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Rev. Rul. 78-104, 1978-1 CB 194

REV-RUL, Timber cutting contract; payment for failure to cut., Rev. Rul. 78-104, 1978-1 CB 194, (Jan. 01, 1978)

Section 631.--Gain or Loss in the Case of Timber, Coal, or Domestic Iron Ore

26 CFR 1.631-2: Gain or loss upon the disposal of timber under cutting contract.

[IRS Headnote] Timber cutting contract; payment for failure to cut.--
Amounts received under a timber cutting contract for cut timber, the quantity of which is based upon a "cruise" rather than scaling, qualifies for treatment under section 631(b) of the Code. A penalty payment received for failure to cut the "cruised" or marked trees during the term of the contract is ordinary income.

Advice has been requested whether, under the circumstances described below, the amounts received under a timber cutting contract will qualify for treatment under the provisions of section 631(b) of the Internal Revenue Code of 1954.

W is the fee owner of several thousand acres of timberland. W had owned the timberland for more than 1 year when it decided to dispose of selected timber growing on a portion of its timberland.

W marked each tree with paint that was to be included under the contract. At the time each tree was marked it was measured (cruised) to determine the number of merchantable units of timber in the tree. The right to cut the marked timber was offered for sale. X, an unrelated corporation, and W entered into a contract under the terms of which W agrees to sell only the marked timber and X agrees to purchase and cut only the marked timber located on a certain described tract of land. The term of the contract is 1 year. W retains title to all timber included under the contract until the timber is severed. Title then passes to X. W is responsible for any loss or damage to the marked timber prior to severance unless the loss or damage is caused by X.

The terms of the contract do not require X to scale (measure) the logs cut from the timber to determine the quantity of timber cut as is the usual procedure in the timber industry. Instead the contract provides that if all the marked trees are cut, the cruised quantity of timber must be paid for by X. The contract also specifies the quantity of hardwood and softwood (as determined by the cruise), the price per unit of hardwood and softwood, and the total consideration to be paid if all the marked timber is cut.

If only part of the timber has been cut when the 1 year term of the contract expires, a forestry consultant designated in the contract will measure (cruise) the uncut marked trees to determine the quantity of uncut hardwood and softwood timber remaining. These quantities will be subtracted from the originally measured (cruised) total quantities of hardwood and softwood timber and the difference will establish the quantities of timber cut. The quantities of hardwood and softwood cut multiplied by their respective unit rates will determine the amount to be paid by X for timber cut.

The contract also provides that X must pay a penalty of 1/3 of the bid rate multiplied by the quantities, if any, of marked hardwood and softwood left uncut when the contract term expires.

Section 631(b) of the Code provides that in the case of the disposal of timber held for more than 9 months for taxable years beginning in 1977, or for more than 12 months for taxable years beginning after December 31, 1977, by the owner thereof under any form or type of contract by virtue of which such owner retains an economic interest in such timber, the difference between the amount realized from the disposal of such timber and the adjusted depletion basis thereof, shall be considered as though it were a gain or loss, as the case may be, on the sale of such timber.

Section 1.611-1(b)(1) of the Income Tax Regulations provides that an economic interest is possessed in every case in which the taxpayer has acquired, by investment, any interest in standing timber and secures, by any form of legal relationship, income derived from the severance of the timber, to which he must look for a return of his capital.

Rev. Rul. 61-56, 1961-1 C.B. 243, holds that an actual disposal of timber, under the facts described, would qualify for treatment under section 631(b) of the Code. However, in the event of the grantee's default by reason of which the grantor would receive payment of an amount under the cash performance bond, such amount would not constitute payment for the disposal of timber and would be taxable as ordinary income to the grantor.

Under the terms of the contract, W, the owner of timber, gives X the right to enter on the described lands to cut and remove only certain specified timber from those lands. X is required to pay X, at bid rates, for the cruised quantity of timber if such timber is cut. If all the marked timber is not cut, the uncut marked timber is cruised and X must pay the bid rates only for the difference between the cruised quantity listed in the contract and the cruised quantity of uncut marked timber.

If all the marked timber is not cut by the contract termination date, X is also required to pay an amount determined by multiplying the cruised quantity of marked uncut timber by 1/3 of the bid rate for timber. Therefore that amount is not attributable to the disposal of the timber, but is a form of damages. Any amount so received is not for timber cut. See Rev. Rul. 61-56.

Because the amount received by W for timber is dependent solely upon the quantity of timber cut, W has retained an economic interest in the timber in accordance with section 1.611-1(b)(1) of the regulations. W is the owner of the timber, as the term "owner" is defined in section 1.631-2(e)(2), and has held the timber for more than the requisite holding period provided in section 631(b) of the Code.

In this instance the marked timber has little defect, each tree is cruised when marked, the term of the contract is only one year and the transaction is between unrelated parties. Under these conditions the cruise is considered to be an accurate determination of the quantity of timber cut and paid for by X for Federal income tax purposes. The fact that the quantity of timber cut is determined by a cruise, rather than by scaling, has no bearing on whether W has retained an economic interest in the timber included under the contract.

Accordingly, amounts received by W as payment for timber cut under the terms of the contract qualify for treatment under section 631(b) of the Code. Any amount received by W as a penalty for X's failure to cut marked timber is ordinary income and does not qualify for treatment under section 631(b).