Spreading Income

The substantial and unusual increase in income, which may occur when timber is sold, may put you in a higher tax bracket.  Tree farmers are forced into such situations by the nature of the timber growing process, not by choice.  Historically, the policy has been to provide relief from jumps in marginal tax rates if the income level for that one year is not representative of your normal income level.  Congress felt that income averaging was no longer necessary because of the reduction in the number of tax brackets.  Thus, income averaging was eliminated in 1986.  It is no longer possible to spread the tax liability without spreading receipt of the income over more than one tax year, or over more than one taxpayer.

The Taxpayer Relief Act of 1997 restored income averaging for farmers.  The growing of timber does not qualify as farming for purposes of this provision.

It is necessary to consider spreading income only if the additional income would put you in a higher tax bracket, or if the gain in a later year could be used to offset losses.  Given current taxable income, how much additional income can you receive before entering a higher tax bracket?  This will depend on how you file.

The capital gains tax rate is determined by the length of the holding period and whether you are in the 15%, or 28% or higher tax brackets for ordinary income.  The capital gains rate increases from 10% to 20% when you go from the 15%, to the 28% or higher ordinary income bracket.  Your ordinary income bracket is determined before adding in your net long-term capital gain.  Thus, its not the spreading of timber income, but controlling your ordinary income that might keep your capital gains rate from increasing.   For more information on the new capital gains rates click here.

When deciding whether or not to spread income you should consider the opportunity cost of not receiving the entire amount immediately.  What would the interest earnings on the deferred payments be if placed at interest?  Would you have to borrow funds to meet your needs while waiting for the payments?  If so, what would it cost (interest rate) you to borrow the additional funds.  These "opportunity costs" need to be compared to the tax savings before making a final decision.

The following tables (2004 rates) show the different ways to file, the breakdown of the marginal rate based on your taxable income (ordinary income), and the bracket width. The bracket width shows the maximum increase in ordinary income needed to go from one bracket to the next highest.

Single Taxpayer			Married Filing Jointly and Surviving Spouse
Taxable Income($)	Bracket Width($)	Marginal Rate (%)	Taxable Income($)	Bracket Width($)	Marginal Rate (%)
0 - 7,150	7,150	10.0	0 - 14,300	14,300	10.0
7,150 - 29,050	21,900	15.0	14,300 - 58,100	43,800	15.0
29,050 - 70,350	41,300	25.0	58,100 - 117,250	59,150	25.0
70,350 - 146,750	76,400	28.0	117,250 - 178,650	61,400	28.0
146,750 - 319,100	172,350	33.0	178,650 - 319,100	140,450	33.0
Over 319,100	unlimited	35.0	Over 319,100	unlimited	35.0

 

Married Filing Separately			Head of Household
Taxable Income($)	Bracket Width($)	Marginal Rate (%)	Taxable Income($)	Bracket Width($)	Marginal Rate (%)
0 - 7,150	7,150	10.0	0 - 10,200	10,200	10.0
7,150 - 29,050	21,900	15.0	10,200 - 38,900	28,700	15.0
29,050 - 58,625	29,575	25.0	38,900 - 100,500	61,600	25.0
58,625 - 89,325	30,700	28.0	100,500 - 162,700	62,200	28.0
89,325 - 159,550	70,225	33.0	162,700 - 319,100	156,400	33.0
Over 159,550	unlimited	35.0	Over 319,100	unlimited	35.0

 

Estates and Non-Grantor Trusts (2003 Rates)
Taxable Income($)	Bracket Width($)	Marginal Rate (%)
0 - 1,900	1,900	15.0
1,900 - 4,500	2,600	25.0
4,500 - 6,850	2,350	28.0
6,850 - 9,350	2,500	33.0
Over 9,350	unlimited	35.0

Installment Sale

An installment sale occurs whenever property is sold and at least one payment is received in a tax year subsequent to the year of the sale.  If you elect not have the installment sale rules apply the entire gain is included in gross income for the year of the sale.  Tax on the entire gain will be due, even though all of the payments have not been received.

Taxpayers who are not dealers in the particular type of property but who make casual sales of property must recognize income from the sale by using the installment method, unless they elect to recognize the entire gain in the year of the sale.  The installment method is based on the wherewithal-to-pay concept and recognizes income proportionally as the selling price is receives.  For further information see IRS Pub. 537, Installment Sales.

These rules apply to sales of real estate and casual sales of personal property.   Any outstanding debt on the sale (deferred payments) must be owed to the seller, not a third party such as a bank.  Guaranteeing the deferred payments with an escrow account will result in the gain being fully taxable in the year of the sale unless there is a substantial restriction on the escrow account.

The installment sale provisions are used by filing Form 6252, "Installment Sales" in the year of the sale and each year a payment is received.  Taxable gain each year is determined by multiplying the total payments received during the year by the "gross profit percentage."  The gross profit percentage is the gross profit to be realized from the sale expressed as a percentage of the total contract price.

The gross profit percentage is figured by taking the:

contract price,

less

allowable basis.

less

selling expenses,

This gives you the "gross profit"

The gross profit percentage = "gross profit" / contract price

Unstated interest rules - The unstated interest rules penalize sellers who accept deferred payments without requiring the buyer to pay reasonable interest for the privilege of deferring the payments.  These provisions were enacted under the assumption that a buyer is willing to pay more for an asset if they don't have to pay for it all at once.  Therefore, if a contract doesn't provide for the payment of interest on deferred payments the higher selling price results in the receipt by the seller of income qualifying for capital gains treatment that actually represents disguised interest.  Interest of course must be reported as ordinary income.  The penalty is to require the seller to report a portion of each payment otherwise qualifying for capital gains as interest payments taxed as ordinary income.  This requirement remains in effect, even though there is no longer a significant differential tax rate for capital gains.

Multiple Sales

The decision to sell timber by type, stand or block, product class (veneer, sawtimber, pulpwood), or some other category should be made by balancing marketing and tax factors.   For small holdings in areas with relatively poor markets for some types of timber, it simply may not be possible to break the sale into units and sell each separately.

The decision making process should start by deciding what is best from a marketing standpoint, i.e. how to maximize the total revenue received for the timber.  Then the tax consequences of this and other alternatives should be analyzed

Dividing Income

If the income from your timber investment is to be used for the benefit of the family as a whole, after-tax income can frequently be increased by dividing the before-tax income among the family members.  Methods for doing this include filing a joint return with your spouse, transferring title, forming a family partnership or corporation, creating trusts and employing family members.  Many of these arrangements are complex and should be undertaken with the guidance of competent legal counsel. 

Transferring title - The tax liability for income earned through personal services (wages, salary, profits from a business owned and managed by you) cannot be shifted by assigning the income before you receive it.  Income from property, however, belongs to the owner(s) of the property.  Therefore, transferring title to the timberland or timber itself before a timber sale is held spreads the tax liability among the individual owners.  This only makes sense if those receiving interest in the property are the intended beneficiaries of the income from the property.  Several precautions should be noted.

The transfer must include the technical transfer of legal title.  In addition it must be a complete transfer of all ownership rights, including practical control of the management, use, and disposition of the property.  This means that in most circumstances the individuals receiving the property should not be minors.   Guardianship or trust arrangements are generally required for transfers to minors.

A transfer at less than fair market value constitutes a gift.  The amount of the gift is the difference between the sale price and the fair market value of the interest transferred.  The gift tax liability can be avoided in some cases by taking advantage of the $11,000 annual gift tax exclusions.  The annual gift tax exclusion provides that a donor can make annual gifts of no more than $11,000 to any number of recipients without incurring a gift tax liability.  In addition, a husband and wife, with mutual consent, can elect to have any gifts made treated as made one-half by each.  This election allows you and your spouse to make annual gifts of $22,000 to any number of recipients without incurring a gift tax liability.  Even if the annual exclusion is exceeded no gift tax is due until the unified credit is used up.

Partnership not necessarily created - The mere joint ownership of property does not create a partnership.  A partnership exists for tax purposes only if the joint owners are carrying on a trade or business for the production of income.   If the activity is simply an investment each person would report their proportionate share of all incomes and expenses from the property as if they owned it individually.  They may want, however, to implement a partnership agreement to formalize the relationship of the people managing the property.  It may be helpful to designate a "managing partner."  This is especially useful in business dealings, avoiding the necessity of getting everyone involved in the day-to-day affairs.

Whether or not Form 1065, partnership tax form, is filed with the IRS, for all practical purposes the information required to complete this form is needed to provide the joint owners with the information needed to report transaction on their individual Form 1040's

Cutting Contract

A cutting contract gives the buyer (lessee) the right to cut designated timber and the obligation to pay for it at a designated price.  Payment is usually based on the volume cut.  Actual sale of a unit of timber doesn't occur until the timber is cut, and/or cut and paid for.  This is not the same as an installment sale.  In an installment sale the timber has literally been deeded over to the buyer and the total amount to be paid to the seller fixed.

The seller (lessor) in a cutting contract reports the payments in the tax year received.  If the cutting extends over more than one year, the tax liability will also be spread.  The installment sale rules are not applicable to the cutting contract, unless payment for cut timber is made on an installment basis.

Ideally cutting contracts are used when that is the best way to dispose of the timber, that is when it provides the greatest return.  However, the most common reason for using them is probably to qualify the disposal for capital gains treatment.  If you are primarily holding the timber for sale to customers in the ordinary course of a trade or business, you can qualify for capital gains by disposing of it with an economic interest retained under the provisions of Section 631(b) of the Code.

A disadvantage to a cutting contract is that you don't get your money up-front.   Payments are generally made as the timber is cut, although advance payments are frequently called for in these contracts.  Since payment is tied to the volume cut, it is necessary for the seller to have assurance that the volume of logs produced is accurately measured and summarized.  Many tree farmers use a forestry consultant to assure that the terms of the contract are followed.

Reporting Income

Before proceeding any further it is important to understand the rules for when income is recognized, that is, in which accounting period it should be taxed.  The accounting method that you use will help to resolve this question.  The realization concept states that no income is recognized for tax purposes until it has been realized by the taxpayer.   A realization occurs whenever an amount is received without any restriction as to its disposition.  In most cases, realization occurs when an arm's-length transaction takes place. 

Cash basis taxpayers - Gains from the disposal of assets, profits from a trade or business, and earned income such as wages and salaries are included in gross income for the taxable year in which the amounts are actually or constructively received.

Although not actually reduced to a taxpayer's possession, income is constructively received in the taxable year during which it is credited to your  account, set apart for you, or otherwise made available so that you may draw upon it at anytime, or so that you could have drawn upon it during the taxable year if notice of intention to withdraw had been given.  However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

All that is required is that something with a fair market value (property, services, etc.) be received.  In addition this method gives taxpayers a somewhat limited ability to determine the year of taxation by accelerating or deferring cash receipts.   Because of this ability to determine the year of taxation using the cash method, restrictions are placed on the use of the method by certain types of taxpayers.  The most basic restriction on the use of the cash method is that taxpayers who sell inventories must account for sales, purchases, and inventories using the accrual basis.

Accrual basis taxpayers - Gains from the disposal of assets, profits from a trade or business, and earned income such as wages and salaries are included in gross income when it is earned, regardless of the actual period of receipt.  Income is considered earned when (1) all the events have occurred which fix the right to receive such income, and (2) the amount of income earned can be determined with reasonable accuracy.

Two important aspects of the accrual method should be noted.  First, the checkbook approach commonly used by cash basis taxpayers is not sufficient to account for the many accruals and deferrals of income required by the accrual method.  Second, accrual basis taxpayers have little control over the timing of their income, because the earning of the income, not the receipt of payment, is the critical factor.

The receipt of prepaid income by accrual basis taxpayers is generally taxable in the tax year in which payment is received.  Thus, advance receipts of rent, royalties, payments for goods, and payments for services are taxable when the cash payment is received, even for accrual basis taxpayers.