Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA
The federal tax rules that apply to timber growth and harvesting are, in many respects, counterintuitive to almost every “rule of thumb” related to the Internal Revenue Code. Timber is its own, special category of activity. It is separate from other ordinary trades or businesses selling stock in trade and the general farming tax rules. Its treatment is even different from the general tax principles that apply to other natural resources.
Special timber rules are contained in Sec. 631, which applies generally to gain or loss from timber, coal, or domestic iron ore. Specifically, under Sec. 631(b), gains or losses from the sale of standing timber shall, solely for purposes of determining character of income, be considered gains and/or losses from the sale of business use property as defined in Sec. 1231 (i.e., capital gain property used in a trade or business), as long as the taxpayer held the standing timber for more than one year. Basically, sales of standing timber with a short-term holding period (one year or less) are considered ordinary trade or business or royalty income, or short-term capital gain, but gains on timber sales with a long-term holding period are allowed favored capital gains rates, while losses are deemed ordinary.
Corporations, Individuals, and Tax-Exempt Entities
C corporations: The distinction between ordinary income or loss and capital gain or loss does not benefit all taxpayers. The most glaring example is a C corporation, which does not receive different treatment between ordinary income or loss or capital gain or loss (although some benefits may lie in losses being Sec. 1231 losses rather than Sec. 1221 losses, this is outside the scope of this item). Generally, regular, domestic C corporations are indifferent as to whether Sec. 631(b) applies to timber sales, since no lower tax rate applies to capital gains.
Individuals: Individuals who hold timber for use in a business, including U.S. citizens or residents and nonresident aliens, however, receive a definite benefit. If they were dealing in almost any other raw material, the longer holding period would most likely not change the view under the Code that the raw material is “inventory,” and thus is not an investment—thus, any income derived from the sale of this “inventory” would be ordinary trade or business income of a dealer in stock or trade. Given the favorable rules under Sec. 631(b), however, individuals enjoy the good result of long-term capital gains rates (maximum of 20% for 2013 forward under current tax law plus a 3.8% net investment income tax, if applicable, under Sec. 1411), and also ordinary loss treatment if their overall Sec. 1231 position is negative.
Note that Sec. 631(b) does not apply to (1) the sale of the underlying land, or portion thereof, or (2) to the sale of felled timber after cutting, since felled timber is no longer considered “standing,” or attached to the land. Also note that under Sec. 631(a) the owner can elect to treat the cutting of timber as a sale or exchange of the timber in the year it is cut, even though the timber is not actually sold in that year.
Tax-exempt entities: Since they are not subject to income tax for income from activities related to their exempt function, tax-exempt entities would seem indifferent to the benefits of Sec. 631(b). Any tax-exempt entity whose exempt purpose is to benefit forest preservation or the like would not care whether Sec. 1231 treatment applied.
However, most tax-exempt entities, in particular retirement plans, do not have as their exempt purpose the preservation of U.S. forestlands. Therefore, without Sec. 631(b), any income from the sale of timber from an investment made by a U.S. tax-exempt retirement plan would potentially be unrelated business taxable income (UBTI) and thus be subject to the putative unrelated business income tax (UBIT) of Secs. 511–514.
By classifying sales of timber as “capital” under Sec. 1231 via Sec. 631(b), these tax-exempt entities are able to reclassify timber gains from “ordinary trade or business income” to “investment income,” which is not included in the tax base for UBTI, and thus these gains escape current federal income taxation altogether, an even better result for their stakeholders. However, tax-exempt entities should exercise additional care when the timber investment is leveraged, since the Sec. 514 rules on debt-financed property and acquisition indebtedness may limit the exemption of this income from UBTI.
Effect on Foreign Investors
In general, the rules of Sec. 631(b) are relatively easy to translate for foreign corporations filing in the United States, as well as nonresident alien individual filers in the United States, whether they are directly investing in U.S. timber or investing through a U.S. conduit.
As with domestic C corporations, foreign corporations that file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, generally do not receive any benefit from the Sec. 1231 treatment of timber sales as long-term capital gains for federal income tax purposes. (However, care should be taken when evaluating the potential for additional Sec. 884 branch profits tax.)
Nonresident alien filers who are direct owners of the timber that is sold generally enjoy the same capital gain and loss benefits as U.S. citizens or resident alien individuals. (However, Sec. 1445, which requires the purchaser of real property in the United States to withhold tax on the sale proceeds when the property is purchased from a foreign person, may apply.)
Nonresident alien filers who are indirect owners of the timber through a partnership (whether domestic or foreign) also generally enjoy the same capital gain and loss benefits as U.S. citizens or resident alien individuals. (Note, however, that Sec. 1446 requires a partnership to withhold tax on a nonresident alien partner’s effectively connected income.)
Nonresident alien filers who are indirect owners of the timber through a C corporation (whether domestic or foreign) do not enjoy the same capital gain and loss benefits as U.S. citizens or resident alien individuals, as the corporation is taxed on the gains at the corporate level. In addition to the C corporation tax burden, Sec. 1441 income tax withholding (or a lower treaty amount) will likely be assessed on the corporation on behalf of its nonresident alien shareholders on dividends paid.
For foreign entities that are not considered C corporations under subchapter C, or are not considered partnerships under subchapter K, such as foreign pension funds, life insurance company common trust funds, and the like, the guidance is much less clear. In general, one must evaluate what the entity’s default entity classification would be if it had a U.S. federal tax return filing requirement. For most non-U.S.-based retirement plans, the default classification is as a C corporation. However, great care and research may be required, as there are several exceptions to this general rule in the Code (e.g., in the case of pension plans for the benefit of foreign sovereign employees) or contained within the income tax treaties between the United States and the contracting state.
Given the overwhelming tax benefit of timber investments, the majority of investors in timber funds over the last couple of decades have been U.S. retirement plans, life insurer common trust funds, and U.S. citizens. However, a minority of investors have traditionally been foreign nationals, mostly German, because of the relatively low cost of U.S. timber and the preferential U.S.-Germany income tax treaty benefits for immovable property income.
Because the European Union is now more focused on green and non-nuclear energy sources, there is more interest from European investors in U.S. timber, which makes understanding these somewhat complicated U.S. tax rules all the more important for the tax practitioner. This will help the tax practitioner not only understand the compliance aspects of tax reporting and payment depending on the type of taxpayer the investor is or what treaty benefits it may enjoy, but also enables the practitioner, as a trusted adviser, to assist clients here in the United States that manage the timber assets in understanding how the changing global climate in timber needs affects the returns they should expect for their services and property.
Michael Koppel is with Gray, Gray & Gray LLP, in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.