selling expenses applied in reduction of the .amount realized on the sale. ¹⁴ Clearly, the expenses will not be currently deductible. Woodward v. Commissioner, supra. ¹⁵

Petitioner's position is that the forestry activities were not directly related to the sales of timber but were primarily directed at carrying out its timber management program, even though some of the activities may have had some incidental connection with the sales of timber. Accordingly, petitioner contends that the full amount of the salaries paid for forestry work is deductible against ordinary income as a section 162 business expense. Respondent's position is that the allocated expenses here involved are directly related to the sales of timber under section: 631(b) and must be offset against the price received for the timber, thus reducing the capital gain realized on the disposal of the timber.

Respondent's position herein follows the one taken by him in Revenue Ruling 71-334, 1971-2 C.B. 248, dealing with expenses directly related to timber disposals under section 631(b), and in Revenue Ruling. 58-266, 1958-1 C.B. 520, dealing with expenses directly related to disposals under the predecessor of section 63[(b), section 117(k)(2) of the 1939 Code. Both of these rulings conclude that direct expenditures are to be applied as offsets to the capital gains from such disposals.

Revenue Ruling 71-334 provides in part:

In connection with a disposal of timber, so as to produce the maximum income therefrom, the taxpayer expended certain amounts directly attributable to the disposal for:

(1) advertising the timber for disposal;

(2) cruising to determine the quantity and quality of timber to be disposed of;

(3) marking or otherwise designating the timber for cutting;

(4) marking seed trees to be retained;

(5) scaling, measuring, or otherwise determining the quantity of timber cut;

(6) fees paid to consulting foresters, selling agents, and others for services directly related to the timber disposal;

(7) supervising or checking performance under the contract; and

(8) other expenses directly attributable to the disposal.

* * *

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. [Citations omitted.] Since the selling expenses in a sale of a capital asset are considered in arriving at income subject to a capital gain tax, it is reasonable to give like consideration to direct expenses in connection with income from leases. * * *

* * * it is held that expenditures directly attributable to a disposal of timber subject to the provisions of section 631(b) of the Code are reductions of the "amount received" for the purpose of computing gain or loss from such disposal.