Oregon Mesabi Corp. v. Commissioner

OREGON MESABI CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Oregon Mesabi Corp. v. Commissioner Docket No. 90392. United States Board of Tax Appeals 39 B.T.A. 1033; 1939 BTA LEXIS 945; May 24, 1939, Promulgated *945 The timber of a taxpayer was entirely killed in 1933 by a forest fire. It was not, however, thereby made worthless. It began immediately to be attacked by insects and fungi, with progressively destructive effect. Held, the entire timber was not the subject of a loss deduction in the year of the fire, but such a deduction is to be taken in the years and amounts in which, as shown by the evidence, the destruction and worthlessness occur. Lowell P. Mickelwait, Esq., and DeForest Perkins, Esq., for the petitioner. B. H. Neblett, Esq., for the respondent. STERNHAGEN *1034 The Commissioner determined a deficiency for 1934 of $181.07 in income tax and of $547.06 in surtax, and a deficiency for 1935 of $4,195.11 in income tax. Petitioner assails the disallowance in each year of deductions claimed in its returns for depletion of timber and now claimed as losses following a forest fire in 1933. FINDINGS OF FACT. Petitioner, a Delaware corporation with principal office at Seattle, Washington, is the owner of 3,500.41 acres of timberland in Tillamook County, Oregon, which it acquired on May 16, 1932, in exchange for its capital stock. *946 The holdings consist of nine separate, heavily timbered parcels in a rough and precipitous area the elevations of which vary between 500 and 3,000 feet. At the time of acquisition the parcels contained 225,830 M feet of Douglas fir, 17,390 M feet of hemlock and 197 M feet of cedar. The "adjusted basis" to petitioner of these properties was $316,602.14, of which $304,141.42 is applicable to the Douglas fir; $8,695 to the hemlock; $265.31 to the cedar; and $3,500.41 to the land. The surrounding area was owned by other timber companies, and about two miles from two of petitioner's parcels, lying in sections 2 and 10, a private railroad had been built in 1928, and logging operations had been conducted by the Flora Logging Co. There were no other facilities of transportation into the area, and the character of the terrain made construction of such facilities difficult and costly. In August 1933 the Tillamook fire swept over 400 square miles of the region and killed more than ten billion feet of timber. It was primarily a crown fire, which flashed quickly through the tree tops, consuming foliage, twigs, and small branches, charring the bark, and killing the trees. The fire itself*947 did not destroy the trees as sound timber. In places it burned near the ground, consuming twigs, brush, and humus, and leaving underlying rock exposed. After the trees were killed, the sapwood immediately began to stain. The trees then became vulnerable to insects and fungi which quickly attack dead timber. The resulting damage goes on increasingly for many years. The burning, stains, and insects destroyed about half of the sapwood of the fir trees by the end of 1934 and all of it by the end of 1935. As the sap dried and insect damage increased, there was progressively greater difficulty and danger of breakage in felling. Deterioration is fairly uniform during the first three years following a fire. Thereafter the large borers may attack the heartwood, which is the principal part of the tree, and deterioration is less uniform. *1035 At the end of 1935 these borers had laid eggs in the sapwood and in some instances had penetrated the heartwood. For unknown reasons some areas are worse infected with them than are others; they may appear within a few years or many years after a fire, and small trees normally succumb to them more rapidly than larger ones. About eight*948 or ten years after a Douglas fir tree has been burned, the heartwood is usually penetrated to an average depth of four inches. The timber is then practically worthless except in the case of very large trees. Hemlock, having a thinner bark, is damaged more quicklyn, and within three years is practically worthless. Soon after the Tillamook fire, the interested owners appointed a committee to make a survey and report on the damage. On December 7, 1933, all entered into an agreement contemplating the formation of a corporation to which each would convey its burned timber property in exchange for common shares proportionate to the "comparative value" of the property conveyed and each was also to subscribe for specified amounts of the corporation's preferred shares. Some owners thereafter made independent logging arrangements, and the plan was finally abandoned. Petitioner attempted, without success, to sell its properties, and in October 1934 it entered into a contract with Edward Murphy, which recited its belief that "to realize any substantial sum from its investment in its timber lands, salvage operations in said timber must be begun promptly and prosecuted vigorously" and*949 "substantially concluded within a period of approximately eight years." Murphy agreed to proceed vigorously, and to pay $1.50 per M feet for logs, as cut and removed, and also 25 percent of the amount by which the average market price of logs for each quarter year should exceed $14.50 per M feet. On April 18, 1935, Murphy assigned his contract to the Trask-Willamette Co., which procured the right to use the Flora Logging Co.'s railroad, and at the end of 1935 began logging in section 2. The Flora Logging Co. had begun operations in August 1934, having by that time repaired its road and begun construction of an extension into section 2. In August 1933, No. 1 logs of Douglas fir had a market value of $15.50 per M feet, which was $6 to $8 less than prices in 1929; the demand at this price was very small, and less than the amount of available green timber. Operations of the Flora Logging Co. had been suspended because of the depressed market. The cost of cutting and removing fire-killed timber is greater than that of cutting and removing green timber. Since 1934 market conditions have improved to some extent. The prices of No. 1 logs went from $17.50 per M feet in 1934 to $19.50*950 in 1935. Since the fire, a substantial amount of logging has been done in the burned region, some with *1036 trucks, which had previously been regarded as impractical. In 1938 between 800 and 900 million feet of timber had been removed. Some of this was green timber which in patches here and there had escaped burning. Under petitioner's contract with the Trask-Willamette Co., which is still in effect, 869,273 feet of fir and 17,898 feet of hemlock were removed in 1935 from 20 acres of petitioner's property, and between 20 and 30 million feet of its timber had been removed by August 1938 from section 2, and $30,000 had been received for it. Another two million feet had been removed by the Coast Lumber Co. Before the fire, section 2 contained 52,950,000 feet of green timber. Petitioner has not abandoned any of its properties, and none has been sold for taxes, although since 1932 it has paid taxes only on parcels in sections 2 and 10. It was physically and economically impracticable to remove and dispose of any of petitioner's timber in 1933. Its entire ultimate losses were not then certain or ascertainable. As a direct result of the fire, petitioner sustained a loss*951 of some of its timber in 1933. In 1934 petitioner sustained a loss of not less than $19,425.71 because of the destruction of fir and hemlock timber. In 1935 it sustained a loss of $38,000 because of the destruction of fir and hemlock. These losses have not been compensated for by insurance or otherwise. OPINION. STERNHAGEN: The taxpayer took deductions of $19,425.71 for 1934 and $45,234.64 for 1935, which the Commissioner disallowed entirely. The Commissioner held that any loss resulting from the Tillamook fire was sustained in 1933, when the fire occurred, and was therefore entirely deductible in that year. In the notice of deficiency, the explanation of the disallowance is stated as follows: The fire occurred in 1933 and the entire loss is held to be deductible in that year. All of the cedar and the hemlock as well as practically all the fir were fire killed. The petitioner attacks this as contrary both to fact and law. The contention is that although the fire occurred entirely in 1933 and killed the timber in that year, this alone was not the occasion of a complete loss in 1933, because the timber was not destroyed but was still useful and valuable; that the*952 destructive agents were the insects and fungi which invaded the dead timber with progressively destructive effect in the following years, resulting in successive annual losses. To support its contention, petitioner has produced scientific and practical evidence showing that although the fire killed the trees, *1037 they still remained useful and valuable as timber. As they stood immediately after the fire, they were hardly less desirable as wood than before. Vitality per se was not a factor of immediate usefulness; the timber would still have been good if nothing more had happened to it. In the mass, however, the fire operated to increase the extent of breakage both from natural falls and from felling, because the dead trees have less resilience to soften the fall, the humus cushion has been burned, and the trees are more brittle when they strike. Apparently, too, the risks of felling and consequent breakage are generally, in one way or another, enhanced by the fire. This the initiated are able to estimate in approximate percentages. As soon as the trees are killed by fire they become the object of a continuing onslaught by insects and fungi. These insects enter*953 at the outside, go through the bark, then penetrate the sapwood, and finally bore into the heartwood. If the owner is fortunate enough to have an immediate market and facilities for getting to it, he can sell his timber at once despite the killing by the fire. The attack by the insects is not immediately effective, but takes time. Witnesses from the United States Forestry Service and the Bureau of Entomology, testifying disinterestedly, left no doubt that this sort of damage was not felt at once but could be expected to progress over a period of years. Supplementing this testimony was that of practical and experienced timber men, those for petitioner reiterating it explicitly and those for respondent tacitly, while shifting the emphasis to marketing and transportation difficulties. From all the evidence it has been found as a fact that petitioner's entire investment in its timber was not lost in the year of the fire, and it follows that any deduction for loss on that account was not limited to 1933. That year is not directly involved in this proceeding, and hence it is not proper that a finding be made as to what loss was in fact sustained that year. There was, doubtless, *954 an immediate loss of some sort, and it may be presumed that a proper deduction for that year was taken and allowed. But, in the light of the evidence, it would have been clearly incorrect for petitioner on its 1933 return to have taken a deduction for the entire cost of its timber as a loss, and equally incorrect for the Commissioner to have allowed it. It is not suggested that either committed that error. The respondent, having in this proceeding determined that all the timber loss occurred in 1933, held that there could be no deduction for 1934 or 1935. His position here is absolute and unyielding. Therefore the issue is not a choice between a presumptively correct amount or formula used by the Commissioner and an amount claimed *1038 by the taxpayer; it is a choice between no deduction whatever, upon an invalid postulate, and some amount supported by the evidence. The respondent has not pleaded an alternative amount of deduction if his assumption of an entire loss in 1933 should turn out to be disapproved. The Government's witnesses testified not that the damage or destruction of the timber all occurred in 1933; indeed they left it fairly clear that they did not*955 believe it had. Their testimony was directed more to the adverse condition of the timber market and the difficulties of logging operations and transportation. It was indicated that it would have been impracticable to remove the timber from the forest, and in any event unprofitable to do so because the prevailing price was less than cost. This condition, however, was not demonstrably permanent; it would not have reasonably justified an abandonment of the timber in 1933 as worthless. Indeed, the evidence shows that logging was carried on to a substantial extent in 1934 and 1935 in the Tillamook area, this petitioner's tract alone in 1935 yielding 869,273 feet of fir and 17,898 feet of hemlock under the Trask-Willamette contract. If, therefore, petitioner had sought a deduction for 1933 based upon the evidence relied upon by respondent, the deduction must have been disallowed because there had been no definitive loss - no identifiable event such as sale, abandonment, or demonstrable worthlessness. There was only a showing of operating difficulty and commercial depression similar for our purposes to a mere market fluctuation. Such a showing would not support a deduction for loss, *956 but indicates that the capital asset did not disappear in the earlier year. Respondent also argues that petitioner's evidence indicates that there will be substantial salvage, and that this must serve to reduce the present loss. This argument proceeds from a misconception of the petitioner's claim. The claim is for an annual loss of an estimated portion of the composite whole, consisting of all of the timber on petitioner's tract. Even though there be a profitable disposition of some of the units of the mass, it is a mistake to treat this as if it were the salvaging of a part thought to have been destroyed. The rejection of the conception of a complete loss in 1933 carries with it the rejection of the idea that there may be salvage in later years in respect of the property mistakenly believed to have been lost. In addition to this it must be borne in mind that all logging operations resulting in commercial disposition of the timber will present the usual problems of depletion. In the entire record there is, in our opinion, nothing to prevent the petitioner from deducting in each of the years in question the cost of the proportionate amount of timber which by fair and reasonable*957 estimates can be found to have been destroyed in that year. *1039 The next question is, how much in each year? The petitioner's two witnesses gave different figures. Each estimated the loss on fir and the loss on hemlock for 1934 and for 1935. There is no evidence as to cedar; but the quantity of cedar was comparatively small and petitioner was perhaps willing to give it no thought, so no finding has been made as to cedar and no deduction may be allowed for it on this record. The petitioner treats its two witnesses as equally qualified, and submits the alternative of their two computations. Neither computation is presented as more than an estimate, and neither has been or, we apprehend, can with entire logic be demonstrated. Upon this question of fact a finding has been made as to the quantum of loss. That there is room for a flexible judgment as to amount must be obvious. Hence as to 1934 the finding has been expressed in terms which limit the deduction to the amount claimed by petitioner on its return and disallowed by the Commissioner. Perhaps a greater deduction might have been supported, but there can be no complaint if the finding stays within the pleadings. *958 As to 1935, while it is clear from the evidence that the loss was substantially greater than in 1934, it is, in our opinion, not established that it was as great as the $45,234.64 which petitioner claims. It has, therefore, been found as a fact that the loss for that year amounts to $38,000, which is the amount deductible, including both fir and hemlock. Reviewed by the Board. Decision will be entered under Rule 50. ARNOLD dissents.