course of his business. Beginning in 1922, and until 
the 1986 Tax Reform Act, if these requirements were 
met, and if the owner had held the timber for the 
required length of time, any profit was treated as a 
long-term capital gain and taxed at lower effective 
rates than ordinary income. There was no specific 
language in the Revenue Code or regulations deal- 
ing with timber under these circumstances. Nor is 
there any today, nor is any necessary. 
However, during the years prior to 1944, if a 
landowner cut his timber himself and then sold it, or 
else used it in his business, he had to pay taxes at 
the ordinary income tax rate on whatever gain re- 
sulted. Such transactions were not given the benefit 
of capital gains treatment. For example, the owner 
who cut his own trees and then sold the logs to a 
sawmill was taxed at a higher rate than if he had sold 
the trees outright on the stump and let the purchas- 
er come on his land to do the cutting. Also, the 
sawmill owner who cut his own standing timber for 
use in his mill had to pay the higher ordinary income 
tax rates on the timber's increase in value. Thus, as 
a practical matter, such a mill owner might have 
been better off had he sold his timber outright as a 
Capital asset and then bought other timber for use 
in the mill. 
As tax rates climbed, woodland owners found 
that outright, lump-sum sales of their standing tim- 
ber worked to their distinct advantage. This tended 
to encourage liquidation rather than long-term man- 
agement. The situation became more serious when 
the Bureau of Internal Revenue (forerunner of the 
Internal Revenue Service) took the position in 1941 
that the sale of standing timber at an agreed price 
per unit of measure involved “retention of an eco- 
nomic interest" by the owner. In other words, such 
a disposal did not constitute a sale for capital gains 
purposes. Therefore, if a timber owner tried to man- 
age his lands properly and marked the trees for 
cutting, with the purchaser paying on a unit basis as 
the timber was cut and removed, the proceeds were 
generally treated as ordinary income. Here again, 
the timber owner who wanted to dispose of his tim- 
ber under a cutting contract was penalized as op- 
posed to one who made a lump-sum sale. 
Under the pressure of demand for timber during 
the Second World War, remedial legislation was 
sought. It was obtained in the Baily Amendment to 
102 
the 1943 Revenue Act, the latter being passed by 
Congress over President Roosevelt's veto. This leg- 
islation placed owners who cut their timber them- 
selves, or who disposed of it under a pay-as-cut 
contract, on the same tax basis as people who sold 
their timber outright in a lump-sum transaction. 
Such cutting or exchange was now, and is today, 
treated as a sale or an exchange of a capital asset. 
Transactions qualifying under these provisions of 
the law (originally Section 117(k), now 631, of the 
Internal Revenue Code) are given capital gain sta- 
tus regardless of whether the timber is includable in 
business inventory or whether it was held by the 
taxpayer primarily for sale to customers in the ordi- 
nary course of a trade or business. 
Section 631 (a) of the Code specifically permits 
taxpayers who cut their own timber, either for sale or 
for use in their trade or business, to qualify for capi- 
tal gain or loss treatment. The gain or loss is calcu- 
lated as the difference between the fair market value 
of the cut timber on the first day of the taxable year 
and its adjusted basis for depletion. The "sale" is 
hypothetical--a sale of the timber by taxpayers to 
themselves. Thus the capital gain tax is backed up 
against the corporate or personal income tax that is 
paid on the ordinary income that results from the 
profits from sale of the processed or manufactured 
products. 
Section 631(b) permits taxpayers to treat in- 
come derived from the sale of standing timber as a 
long-term capital gain when they retain an econom- 
ic interest in the timber. The gain or loss is calculat- 
ed as the difference between the income from the 
timber and its adjusted basis for depletion minus 
the costs of sale. Fair market value of the timber is 
not involved. For the seller to retain an economic 
interest, the buyer's obligation to pay must be con- 
tingent on the volume of the severed timber mea- 
sured either before or after it has been cut. Lump- 
sum sales do not qualify. 
Changes Made by the 1986 Tax Reform Act--Prior 
to 1987, individual taxpayers paid Federal income 
tax on ordinary income at one of 15 rates, ranging 
from 11 to 50 percent. Bracketed into five groups, 
these were as follows for married taxpayers filing 
joint returns: 
