Structuring Timber Activities
"Structure" refers to how you set up your timber investment for legal and tax purposes. How should the property be titled? Should you treat it on your tax return as an investment or a business? If you file as a business should it be a sole proprietorship, or should you form a corporation? Whether you are a new timberland owner or someone who has owned the property for a long time, these are just a few of the questions that should be considered when structuring your timber investment.
Timber is a unique investment with several characteristics that are not typical of normal business situations. These unique characteristics affect how an activity should be structured. The first, and probably most obvious, is the long growth (investment) period. It is quite possible that as the current owner you may never see any returns from your investment. While at the same time you are making annual expenditures for operating and management costs, the annual deduction of which is directly tied to your profit motive. Timber is however, excluded from the uniform capitalization rules. Because of theses long pre-productive periods timber investments tend to be inherently passive in nature, which can have a direct affect on how losses are handled under the passive loss rules.
Timber owners also face a variety of risks that do not affect more conventional investments. Furthermore timber resources are generally exposed to risks for a much longer time period than other forms of investment. Another important consideration is the intergenerational nature of a timber investment. Is the property being held only for speculative purposes, or do you plan to pass the property on? When is it best to start dispersing your wealth? Creating an estate for future generations can be a very complicated process. For a more in depth look at estate planning click here.
In addition to the monetary return that timber investments offer, their are many non-timber benefits that you as a landowner derive such as wildlife, outdoor recreation, clean water, aesthetic beauty and a sense of pride from being a good steward.
Before you begin structuring your timber investment there are three important considerations:
Deductibility of annual management and carrying costs - Because of the long time periods over which costs must be carried, realizing an adequate rate of return on your investment requires that costs be minimized and recovered for tax purposes as soon as allowable.
Capital gains treatment - The long-term nature of timber investments makes it important to minimize the tax liability on any income realized. Capital gains treatment is also important even without a significant differential rate because capital gains are not subject to the self-employment tax. A tax planning opportunity may also result from the fact that capital gains and losses still offset each other.
Intergenerational - Their long term nature also means that planning may need to incorporate at least two and frequently three generations. Clear lines of affordable transfers between generations must be planned. If the tree farm is not transferred in-kind, then the wealth that it represents must be transferred.
Before getting into the different "structures" that are available it is important to have a general understanding of the basic forms of joint ownership.
Joint Tenancy - A joint tenancy may be created between two or more natural persons (as opposed to a corporate person). The interest of each joint tenant must be acquired at the same time using a single instrument with each owner having the same basic legal for of title, and each owner must have an undivided right to use the whole property (undivided interest), not a right to use only a certain portion of it. The critical aspect of this form of ownership is that when one co-owner dies the other co-owners automatically gets the interest of the deceased.
Tenancy in Common - Each co-owners has an undivided interest in the whole property. Upon the death of a co-owner title passes according to the provisions of the deceased's will or state law if a valid will is not in effect.
Tenancy by the Entirety - This is a joint tenancy between spouses. Upon the death of one the surviving spouse takes title to the property.
Although the decision on which type of entity to use is not reducible to a formula, it may help to use a stepwise approach.
Investment vs. Business
The nature of the timber growing process is more characteristic of a business as contrasted with classical investments such as stocks and bonds. But if you have a small acreage and like to keep things as simple as possible, the investment structure may be best for you. The factors that should be considered include:
Itemize vs. above the line deduction - With the investment structure you deduct the property tax as an itemized deduction and your operating expenses as miscellaneous itemized deductions. If you do not normally itemize the business structure is preferable. If you itemize but have few, if any, non-timber miscellaneous itemized deductions, the 2-percent floor on miscellaneous itemized deductions favors a business structure.
Passive activity loss restrictions - If you want to avoid the complications of the passive activity loss restrictions, the investment structure is preferable.
Administrative burden - There is little difference in the paperwork involved in reporting an investment and a sole proprietorship business. Partnerships and corporations may involve a substantial administrative burden.
Capital gains treatment - The prevailing perception is that if you structure as a business you do not qualify for capital gains treatment on lump sum sales of timber, unless you sell with a "pay-as-cut contract." This is not necessarily true, however. Lump sum sales qualify if the timber is considered to be a capital asset, or if it is held for use in a trade or business. The confusion between "held for use in a trade or business" and "held primarily for sale to customers in the ordinary course of a trade or business" results from one of the unique aspects of timber.
In comparison with a typical manufacturing process, your timber is both the "machine" that produces the wood (annual growth) and the product itself. Cutting a tree results in a disposal of the "wood making machine" and the wood made over the life of the "machine." In the case of a normal manufacturer it's obvious when the machine used to make the product is disposed of and when the product made is disposed of. They are normally completely separate physical things.
In the case of timber the distinction must be made on the basis of whether the timber is "held for use in a trade or business" or "held primarily for sale to customers in the ordinary course of a trade or business." The following may help to clarify the difference.
Primarily held for use in a trade or business - The business has timberland holdings from which they cut timber to be processed in their mills or to produce logs sold to other mills. They rarely, if ever, sell timber on the stump to others, and if they do the gains would not qualify unless the stumpage was disposed of under a so-called pay as cut contract (Section 631(b) of the Code).
Primarily for sale to customers in the ordinary course of a trade or business - If instead of cutting timber for processing in its own mills, a company grows timber to sell on the stump to other companies, it would be holding the timber primarily for sale.
The distinction may be less obvious but is still valid in the case of a tree farmer who's not in the lumber or other timber conversion business. You can be in the business of growing timber, and when the time is right you will entertain offers to buy your timber. You haven't held yourself out to the public as being in the ongoing business of selling timber. Thus you are able to classify your tree farm as a timber business and still qualify for capital gains on lump sum sales.
Corporation vs. partnership
A factor to consider in deciding whether or not to incorporate is the total tax liability that would be incurred on income earned by the corporation after distribution to the stockholders. In most circumstances the double taxation of corporate income favors non-corporate forms of business for small enterprises receiving income from timber. Those wishing to incorporate for some other reason should consider a subchapter S election.
From a tax standpoint the S corporation and partnership tax accounting rules are similar. The corporation presents the most complicated legal situation since the requirements of state law regarding the conduct of business as a corporation must be followed. Liability protection is frequently given as a reason for incorporating. You should discuss this aspect with your legal counsel. The courts look very closely at the extent to which you and your corporation in fact constitute separate entities.
Active Timber Production Business - Timberland is titled to the business (individual owner if sole proprietorship, partners if a partnership, or corporation if incorporated). Owners are "materially participating" in the business under the passive activity loss rules. Costs are reported on the appropriate business tax form. Timber is generally, but not always, held primarily for sale to customers in the ordinary course of the timber production business. Gains from the disposals of timber on the stump qualify for capital gains treatment if he disposals meet the requirements of Section 631(b), disposal with an economic interest retained, of the Internal Revenue Code. Occasional sales of stumpage to outsiders may qualify for capital gains treatment under Section 1231. If the age structure of the timber has not allowed many previous timber sales, the timber may be considered as being held for use in a trade or business, but not primarily for sale.
Because of the need for the owner to be personally involved in the activity, tree farming inherently has the characteristics of a business, at least in comparison to financial investments such as stock and bonds. Most small tree farmers, however, do not have the regularity of incomes and other transactions generally associated with carrying on a trade or business. A business is an activity which is carried out on a regular basis for the production of income. A factor frequently cited by the courts is the holding out of the activity to the public as a trade or business, usually for the sale of goods or services.
Passive Timber Production Business - The treatment is the same as for an active timber production business, except the deductibility of operating losses is restricted by the passive activity loss rules.
Timber Production and Utilization Business - Same as active timber production business, except that timber is produced primarily for utilization by the business, not for outside sale. Any gain on timber cut for use in the business qualifies for capital gains treatment if the requirements of Section 631(a), election to treat cutting as a sale, are met and 631(a) treatment is elected. occasional sales of stumpage to outsiders may qualify for capital gains treatment under Section 1231, but Section 631(b), disposal with an economic interest retained, is generally used to assure such treatment.
There are two basic types of taxpayers, individual and corporate, but several forms of businesses. Business entities are further broken down into either "taxable entities" or "conduit entities." Taxable entities must pay a tax based on their taxable income, whereas a conduit entity is one in which the tax attributes (income, deductions, losses, credits) of the entity flow through the entity to the owner(s) and are reported on the owner's individual tax return. All but the C corporation are conduit entities.
Under common law there are certain characteristics that are looked at to indicate that a business entity actually exists:
- The activity is carried on for livelihood or profit
- That a profit motive is clearly present
- Some type of economic activity must be involved
- The activity is not engaged in purely for personal satisfaction
- Activities are carried out on a continuous basis
- The activity has regular transactions that produce income
- Continuous losses from little or no income raises questions about the existence of a business
Income taxation is only one factor to consider when an economic decision must be made. There are several non-tax factors that should be considered when making the choice of the appropriate business form:
The number of owners - The number of current and potential future owners can restrict the choice of the entity.
Limited personal liability - An investor's personal assets are not at risk to cover liabilities incurred by the entity. Limiting personal liability is often the most important factor for investors choosing a legal form for operating their business.
Freedom to choose how to transfer ownership - The transferability of ownership interest refers to the ease with which ownership can be transferred. In certain situations, placing restrictions on the buying and selling of an ownership interest may be desirable. Most restrictions generally occur with closely held businesses.
Anticipated life of the enterprise - Continuity of life refers to whether an entity continues to operate or technically dissolves and ceases to exist in its present form when a change occurs in the ownership structure. State law dictates whether an entity continues or technically dissolves if its ownership structure changes. Under most state laws partnerships technically dissolve when ownership changes.
Ability to participate in business management - The degree of management control varies across different entities. Corporations use centralized management structures, partnerships use a broad-based management in which all partners have the right to participate in management decisions.
The cost of organizing the entity - The cost of organizing each entity varies according to legal requirements. In general, corporations are more costly to organize than are sole proprietorships; partnerships cost more than sole proprietorships but less than corporations
Ability to raise capital - Each entity has legal characteristics that can affect the ability of the entity to raise additional capital should the need arise.
These non-tax factors arise primarily because of the legal differences in the various entity forms.
Sole Proprietorship
A sole proprietorship is a business owned by one individual. It is the simplest and most common business form in the United States. Individuals need do nothing formal to establish a sole proprietorship. A sole proprietorship is easy to form because the business is not separate from the individual owner from both a legal and tax perspective. The only restriction is that the business can have only one owner, who must be an individual. The sole proprietor is personally liable for all debts of the business. As the only owner of the business, the sole proprietor has the freedom to transfer ownership at any time and in any manner. When a sole proprietor dies, the business becomes part of the owner's estate and can be passed on to a spouse, children, or others according to the owner's desires.
When you figure your taxable income for the year, you must add in any profit, or subtract out any loss, you have from your sole proprietorship. You report your profit or loss from each of your sole proprietorship on a separate Schedule C Form 1040, Profit or Loss From Business. The amount of the business profit or loss is entered on line 12 of your individual Form 1040. Capital gains are reported separately on your individual Schedule D, Form 1040.
Each asset in your sole proprietorship is treated separately for tax purposes, rather than as part of one overall ownership interest. For example, a sole proprietorship selling an entire business as a going concern figures gain or loss separately on each business asset.
Partenership
A partnership is the relationship existing between two or more persons who have joined together to carry on a trade or business for profit. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business. A partnership is a flexible business form because the arrangement is purely consensual. Any individual owner in the partnership may dissolve the partnership at any time and depart with his or her share of the assets. Partnerships, like sole proprietorships, usually have no special state reporting requirements other than tax returns that report the results of the operations.
Each general partner is personally responsible for any partnership obligations that arise during the existence of the partnership. Also, general partners legally have equal abilities to contribute to management decision making. Although partnerships are considered conduits for the purpose of income taxation, they are treated as separate entities under local law. Thus, partnerships can transact business and own property in their names, separate from the partners. This characteristic is a major difference sole proprietorships and partnerships.
A partnership is not a taxable entity. However, it must figure its profits or loss and file a return, Form 1065, U.S. Partnership Return of Income. Capital gains (losses) are determined at the partnership level and distributed to the individual partners according to the applicable distribution percentages. The partners report their distributed share of capital gains on their individual Schedule D, Form 1040.
For income tax purposes, the term partnership includes a syndicate, group, pool, joint venture, qualified limited liability company or unincorporated organization that is carrying on a business and that may not be classified as a trust, estate, or corporation. Factors used to determine if the parties intend to carry on a partnership include:
1) The parties' conduct in carrying out the provisions of the partnership agreement,
2) The testimony of disinterested persons,
3) The relationship of the parties,
4) The abilities and contributions of each, and
5) The control each owner has over the partnership income and the purpose for which the income is used.
A joint undertaking merely to share expenses is not a partnership. Mere co-ownership of property that is maintained and leased or rented does not necessarily constitute a partnership. However, if the co-owners provide services to the tenants, a partnership exists.
The partnership agreement includes the original agreement and any modifications of it agreed to by all the partners or adopted in any other manner provided by the partnership agreement. The agreement or modifications may be oral or written. Generally, a partner's share of income, gain, loss, deductions, or credits is determined by the partnership agreement.
Corporation
For legal purposes a corporation is an organization chartered by the state to exist as a person under the law. A corporation, for federal income tax purposes, includes associations, joint stock companies, trusts, and partnerships that actually operate as associations or corporations. As a separate statutory entity, a corporation can enter into contracts in its name, own property, and be sued, and it must pay income tax based on its taxable income.
Unincorporated organizations with certain characteristics are classified as associations and taxed as corporations. These characteristics are associates who join together to carry on business and divide gains. In addition, the organization must have a majority of the following characteristics:
1) Continuity of life,
2) Centralized management,
3) Limited liability,
4) Free transferability of interests.
Corporate profits are taxed to the corporation. When the after-tax profits are distributed as dividends, the dividends are taxed again to the shareholders. In figuring its taxable income, a corporation generally takes the same deductions as a sole proprietorship. Corporate capital gains are reported on Schedule D, Form 1120 and taxed at the corporate tax rate.
S Corporation
An S corporation is a regular corporation with special tax attributes. Corporations may obtain conduit entity tax status by making a valid election per Subchapter S of the Internal Revenue Code of 1986. The S corporation retains the legal characteristics of the corporate form (limited liability, free transferability of interests, continuity of life, and centralized management) while obtaining taxation characteristics similar to those of a partnership.
Thus, a corporation making this election would be exempt from federal income tax. Its shareholders would include in their income their share of the corporation's separately stated items of income, including corporate capital gains, deductions, losses, and credit and their share of non-separately stated income or loss. Management and operating expenses of an S corporation are reported on Form 1120S, Income Tax Return from an S Corporation.
To qualify as an S corporation, a corporation:
1) Must be a domestic corporation,
2) May not have more than 35 shareholders (married individuals who are both shareholders are deemed to be one shareholder for S corporation status)
3) Must have as its shareholders only individuals, estates, tax-exempt organizations, and certain trusts
4) Cannot have a nonresident alien as a shareholder
5) Must have only one class of stock outstanding
6) Must have the consent of all shareholders to the election of S corporation status
Every qualifying requirement must be met at the time of the election and at all times thereafter. The S corporation election terminates immediately when one or more of the qualifying characteristics ceases to exist. As of the date of termination, the corporation becomes a taxable corporate entity. The election is only for federal tax purposes. Certain states do not recognize this election for state income tax purposes. You should consult the state taxing authority to determine whether the S corporation election is valid for your state's income tax system.
Limited Liability
The limited liability company is a relatively new and unique form of business organization created under state laws. The limited liability company (LLC) combines the corporate characteristic of limited liability with the conduit tax treatment of partnerships. Like a corporation, an LLC is created by following the requirements of state law. It is treated as a legal entity, separate from its individual owners, and is recognized as the owner of the trade or business property.
"Member" is the term generally used to refer to individuals or other organizations with an ownership interest in an LLC and the right to manage it. This reduces confusion since owners of a partnership are called partners, and owners of a corporation are called shareholders. It is possible, however, to have in effect two classes of ownership interests in an LLC. An individual or other organization owning an interest but not the right to manage is simply called an owner. This provides the organizational flexibility of a limited partnership. Most states also allow the centralization of management in the hands of a few members, or by non-members.
Like an S corporation an LLC provides pass-through of capital gains, tax credits, and other tax items from the business to the member's individual tax return. They both also provide liability protection for the members. The liability protection in an S corporation comes from incorporation. Its pass-through comes from qualifying for and making the election to be taxed as a partnership. These two benefits can also be achieved with a limited partnership, however, only limited partners get both. The cost to limited partners is not being involved in the management of the business.
A LLC provides complete pass-through, limited liability, and management participation by all "members"
Chartered by state - An LLC is formed by filing articles or organization with your state, usually the same office where you would file articles of incorporation. The entity must have two or more members, have an objective to carry on a business, and establish a specific method for dividing the profits and losses from the business. LLC's conducting business outside the state of organization may also need to file for certificate of authority to transact business with the other states in which they intend to conduct business. Once approved by the appropriate state office an LLC becomes a legal entity separate from its members. It may own property, incur debts and enter into contracts, and sue or be sued. An ownership interest in an LLC is personal property, not an interest in real estate, even if the LLC's principal assets are land and timber.
Partnership tax treatment - Treatment of an LLC as a partnership for Federal income tax purposes is based on long-standing criteria distinguishing an activity by whatever name that has a majority of the characteristics of a corporation from one that doesn't. An organization having a majority of the characteristics of a corporation is taxed as a corporation, regardless of what it's called. Thus, an LLC's treatment as a partnership for tax purposes generally requires including in the articles of organization restrictions on the transfer of membership. The typical restriction is to require consent of the other members for transfers of interest.
LLC also usually don't have the corporate characteristics of perpetual life, although some states allow it. Your attorney can discuss with you how the statutes authorizing LLC's in your state match the Internal Revenue Code requirements to be taxed as a partnership. If the statute is "bullet proof" complying with it will assure taxation as a partnership. If your state's statute is "flexible" your articles of organization would have to be crafted to assure partnership treatment. Most states are flexible.
As a partnership an LLC files IRS Form 1065 for federal income tax purposes and the corresponding state tax form, if any. All LLC members are treated as partners. No distinction is made between general and limited partners. Distributions of income, losses, tax credits, and other items are usually based on the value of each members capital contribution.
The tax accounting process for partnerships is quite burdensome and complex. The concern isn't the rules for determining annual net income, it's the rules for partner's basis and resulting distributions that can get complex. If you currently do your own tax accounting read through IRS Publication 541 before becoming a partnership's or LLC's accountant.
When LLC's are not appropriate - LLC's are not suitable for a large number of owners. The requirement to obtain consent when ownership interests are transferred is the main concern. In such cases a limited partnership, or some combination of partnership, or an LLC or S corporation combined with a partnership might be better.
LLC's are not suitable for one owner. Although some states allow single member LLC, the IRS has indicated it won't consider such an entity to be a partnership for tax purposes.
The LLC is a relatively new entity in the United States, and as such little case law has been established in either state or federal courts. Thus, there is some uncertainty as to how state courts will interpret the statutes in the context of limited liability and how the federal courts will apply the Internal Revenue Code to LLC's. Whenever in doubt consult your attorney if you think an LLC might be appropriate for you.
Trust
A trust is an arrangement in which a trustee manages assets for the benefit of another, referred to as the beneficiary. Trusts are a mixture of taxable and conduit entities. The trust reports the results of its operations to the government (a conduit characteristic). Any income distributed by the trust to the beneficiary is taxable to the beneficiary. However, the trust must pay income tax on any income that is earned but not distributed to the beneficiary (a taxable entity characteristic). Thus, trusts are both taxable and conduit entities in that they are taxed on income that is retained and are not taxed on income that is distributed.
Non-Business
Personal Use - Title to the timberland is in name of the taxpayer. Property taxes are reported as itemized deduction of Form 1040, Schedule A. The timber is a "capital asset" and if sold on the stump qualifies for capital gains treatment which is reported on Schedule D, Form 1040. Timber management expenses are not deductible and must be capitalized to the appropriate capital account.
Hobby - Title to the timberland is in name of the taxpayer. Property taxes are reported as itemized deduction of Form 1040, Schedule A. The timber is a "capital asset" and if sold on the stump qualifies for capital gains treatment which is reported on Schedule D, Form 1040. Timber management expenses are deductible under the provisions of the "hobby loss rule," only to the extent of current income from from the tree farm. This is because it is not held primarily for the production of income. Deductions allowable under the hobby loss rules are not subject to the passive activity loss rules.
Investment - Title to the timberland is in the name of the investor(s). Joint title may be appropriate if timber income will be realized during the investor's lifetime and spreading income among taxpayers maximize net after-tax income in the hands of the beneficiaries. If most of the tree farm wealth is to be transferred at death, concentrating ownership in as few individuals as possible will maximize the step-up in basis.
Property taxes are reported as an itemized deduction. Management and carrying costs are reported as miscellaneous itemized deductions of Form 1040, Schedule A, and are subject to a 2-percent of adjusted gross income (AGI) floor. This means that the deductions provide provide a tax benefit only to the extent they exceed this limit. Interest deductions are also limited. Deductible costs include timber management expenses, since the timber is held primarily for the production of income. The timber is a "capital asset" and if sold on the stump the gain (loss) qualifies for capital gains treatment, reported on Schedule D, Form 1040. The passive activity loss rules do not apply to investment expenses.
An investment is an activity carried out for profit but one which does not involve as much "work" as is normally associated with a business. A business is normally characterized as an activity comprising your major source of income. The distinction is relative, and the IRS does not provide hard-and-fast rules for making this distinction. Historically this distinction has not been very important, based on the small amount of case law dealing with this issue in general and timber in particular.
How big does the woodlot need to be to qualify as a business? It should probably be big enough to require a "significant" portion of your available time. You might consider using the material participation requirements under the passive activity loss rules as a guideline, although this is clearly not one of the intended uses of these rules. If under the rules you are considered to be materially participating, then it is logical to conclude that the activity constitutes a business.
Tree Farm
This structure offers the advantage that the tree farm expenses are merged with the expenses of the business with which it is associated, helping to meet the material participation test under the passive loss rules. It also avoids the need for a separate accounting for the profitability of the tree farm activity. Another advantage is that since the timber is not held for use in the main trade or business, nor primarily for sale if few sales are made, it receives capital gains treatment on lump sum sales.
These advantages are premised on the assumption that the tree farm is such an incidental part of the larger business, that it is literally lost in the workings of the non-timber business, and the IRS is not likely to require that it be treated as a separate activity for tax purposes.
Regulations for both the hobby loss rules, Section 183, and the passive activity restrictions, Section 469, contain guidelines on how to determine what constitutes separate activities.
Activity Incidental to Farm Business - The timberland is titled with the other farm business property. Deductible timber expenses are reported on Form 1040, Schedule F, if operated as a sole proprietorship. If the farmer is not holding timber primarily for sale to customers in the ordinary course of a timber business, the timber is considered a capital asset. If sold on the stump the gain (loss) qualifies for capital gains treatment, reported on Schedule D, Form 1040. If the farm business is a partnership or corporation, the timber related expenses and income are reported on the appropriate business tax form. The passive loss restrictions apply to the farm as a whole.
Technical Note - Are tree farmers "farmers" if the only crop they produce is timber? Most IRS employees would say they are and in fact many tree farmers use Schedule F (Farming), Form 1040. If you are doing so there is no reason to change. The IRS has no official position on this point. The term "farm" (farming) is defined many places in the Code, but only within the context of the particular section to which the term applies. In general, a farmer is someone receiving farm income and farm income is defined by most sections of the Code as being from the sale of agricultural commodities (grain, fruit, vegetables, etc.) or livestock.
Activity Incidental to Non-farm Business - Timberland is titled with other business property. Costs are reported on the business tax return. Treatment of income is the same as for a farm business. The passive loss restrictions apply to the overall business.
