SERVICE HOLDS THAT LUMBER COMPANY ELECTING TO TREAT CUT TIMBER AS SALE OR EXCHANGE MAY NOT USE LIFO METHOD TO COMPUTE GAINS OR LOSSES

Rev. Rul. 86-152

ISSUE

Can a taxpayer that has elected to treat the cutting of timber as a sale or exchange under section 631(a) of the Internal Revenue Code use a last-in, first-out (LIFO) inventory identification method in arriving at the adjusted basis of the timber for purposes of computing gain or loss when the timber is cut?

FACTS

The taxpayer, a domestic corporation, owns timber lands from which substantial quantities of timber are cut each year for use in its manufacturing operations. The taxpayer elected to treat the cutting of timber as a sale or exchange under section 631(a) of the Code.

The taxpayer operates on a 35 year cutting cycle. After it cuts a tract of timber, taxpayer reforests that tract and does no further cutting there for 35 years. In 1985, the taxpayer cut timber it had planted on 9x acres in 1950. On its federal income tax return filed for 1985, the taxpayer reported the cutting as a sale or exxhange under section 631(a) of the Code. The "seetion 1231 gain" reported on the cutting was computed by subtracting the taxpayer's adjusted depletion basis for the timber from the fair market value of the timber on the first day of the taxpayer's 1985 tax year. The taxpayer determined its adjusted basis for depletion for the timber, under the LIFO method, by using its cost for the planting of 9x acres of timber that was added to this merchantable timber account in 1985.

LAW AND ANALYSIS

Section 1.631-1(d)(1) of the Income Tax Regulations provides that if the cutting of timber is considered as a sale or exchange pursuant to an election made under section 631(a) of the Code, gain or loss shall be recognized to the taxpayer in an amount equal to the difference between the adjusted basis for depletion in the hands of the taxpayer of the timber that has been cut during the tax year and the fair market value of such timber as of the first day of the tax year in which such timber is cut. The adjusted basis for depletion of the cut timber shall be based upon the number of units (feet board measure, log scale, or other units) of timber cut during the tax year that are considered to be sold or exchanged and upon the depletion unit of timber in the timber account or accounts pertaining to the timber cut, and shall be computed in the same manner as is provided in section 611 and the regulations thereunder with respect to the computation of the allowance for depletion.

Section 1.631-1(d)(3) of the regulations provides that the fair market value as of the beginning of the tax year of the standing timber cut during the year shall be considered to be the cost of such timber, in lieu, of the actual cost or other basis of such timber, for all purposes for which such cost is a necessary factor.

Section 1.631-1(d)(4) of the regulations provides that for any tax year for which the cutting of timber is considered to be a sale or exchange of such timber under section 631(a) of the Code, the timber so cut shall be considered as property used in the trade or business for purposes of section 1241, along with other property of the taxpayer used in the trade or business as defined in section 1231(b), regardless of whether such timber is property of a kind that would properly be includible in the inventory of the taxpayer if on hand at the close of the tax year or properly held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.

Section 1.611-3(b)(3) of the regulations provides that when a taxpayer has elected to treat the cutting of timber as a sale or exchange of such timber under the provisions of section 631(a) of the Code, the taxpayer shall reduce the timber account containing such timber by an amount equal to the adjusted depletion basis of such timber.

Section 1.611-3(c)(1) of the regulations provides that every taxpayer claiming or expecting to claim a deduction for depletion of timber property shall keep accurate ledger accounts in which shall be recorded the cost or other basis provided by section 1012 of the Code of the property and land together with subsequent allowable capital additions in each account and all other adjustments provided by section 1016 and the regulations thereunder.

Section 1.611-3(c)(2) of the regulations provides that the timber accounts shall be credited each year with the amount of the charges to the depletion account computed in accordance with paragraph (b) of this section.

Section 1.611-3(b)(2) of the regulations sets forth the manner in which the depletion unit of the timber for a given timber account in a given year is to be computed. The depletion unit of the timber for a given timber account in a given year shall be the quotient obtained by dividing (i) the basis provided by section 1012 of the Code and adjusted as provided by section 1016, of the timber on hand at the beginning of the year plus the cost of the number of units acquired during the year plus proper additions to capital, by (ii) the total number of units of timber on hand in the given account at the beginning of the year plus the number of units acquired during the year plus (or minus) the number of units required to be added (or deducted) by way of correcting the estimate of the number of units remaining available in the account.

Section 1012 of the Code provides that the basis of property is its cost. Section 1.1012-1(a) of the regulations provides that cost is the amount paid for property in cash or other property.

Section 1016 of the Code provides for an adjustment to basis for the amount of depletion allowed as a deduction in computing taxable income.

Section 471 of the Code provides that whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by the taxpayer on such basis as the Secretary may prescribe as conforming as nearly as possible to the best accounting practice in the trade or business and as most clearly reflecting the income of such business or trade.

Section 472(a) of the Code provides that a taxpayer may use the LIFO method in inventorying goods.

Section 1.472-2(e)(8)(x) of the regulations provides, among other examples not pertinent here, that the use of actual cost of cut timber or the cost determined under section 631(a) of the Code is neither inconsistent with the inventory method referred to in section 1.472-1 nor at variance with the requirements of section 1.472-2(c). Section 1.472-2(e)(8)(x) further provides that under section 1.472-2(e)(1)(vi) either of these costing methods may be used to ascertain income, profit, or loss for credit purposes or for purposes of financial reports regardless of whether such method is also used by the taxpayer for federal income tax purposes.

The use of the LIFO method in computing the taxpayer's adjusted depletion basis under section 631(a) of the Code is incompatible with the requirements of section 1.611-3 of the regulations. Under the LIFO concept the latest cost incurred in acquiring timber added to the merchantable timber account would be applied against the timber being cut during the year. Sections 1.611-3(b)(2) and 1.611-3(c) require specific identification of the cost or other basis of each unit of timber under section 1012 and the adjustment to this basis of each unit under section 1016 for depletion.

When a section 631(a) election is in effect two realization events occur with respect to the timber. First, the deemed sale or exchange upon the cutting of th timber results in a section 1231 gain to the taxpayer to the extent the fair market value of the timber cut exceeds the actual basis of the timber cut, which basis is a cost basis with adjustments to reflect depletion and capital additions as required under section 1016 of the Code. The fair market value, as of the beginning of the tax year in which the standing timber is cut, becomes the cost basis of such timber. See section 1.631-1(d)(3) of the regulations. The second realization event occurs when the cut timber product is carried in inventory by the taxpayer and subsequently sold. Section 1.631-1(e)(2) states that the fact that the fair market value as of the first day of the tax year in which the timber is cut is deemed to be the cost of such timber shall not preclude the taxpayer from computing its inventories upon the basis of cost or market, whichever is lower, if such method is used by the taxpayer. Nor shall it preclude the taxpayer from computing it inventories under the LIFO inventory method. [sic]

Rev. Rul. 60-244, 1960-2 C.B. 167, holds that a taxpayer who eeects to treat the cutting of timber as sale or exchange under section 631(a) of the Code and adopts the LIFO method under section 472, may use, in financial statements to shareholders and for credit purposes, an inventory reserve reflecting the difference between the fair market value of the timber cut and the adjusted cost basis of such timber, determined without reference to such fair market value. See also section 1.472-2(e)(8)(x) of the regulations. The references to the use of the LIFO inventory method in Rev. Rul. 60-244 and section 1.472-2(e)(8)(x) are made with respect to the inventory valuation of cut timber subsequent to the section 631(a) computation. Rev. Rul. 60-244 and section 1.472-2(e)(8)(x) do not sanction use of the LIFO method in arriving at the adjusted depletion basis of the timber.

HOLDING

The taxpayer cannot use a LIFO inventory identification method in arriving at the adjusted depletion basis of timber for the purpose of computing the gain or loss when timber is cut and treated as a sale or exchange under section 631(a) of the Code.

Any change in the taxpayer's method of accounting to conform with the conclusion of this revenue ruling is a change in method of accounting to which the provisions of section 446 and 481 of the Code apply.

This ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84-74, 1984-2 C.B. 736.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 60-244 is clarified.