Are you a timber company that’s recently purchased timberland, plans to make significant investments in timberland ownership, or has significant timberland holdings that produce taxable income?
If so, your approach to timber depletion is one of the more significant planning areas to garner potential tax savings or deferrals. Various methods can be used to recover the cost basis of your investment in timber assets. The recognition of these expenses for accounting and tax purposes occurs as the timber is harvested.
At the end of the day, the goal is to establish a method that increases current cash flow on the front end by reducing your current tax liability, which ultimately frees up cash to reinvest in your operations.
Depletion methodology starts with the original purchase price allocation of a timberland acquisition to timber, land, and other identifiable property.
Finding the appropriate balance of complexity within your approach and ascertaining the benefit provided can often be a detailed but flexible process. Here are some things to consider:
As you think through an initial purchase price allocation and the creation of timber depletion pools, here are some factors that might impact your decision:
As you determine whether assessing depletion alternatives might be beneficial to your company, ask these questions:
The last question is of particular importance because a large purchase with long-term prospects has more value if you speed up the depletion, freeing up cash flow you can reinvest in timberland acquisitions or other business investments. These timberland owners are more likely to benefit from analyzing the allocation of cost basis to various depletion pools.
On the other hand, you’re less likely to find value if your plan is to purchase and harvest timber in the short term or if there’s no taxable income to offset (for owners with passive loss carryovers or tax-exempt owners, for example).
Timber depletion is limited to your total cost basis in timber. You wouldn’t deplete your timber in full until you’ve harvested all of the applicable standing timber.
Here’s a very simplified example: If you have $1 million of cost basis in your merchantable timber and you have 5,000 MBF (thousand board feet) of standing merchantable timber, you would deplete $1 million of cost over that 5,000 MBF of timber. For every MBF of timber harvested, you would deplete $200 of merchantable timber cost basis.
The goal is to optimize your cost allocation process between merchantable timber and other asset categories in order to create the most appropriate economic result that accomplishes your business’s financial and tax objectives. With that goal in mind, this thought process is often meant to reduce your current tax liability and increase current cash flow.
It’s important to remember that you may be able to change your depletion method at a later date if the situation warrants it—you aren’t necessarily locked in.
Many timber companies take the simplest approach, which might not be the wrong approach in their circumstances. However, in some situations, it may be advantageous to look at alternative ways to bifurcate timber depletion pools to achieve the best financial results.
There are typically two reasons companies evaluate alternative depletion options:
It’s difficult to understand the value of this thought process until you’ve taken some time to analyze your alternatives. While selecting a depletion methodology is an opportunity for thoughtful analysis, it may also require additional commitment, due to additional administrative and record-keeping requirements.
The complexity of the process can be driven by the targeted benefit. It does generally require a tax appetite in order for the benefit to be worth the commitment of cost and time.
There are multiple factors to consider depending on your company’s particular situation when it comes to depletion. It’s important to note any methodology you choose will hinge upon your company’s tax and financial goals—and those goals can oftentimes be different.
Contact your Moss Adams professional if you’d like to assess your situation to see if an alternative depletion methodology will better address your financial goals.