Defining an involuntary conversion.
Willamette Industries is a forest products company that owns timberland it converts to lumber, paper and the like. From 1992 to 1995, ice, windstorms, wildfires and insect infestations damaged the trees Willamette was growing for future harvesting. To avoid further losses, it harvested and processed the damaged trees as if they were fully mature. On its corporate tax returns, the company treated the difference between its basis in the trees and their value at the time of the harvest as an involuntary conversion eligible for deferment under IRC section 1033.
The government denied Willamette Industries deferral treatment on the grounds section 1033 applied only to gains that stemmed directly from a casualty. The company responded it was compelled to harvest the trees early and therefore was entitled to involuntary conversion treatment.
Result. For the taxpayer. The legislative history of section 1033 indicates the rule was designed for taxpayers that reinvested the proceeds from an involuntary conversion in qualified business property. There is little dispute if the property is completely destroyed. However, numerous questions arise when property is only partially destroyed. A review of the early case law involving partial destruction points out two requirements for claiming an involuntary conversion:
* The property must be damaged.
* The damage is such that the property is no longer suitable for its intended purpose.
The government originally had ruled that the involuntary conversion of timber required the trees to be directly converted into cash. In revenue ruling 80-175, however, it changed its position and allowed the sale of damaged timber to qualify for section 1033 treatment.
The Tax Court concluded the government's position in the current case was an attempt to reestablish a direct conversion requirement before permitting an involuntary conversion. The court rejected this effort. To qualify, a taxpayer must show that unexpected damage occurred that prevented it from using the asset as originally intended. The fact that Willamette chose to process the damaged timber rather than sell it doesn't change the fact that the timber was damaged--forcing the company to use the trees before the normal time. Therefore a valid involuntary conversion had taken place.
The court raised an interesting question in a footnote. Section 1033 requires taxpayers to reinvest the proceeds in qualified replacement property. Given that Willamette processed the trees rather than sold them, how would it demonstrate compliance with the reinvestment requirement? Since the IRS did not raise the question, the court did not address the issue.
Although this case involved timber, it applies to all taxpayers that suffer partial damage to their property that prevents them from using it as originally intended. The method of converting the damaged property to cash no longer should prevent a taxpayer from receiving the benefits of involuntary conversion treatment. It will not have to show it converted the property directly to cash to qualify for tax deferral. However, the taxpayer must be able to prove it reinvested the proceeds in qualified replacement property if the IRS raises the question.
* Willamette Industries Inc. v. Commissioner, 118 TC no. 7.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
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|Author:||Schnee, Edward J.|
|Publication:||Journal of Accountancy|
|Date:||Jul 1, 2002|
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