Tax Court Expands Sec. 1033's Scope

The Tax Court ruled in Willamette Industries, 118 TC No. 7 (2002), that Willamette could use Sec. 1033's involuntary-conversion provisions to defer gain on damaged property, even though Willamette processed and sold the property in the same manner as undamaged property. The court also allowed the taxpayer to defer the gain, even though it was almost as large as it would have been if the property had not been damaged. This ruling provides more options for taxpayers with partially damaged involuntarily converted property.

Sec. 1033(a) provides that "if property (as a result of its destruction in whole or in part) is compulsorily or involuntarily converted," any gain would not be recognized if the property were converted into money used to purchase replacement similar property. Thus, Sec. 1033 allows a taxpayer to postpone gain recognition until it sells the replacement property. In Rev. Rul. 72-372, the Service denied involuntary-conversion treatment when an uninsured taxpayer sold trees damaged in a hurricane, even though the trees would have decayed or been destroyed by insects if not sold. The IRS pointed out that there was no direct conversion into money (as typically occurs when damages or insurance proceeds are paid).

However, in Rev. Rul. 80-175, which also involved the sale of trees damaged in a hurricane, the Service revoked Rev. Rul. 72-372. It concluded that the taxpayers satisfied Sec. 1033's requirements, which was to allow them to postpone recognizing gain when compelled to dispose of involuntarily converted property. Therefore, Rev. Rul. 80-175 eliminated the requirement that the taxpayer convert the damaged property directly into cash. Citing Masser, 30 TC 741 (1958), Rev. Rul. 80-175 held that the conversion event must render the property "unfit or impractical for its intended use." The IRS distinguished Willis, 41 TC 468 (1964), in which the Tax Court denied involuntary-conversion treatment, because the damaged property (a ship) was repairable, which made its sale voluntary.

In Willamette Industries, an Oregon corporation grew and processed trees into lumber, plywood and paper products. In 1992–1995, wind, ice storms, wildfires and insect infestations damaged some of Willamette's crop. To avoid further loss from insects and decay, Willamette salvaged the damaged trees and cut them into logs. It processed the logs into wood and paper products, instead of selling the damaged trees or the logs to third parties. Therefore, except for being processed prior to reaching maturity, the damaged trees were treated the same as Willamette's healthy trees.

Willamette realized gain from the damaged trees when it sold the products processed from them. It sought to defer the gain accrued up to the time of damage under Sec. 1033. Willamette's calculation of gain indicated that the normal processing subsequent to harvest added relatively little gain to the gain already accrued when the trees were damaged. Willamette's average deferred gain per year from the damaged trees for 1992–1995 was $2.8 million. Although not addressed in this proceeding, the qualifying replacement property was presumably young trees, which would result in gain deferral for several years until their maturation, processing and sale.

The Service disallowed the gain deferral under Sec. 1033, arguing that Willamette's conversion was not involuntary, because it processed the damaged trees into end products in the ordinary course of its business. Also, Sec. 1033 is a relief provision, not intended for this type of situation. Willamette argued that the conversion was involuntary because the trees were not scheduled for harvest when damaged. Also, it was compelled to dispose of the trees by selling or processing them to avoid further loss. Willamette concluded that this choice did not change the disposition's involuntary nature.

The Tax Court ruled that Willamette could use Sec. 1033 to defer the gain on the sale of the trees because it was forced to sell them earlier than intended due to the involuntary conversion events. The deferred gain is the trees' value when damaged, less their basis. Sec. 1033 does not require taxpayers to derive deferred gain in a particular manner; therefore, sales with or without further processing qualify. Also, Sec. 1033 does not set a quantitative threshold on the amount of damage to a taxpayer's property. Therefore, the Tax Court ruled that Sec. 1033 would apply even if the damage produces a substantial deferred gain involving only a small reduction from the gain that would have been realized without the involuntary-conversion event.

Finally, the Tax Court pointed out that the IRS's position would allow Sec. 1033 to apply (following Rev. Rul. 80-175) if Willamette had sold the damaged trees and the buyer had further processed them into lumber or paper products. Therefore, Willamette should be allowed to do so. The court concluded that Sec. 1033 is a relief provision, requiring liberal interpretation to achieve its purpose.

Willamette Industries extends Sec. 1033's scope. It will typically apply when an act of nature or vandalism partially damages a taxpayer's uninsured property, provided that repairing the property will not be possible, given the taxpayer's intended use of the property. Willamette Industries gives taxpayers other options to dispose of involuntarily converted property besides a more traditional sale. The Service expressed concern about the effect this decision will have on the administration of Sec. 1033; therefore, it will probably appeal.

From Peter Barton, MBA, CPA, J.D., Professor of Accounting, and Roy C. Weatherwax, Professor of Ac-counting, University of Wisconsin-Whitewater, Whitewater, WI (Neither affiliated with KPMG LLP)