Forest Landowners Tax Council

FLTC Position on Passive Loss Regulations

Reform the passive loss regulations by removing time limitations for forest landowners and limitations on the activities of other persons, so as to permit the deduction of operating costs in the year incurred.

Background: In 1986 Congress enacted the passive activity loss (PAL) provisions of the Internal Revenue Code. The Internal Revenue Service subsequently enacted rules to implement the new provisions. Although forestry businesses and investments are normally not considered to be tax shelters, they still must abide by the passive loss rules, which separate all income, passive business income and investment income. In order to deduct all current expenses associated with a timber business against ordinary income, and to apply tax credits associated with a timber business against taxes on ordinary income, the timber owner must "materially participate" in the business, which is defined as being involved in the business on a "regular, continuous and substantial" basis. A timber owner is considered to "materially participate" if he or she meets one of the following tests:

He or she participates in the timber activity more than 500 hours during the tax year;

His or her personal participation in the timber activity constitutes substantially all of the participation (including all participation by all other individuals) for the tax year;

He or she participates in the timber activity for more than 100 hours during the tax year and no other individual participates more;

His or her aggregate participation in all of his or her "significant participation activities," including the timber activity, exceeds 500 hours during the tax year;

He or she materially participated in the timber activity for 5 of the preceding 10 tax years;

If the activity is a personal service activity, he or she materially participated in the activity for any three consecutive years, or

All facts and circumstances of the situation indicated that he or she participated in the activity on a regular, continuous and substantial basis during the tax year, and that such participation exceeded 100 hours.

Forest landowners seek reform of these rigid "material participation" rules for timber management activities since timber growing is unlike most other businesses in that timber is required to remain in place for a number of years without being harvested.

Rationale: Because of the cyclical nature of timber cutting and sales, active management of timberland often does not require a full 100 hours of "material participation" every year. It is an undue hardship on private timberland owners to show that he or she participated for a full 100 hours in order to be treated as an owner of an "active trade or business." Even when this test or others can be met on the landowner’s part, he or she may not qualify because another person, such as a consulting forester or a hired laborer, may devote more hours to the activity than the landowner. Timber management is unique in that the product takes years to grow and prepare for the sale. In the interim, management of timberland often requires the special skills of a forestry expert and the use of hired labor. Consequently, it is often very difficult for a landowner to know for certain that he or she meets one of the material participation tests even though management of the timberland may involve substantial activity on the owner’s part. Maintaining economic viability for America’s forest owners is key to preserving a sufficient supply of forest products. FLTC strongly supports reform of the passive activity regulations so as to reflect the realities of non-industrial timber management.