IRS has published new guidance for its examiners on auditing of timber casualty losses, characterized by IRS as a “significant compliance risk” in an earlier Field Directive. The guidance consists of a new Audit Techniques Guide (ATG) providing IRS examiners with the tools they need to audit returns showing timber casualty losses.
Background. A deduction for a casualty loss incurred in a trade or business or a transaction entered into for profit generally can't exceed the lesser of (1) the reduction in the property's value, or (2) its adjusted basis. However, if the property is totally destroyed and its fair market value before the casualty is less than its adjusted basis, the full adjusted basis is deductible. (Reg. §1.165-7(b)(1)) A business or investment casualty loss must be determined by reference to the “single identifiable property” (SIP) damaged or destroyed. (Reg. §1.165-7(b)(2)(i))
IRS's original rulings position was that the SIP damaged or destroyed by casualty is the quantity of timber—the units (board feet, log scale, cords, or other units) of wood in standing trees that are available and suitable for exploitation and use by forest industries—rendered unfit for use by casualty. The SIP was the quantity of timber destroyed by the casualty and a casualty loss was triggered only by total destruction of the timber. However, following several contrary court decisions, IRS, in Rev Rul 99-56, 1999-51 IRB, revoked the earlier rulings, held that the SIP was the entire depletion block, and acknowledged that partial damage may be sufficient for claiming a casualty loss.
In general, a “depletion block” is an account for timber basis that may be defined as an operational unit or a logging unit, or may be established by geographical or political boundaries or logical management areas. Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value (of the SIP) or the adjusted basis (of the SIP).
Illustration: Corp A has a 200,000-acre block of timber with a fair market value of $300 million and a basis of $10 million. The block is the area into which it aggregated its timber for depletion purposes, i.e., its depletion block. A storm destroys 20% of the trees, and the block's fair market value is reduced to $240 million. Under Rev Rul 99-56, Corp A may claim a casualty loss deduction equal to its entire $10 million basis in the timber, even though 80% of the trees in the timber block are undamaged.
An earlier Field Directive on timber casualty losses provides a simplified method for “assessing whether IRS resource allocation is feasible when determining the issue of timber casualty losses.”
To “effectively utilize” IRS resources in the classification and examination of a forestry industry taxpayer, the Field Directive provides a simplified method for “assessing whether IRS resource allocation is feasible when determining the issue of timber casualty losses.” When reviewing the taxpayer data, if the values claimed by a taxpayer are less than the values computed under these simplified method, “resources would not need to be expended” (i.e., IRS will allow the claimed loss). The simplified method includes an adjustment related to size of the timber block, that is, any allowable loss is reduced if the block size is 100,000 acres or more.
New timber ATG. The new Timber Casualty Loss ATG provides IRS examiners with the tools they need to audit returns showing timber casualty losses. It summarizes the following consequences associated with using a depletion block as the SIP:
(1) It permits the “borrowing of basis” from non-damaged units within the block (see illustration above), but at a price, namely that both the basis limit and the loss in value must be determined with reference to the same property unit. Thus, the selection of the depletion block as the SIP means that the valuation requirement changes from a valuation of damaged timber units (cords, board feet), which is fairly easy to determine, to a valuation of the entire depletion block, which could potentially include hundreds of thousands of acres and is difficult to value.
(2) Valuing a depletion block may be prohibitively expensive and, as a result, taxpayers often use a variety of short-cut techniques which are often flawed.
(3) The larger the depletion block (SIP), the more the taxpayer is able to “borrow basis,” but the less the damaged volume contributes to the value of the property unit as a whole. Thus, small volume losses, as part of a large SIP, may reflect little or no loss in overall value when the required “before and after” valuation is properly performed.
(4) The depletion block size may not be accurate and may have been “re-engineered” to take advantage of the simplified method in the Field Directive (discussed above). If the examiner determines that the taxpayer's blocks should be disregarded, the examiner should determine the taxpayer's correct blocks with respect to the most appropriate divisions. This determination should take into account the historical timber accounting records, as well as the geographic and political boundaries and any blocks that the taxpayer has customarily used for management purposes.
(5) Declining timber markets, such as those experienced since 2000, may adversely impact a taxpayer's ability to recover basis and put pressure on improper (excessive) valuations. For example, if a timber property were acquired in '99 (at peak prices) and experienced a casualty event in 2002, when timber values were at depressed levels, the aggregate basis of the property may be significantly higher than its value, particularly if the property were valued as a unitary whole (in a depressed market). Thus, there is more tax incentive to inflate values to recover more of the basis.
The ATG carries a detailed discussion of various timber valuation method, provides detailed examples, and cautions examiners to, among other things, look out for improper valuation methods, failure to document tax basis, inflation in the diminution in fair market value on account of the timber loss, and mistaken aggregation of the basis of the land (which is not allowable in computing a timber loss deduction) with the basis of the timber. It also tells examiners to determine whether the taxpayer has conducted a salvage of the damaged timber, or is attempting to claim a nondeductible loss from diseases or insects (only losses from fire, storm, hurricane, etc., qualify).
References: For single identifiable property for casualty loss purposes, see FTC 2d/FIN ¶M-1827; United States Tax Reporter ¶1654.304; TaxDesk ¶368,025; TG ¶16961.