This article discusses the application of IRC § 631 to Christmas tree farms. If you are a forest landowner, read this article about the application of § 631 to timber.
I recently received a great question from a reader:
I have read lots of information on the capital gains treatment. Seems many places recommend 631(b) treatment, but I have also seen a ruling that says a U-Cut farm doesn’t qualify for 631(b) and should elect 631(a). I can’t get a clear answer.
If you have u-cut operations, can you truly qualify for 631(b) or should we just choose 631(a) and value as of January 1st of the year, making some of the earnings ordinary income?
§ 631(a) vs. § 631(b)
I’ve written and spoken many times about how the number one way Christmas tree growers save taxes is by qualifying for the capital gain method of taxation.
A choose-and-cut farm must elect capital gain treatment under § 631(a) in order to qualify for capital gain treatment. Revenue Ruling 77-229 and Eck v. Commissioner hold that a choose-and-cut farm cannot qualify for capital gain treatment under § 631(b).
§ 631(a) applies when the Christmas tree grower cuts the trees himself or has someone else cut them for him. In the case of a choose-and-cut farm, a Christmas tree grower may cut the trees himself (or an employee of the grower) or the customer may cut the tree they are purchasing. Either way, ownership of the tree does not pass until the customer pays for the tree after cutting.
Alternatively, § 631(b) applies to sales of standing timber, either in a lump-sum sale or a pay-as-cut arrangement. This section could apply to wholesale growers if they sell standing Christmas trees to a buyer. However, many wholesale growers will qualify under § 631(a) because they cut the trees themselves or pay someone else to cut them.
Value of Trees as of January 1st
Under Treas. Reg. § 1.631-1(d), the amount of the capital gain under § 631(a) is the difference between the grower’s basis in the Christmas trees and the trees’ fair market value (FMV) as of January 1 of the year they are cut. The difference between the final sales price of the tree and the FMV as of January 1 is ordinary income. This ordinary income amount is meant to capture the added value a Christmas tree grower adds as a result of operating a choose-and-cut farm.
The ordinary reading of this provision generally means that the final year of growth, as well as all harvest costs, should be treated as ordinary income, rather than capital gain.
However, a Ninth Circuit court ruled in Schudel v. Commissioner, that the value of the trees as of January 1 should take into account the condition of the trees when cut. Simply put, the court ruled that all value due to natural growth of the trees should be capital gain.
A grower would prefer to calculate their capital gain using the Schudel method because it would result in a larger capital gain and lower taxes as compared to including the final year of growth in ordinary income. However, Schudel is only precedent for the Ninth Circuit (AK, AZ, CA, HI, ID, MT, NV, OR, WA), but it may provide an indication of how other courts might rule. Regardless of location, a Christmas tree grower electing capital gain treatment under § 631(a) should discuss with their tax professionals whether to use the Schudel method or include the final year’s growth in ordinary income.
