FEDERAL TAX ISSUES FACING VINEYARD AND WINERY OWNERS

Transcription

1 FEDERAL TAX ISSUES FACING VINEYARD AND WINERY OWNERS I. ACCOUNTING RULES In May 1995, the Internal Revenue Service ( IRS ) released a report highlighting tax issues of specific importance to the wine industry and setting forth, in a sense, a tax compliance checklist for use by IRS personnel in selecting winery and vineyard tax returns to audit. The report suggests that winery and vineyard operations should exercise particular care in ensuring compliance with federal income tax accounting rules. Tax accounting rules about which winery and vineyard owners should be particularly aware include the following: A. Costs and expenses must be taken into account under the proper method of accounting; for wineries, this method usually is the uniform capitalization method ( UNICAP ). B. Income from a vineyard s sale of grapes to a related winery must not be improperly deferred; ordinarily, if deferral of such income is allowed, it is limited to the year following the year of sale. C. Grape growing costs generally must be capitalized and, thus, cannot be taken into account for tax purposes prior to the time income from the sale of the grapes is subject to taxation. D. The following vineyard operation costs, among others, must be capitalized: 1. Direct cost of vines (rootstock and trellis); 2. Labor and indirect costs of planting vines; 3. T-budding expenses; 4. Fumigation costs; and 5. Vine replacement costs (engineering and design of new vineyard, preparation of land for replanting, planting and installation, purchase of new vines, purchase of irrigation equipment and trellis system). 6. The costs in designing or developing labels and packages must be capitalized and amortized over a 15-year period. II. DEPRECIATION Proper depreciation periods must be used in determining depreciation deductions. 1

2 III. DEDUCTIONS Deductions taken with respect to personal residences located on winery or vineyard property must be authorized under the Internal Revenue Code; generally, deductions relating to lodging provided to an employee are allowed only if the employee occupies the lodging in order to perform employment duties properly. Down payments on wine futures sales must be properly treated as advance payment for goods or as deposits, as the case may be. IV. GENERAL PRINCIPLES OF ACCOUNTING The computation of income for federal tax purposes depends in part upon the taxpayer s method of accounting. Two of the general methods of accounting are the cash method and the accrual method. Under the accrual method of accounting, a seller generally recognizes income and is entitled to deductions when all events have occurred such that the seller has a right to the income or owes the expense and the amount thereof can be determined with reasonable accuracy; usually, income is recognized at the time of sale and expenses are taken into account at the time payment becomes due. Under the cash method of accounting, a seller generally recognizes income at the time of actual or constructive receipt of payment from the sale. In addition, the seller may claim a deduction for expenses as they are paid. V. WINERY OPERATIONS: INVENTORY ACCOUNTING Some categories of transactions require use of an accounting method that differs from the general methods. The production, purchase, or sale of goods, for example, requires an inventory method of accounting. One such inventory method of accounting is provided under UNICAP, which generally applies to all manufacturers. Wineries are considered manufacturers for tax accounting purposes because they transform one product (grapes) into another product (wine). As a result, wineries must account for their costs using the UNICAP rules. UNICAP is also applicable to vineyard operations, but most vineyards can elect out of UNICAP. Under UNICAP s inventory method of accounting, the costs of producing, acquiring, storing, and handling wine inventories are generally incorporated into the cost of goods sold (i.e., capitalized). As a result, deduction of those costs is delayed until the wine is sold. In accordance with the inventory method of accounting under UNICAP, all of the costs associated with manufacturing the wine during the production period, must be capitalized; any manufacturing costs incurred after the production period may be expensed. 2

3 In the case of property such as wine that is aged before it is sold, the production period begins when the grapes are crushed, continues through the aging period, and ends when the wine is released for sale. In general, the wine-making process has four areas that generate costs (cost centers): (1) grape crushing/juice fermentation, (2) wine aging and storage, (3) general and administrative costs, and (4) wine marketing and sales. The process of accounting for costs under UNICAP begins with assigning all costs to the appropriate cost center. Next, general and administrative costs are allocated to all cost centers. Finally, production (crushing/ fermentation and aging/storage) costs are allocated to inventory and recovered when the wine is sold, while marketing/sales and unallocated general/accounting costs are currently deducted. VI. VINEYARD OPERATIONS: DEFERRED INCOME AND EXPENSING OF GRAPE GROWING COSTS A winery is considered a manufacturer and as such must use the accrual method of accounting. A vineyard, on the other hand, generally can use the cash method. There may be circumstances under which a winery owns or controls a vineyard that produces grapes later purchased by the winery. If the vineyard uses the cash method of accounting and the winery defers payment on grape purchases, income recognition by the vineyard could be deferred. If the vineyard is allowed to defer the recognition of income, the vineyard generally would be able to claim deductions for expenses relating to growing grapes before reporting income from the sale of grapes. The IRS takes the position that a vineyard cannot defer income from grape sales beyond the year following the year of sale. The IRS may attempt to prevent deferral of income by claiming that the vineyard has constructively received the proceeds of the grape sales. In addition, the IRS may require the vineyard to change its accounting method from the cash method to the accrual or installment methods of accounting. Finally, if notes from the winery to the vineyard exist as evidence of the payment for grapes, the IRS could claim that the fair market value of the notes was received as income during the year of the sale. A winery that owns its own vineyard cannot claim a current deduction for grape growing expenses; rather it must wait to report income until after the wine is sold. In such a case, the costs of growing the grapes must be capitalized, because the vineyard operation is considered part of the overall manufacturing process and is therefore subject to the UNICAP rules. 3

4 VII. CAPITALIZATION In general, taxpayers may deduct certain trade or business expenses in the tax year in which the expenses are incurred. However, taxpayers must capitalize expenditures that are used to generate assets with a useful life of more than one year. With regard to a vineyard operation, costs that must be capitalized include: A. Vine development costs, i.e., the direct costs of vines and labor and indirect costs of planting. B. Cost of converting the vineyard from production of one type of grape to another. C. Fumigation costs. D. Vine replacement costs, i.e., costs of (a) engineering and design of a new vineyard, (b) preparation of land for replanting, (c) planting, installation, budding, and purchase of new vines, (d) irrigation equipment, and (e) trellis systems. E. Costs of acquiring, protecting, expanding, registering, or defending a trademark, as well as the costs of designing or developing labels and packaging designs. Although certain expenditures must be capitalized, such expenses may be recovered over time through depreciation; for example, vine fumigation costs may be added to the cost of the vine and depreciated. VIII. DEPRECIATION Depreciation is defined as the decline in value of property over time due to normal wear and tear and deterioration caused by use and the passage of time. A property s decline in value continues until the property s usefulness is exhausted. Thus, taxpayers generally may claim depreciation deductions over a period of time determined in part by the useful life of the asset involved. In general, the Modified Accelerated Cost Recovery System ( MACRS ) applies in determining depreciation deductions of wineries and vineyards. Under MACRS, there are two depreciation systems: general and alternative. The general depreciation system utilizes a shorter depreciation period and, therefore, results in more up-front depreciation. If a vineyard opts out of the UNICAP, the alternative depreciation system applies to all property of the vineyard used predominantly in its farming business and placed in service in a taxable year in which such an election is in effect. Depreciation deductions for the direct costs of the vines and labor and indirect costs of planting begin when the vines start producing grapes. Generally, vines are depreciable over seven years under the general depreciation system and over 20 years under the alternative depreciation system. Depreciation deductions with respect to vines must be calculated under the straight line method. 4

5 Depreciation deductions for the cost of an irrigation system, including the labor to install it, begin when the system first delivers water to the vines. Irrigation systems are depreciable over a period of seven years under the general depreciation system and 15 years under the alternative depreciation system. IX. MISCELLANEOUS ISSUES A winery owner or employee may reside on vineyard or winery property. If the entity, holds title to the residence, the entity may be able to claim depreciation and other deductions with respect to the residence, and the owner or employee may be able to live at the residence without recognizing income relating to the residence. For the entity to claim deductions and the owner to live at the residence without recognizing income, three requirements must be satisfied: A. The residence must be located on the winery or vineyard premises. B. The residence must be provided for the benefit of the entity as an employer, i.e., there must be a valid business reason for having the employee live on the winery or vineyard premises. C. The owner, as the entity s employee, must be required to live at the residence as a condition of employment. X. FUTURES There has been an active market for futures on certain wines. Futures are offered to the public, require a down payment and allow the holder of the future subsequently to purchase the wine at a fixed (or determinable price). If used to secure the performance of a condition or a contract and later returned, a down payment is a security deposit and, thus, nontaxable when received. If paid pursuant to an agreement for the sale of goods and applied to the price of the goods, a down payment is an advance payment and, thus, taxable when received. Down payments for most wine futures are advance payments, and as such constitute taxable income when received because the down payments are made pursuant to a contract to buy specific quantities of wine and are applied against the wine s sale price. XI. TAX CONSIDERATIONS IN ADDING ADDITIONAL OWNERS TO AN EXISTING WINERY OR VINEYARD Wineries and vineyards may consider bringing in new owners for a variety of reasons: to raise capital, to acquire expertise, or to increase market span. An interest in an existing entity owning a winery or vineyard may be acquired by contributing money, tangible or intangible property, or services. 5

6 The effect of bringing in a new owner depends, in part, on the way in which the entity is taxed. In general, there are two ways for a business enterprise to be taxed: as a partnership or as a corporation. Generally, if an entity is taxed as a partnership, neither the entity nor an investor recognizes gain or loss when the investor contributes property, including money, real property, or personal property, in exchange for an ownership interest in the partnership. If the entity is taxed as a corporation, the entity generally recognizes no gain or loss on the contribution of property in exchange for stock. However, unless the investor and any other parties contributing property in the same or related transaction own 80 percent or more of the entity immediately after the exchange, the investor could recognize gain. Moreover, even if the 80 percent test is met, the investor may recognize gain if the investor receives money or property other than stock in the transaction. Generally, whether an entity is taxed as a partnership or a corporation, if the investor provides services in exchange for an ownership interest, the investor recognizes taxable compensation income and the entity is entitled to a corresponding deduction. In addition, the entity could be required to withhold income and employment taxes from the compensation. If an investor only contributes services in exchange for stock of an entity taxed as a corporation, the investor s stock is not considered for purposes of the 80 percent ownership requirement. On the other hand, if an investor contributes both property and services in exchange for the stock of an entity taxed as a corporation, and the value of the property is not insubstantial in relation to the value of the services, the investor s stock is considered for purposes of the 80 percent ownership requirement. Regardless of whether the entity is taxed as a corporation or a partnership, if an investor contributes property subject to a liability, or the entity assumes a liability of the investor, the investor could recognize gain as a result of the transaction. If an owner makes a loan to the entity, the transaction is generally treated like atypical debtorcreditor relationship. Thus, repayment of the loan is nontaxable, and the entity/debtor may deduct any interest paid. In addition, the owner/creditor does not pay tax on the principal amount as it is repaid. The owner-creditor, however, must pay tax on any interest payments received. Under certain circumstances, the entity-debtor is not entitled to an interest deduction before the time at which the owner-creditor includes the interest as income. Loans from an owner to the entity are closely scrutinized, and the loan repayment may be recharacterized as a payment related to an ownership interest. If repayment of a loan is recharacterized as a contribution in exchange for an ownership interest, the investor may have to pay tax on payments received and the entity would not be entitled to interest deductions. 6