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Christmas tree production has expanded rapidly in North Carolina: sales have grown from slightly over $1.6 million in 1972 to $73.5 million in 1993, a 46-fold increase. A survey conducted in the mid 1980s showed that Fraser fir represented 55 percent of the species grown; white pine, 22 percent; and balsam fir, 14 percent. The remaining 9 percent of species included redcedar, Virginia pine, Norway spruce, and white pine. Traditionally, production was confined primarily to the western part of the state, but some production now occurs in the piedmont and coastal plain. As production has become more scattered throughout the state, a larger number of growers are involved, and both growers and tax preparers are asking an increasing number of questions about how the income from sales of evergreen trees is taxed.
The material presented here is based on an interpretation of the current Internal Revenue Service Code and analyses provided by various tax advisory services. Readers, however, are responsible for any action they take as a result of this information.
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When establishing a stand of evergreen trees, growers must choose among various species to plant. Different species have different growth rates, which affects the time between planting and harvesting a cash crop. The time when trees are harvested not only affects cash flow but also determines whether evergreen trees are harvested and sold as horticultural products or as timber (Christmas trees). An evergreen tree that is more than six years old when it is severed from its roots and sold for ornamental purposes is considered by Internal Revenue Service Code as timber, and profit is treated as long-term capital gains income (Code Section 631 [a]). The age of a tree is measured from the time of seed germination to the time of harvesting. If trees are not six years old when cut, or if they are six years of age or older and dug and sold as ball-and-burlapped trees, they are considered to be horticultural products and profits are classified as ordinary income (Reg 1.631-1 [b] [2]).
The advantage of selling evergreen trees as timber and in having any gain or loss from the sale considered capital gains or losses is that the highest marginal tax rate (28%) on long-term capital gains is less than the highest marginal tax rate on ordinary income. Also, capital gains income is not subject to self-employment taxes as is ordinary income generated from the sale of horticultural products.
Growing evergreen trees usually constitutes a trade or business, which means that growers can deduct ordinary and reasonable expenses, with some exceptions. The costs incurred in growing Christmas trees must be classified into one or more of the three production stages: establishment, growing, and sales.
The establishment period begins with site preparation and ends when the last tree is planted. Examples of costs include land preparation, lime, fertilizer, grass seed, herbicide, interest, hired labor, small tools, seedlings, and depreciation on equipment and other capital assets. Any costs necessary to establish the stand are considered capital expenditures, which are not deductible in the year incurred. These costs can, however, be deducted from the gross income from sales, thereby lowering the amount of taxable income. Therefore, it is important that you keep a careful record of these expenses; this record is called a capital account.
The growing period begins when all the activities that ensure seedling survival have been completed. Expenses that may be incurred during this period include hired labor, cost of shearing, insect control, fertilization, weed control, rental payments, interest on production loans, road and fire line maintenance, and depreciation deductions on equipment used in the business. During the growing period, growers have the option to deduct annual expenses from income or to add the expenses to the capital account. This choice is made each year.
The sales period is the time during which trees are sold. Examples of sales costs include the expenses of tree marking, harvesting, bagging material, baling, hauling costs, advertising, and hired labor. All costs associated with the sale of Christmas trees are recovered by deducting them from sales proceeds.
Fraser fir is the most popular variety of Christmas trees, so we present a summary of budgets for this species (Table 1) to illustrate the costs and resulting income for a stand of trees from site establishment to harvest. These budgets were developed with 1994 costs and with the assumptions that five-year-old seedlings were transplanted into the field and that harvest would begin in the sixth year after transplanting. Remember that costs, income, and growth rate vary among species.
Table 1. Annual Per Acre Costs, Income, and Cash Flow for
Fraser Fir Christmas Tree Plantation, 19941,2
| Year | Activity | Total Cost ($) | Income ($) | Cash Flow ($) |
| 0 | Establishment period | 1,226 | 0.00 | –1,226 |
| 1 | Establishment period | 1,958 | 0.00 | –1,958 |
| 2 | Growing period | 864 | 0.00 | –864 |
| 3 | Growing period | 842 | 0.00 | –842 |
| 4 | Growing period | 1,065 | 0.00 | –1,065 |
| 5 | Growing period | 1,164 | 0.00 | –1,164 |
| 6 | Harvesting period | 2,164 | 6,400.00 | 4,236 |
| 7 | Harvesting period | 2,817 | 14,600.00 | 11,783 |
| 8 | Harvesting period | 1,770 | 8,050.00 | 6,280 |
| Totals | 13,870 | 29,050.00 | 15,180 |
1Jeff Owen and Ross Young, Extension Agents and Lenny Rogers, Area Farm Management Agent, North Carolina Cooperative Extension Service.
2Summary prepared from data in the yearly budgets included in the appendix.
In this example, a grower would have to spend $7,119 (a negative cash flow) during the first five years before any income was realized. When harvesting begins in the sixth year, cash flow becomes positive.
All expenses incurred while preparing the site and establishing a stand of evergreen trees must be capitalized. Again, capitalization means that these expenses cannot be deducted immediately but must be placed in a capital account and deducted when income from the sale of trees is realized. In the example here, the costs of site preparation ($1,226) and establishment ($1,958) must be capitalized. This is assuming that all first-year costs are establishment costs. The total amount of $3,184 would be recovered by a depletion allowance when the trees are sold. For example, if at harvest there were 1,600 salable trees then the depletion allowance would be $1.99 ($3,184 divided by 1,600) per tree. This depletion allowance of $1.99 would be used as a cost to offset the taxable income per tree when the trees are sold.
During the growing period, growers have the option to either deduct costs as current expenses or to add these costs to the capital account. For example, the second year costs of $864 per acre could either be deducted as a current expense for tax purposes or added to the capital account. If a grower has a significant taxable income that year, it probably would be advantageous to deduct growing costs as a current expense. If not, the expenses should be added to the capital account and deducted as a depletion allowance when the trees are sold.
To be eligible to deduct growing-period expenses, however, a grower must be "materially participating" in a trade or business. A grower who is materially participating can deduct all ordinary and reasonable expenses incurred in operating a trade or business. A grower is considered to be materially participating if he or she meets at least one of the following tests:
If a grower does not materially participate in a Christmas tree trade or business, the operation is defined as a passive activity. Generally, deductions for a passive activity are allowed only to the extent of total income from all passive activities for the year. Excess deductions must be carried forward until there is passive income.
Timber is defined by the Internal Revenue Code as the wood in standing trees that is recovered when the trees are cut and processed. It includes the parts of standing trees that are used or can be used for lumber, pulpwood, veneer, poles, crossties, piling, or other wood products. Generally, the gains and losses resulting from the sale of timber qualify for special tax treatment as capital gains income. If held as an investment or for a trade or business, the sale of timber could qualify for capital gains treatment. If used in a trade or business, sales should qualify for capital gains treatment if the owner elected to treat the cutting of timber as a sale under Code Section 631(a) or with a retained economic interest under Code Section 631(b).
For purposes of Code Section 631 (a) and Section (b), the term timber includes evergreen trees that are more than six years old at the time they are severed from their roots and sold for ornamental purposes, such as Christmas trees. Tops and other parts are not considered as evergreen trees within the meaning of section 631 (a) or Section 631 (b). The term evergreen trees is used in its commonly accepted sense and includes pine, spruce, fir, hemlock, cedar, and other coniferous trees (Reg. 1.631-1 [b] [2]).
Section 631 (a) is not applicable to evergreen trees sold live, whether or not they are sold for ornamental purposes. Dug trees sold live would be considered horticultural products, and all income would be classified as ordinary income.
Net gains from the sale of Christmas trees can qualify as capital gains income if growers use one of two selling methods. These methods are (1) cutting standing timber with an election to treat as a sale (Code Section 631 [a]), and (2) disposing of timber with an economic interest retained (Code Section 631 [b]).
|
Method 1: Cutting Timber with an Election to Treat as a Sale (Section 631 [a])
Under this sales method, evergreen trees (standing timber) are cut by the owner who then sells or disposes of the trees. The owner must cut the trees or have them cut by someone under contract. In all cases the owner must retain title. Using this sales method growers report gain in two parts. | |||
| 1. | The difference between the depletion cost (depletion allowance x number of trees) and the fair market value of the standing trees as of January 1 in the year they are cut is capital gain or loss. The fair market value on January 1 is determined by the condition of the trees when they are actually cut. This was the opinion of the Ninth Circuit Court in the case of Harold Schudel versus the Commissioner. It was the opinion of the court that using the beginning of the year date in Code Section 631 (a) was used by Congress only to simplify preparing and processing tax returns. | ||
| 2. | The fair market value on January 1 becomes the new basis. Proceeds from the sale minus the fair market value is ordinary income. Example: A grower established a 10-acre plot of Christmas trees in 1988 with a planting of 19,000 trees at a total cost of $31,840. During the growing period, which extended from 1989 through 1993, the grower incurred expenses of $60,990 for hired labor, chemicals, weed cutting, shearing, and other outlays. The grower elected to capitalize these expenses. In 1994, when the grower began to sell the trees, he/she had a basis (from the capital account) of $92,830 ($31,840 plus $60,990) in 16,000 merch antable trees for a depletion unit of $5.80 per tree ($92,830 divided by 16,000). The grower cut 4,000 trees in 1994 and sold them to a wholesaler for $64,000. As of January 1, 1994, the fair market value for trees averaging 6 ½ feet tall was $2.25 p er foot, for a total value of $58,500. This value was estimated for tax purposes. The grower incurred harvesting expenses of $2,500. Taxable gain was computed in two steps as follows: | ||
| Step 1 | Fair market value on January 1, 1994 (tax value) | $58,500 | |
| (4,000 trees at $14.63 each) | |||
| Less depletion costs | $23,200 | ||
| (4,000 trees at $5.80 per tree) | |||
| Long term capital gain | $35,300 | ||
| Reported on Part 1, Form 4797 | |||
| Step 2 | Sold trees in November 1994 (sales price) | $64,000 | |
| (4,000 trees at $16.00 per tree) | |||
| Less fair market value on January 1, 1994 | $58,500 | ||
| Less harvesting cost | $2,500 | ||
| Gain: Ordinary income Reported on Part 1, Form 4797 |
$2,980 | ||
| Method 2: Selling Trees with an Economic Interest Retained (Section 631[b]) In 1994, a grower sold 4,000 trees by entering into a cutting contract with a wholesaler. A price of $2.50 per foot was agreed upon. The taxpayer retained title to the trees until they were cut by the buyer. Title transferred hands at the time the trees w ere cut. The wholesaler cut 4,000 trees averaging 6 feet in height. Gain would be reported as follows: |
| Total receipts (4,000 trees x $2.50 per foot x 6 feet) |
$60,000 | ||
| Less depletion costs (4,000 trees x $5.80 per tree) |
$23,200 | ||
| Gain (long-term capital gain) | $36,800 | ||
| The gain of $36,800 would be reported on Part 1, Form 4797 | |||
Christmas tree production is a long-term investment of capital, labor, materials, and land. To take full advantage of legal tax deductions, it is essential that growers maintain an accurate record-keeping system, called a capital account. Keeping this account will help track establishment costs and non-deducted costs of production (cost basis). Growers can recover cost basis through depletion when Christmas trees are sold or disposed of. Most annual growing expenses incurred after establishment may be deducted in the year incurred if the grower is active (as defined by the Internal Revenue Service) in the Christmas tree business. If growers are considered by IRS regulations to be "passive" in the business, or if deductions are not needed in the given tax year, they may choose to add annual growing expenses to the capital account. Carefully analyze the method you use in selling Christmas trees to ensure that your income qualifies for capital gains treatment.
It is strongly recommended that you enlist the services of a CPA, a tax attorney, or a financial advisor. For more information, contact your local county Extension center.
The appendix contains an example budget of the production of one acre of Fraser fir for Christmas trees in Avery County, North Carolina. It was prepared for an enterprise that was to begin with site preparation in Fall 1993. We present this budget to show the complete nonland costs and receipts per acre of such an enterprise. Remember that only paid costs and depreciation and depletion allowances (based on previously paid amounts) are deductible in determining each year's taxable income. The costs are itemized and accounted for by year they are incurred in production. The subtotals for site preparation, stand establishment, and yearly growing costs are carried forward with interest until the harvest years when a (tree-count based) portion of their total is deducted as a prorated depletion allowance from each harvest year's estimated receipts.
Prepared by
R. A. Hamilton, Extension Forestry Specialist, Taxation
W. D. Eickhoff, Extension Economist
C. R. McKinley, Extension Forestry Specialist, Christmas Trees
College of Natural Resources, NCSU
11/96—2M—GBB— (Reprint)
AG-525
E97 27302
Christmas Tree Programs
NC Cooperative Extension
NC State University