Market Segment Specialization Program (MSSP)
Placer Mining Industry
Table of Contents
Placer mining is a special opencut method for exploiting deposits of sand or gravel containing workable amounts of valuable minerals. Native gold is the most important placer mineral, but platinum and tin are also found in gravels. Minerals also include zircon, diamond, ruby, and other gems.
The Market Segment Specialization Program (MSSP) presents this manual as a guideline for the examinations of taxpayers in the Placer Mining Industry. This guide focuses on small mining operations represented as sole proprietorships on Schedule C, but it can be adapted for partnership and corporate returns.
This text is supplemental to the Audit Technique Guide previously published and which contains in-depth discussions of issues associated with the mining industry.
Chapter 1 - Introduction
Major operators produce the bulk of gold recovered and refined, but small-scale, independent miners make up the majority of the returns filed. Mining has historically been a cash-based activity. Often the miner will have little, if any, documentation to support the activity. If there are records, they are often disorganized. Hand-written receipts are common. This guide addresses some specific problem areas encountered in the examination of the smaller mining operations, with emphasis on the placer miner.
Under current tax law, exploration and development expenses can be deducted in full in the year they are paid or incurred. The expenses must be recaptured in the year that the mine goes into the producing stage or upon disposition of the property. In reality, few miners ever claim to be in the producing stage, disposals are seldom reported, and it is unlikely that proper accounting for the recapture of expenses will be found. In the past, taxpayers have deducted large mining losses with little or no recourse by the Government. IRC section 183 has strengthened the position of the Service in holding that a miner must be in a trade or business or engaged in an activity for the production of income with the objective of making a profit in order to claim mining related expenses such as those for exploration and development.
The small placer miner usually claims a Schedule C loss created by deducting exploration and development expenses with little or no mining income. The miner claims to be in the exploration or development stage when, in fact, gold is being produced and sold. The examiner will generally find that the expenses are related to the extraction of gold while the sales of gold are not reported.
The miner may be required to maintain a mineral inventory and claim cost-of-goods sold, including the costs necessary to clearly reflect income following the matching of income and expenses principal. Examiners should verify the mining stage, search for unreported income, and confirm the existence of an inventory. Most expenses will be found to be either direct or indirect mining costs which should be included as part of cost-of-goods sold. As a result, mining losses can be reduced by either the increases to income or the decreases in deductible expenses or both.
There is no one inclusive definition of "mining" for federal income tax purposes. The key definitions needed for a quality examination of mining operations are defined below. The glossary includes more definitions of mining terminology.
The term mine as defined in Treas. Reg. section 1.617-3(c)(1) states:
The term "mine" includes all quarries, pits, shafts, and wells, and any other excavations or workings for the purpose of extracting any known deposit of ore or other mineral.
The term mining property defined in Treas. Reg. section 1.617-3(c)(3) states:
The term "mining property" means any property (as the term is defined in IRC section 614(a) after the application of subsection (c) and (e) thereof) with respect to which any expenditures allowed as deductions under IRC section 617(a) are properly chargeable.
The term property as defined in IRC section 614(a) states:
For the purpose of computing the depletion allowance in the case of mines, wells, and other natural deposits, the term "property" means each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land.
The term mining as defined in IRC section 613(c)(2) states in part:
The term "mining" includes not merely the extraction of the ores or minerals from the ground but also the treatment processes considered as mining described in paragraph (4) (and the treatment processes necessary or incidental thereto), and so much of the transportation of ores or minerals (whether or not common carrier) from the point of extraction from the ground to the plant or mills in which such treatment processes are applied thereto as is not in excess of 50 miles unless the Secretary finds that the physical and other requirements are such that the ore or mineral must be transported a greater distance to such plants or mills.
The life of mining property is generally classified into three separate stages: Exploration, Development, and Producing. The term "exploration expenditures" as defined in IRC section 617(a)(1) provides in part:
* * * At the election of the taxpayer, expenditures paid or incurred during the taxable year for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, and paid or incurred before the beginning of the development stage of the mine, shall be allowed as a deduction in computing taxable income. * * * In no case shall this subsection apply with respect to amounts paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of oil or gas or of any mineral with respect to which a deduction for percentage depletion is not allowable under IRC section 613.
The term development expenditures as defined in IRC section 616(a) provides in part:
* * * there shall be allowed as a deduction in computing taxable income all expenditures paid or incurred during the taxable year for the development of a mine or other natural deposit (other than an oil or gas well) if paid or incurred after the existence of ores or minerals in commercially marketable quantities has been disclosed.
The term producing stage as defined in Treas. Reg. section 1.616-2(b) states:
The mine or other natural deposit will be considered to be in a producing stage when the major portion of the mineral production is obtained from workings other than those opened for the purpose of development, or when the principal activity of the mine or other natural deposit is the production of developed ores or minerals rather than the development of additional ores or minerals for mining.
The term Producing Stage is defined in Treas. Reg. section 1.617-3(c)(2) as follows:
The term Economic Interest as used in Treas. Reg. section 1.611-1(b)(1) is defined as follows:
Annual depletion deductions are allowed only to the owner of an economic interest in mineral deposits or standing timber. An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from extraction of the mineral or severance of the timber, to which he must look for a return of his capital.
Exploration, Development, and ProductionOne of the first determinations to be made in an examination of small mining operations is the type and current stage of the mining activity.
Exploration expenditures include amounts paid or incurred during the taxable year, prior to the development stage, for ascertaining the existence, location, extent, or quality of the mineral deposit. Some activities associated with placer mining exploration include staking the claim, removal of property line obstructions, limited removal of overburden (the removal of large amounts of overburden would indicate that a deposit may have already been found and the mine may be in a different stage), and limited sluicing.
Rev. Rul. 70-287, 1970-1 C.B. 146, holds that exploration expenditures include geological and geophysical investigations, reconnaissance, surveying, testpitting, trenching, drilling, driving of exploration tunnels and adits, and similar types of work. However, the physical means or method by which the work is performed does not distinguish exploration from development. For example, core drilling expenditures incurred in a mineralized outcrop after minerals are found to exist in commercially marketable quantities are not exploration expenses.
Exploration expenditures constitute capital expenditures which increase the basis of the mineral property unless the taxpayer makes an election to currently deduct the expenses. The election is made for the first year the taxpayer wishes to deduct the expenditures. The expenditure deductions are subject to recapture when the mine reaches the production stage. The recapture may be accomplished by either the disallowance of depletion deductions until the disallowed amounts equal the previously deducted exploration expenses or the inclusion in non-depletable gross income in an amount equal to the previously deducted expenditures.
The majority of Schedule C returns may appear to be in the exploration stage, but this should be verified. Since reporting requirements for the various stages of the operation differ, it is important to establish, preferably in the initial interview, the stage of mine operation.
The exploration stage encompasses prospecting, which does not necessarily require a state filing and actual exploration. If prospecting is conducted on public lands, a minimum requirement is the filing of Affidavits of Annual Labor. Due to the inclusion of prospecting under IRC section 617, an examination cannot be based on the sole fact that the taxpayer did or did not file the required forms with the state. Filings are not required if the land is privately held.
It is helpful, at the initial interview, to determine the approximate amount of time that was spent at the mine during the tax year since the mining season varies and can be relatively short. Only larger operators will have the equipment and resources to work through the winter. Once this information is obtained, it can be verified with the Affidavit of Annual Labor. However, remember that the Affidavits of Annual Labor are NOT verified by the Department of Natural Resources so they should only be used as a comparison tool.
It may be necessary to explain the various stages of mining to the taxpayer. If this situation arises, examiners should allow taxpayers to describe their activities before determining which stage the taxpayer is in or explaining the tax ramifications.
Taxpayers generally have difficulty distinguishing between the exploration and development stages. If the development stage is claimed, examiners should verify with the taxpayers that they have discovered commercially marketable quantities of ore. In following Paul R.. Schouten and Mary Kay Schouten v. Commissioner, T.C. Memo., 1991-155, CCH 47,277(M), development expenses can be disallowed when a taxpayer cannot present evidence as to the existence of minerals in commercially marketable quantities.
There should be very little, if any, income during this period. Activities associated with development are building roads, clearing the land, and other activities to prepare a site for the production stage.
Development expenditures must be for preparing a mineral deposit for extraction of the mineral and not for equipment or facilities which relate solely to the extraction of the mineral from the deposit.
Pre-stripping is a process found in open pit and strip mines. The process involves the removal of top soil or earth to expose a coal or ore deposit for later mining. The actual ore may not be removed until the next year after the covering layer of earth is removed or stripped away.
Where the removal of the overburden is related to the extraction of the mineral in the day-to-day mining cycle, and the removal of overburden makes it possible to extract only a small portion of the ore directly beneath the overburden, the costs of overburden removal are operating expenses of mining to be taken into account as costs-of-goods sold under the provisions of Treas. Reg. section 1.61-3. See Rev. Ruls. 67-169, 1967-1 C.B. 159 and 77-308, 1977-2 C.B. 208.
Where a portion of the coal seam is exposed in excess of what is needed to maintain a desired level of coal production, these expenses are developmental expenses under IRC section 616. See Rev. Rul. 86-83, 1986-1 C.B. 251. Accordingly, where expenditures incurred for removing overburden serve both to expose ore for mining and make possible the future mining of additional ore, the costs are developmental expenditures under IRC section 616 because they are incurred for the purpose of making the ore accessible for sustained extraction over a relatively long period.
The time involved with development can be for a short or relatively long period, depending on the location of the mine, the taxpayer's resources, and the amount of work needed to ready the ore body for production. Taxpayers should be questioned on their plan for development of the property. Have the required permits been submitted to the Department of Natural Resources, the Department of the Interior, the Department of Environmental Conservation, etc.? Ask and determine if they are familiar with the filing requirements concerning the property being worked. If they are unaware of the requirements or activity, this may be an indication that the claim owner is not working the mine and possibly making it a passive activity or an activity not engaged in for profit pursuant to IRC section 183.
If the taxpayer is claiming to be in the production stage, the issues of recapture and depletion should be considered. In all instances, regardless of the mining status, expenditures should be reviewed for possible examination issues. Consider if the alternative minimum tax applies or if a passive activity exists.
Recapture of previous expenditures is an important issue when the taxpayer is claiming to have always been in production. If taxpayers state they have always been in production, ask to see returns as far back as possible to derive some type of history of the operation. There should at least be some income in each year, although taxpayers can legitimately state they are in production while having no income shown on the return. If a taxpayer claims to be in production, yet a history of the operation shows continual losses, then the "not for profit" issue under IRC section 183 can be raised and pursued.
The Alaska Department of Natural Resources office contains information on all mining claims in Alaska, on both state and federal lands. Examiners should identify similar regulatory agencies within their state.
Records should be available to identify the claim holder by name and location of the claim. Records may also list the type of activity, the discovery date, the legal description, the years annual labor reports were filed, and any transactions pertaining to the property. They will also indicate if a claim has been abandoned.
The files may contain copies of all recorded documents pertaining to the property, such as quitclaim deeds, warranty deeds, affidavits of annual labor, and any other documents which have been officially recorded.
These documents are public record and easily researched. When a claim is established, on either state or federal land, the proper documentation is submitted to the Bureau of Land Management (BLM) for federal land and Department of Natural Resources (DNR) for state land. A number is assigned to the claim and remains with the claim indefinitely.