2016 Maine Tax Forum Selected Issues in Taxation of Natural - - PowerPoint PPT Presentation

2016 Maine Tax Forum

Selected Issues in Taxation of Natural Resources

Lee J. Chick, CPA

November 2, 2016 2016 Maine Tax Forum

Natural Resources

• Taxation covered in Subchapter I, which includes

the following sections:

– Deductions: Secs 611 – 617 – Sales & exchanges: Sec 631 – Mineral production payments: Sec 636 – Continental shelf areas: Sec 638

• In broadest sense, it includes all valued naturally-
• ccurring characteristics including sunlight,

atmosphere, water, land, minerals, vegetation and animal life

November 2, 2016 2016 Maine Tax Forum 2

Natural Resource Tax Issues to Cover Today

• Cost recovery – depletion
• Limited coverage on oil & gas
• Most time spent on timber issues

Today’s goal: No V-8 moments!

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Natural Resource Depletion

• The basic theory of resource depletion is that

the taxpayer is entitled to cost recovery as units of the resource are consumed

• A reasonable deduction for depletion is

allowed in computing taxable income from mines, oil and gas wells, other natural deposits, and timber

• Depletion is allowable to the owner of an

economic interest in the resource.

November 2, 2016 2016 Maine Tax Forum 4

Natural Resource Depletion

• The term ‘Economic Interest’ is undefined in

the Code but provided in Reg 1.611-1(b)(1) and includes royalty interests, operating or working interests, and net profits interests. Some production payments are also economic interests

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Depletion Methods – Section 611 through 613A

• Cost depletion - units of production
• Percentage depletion

– Based on lesser of

• Gross income from resource property times the stated

depletion rate (rates range from 5%-22% based on the resource extracted), or

• 50% of the taxable income from the property
• Taxpayer deducts the higher of cost or

percentage depletion

November 2, 2016 2016 Maine Tax Forum 6

Cost vs. Percentage Depletion

• Both methods are not available for all

resources

November 2, 2016 2016 Maine Tax Forum 7

Cost Depletion Percentage Depletion Oil & Gas yes yes Coal yes yes Minerals & metals yes yes Gravel, peat, sand yes yes Soil, sod, turf yes no Timber yes no Water maybe no

Character of Natural Resource Income

• Most revenue from sale of extracted natural

resources is ordinary income, but Sec 1231 treatment is available for

– Coal or domestic iron ore disposed of by a contract under which the seller retains an economic interest in the coal or domestic iron ore sold (Sec. 631(c)) – Qualifying sale of timber under either

• Contractual disposal where seller retains an economic

interest in the cut timber (Sec. 631(b))

• Election to treat the cutting of timber as a sale or exchange

for tax purposes (Sec 631(a))

November 2, 2016 2016 Maine Tax Forum 8

Types of Interests in Mineral Properties

• Operating or working interest: typically describes the party

responsible for getting the resource out of the ground

• Royalty interest: entitles the owner to a share of the gross

production from a specific mineral property. It is a “non-

• perating” interest since a royalty doesn't bear any part of

the exploration, development and operating costs

• A “production payment” is, in general, a right to a specified

share of the production from mineral in place, or the proceeds from that production. A production payment may be limited by a dollar amount, a quantity of the mineral extracted, or time.

November 2, 2016 2016 Maine Tax Forum 9

Natural Resource Interests in Estates & Trusts

• Maine has adopted the Uniform Principal & Income

Act of 1997 (Title 18-A, Article 7, Part 7) – Special rules are provided for allocation of receipts between income vs. principal for minerals, water and other natural resources (Sec. 751) and timber (Sec. 752) – Trust documents should be reviewed for flexibility afforded to Trustee

November 2, 2016 2016 Maine Tax Forum 10

Oil & Gas Investments in Master Limited Partnerships

• Restructuring prevalent due to volatility in

energy markets – two major motivations:

– Reduce the cost of capital (eg, Kinder Morgan, Plains All American) – Bankruptcy and debt restructuring (eg, Linn Energy, Breitburn Energy, Atlas Resource Partners)

November 2, 2016 2016 Maine Tax Forum 11

Timber Tax Issues

• Reasons for holding timber and its impact on

tax reporting

• Qualifying timber sale income as Sec 1231
• Establishing timber accounts
• Road cost recovery
• Timber incentives
• Maine issues

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Reasons for Holding Timberland

• Personal Use
• Investment

– Timber sale proceeds reportable on Sch D – Expenses to Sch A

• Trade or business

– Schedule C or F reporting – Qualifying timber sale proceeds reportable on Form 4797

November 2, 2016 2016 Maine Tax Forum 14

Timber Income Considerations

• Whether gain/loss from timber transactions

qualifies for capital gain rates is determined by:

– primary purpose for holding timberland – how the timber is disposed of – holding period

• Sec 631 provides two options to provide certainty

for use of capital gain rates:

– 631(b): disposal of timber with retained economic interest, or lump sum sale – 631(a): election to treat cutting of timber as a sale or exchange

November 2, 2016 2016 Maine Tax Forum 15

Disposal of Timber under Sec 631(b)

• Timber must have been held for at least 1 year
• Disposition is via contract that takes the form
• f either a lump sum sale, or a contract for

disposal where the owner retains an economic interest in the standing timber

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Section 631(a) Election

• Legislative compromise to deal with the issue
• f a land owner cutting his/her own timber

and disposes of the resulting products: is it

• rdinary income or 1231 gain? Sec 631(a)
• perates to split the income recognized

between the appreciation of the timber while standing (1231 gain), and the value-added activities that occur after the tree is cut (ordinary income)

November 2, 2016 2016 Maine Tax Forum 17

Section 631(a) Election

• Timber must be held 1 year to qualify
• Election must be made on the original return

for the year you first want it to apply

– Election can’t be made on an amended return – Election can be revoked only with permission of the IRS – Make election by using checkblock on Form T

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Effect of Section 631(a) Election

Total Sec 1231 gain Ordinary Income Delivered price at mill 18,000 18,000 Logging & trucking costs (7,000) (7,000) Cost of logs sold (10,000) FMV of standing timber at BOY = 10,000 10,000 Basis of standing timber for depletion (3,000) (3,000) Total profit from activity 8,000 Profit allocated 7,000 1,000

November 2, 2016 2016 Maine Tax Forum 19

Sec 631(a) Election to treat cutting of timber as a sale or exchange

• Issues to be aware of:

– Cut, but untrucked timber at year end – Gain recognized for the excess of stumpage value over cost for depletion purposes – Impact on tax-exempt timberland owners – Capital gain income is excluded from UBTI by Section 512(b)(5), but gains from Sec 631(a) transactions fall outside the exclusion

November 2, 2016 2016 Maine Tax Forum 20

Qualified Timber Gain of C corps.

• PATH Act change (Sec 334(a)) provides for

23.8% rate for Qualified Timber Gain

• Qualified Timber Gain = Taxpayer’s 631(a) &

631(b) gains over 631(a) & 631(b) losses, but

• nly for timber held more than 15 years
• Effective for tax years beginning in 2016

November 2, 2016 2016 Maine Tax Forum 21

Establishing Timber Accounts

• Upon acquisition of timber property, basis is

allocated among assets acquired

– Land – Merchantable timber – Young growth – Road system, bridges – Shorefront lots – Mineral deposits – Other assets

November 2, 2016 2016 Maine Tax Forum 22

Establishing Timber Accounts

• Taxpayer purchases a 500-acre parcel for

$250,000 and incurs the following:

November 2, 2016 2016 Maine Tax Forum 23

Purchase price 250,000 Legal fees 2,000 Timber cruise 5,000 Survey costs 3,000 Total cost 260,000

Establishing Timber Accounts

• The timber cruise determined that the tract

contains the following:

– 3,000 cords of merchantable timber with stumpage value of $210,000 – Young growth of $30,000 – Raw land at $40/acre = $20,000 – Road system = $25,000

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Establishing Timber Accounts

• Purchase price allocation
• Depletion rate = 63.87 per cord (191,620/3,000)
• Could things be done differently?

November 2, 2016 2016 Maine Tax Forum 25

Asset Value % of total Cost allocated Land 20,000 7.0% 18,200 Young Growth 30,000 10.5 27,300 Merchantable timber – 3,000 cords 210,000 73.7 191,620 Road system in place 25,000 8.8 22,880 Total 285,000 100.0% 260,000

Establishing Timber Accounts

• What if the 3,000 cords of merchantable

timber consisted of 2,000 cords of high-value spruce & fir sawlogs and 1,000 cords of low- value hardwood pulp, and the management plan called for extracting the 300 cords of sawlogs per year in the first two years of

• wnership? Separating the merchantable

timber account into its two components could improve the landowner’s tax situation

November 2, 2016 2016 Maine Tax Forum 26

Establishing Timber Accounts

• Annual depletion using one account for merchantable timber with total

cost of $191,620: 300 cord harvest x depletion rate of 63.87/cord = 19,161

• Split species into separate accounts:
• Depletion deduction on 300 cord Spruce & Fir harvest becomes 27,363

versus 19,161

November 2, 2016 2016 Maine Tax Forum 27

Value % of Total Allocated cost Depletion rate 2,000 cds S&F 200,000 95.2% 182,422 91.21 1,000 HW pulp 10,000 4.8% 9,198 9.20 Total 210,000 100.0% 191,620

Form T

• Form T should be filed for any tax year in

which a timber depletion deduction is claimed

– Shows calculation of depletion deduction – Profit/loss from timber sales – Whether a Sec 631(a) election is being made or has been made

November 2, 2016 2016 Maine Tax Forum 28

Logging Roads

• Rev Rul 88-99 provides that depreciation may be

claimed for the portions of roads that have determinable useful lives – Permanent roads (ie, roads that are expected to be used indefinitely):

• Cost of roadbed – not depreciable
• Cost of road surface, culverts, bridges – depreciable

– Temporary roads (used solely to access a particular stand of timber): depreciable

• Units of production

November 2, 2016 2016 Maine Tax Forum 29

Timber Incentives

• Reforestation Costs – typically constitute capital

expenditures, but Sec 194 permits Taxpayers to elect to deduct up to $10,000 of Qualified Forest Expenditures in the year paid or incurred, with the balance amortized over 84 months

• Qualified Forest Expenditures = direct costs

incurred in forestation or reforestation of planting, including costs of site preparation, seeds or seedlings, labor and tools

• Procedures for making the election are provided

in Notice 2006-47

November 2, 2016 2016 Maine Tax Forum 30

Timber Incentives

• Government Payments – Sec 126 provides an

exclusion from income for certain qualifying cost sharing payments that meet the following general criteria:

• 1. Secretary of Agriculture has approved
• 2. Secretary of the Treasury has determined that

the payment does not substantially increase the annual income of the property, and

• 3. Payment is for a capital expense

November 2, 2016 2016 Maine Tax Forum 31

Timber Incentives

• Conservation easement – For landowners who

wish to limit future development on the land, a charitable contribution may be available for gifts to qualifying organizations that achieve

• ne or more of the following:

– Preservation of land for outdoor recreation – Protection of wildlife habitat – Preservation of open space – Preservation of a historically important land area

November 2, 2016 2016 Maine Tax Forum 32

Timber Incentives

• Conservation easements

– Value of donation is determined by valuing the subject property both with and without the restriction – Qualified appraisal required to support the deduction and appraisal summary should be attached to Form 8283

November 2, 2016 2016 Maine Tax Forum 33

Timber Tax – Maine Issues

• Forest Management Planning Credit repealed for

years beginning after 1/1/16

• Gain on sale of timberlands: For tax years

beginning on or after January 1, 2015, the taxable gain on the sale of sustainably managed eligible timberlands held by the taxpayer for at least a 10- year period beginning on or after January 1, 2005 is deducted from federal adjusted gross income. 36 MRSA §5122(2)(U)

November 2, 2016 2016 Maine Tax Forum 34

Timber Tax – Maine Issues

• Maine Exclusion for gain on sale of timberland

– “Eligible timberlands” = Land of at least 10 acres located in Maine and used primarily for the growth of trees to be commercially harvested – “Sustainably managed” = (1) a forest management and harvest plan has been in effect during

• wnership, and (2) taxpayer has received a written

statement from a licensed forester that the timberland has been managed in accordance with the plan

November 2, 2016 2016 Maine Tax Forum 35

Resources

• Forest Landowner’s Guide to the Federal

Income Tax, US Dept of Agriculture, Forest Service, Agriculture Handbook #731, Feb 2013

• Maine Forest Service annual reports

– Stumpage prices – Silvicultural activities – Wood processor reports

• National Timber Tax website:

www.timbertax.org

November 2, 2016 2016 Maine Tax Forum 36

November 2, 2016 2016 Maine Tax Forum 37

Break Time!

Thanks for your kind attention!

• Lee J. Chick, CPA
• Contact info - Phone: 207-991-2498

Email: lee@leechick.com