A Decade-Long Battle
In this post, we revisit the 12-year battle fought with the IRS: If vineyard and winery operations are considered part of the same “group” for tax purposes, there ought to be significant tax deferral opportunities. The IRS didn’t want to allow these, because it was just “too good.” It took 12 years before the IRS finally acquiesced.
Vineyard and Winery–Separate or Combined?
We always advise clients with integrated wineries to put their winemaking operations into a separate legal entity from their farming operations. Vinification involves manufacturing processes and tasting rooms, both of which can easily lead to liability issues. Why are we then suggesting here that they should be combined with vinyards?
We are not suggesting combining them completely, at least not on an operational and legal entity level. It is very important that the vineyard and winery operations are managed separately. This is done to ensure that they are respected as separate legal entities for potential liability issues. However, if they are considered as part of the same “group” for tax purposes, there are significant tax deferral opportunities. Greg Scott explains this best in his article published originally in the Practical Vineyard and Winery Journal‘s May/June 1999 issue. Because this idea is still very much applicable today, 15 years later, we included his article below as highly recommend reading. Greg and other wine industry representatives battled with the IRS for a number of years, and it is worth revisiting how this very beneficial position, which is still used today, was defended.
First, however, we would like to start with an extract from the March 2011 Wine Industry Audit Technique Guide, showing that the IRS has accepted this position. This audit technique guides was issued by the IRS to its field staff to provide them with guidance when they audit wineries.
“The farmer deducts the grape growing costs and has no gross receipts. The winery takes the grapes into inventory at zero basis and reflects a much smaller cost of goods sold when the wine is eventually sold. […], there is a deferral until the wine is sold.
[…] the new regulations at Treas. Reg. § 1.263A-4(a) were published 8/22/1997, making it clear that farmers, eligible to use to cash method, could do so in a consolidated setting or single entity with different operating divisions.
Since the publication of those regulations, the single entity concept has become very popular.”
Tax Deferral of Combined Vineyard and Winery Operations–by Greg Scott, first published in the Practical Vineyard and Winery Journal’s May/June 1999 issue.
In the last 12 years, a drama of sorts has been played out between the Internal Revenue Service (IRS) and the California wine and vineyard industry. The IRS attempted to eliminate what had been clearly intended benefits of the cash method for farming operations.
In response to substantial changes in the tax law, which significantly changed the inventory costing rules for winery operations, the IRS organized a wine industry group that examined the returns of the majority of winery and vineyard operations in northern California.
This group’s mission was to insure that wineries conformed to the “costly” uniform cost capitalization rules. These rules require all manufacturers to add to inventory many costs which wineries previously had been able to deduct. For wineries, the effect of these rules was usually quite large.
Additionally, the leadership of the IRS specialty group felt that combined and related winery/vineyard operations enjoyed too large a tax benefit for too long. They challenged the ability of combined and/or related winery and vineyard operations to deduct farming costs and not recognize any income related to the crop until the wine made from those grapes was sold.
Farmers have always been able to use the cash method for tax purposes even though farmers are in a “production” business. The reasons for this historically were to allow the farmer to use a simple method to calculate taxable income and not to burden farmers with cumbersome inventory accounting rules for the products they produce in the business of farming. Farmers had always enjoyed this clearly intended benefit.
The first narrowing of availability of this benefit was enacted in the 1976 Tax Reform Act. With this tax act, corporate-owned farms that were not “family owned” could no longer use the cash method for farming. However, non-corporate farmers, (excluding those that had been marketed as tax shelters) continued to be eligible to use the cash method, and even family-owned corporate farming operations continued to be eligible to use the cash method.
From 1976 until 1986, further changes were made, refining the exceptions to the ability to use the cash method, but none of them affected a closely held farm run by family members. Then in 1987, a dollar limit was set on a family-owned corporate farmers’ ability to use the cash method. As a result of the 1987 tax act, family-owned corporations with gross receipts in excess of $25 million per year could no longer use the cash ‘method for tax purposes.
Though these large family-owned farming operations were forced off of the cash method, they were initially given a permanent tax holiday on the adjustment necessary to convert and undo the benefits of the cash method. The adjustment required to convert from the cash to the accrual method was not included in taxable income as long as the size of the business operation did not decrease and it remained family owned. The holiday was changed in 1996 and now requires the amount to be included in taxable income, and spread over 10 years.
Those family-farming operations that were S Corporations or partnerships could still use the cash method regardless of gross receipts, but the IRS wine industry group next attempted to eliminate this benefit.
There are three basic ways that winery and vineyard operations under common control are structured in terms of their ownership. Depending upon how the ownership of the winery and vineyard operations are structured, different tax rules apply in determining how to achieve the maximum tax deferral from the use of the cash method for the farming operations. The three basic forms of ownership are
- a parent and subsidiary corporation filing a consolidated return, (not a common form today for smaller operations),
- a single entity with both winery arid vineyard operations, and
- brother/sister entities under common control.
The brother/sister could comprise any mix of organizational forms, usually with common if not completely identical ownership. One might be a partnership, while the other could be another partnership or an S corporation.
In the consolidated return setting, regulations provide guidance as to how and when the profit can be recognized in taxable income when one company in a consolidated return sells products to another company in the consolidated return.
In the past, the IRS’ position was that the cash basis farmer, which was one of the companies in the consolidated return, could continue to deduct its ‘farming costs and defer the gross proceeds from the sale of grapes to the winery company in the consolidated return, triggering or recognizing that profit as taxable income only as the winery sold the wine made from those grapes.
In the brother/sister setting, prior to the IRS wine industry group scrutiny, the cash basis vineyard entity sold the grapes to the winery under an installment sales contract calling for payment to the vineyard by the winery only at the time that the winery sold the wine.
The related party provisions in the tax code would preclude the winery from taking a deduction for the cost of grapes as part of cost of goods sold if it had not paid the related cash basis vineyard entity by the time the wine was sold. Thus, there was a clear safeguard in the tax code to preclude an indefinite deferral of the vineyard profit beyond the time the related winery sold the wine.
Finally, in the single entity approach, the tax rules provide and recognize that a single entity can operate multiple trades or businesses within that single entity and use a different method of accounting for each trade or business.
Other provisions of the tax code and regulations clearly recognized that farming and winemaking were separate and distinct trades or businesses. What was unclear, until regulations were issued by the Treasury Department with respect to its Uniform Cost Capitalization provisions enacted in 1986, was how a combined farming and manufacturing operation would deal with the interdivisional transfer of product.
In the regulations, the IRS defined a farming activity and a non-farming activity. A farming business includes the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity, the raising or harvesting of crops, or harvesting of trees bearing fruits, nuts, or other crops, and so on.
The regulations also state that the farming business includes the processing activities that are normally incident to the growing, raising, or harvesting of agricultural products, and thus, the picking, washing, and packaging of fruits and vegetables for sale would all be part of the farming business.
However, the regulations state that the farming business “does not include the processing of commodities or products beyond the state in which they were normally available as a farm product.” The regulations include the example of growing wheat as a farming activity but the further milling of that wheat into flour and making that flour into bread are identified as non-farming activities.
The rules clearly state that, when there are both farming and non-farming businesses in a single entity, taxpayers only have to capitalize (and not deduct) the costs of further processing the farm product beyond the state in which it is normally available as a farm product. Thus, before the IRS change of heart, it was felt to be generally clear that a combined vineyard and winery operation in a single entity–which because of its form or ownership was eligible to use the cash method for its farming activities and which had chosen to do so–could deduct all of the costs of growing the grapes. Only the post-harvest processing costs of crush fermentation, cellaring, ageing, and bottling would have to be capitalized. In essence, the winery would have no “grape cost” in its wine inventory produced from its own grapes for income tax purposes.
This enabled the combined winery and vineyard operation to be able to deduct its crop costs up front. The income related to the vineyard activity was recognized as the wine was sold through higher gross margins for tax purposes because there was no grape cost in inventory.
Additionally, so long as ‘one remained In the vineyard ‘and winery business, one would always be “replacing” this deferral with a subsequent year’s crop cost deductions. If, for example, one’s average inventory turn was two years; the combined winery/vineyard operation would have what would be a quasi-permanent upfront tax deduction equal to two years of crop costs. This would shelter other income from the operation. As long as the company remained in business with the same level of inventory or more, the tax benefit of the upfront deductions of the farming costs would never be eliminated.
For example, a 100-acre vineyard with $3,000 per acre of crop costs and a two-year inventory would enjoy a $282,000 tax deferral. 100 acres X $3,000/acre crop cost times 2-year inventory = $600,000. Deferral ($3,000 x 100 x 2) X 47% = $282,000 quasi-permanent tax deferral.
This represented a very valuable subsidy.
In all three cases, even though those in the industry believed the rules were very clear, the IRS wine industry group declared that the deferrals were “too long,” “too much,” and “too good.”
Discussions with the IRS, pointing out that there was nothing in the tax code that put a time limit on the deferral (beyond the related party provisions mentioned above), did not dissuade the IRS industry group from its position.
All three of these approaches to enjoying this tax benefit were litigated in tax court; only one resulted in a published and unfortunately adverse decision.
In the first instance, a consolidated return case, the taxpayer was successful. The IRS wine industry group’s position did not even have the support of those individuals in the national IRS office that had responsibility for rulings and regulations concerning consolidated return provisions. However, the wine industry group was able to get a technical advice memorandum issued by the inventory group at the national office disallowing benefits of the cash method. When this case was before the tax court, the tax court judge made clear his displeasure with the government’s attempt to “take away” the clearly intended benefits of the cash method. Within days of the tax court hearing and before an opinion was rendered, new consolidated return regulations were issued in proposed form by the IRS national consolidated return group.
The regulations included an example with a winery and a vineyard as separate companies in a consolidated return, and the result sought by the taxpayer in the case before the court was identified as the correct result that should be achieved under the deferred intercompany profit rules. One can only surmise that the clear displeasure of the tax court judge with the government’s position caused the IRS to concede this case before the judge rendered his opinion, thus precluding the publication of a decision adverse to the government.
The government was more fortunate in the Oak Cross Vineyards case. There the tax court judge agreed with the IRS that the sale by Oak Crass Vineyards to Groth Vineyards (the winery) of its grapes on a deferred payment arrangement and the related deferral that Oak Cross Vineyards enjoyed did not “clearly reflect” income. This forced the partnership of Oak Cross Vineyards to change its accounting method for tax purposes from a cash to an accrual method causing it to recognize the income from the sale of grapes in the year harvested.
While the judge offered no logic for this departure from the long-standing ability of farmers to sell their crops on an installment method, he clearly agreed with the IRS that the benefit should not be enjoyed. This was even in spite of earlier cases that indicated that the congressional provision for farmers to use the cash method was deemed to clearly reflect income.
When this case was appealed to the Ninth Circuit, the Appellate Court said that it could not find that the tax court judge had clearly erred. While new arguments were raised at the appellate level that had not been raised at the tax court, the appellate court said that these were issues that should have been raised at the tax court level and unfortunately it could not consider them on appeal. The Appellate Court inferred that, had these issues been raised before it as the trial court, it might have reached a different result thaw the tax court had reached, none the less, it allowed the very surprising tax court ruling to stand.
In the Ferrari-Carano case, again no published opinion exists because the IRS conceded the case prior to the time the judge rendered his opinion. Ferrari-Carano had followed the single entity approach: deducting all crop costs and transferring the grapes from the farming division to the winery division of the single entity resulting in no grape cost in inventory. Again the IRS argued that the result was too good; that the benefit was unintended; that the vine-yard and winery were not separate trades or businesses, but were really a single business enterprise. The IRS group tried to overturn the result of its own regulations.
We understand that the group even attempted to have the regulation re-written to reach a different result. Fortunately this request was denied and now the IRS, in a published news release, has formally conceded that the approach taken by Ferrari-Carano and others in a single entity achieves the result that many others and we believed was the right answer all along.
Cash-basis farmers can deduct their farming costs as paid and only need to add to inventory and defer those costs of processing the crop beyond the state in which it is “normally” available as a. farm product (i.e. grapes) until the wine is sold. This means combined operations that choose to operate in a single entity have certainty. If properly elected, they can deduct farming costs if they are eligible to use the cash method. They will then build up a quasi-permanent deferral of deducted crop costs equal to their average inventory turn.
For example, if you have 200 acres of vineyards, incur $3,000 per acre of crop costs and age your wine on average for two years, you would build up a $1.2 million deferral, which would not reverse so long as you remained in business. This represents a $564,000 quasi-permanent tax deferral.
There are generally ways for winery and vineyard operations that currently exist as brother-sister entities to combine into a single entity on a tax-free basis. This will ensure that they can enjoy the long-standing congressionally-intended benefit that a farmer should be able to deduct (at the time paid) the costs incurred in farming and only recognize the profit at the time the resulting items made from that farm product are sold, even if one further processes their farm product. This is clearly a major win for the industry and brought to a conclusion more than 10 years of controversy between the industry and the IRS over this issue.
Greg Scott currently acts as independent advisor to Capital Coast CPA and Valuation Firm.
Capital Coast provide tax consulting services for California vineyards and wineries. We also provides bookkeeping, accounting, tax, and valuation services for vineyards and wineries in our local area, San Luis Obispo County.
Contact us for more information.