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Revenue Ruling 75-59, 1975-1 CB 177

REV-RUL, Basis for depletion of long-term timber contract., Rev. Rul. 75-59, 1975-1 CB 177, (Jan. 01, 1975)

Section 612.--Basis for Cost Depletion

26 CFR 1.612-1: Basis for allowance of cost depletion.
(Also Section 162; 1.162-1.)

[IRS Headnote] Basis for depletion of long-term timber contract.--
The fair market value of the tiber existing at the time of the execution of a long-term timber purchase contract constitutes the basis for depletion of the timber and payments in excess of the fair market value are consideration for the use of the land deductible as a business expense.

Advice has been requested as to the manner in which a taxpayer, a paper company, should treat the payments made under a long-term timber contract under the circumstances described below.

The contract entered into between the paper company and an owner of timberland provides that for the term of 60 years the owner agrees to "sell" and the paper company to "buy" all timber growing and to be grown upon the described tract of timberland. The paper company must pay for and may cut 4y cords of wood per year during the first ten years of the contract, and must pay for and may cut 8y cords of wood per year during the next ten years. During the remaining 40 years, quantities of annual growth of timber are to be estimated at specified intervals based on timber cruises. Over this period of 40 years, the company must make annual payments for 8y 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.

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.

During the term of the contract, the paper company is required 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 that the company will assume the ad valorem taxes, have the use of existing improvements, have the right to construct additional improvements, and have the right to the full beneficial possession of the surface to an extent not detrimental to timber growth.

According to the contract, title to the timber passes to the company as it is 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 the company is obligated to continue paying under the original schedule. In the event performance of any part of the agreement is prevented by specified factors beyond the control of the parties (including infestation of timber but not including fire), the company's obligation to pay is to be reduced in proportion to the extent and duration of such factors.

Rev. Rul. 62-81, 1962-1 C.B. 153, considers the question of treatment by the owner of the payments received under the type of contract in the instant case and holds that, for Federal income tax purposes, the contract accomplishes a sale of the timber existing at the time of the execution of the contract rather than a disposal of timber with a retained economic interest under section 631(b) of the Internal Revenue Code of 1954, and that payments under the contract in excess of the fair market value of the existing timber are not proceeds of sale of timber by the landowner but are consideration received for the use of the land by the paper company.

Where, in accordance with the contract, the landowner sells the existing timber and leases the land, the consideration paid by the purchaser is for the purchase of the same timber and the lease of the same land.

Accordingly, in the instant case, the amounts paid under the contract equal to the fair market value of the timber existing at the time of the execution of the contract are capital costs of timber to the purchaser, recoverable through allowance for depletion as the trees are cut, or as adjusted basis of the standing trees in the case of sale, exchange, or other disposition. Any excess of such payments over the fair market value of the timber existing at the time of the execution of the contract is consideration for the use of the land and is deductible under section 162(a) of the Code.