Is my vineyard a hobby or a business?

Vineyard Hobby or Business?

We regularly get this question from our clients. This is a very important question, and one that should be asked as early as possible because; it will affect the way you run your vineyard, how you keep records, the taxes you pay, and the amount of enjoyment you derive from your farming activities.

First off, it is very important to understand that the amount of taxes you are expected to pay, or save, does not determine whether your vineyard is a business or a hobby. The IRS presents nine factors in Reg. Sec. 1.183-2(b)(1)–(9) that needs to be applied to each case’s unique facts and circumstances. CPAs and their clients should record their evaluation based on these factors, and re-evaluate it regularly. If the IRS audits you fifteen years down the line after ten years of losses due to bad weather and disease, they need to be convinced that you and your advisers truly believed that that this was going to be a profitable business. Although profit expectation is an important factor, it is by no means exclusive evidence of a business endeavor.

Let’s look at two examples and run them through the nine factors. We will look at Jennifer and Peter.

vineyard as a businessJennifer is a Cal Poly graduate, has a degree in organic farming, and earns $25,000 a year from working part-time as an acupuncturist. She and her husband inherited 10 acres of land in Paso Robles, where they now live in a modest house.

Peter is an urologist, works full-time, and owns a medical clinic. He earns $800,000 a year. His gardening skills are limited to raking leaves and flinging the watering hose in the direction of dry patches. He bought a 10 acres property in Paso Robles where he built himself a weekend cottage worth $900,000.

What is the same for Jennifer and Peter? Both Jennifer and Peter are planting four acres of grape vines, and both hope that their grapes will one day be used in a vineyard designate wine. Both expect the value of their property (plantable vineyard land) to grow. They also both make use of a vineyard management team because the small scale of their vineyards does not justify buying all the equipment needed. They also need the vineyard management team’s expertise and advice.

Running the numbers for Peter and Jennifer–both expect to make an operating loss before tax of about $300,000 on the grapes over a 25-year period (establishment plus life of vineyard). Both expect the value of their plantable vineyard land to increase by about $500,000 over the 25 year period, providing them each with a positive net return of about $200,000.vineyard as a hobby

Let’s now look objectively at the 9 factors in Reg. Sec. 1.183-2(b)(1)–(9) to determine if a profit objective exists:

 

“(1) Manner in which the taxpayer carries on the activity.”

Jennifer is constantly trying new farming methods, implementing cost cutting measures, and maintains detailed records of each penny she is spending on the farm. (business)

Peter is also meticulous in his record keeping. He contracted his CPA to keep track of all farming expenses, calculate when each deduction can be taken, and to measure actual performance against a detailed business plan annually. (business)

 

“(2) The expertise of the taxpayer or his advisors.” 

Jennifer attended a two-week grape growing course at UCDavis. She also plans to attend more courses in the future. Her degree in organic farming is coming in handy. She consults regularly with her vineyard management company, and reads up on new farming techniques and practices. (business)

Peter compensates for his lack in expertise by regularly consulting with his vineyard management company. He appointed them after doing thorough research. He also consults regularly with other farming consultants to be sure that he is implementing only the best farming practices. (business)

 

“(3) The time and effort expended by the taxpayer in carrying on the activity.” 

Jennifer spends every minute she gets in her vineyard. (business)

Peter does not have as much time to spend on the farm as he would have liked. He has a full-time job and other business responsibilities to attend to as well. He is only on his farm about every second weekend. For this reason, he employed a very competent and qualified vineyard management company, after extensive research and due diligence. (business)

 

“(4) Expectation that assets used in activity may appreciate in value.” 

“The term profit encompasses appreciation in the value of assets, such as land, used in the activity.”

Even though both Jennifer and Peter expect a loss on the grapes, they expect a bigger profit on the appreciation in value of the land used for business purposes. The overall effect is a net profit. (business)

 

“(5) The success of the taxpayer in carrying on other similar or dissimilar activities.” 

Jennifer has never owned a vineyard before. She has never been involved with any other business ventures either. (hobby)

Peter previously owned a share in some land with a vineyard on it. He and his business partner used a vineyard management company to improve the yield of the vineyard, and they sold the established vineyard five years ago at a significant profit. Peter also owns a medical clinic that is making healthy profits. He is a well respected businessman in the community. (business)

 

(6) “The taxpayer’s history of income or losses with respect to the activity. 

A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. However, where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status such continued losses, if not explainable, as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. If losses are sustained because of unforeseen or fortuitous circumstances which are beyond the control of the taxpayer, such as drought, disease, fire, theft, weather damages, other involuntary conversions, or depressed market conditions, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized would of course be strong evidence that the activity is engaged in for profit.”

Jennifer and Peter are just starting their vineyards now, so past income or losses does not apply in our example.

However, the above illustrates an excellent reason to create a professional business plan from day one. A vineyard takes longer than most businesses to be profitable, and if things go wrong ten years down the line, you deserve at least to be able to get the tax write-offs (if it was genuinely a business). We will get back to this point in the next article when we compare the tax consequences of a vineyard business with a vineyard hobby.

In a recent court case, Samer Mikhail and Mariana Mikhail v. Commissionerthe court disallowed losses under the hobby loss rules of §183. One of the arguments of the court was that although the taxpayers kept records of their expenses, they did not use the records to analyze their business performance or to prepare profit projections, an analysis, or a budget. They did not change their strategy or tactics to increase the likelihood of earning a profit. If it was genuinely a business, the taxpayers would have been concerned when losses were being incurred and would have taken corrective action.

 

“(7) The amount of occasional profits, if any, which are earned.” 

If both Jennifer and Peter allocated to their vineyard operations only 4 of the 10 acres of their land, their expected net return over the investment would be the same. For Jennifer, there is an opportunity cost because she could have sold the inherited land but decided to keep it. For Peter, it was an out-of pocket expense.

For both of them, the overall net return is rather small- about $200,000 over a 25 year period. This is from about $500,000 for the initial investment in land and establishment costs, $100,000 in preproductive period costs, plus annual field period costs of about $30,000. It is a small return.

Factor #7, however, actually refers to the size of profits expected in some years compared to the size of losses in others. It also refers to the potential for an extremely big return, even if the odds are low.

A vineyard of this size that depreciates capital costs and recognizes unrealized gains on the land’s appreciation in value is expected to make small losses for about 10-15 years, followed by small profits for the remainder. It is not a venture capital investment.

This factor does not place Jennifer or Peter in either hobby or business categories.

 

“(8) The financial status of the taxpayer.” 

This is an extremely important factor, and often the deal breaker in combination with the next factor.

Jennifer does not have other material sources of income. Her financial success or ruin is dependent on the success of her vineyard (business).

Peter has significant other sources of income (hobby).

“Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit, especially if there are personal or recreational elements involved.”

This is a deal breaker for Peter and puts him solidly in the hobby category. The $200,000 profit over a 25 year period compared to his annual income of $800,000 shows that his financial success is not dependent on the success or failure of this endeavor. The $900,000 weekend cottage on the property also counts against him because of the obvious independence from the vineyard’s profits (hobby).

In a recent court case, Merrill C. Roberts v. Commissioner, the court actually found that, even though the taxpayer had significant other sources of income, he was not an excessively wealthy individual. His house was mortgaged and he continued to work long hours at physically demanding endeavors. If Peter were in the same court, the judge probably would have found this factor to be neutral.

 

“(9) Elements of personal pleasure or recreation.” 

Recreational enjoyment is not always an indication of a hobby. Many of us enjoy and even choose our careers based on our personal interests.

“[…] the availability of other investments which would yield a higher return, or which would be more likely to be profitable, is not evidence that an activity is not engaged in for profit. An activity will not be treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit […]”

As discussed under factor 7 above, both Jennifer and Peter expect a very small return from the vineyard. Even though other investment opportunities are available that are expected to provide higher returns, their motives could still be seen as for-profit. The other distinguishing factors are therefore more important than the size of the expected profit or the amount of personal enjoyment expected.

Jennifer is in the vineyard most every day, getting her hands dirty. (business)

Peter, on the other hand, is happy to leave all the hard work to the vineyard management company, and will only check in with them once a month. Peter does not know much about farming practices, and prefers to stay out of the vineyard management company’s way. He is also not planning to attend any training courses in the wine industry. He is more concerned with hosting elaborate parties at his vineyard residence. (hobby)

Similar conduct got the taxpayer in trouble in the Merrill C. Roberts v. Commissioner case.

 

Based on the above evaluation, Peter has a hobby and Jennifer has a business.

 

If Peter (in addition to what he was doing correct above) attend some farming courses, actively pursue cost cutting measures, truly attempt to find the highest selling price for his grapes, and balance out the elaborate social events on his vineyard with spending some time with his hands in the dirt, he could have possibly also had a business. Having to do all these things might, however, ruin the recreational enjoyment for Peter.

How big a deal is having your vineyard designated a hobby, rather than a business? In the next article we will look at the tax consequences. It might not be as bad as you’d expect. Both scenarios, however, require some tax planning and good record keeping. The last thing you want is to be paying taxes on your hobby, or not be able to write off losses on a business that went south.

Vineyard for Sale–What are the tax benefits?

Vineyard in San Luis Obispo County. Photo from Shutterstock.

Vineyard in San Luis Obispo County. Photo from Shutterstock.

Tax Planning Opportunities

1) Vineyard operations qualify as farming activities, and therefore qualify for the same incentives as other farming operations.  There are a lot of generous tax write-offs here, as long as you can proof that you have a profit motive. A formal and realistic business plan is your best defense against hobby loss attacks by the IRS.

2) If a vineyard’s farming operations and a winery’s manufacturing operations can be seen as part of one “group” for tax purposes, the vineyard is not taxed on its grape sales to the winery, and the winery is only taxed when the bottles of wine are sold. This provides a big quasi-permanent tax deferral.

Buying a Vineyard?

So, you found a small vineyard for sale in California, and you are probably wondering if purchasing it makes financial sense. Or, you want to buy a share in a vineyard. Before you invest in a vineyard, you will want to understand the potential tax benefits, and what you need to do to qualify for them. A few things to look out for are the following:

  • Hobby vs. for-profit classification by the IRS;
  • Business plan;
  • Legal entity selection;
  • Minimum involvement required to be considered “material participation”;
  • Accrual basis of accounting vs. cash-basis of accounting for tax purposes;
  • Tax classification of costs involved in producing the first commercial crop;
  • Valuation of appellation rights; and
  • Vineyard purchase price allocation and identification of all Section 179 depreciable assets.

The IRS often argue that new vineyard operations are hobbies because they usually make losses for the first 7 years or more. Your best defense against this is a thorough business plan, against which annual performance is measured. A business plan is more than the cost estimates your vineyard management company provided you with. It requires forecast cash flow projections, documented marketing strategies, and realistic projections of both income and expenses.

Vineyard operations qualify as farming activities, and therefore qualify for the same incentives as other farming operations. There are, however, a few intricacies unique to vineyards. Appellation rights, for instance, also qualify as a Section 179 depreciable asset. This can be between 5% and 30% of the vineyard’s purchase price! It is therefore very important to obtain an appraisal of the appellation rights.

As an added benefit to an appellation valuation, we frequently discover other depreciable assets “buried” in land value. These include roads, fences, wells, etc. For all of these, catch-up deductions can be claimed. So even if you purchased your vineyard a few years ago and you missed out on these deductions, the problem can be fixed.

Capital Coast, in cooperation with Greg Scott, provides tax consulting services to vineyard owners and individuals interested in buying a vineyard.

We can also prepare a business plan for you.

Vineyard Business Plan

In the business plan, we recommend using the same expense categories as the IRS requires. This allows you to use the actual and projected costs to estimate the timing of your related tax deductions.

Contact Rudi Prozesky, Owner of Capital Coast–CPA and Valuation Firm, for more information at rudi@capitalcoast.us or 844-833-3600.

Buying a Winery?

Whether you are buying a stand-alone winery or an integrated winery (one with its own vineyards), you need to give the selection of a legal entity careful consideration. Winery operations have higher liability risks than vineyards. Wineries involve wine tastings and manufacturing operations, and both of these could potentially get an owner involved in a liability law suit. We therefore strongly recommend that you hold any winery operations in a separate legal entity from farming operations and personal assets.

The selection of a legal structure is complicated by significant potential tax savings available to integrated wineries.  If the vineyard and winery operations can be seen as part of one “group” for tax purposes, the vineyard can use cash basis accounting and the winery accrual basis accounting. This results in a significant amount of farming costs being deducted when paid/incurred, and the revenue is only taxed when the product (bottles of wine) leaves the group. The vineyard is therefore not taxed on its grape sales to the winery. The group is taxed on the profit realized only when the bottles of wine are sold.

A few things to look out for when buying a winery are the following:

  • Hobby vs. for-profit classification by the IRS;
  • Legal entity selection to address potential liability issues;
  • Legal structure that facilitates estate tax planning;
  • Legal structure that supports employee incentive schemes;
  • Winery Business plan to support for-profit claims–Above comments on vineyard business plans also apply here to winery business plans;
  • Minimum involvement required to be considered “material participation”;
  • Accrual basis of accounting for vineyard and cash basis of accounting for winery operations;
  • Inventory costing;
  • Valuation of appellation rights for the vineyard; and
  • Winery purchase price allocation and identification of all Section 179 depreciable assets.

Please contact us for a formal opinion based on your unique circumstances.

Capital Coast, in cooperation with Greg Scott, provides tax consulting services to individuals interested in buying a winery.

Contact Rudi Prozesky, Owner of Capital Coast–CPA and Valuation Firm, for more information at rudi@capitalcoast.us or 844-833-3600.

Also ask about our additional services for vineyards and wineries:

  • Bookkeeping
  • Accounting
  • Wine inventory costing consulting
  • Business plans and tax projections
  • Estate tax planning
  • Tax filings
  • Accounting system design and implementation
  • Valuation of wineries for sale
  • Valuation of vineyards for sale

Tax Deferrals Obtained by Combining Vineyard and Winery Operations

A Decade-Long Battle

Vineyard in California. Photo from Shutterstock.

Vineyard in California. Photo from Shutterstock.

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

  1. a parent and subsidiary corporation filing a consolidated return, (not a common form today for smaller operations),
  2. a single entity with both winery arid vineyard operations, and
  3. 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.

 Capital Coast–CPA and Valuation Firm

Starting a Winery–What is the best legal structure?

Starting a Winery

 

Best Practices

It is best industry practice to put all the operations involved in producing and selling wine into separate legal entities.

Legal Structure for Integrated Winery

The winery operations in particular are usually put in a separate entity, usually an LLC. This provides protection from potential liability issues. Wineries involve manufacturing processes and wine tastings; both of these activities can easily lead to accidents and potentially serious liability issues.

A formal structure indicates to the IRS you are following that a business approach, providing a strong defense against potential attacks by the IRS based on “hobby losses.” It is very important that the business structure is not only put in place, but is also actually adhered to, i.e., the entities are treated as separate entities operationally, and for financial reporting and management purposes. If the different entities are just for show, the IRS or any creditor could easily succeed in having the courts ignore the structure.

LLCs are usually preferred over C and S Corporations because of lower effective tax rates for the individuals holding the interests. C Corporations are subject to double taxation. Income is taxed to the corporation, and then a second time when paid to shareholders as a dividend. S Corporations in California are subject to a 1.5% net income tax at the S Corporation level. Distributions of property by S Corporations could also trigger tax on any gain on the property. Furthermore, LLCs are much more flexible for enacting tax planning changes in the future, should tax rates and laws change significantly.

If an LLC only has one owner (husband and wife filing jointly is seen as one in California), then the default classification is that the entity is “disregarded” for federal income tax purposes. “Disregarded” means that the entity, while clearly a distinct entity for legal purposes, is ignored for federal income tax purposes.

Regarding the contribution of assets to an LLC, there is no gain recognized for property that has a fair market value higher than its tax base. Contribution of an asset with a fair market value higher than its tax basis to C Corporations triggers gains taxes. For an S Corporation, any asset contributed to the S Corporation by an individual is unlikely to come back out without triggering gains taxes.

LLCs are preferable for estate tax planning; for instance, interests in the holding LLC can be gifted in minority interests over a few years, enabling the use of valuation discounts.

A holding LLC, furthermore, facilitates an employee incentive program where key-employees can be granted a “profits interest” in the overall winery business, or only in the sub-LLCs in which they are directly involved.

The above is a general discussion. Everyone’s circumstances and needs are unique, and therefore we commend that you obtain a formal opinion. If desired, Capital Coast would be pleased to perform the requisite research and provide you with a detailed written analysis, taking into account your unique personal and business situation and objectives. Contact us for more information.

 

Tax Planning

Integrated wineries have the ability to implement some very beneficial tax planning strategies. The most important one being the ability to use the cash basis of accounting for their vineyard operations and the accrual basis of accounting for their winery operations. All the wine making activities can, if correctly structured, be viewed for tax purposes as forming part of one “group”. This results in large deductions for producing the grapes being deductible when incurred, and revenue only being taxable when the product leaves the group, i.e., when the bottles of wine are sold. You can read more about this in Greg Scott’s article Tax Deferral of Combined Vineyard and Winery Operations.

Contact us today for tax consulting, accounting, and other related services.

 

Capital Coast–CPA and Valuation Firm

ecoFundAccounting – Private Equity Valuation Assistance

EcoFundAccounting

Fund Administration, PLUS Valuation Assistance

We provide fund administration services for small funds (here is a fun little video), and valuation assistance for funds of all sizes (more information below.)

What makes us different? We encourage fund management to preform valuations in-house, with outside valuation expert assistance. We assist with the fund’s investment valuations and provide support to management with preparing and supporting Level 3 investment valuations.

Why can’t management get help from other fund administrators or their auditors? Most fund administrators lack valuation expertise and are afraid of the risks associated with valuation assistance. Auditors, furthermore, are not allowed to disclose their Level 3 fair value assessment calculations, because this would impede their independence. This leaves fund management with only two options: To do it themselves, or get independent valuations from outside valuation firms.

A third option exists: in-house valuations, with assistance from a valuation consultant.

Although independent valuations (fully outsourced) are commonly obtained by large investment funds, they are also very expensive and often result in a duplication of tasks.

When you prepare valuations in-house, we can provide you with the guidance you need to insure compliance with financial reporting and auditing standards.

We spoke to Massimo Messina, valuation specialist on the AICPA’s PE/VC Accounting and Valuation Task Force at the recent ASA Annual Fair Value Conference in San Francisco. He supports the idea that investment funds perform their valuations in-house. The AICPA assured the private equity and venture capital industry that the new guidance would still allow them to perform their valuations in-house. The guidance to be issued by the Task Force will help fund-management do a better job, and promote some consistency between the requirements and demands of the different audit firms when they audit Level 3 investments.

Level 3 Investment Valuation Assistance

Rudi Prozesky, owner of Capital Coast, is a valuation specialist who has years of experience working with private equity funds from all over the world. He noticed that small private equity firms are particularly troubled by audit firms when it comes to Level 3 investment valuations. Fund administrators and auditors are unable to help these small private equity firms. Most fund administrators lack expertise, and steer clear of the risks involved with valuations, and auditors need to protect their independence.

We found that fund management is very capable of valuing investments for investment and exit strategy purposes, but can benefit from assistance with converting those valuations for use in USGAAP/IFRS financials. We help with exactly that. Here are a few tasks that we can perform for you, to make life easier:

  1. Define and document the unit of account, and market participants for each investment holding.
  2. Calculate and support discount rates, and liquidity discounts.
  3. Perform or assist with cash burn calculations.
  4. Triangulate fair value based on the application of various valuation approaches and methods.
  5. Allocate enterprise value down the waterfall. A contingent claims analysis is performed to determine a probability-adjusted allocation of the enterprise value to the equity and debt holders of the company.
  6. Assist fund management with the preparation of calibration calculations for each investment. We found calibration calculation assistance to be a great way for us to add value, and more and more audit firms are requiring these calculations for Level 3 fair values.
  7. Compile financial statements and prepare draft financials and disclosure notes.

What are calibration calculations?

In calibration calculations, we use the initial entry price paid by the fund for the investment as a starting point to evaluate the reasonableness of a fair value for the investment calculate at a later date. Because this purchase price was an entry price, a little bit of work needs to be done to confirm that it was actually at fair value, i.e., it was not a distressed sale, or single investor specific synergies were excluded, etc.

Valuation analysts should base calibration calculations on changes in investment-specific, as well as industry and market-based elements.

In essence, if:

  • the cost price of the investment was considered to be its fair value the day a fund purchased it,
  • the economy strengthened since then and the industry is flourishing,
  • comparable companies are trading at significantly higher multiples, and
  • the investee company has been hitting all its targets

–we expect the investment’s fair value today to be significantly higher.

Fund management now needs to perform a detailed analysis of each variable to quantify this new fair value for financial reporting. Calibration calculations obviously get more complicated when elements such as the above have moved in different directions.

Management should also investigate the reasons why things have changed, and document their findings. In the end, investment funds need to be able to determine the impact of these changes on the portfolio company’s opportunities, risks, and probability of success.

From the above, it is clear that calibration calculations are an extension of a fund’s already performed due diligence, monitoring, and strategic decision-making activities. We therefore recommend that fund management perform calibration calculations with the assistance of outside valuation experts to ensure its proper documentation and audit friendliness.

Calibration calculations should always be used for private equity valuations for financial reporting purposes.

Contact us for assistance with calibration of your investment valuations.

 

Capital Coast–CPA and Valuation Firm

Tax Considerations for Starting a Vineyard

Tax Considerations

Have a formal business plan.

If you plan on producing quality grapes, it could take up to 3 to 5 years before you harvest your first commercial crop (proceeds exceed harvesting costs). This creates a problem, because the IRS generally expects any new business that is not a hobby to start making profits within 3 years. Your best defense against hobby loss attacks by the IRS, is a good business plan, and genuinely running your vineyard like a business.

A good business plan serves three purposes:

  • It proves to the IRS that you are taking the winery business seriously, and that your intention is to make profits.
  • It helps with managing your business.
  • It helps your CPA complete your tax returns (If the business plan also includes historic financial statements.)

Here are some great resources to use in developing your business plan:

 

You can also contact us for help, templates, consulting, or to request that we prepare the complete business plan for you.

In the business plan, we recommend using the same expense and capital asset categories as the IRS requires. This allows you to use the actual and projected costs to estimate the timing of your related tax deductions.

 

Take all available deductions.

This sounds easy, but many farmers miss out on significant tax deductions because of poor purchase price allocations.

A portion of your vineyard’s purchase price should have been allocated to appellation rights, and this is very often not done. A portion of your purchase price should also have been allocated to previously existing vines, trellises, irrigation, roads, fences, and other Section 179 qualifying property. Everything but the soil is potentially tax deductible. Any of these omissions can usually be fixed, and catch-up deductions can be taken.

You will need a well supported appellation rights valuation and purchase price allocation for catch-up and future deductions.

Here are some extracts from the IRS’s Vineyard and Winery Audit Guide issued to its field staff:

“Review the land/depreciable assets in the vineyard allocation. Did the taxpayer purchase the land with the vineyard already planted? Was the allocation made pursuant to an appraisal?”

“Amortization of Appellation Values: This issue might arise in conjunction with the purchase of a vineyard. The taxpayer would hire an appraiser to make purchase price allocations between land and other depreciable assets (vines, trellis systems, irrigation systems, etc.).”

We provide the above appraisals. Please contact us for more information about these valuations.

Special deductions are also available under I.R.C. Section 175 and 180. Vineyards often miss these. Section 180 deductions are year-by-year elections, and if missed, cannot be rectified.

 

A vineyard should use the cash-method of accounting for tax purposes.

If your vineyard operations are currently being reported on for tax purposes using the accrual method of accounting, change to the cash method!

This provides simplified accounting and tax planning opportunities. This will be considered a “negative Section 481 adjustment,” which means that you get to deduct the difference between the old and new method of accounting entirely in the year that you make the change.

This change from accrual to cash method for tax purposes is an automatic change for farmers, and there is no processing fee charged by the IRS.

Please keep in mind that the above is for tax purposes. Accrual based accounting should still be applied for the purpose of comparing your vineyard’s performance to your business plan.

 

A vineyard should opt out of I.R.C. 263A.

A farmer that is eligible to use the cash-method of accounting, has the option to opt out of the inventory capitalization rules of I.R.C. 263A. It is important that this option is chosen in the first year that it becomes relevant (year vines are planted), because if the opportunity is missed, a change in accounting method request needs to be applied for. This is not an automatic change, and IRS processing fees apply.

Choosing to opt out of I.R.C. 263A allows the farmer to deduct preproduction period costs, and the costs of maintaining the vines after the first commercial harvest. If this option was not chosen, the preproduction period costs would have had to be capitalized into the vines, and the cost of maintaining the vines would have had to be capitalized into the grapes.

 

Further Tax Planning Advice for Starting a Vineyard

We provide tax consulting and filing services to vineyards in California, USA. Contact us, and we would be happy to talk you through the options, and tailor a service for you.

Watch this fun and informative video!

Is my vineyard a hobby or a business?

 

Capital Coast–CPA and Valuation Firm

EcoAccounting

EcoAccounting

ecoAccounting is a CPA-provided bookkeeping, accounting, CFO, tax, and consulting service tailored for small businesses. We also help you to go paperless.

Accounting for Your Fast-Moving Business

There has never been a more exciting time to be in accounting–No joke! Electronic document management, cloud computing, and various new accounting apps are providing opportunities that were previously only available to big accounting firms and big businesses. Now, they are available to anyone who is tech savvy.

The choices can, however, be overwhelming. We have tested a number of these tools, from cloud computing to electronic file sharing, digital signatures, payroll management, and backup services. We found that some platforms are still not quite “there” yet, and that some are significantly better than others. We would love to help you find and implement the best ones for you.

Tailored Accounting

Online accounting is not for everyone. Some prefer to get financial statements in a newspaper-style report–telling it like it is, big picture, with highlights of areas of concern and interest. We would recommend this option for most small business owners. They have more important things to focus on than routine bookkeeping and accounting matters. Being a Jack-of-all-trades in your own business could easily keep you from attending to critical success factors. Here is a hint: There are more important things than keeping track of expenses and filing documents, so leave that to us.

Medium-sized businesses generally have a greater need for real-time data access. For these clients, we generally recommend cloud computing with shared transaction capturing responsibilities. Some transactions are captured by point-of-sale software, some by your employees, and some by us. Desktop accounting software can also be utilized where online accounting software lacks sufficient functionality.

Owners of medium-sized businesses also need to give careful consideration to segregation of duties for protection against embezzlement. We can help with that!

Have a look at this video, to get some ideas, and contact us to talk about your unique needs.

Why eco?

 

Capital Coast–CPA and Valuation Firm