Potential IRS Rule Change Could Cost Wineries
The IRS is challenging an accounting inventory method long used by the wine industry that could result in higher overall tax rates in the long-term and also require some wineries to pay large tax bills for prior years.
CPAs serving the wine industry, possibly joined by industry groups, are trying to work with the IRS to find a favorable industry-wide solution to the problem. As of press time, a series of meetings with individual CPAs or CPA firms and the IRS had been scheduled, said Greg Scott, a partner with PricewaterhouseCoopers in San Francisco.
These efforts follow a wave of recent audits—30 wineries in Napa and Sonoma counties received audit notices in April.
The last-in, first-out (LIFO) inventory accounting method under IRS investigation is used by businesses that maintain inventory to determine both “book” income and tax liability. It has been an accepted accounting method in the US for 70 years.
“One of the big problems with all of this that is happening now is that we have been using a set of rules, and now the IRS wants to change the rules. It would be like, in a baseball game, the umps decided foul balls would be outs,” said Dave Brotemarkle of Brotemarkle, Davis & Co. LLP in St. Helena, California.
Wine industry CPAs who were concerned about the widespread audits in Napa and Sonoma counties contacted Congressman Mike Thompson (D-Napa Valley) with their concerns. On June 4, Thompson submitted questions to the Commissioner of Internal Revenue Douglas Shulman. Responses were received in late July.
According to the responses, the IRS has initiated a Compliance Initiative Project (CIP) on wineries employing LIFO inventory accounting methods in Napa and Sonoma counties because “the largest concentration of tax returns with the potential LIFO issues were identified there.” The IRS said it would “consider expanding to other areas as appropriate.”
When asked what prompted the IRS to initiate a CIP on wineries employing LIFO inventory accounting methods in these counties, the IRS stated, “Through the normal course of examinations of taxpayers in the wine industry, several examinations revealed the LIFO issue where a taxpayer was using only two items, bulk wine and cased goods, to define the wine inventory under the LIFO rules. The examinations concluded that the use of just two items to define numerous wine varietals, each with varying costs and at different states of production, did not properly determine LIFO inventory values and thus did not clearly reflect income.”
Based on those results, the IRS’ Large and Mid-Size Business Division (LMSB) management determined that “further investigation was warranted to determine if this is an industry-wide issue. Through the CIP, we are able to review taxpayer returns in the same industry with similar fact patterns to determine whether the issue is more widespread.”
If so, then the IRS said it can identify what actions need to be taken, such as focused outreach, expanding the number of examinations, and/or legislative proposals to address the compliance gap.
Wineries already under audit have no choice but to go forward with the audits. Others may consider filing Form 3115, Application for Change in Accounting Method, stating they are going to change their method of accounting for inventories under LIFO. According to practitioners, the cost to file the form with the IRS is $3,800 plus accounting fees.
Scott of PricewaterhouseCoopers said he has been warning the wine industry that LIFO was an issue for several years. He pointed out that in August 2006, the IRS issued a general counsel memo regarding the calculation of the LIFO Index. “The IRS did, by releasing this memo, issue a notice saying ‘we’re focused on this,’” said Scott. “There have also been three to four audits where they had focused on this, including a couple I was involved in.”
According to that Office of Chief Counsel IRS Memorandum, a winery had not properly determined its LIFO index in accordance with Internal Revenue Code Section 471 and its regulations because it had not defined its dollar-value LIFO “items” narrowly enough. It concluded that the winery’s “overly broad” definition of items failed to determine properly its LIFO index in accordance with Section 472 and case law and thus the LIFO method did not clearly reflect income.
The memo stated “the next step” would be to consider whether the IRS should seek to terminate the winery’s LIFO method. It also suggested the IRS examine the winery’s records “to confirm placing [the winery] on an alternative inventory method, such as FIFO, will clearly reflect [the winery’s] income.”
Scott said wineries that have not received audit letters could still file forms to change their accounting method. “If you’re on LIFO and think the LIFO definition might be too broad, I’d be filing that form as quickly as I could,” he said.
He called the $3,800 user fee a “pretty cheap insurance policy because some of the wineries have reserves that are in the millions.” He said such wineries were not industry giants but those one would consider boutique.
Scott said the IRS could go back from the first day wineries were on LIFO. “If you take a half-million-dollar cumulative adjustment, you have a $200,000 liability. A half-million adjustment would not be uncommon if there has been distortion.”
Another concern, according to Tom Davis, partner, Brotemarkle, Davis & Co., is that the IRS is now deciding that the LIFO calculation wineries have been using might be better measured using an average price index the IRS has determined, based on the food and beverage industry. “We feel that is not accurate. The cost of farming and production of higher quality grapes and wines has increased at a faster rate than that. LIFO gives you the absolute right to make a calculation based on real costs and how they have changed, not using a government-provided index,” said Davis.
“Under the rules of LIFO you have the right under tax law to use real costs, which we track all the time,” said Brotemarkle. “And the IRS is wondering how many items should be in that cost—for every vintage, for every kind of wine sold. It creates a tremendous burden of record keeping to track all those things in detail.”
Furthermore, if LIFO changes substantially, there could be “a huge tax bill due to wineries. It is an impossible time for that. Here we have an industry that is trying to survive. While the government gives this huge bailout to banks, the IRS comes here and says perhaps wineries owe more to the IRS. We think it’s wrong,” said Brotemarkle.
—Patricia M. Roth
Ontario Faces Double Last Year’s Surplus
Negotiations continue to try to get supply closer to demand as Ontario faces an 8,800-ton grape surplus this autumn.
The anticipated surplus is double last year’s unsold tonnage, which the Ontario government offset somewhat with a CAN$4-million bailout.
No such help is apparent for grapegrowers facing bankruptcy this year. “The government has indicated that it’s not planning to buy grapes,” Hillary Dawson, executive director of the Wine Council of Ontario, told Wine Business Monthly.
At the government’s urging, the WCO and the Grape Growers of Ontario have brainstormed for more than six months on how to match supply with demand.
“We’ve renegotiated prices for this year’s harvest, which will help some of our wineries to determine whether they’re interested in purchasing additional tonnage,” Dawson said.
Overall prices are down by 6.5 percent with the biggest drop in seven varietals currently in oversupply, including Cabernet Franc, Cabernet Sauvignon, Merlot, Chardonnay and Riesling.
“Lower prices will prompt some wineries to purchase more, although we’re not anticipating demand to rise significantly,” Dawson said. “Like wineries everywhere, we’re dealing with inventories moving slower.”
Sales for Ontario’s Vintners Quality Alliance (VQA) products have risen steadily over the past few years, but haven’t kept pace with the amount of grapes.
“Part of this is definitely because of the speculative plantings done over the past three to five years,” Dawson said. “A lot of wineries—especially the bigger ones—are now restricting tonnage, but there are still growers without contracts.”
The global recession hasn’t helped with restaurateurs and bar owners decreasing the amount of wine they keep in stock.
“We’ve also had several great consecutive harvests which our wineries have used to buy extra crop to build up their inventories,” Dawson said. “So if sales continue to be strong, it’ll probably mean larger grape purchases next year or the year after.”
The GGO and WCO have agreed to collaborate to a much greater extent in terms of establishing which varietals are most in demand, where they should be grown, and the desired tonnages and Brix.
Hoping for more progress, the government has urged both sides to continue their discussions and report back later this month.
A huge topic is the regulated pricing system. The WCO hopes to have it changed so a grape’s cost is more in line with its use.
“We’re currently obliged to negotiate a minimum price for each of 29 varietals,” Dawson explained. “So the price for a specific grape is the same whether it goes into a popular $10 wine, where it might be overpriced, or in a premium wine costing $25 or more, where it could be under-priced.”
The WCO wants more of an open-market system, which it says would make its wineries more competitive with foreign producers.
Both the WCO and GGO have flagged the need to enhance their partnership with the Liquor Control Board of Ontario, the province’s largest wine retailer. “There are promotional opportunities, store placements and other things we can do to perform better within our marketplace,” Dawson said.
—Julie Gedeon
Constellation Brands Announces New U.S. Distributor Alignment
Constellation Brands in July announced signing multi-year distribution agreements with Southern Wine & Spirits, Republic National Distributing, National Wine & Spirits and Johnson Brothers Liquor Company, resulting in new appointments for 19 states in the U.S. Each distributor has the exclusive right to sell Constellation’s U.S. portfolio of wines and spirits in its market. The realignment consolidates over half of Constellation’s U.S. wine and spirits business to one distributor per market and is intended to help the company gain share for organic growth.
If the “winners” are Southern, RNDC, Johnson Brothers and National, the “losers” appear to be Glazer’s, particularly in Texas, as well as Charmer, which had Constellation in New York in addition to some independent wholesalers. In every major market, a portion of the business is moving to a new wholesaler.
• Southern will have exclusive distribution rights in nine markets, consisting of Arizona, California, Delaware, Florida, Hawaii, Illinois, Kentucky, New York and Pennsylvania.
• Republic National Distributing Company will have exclusive distribution rights in eight markets, consisting of Colorado, Louisiana, Maryland, Nebraska, Oklahoma, South Carolina, Texas and Washington, D.C.
• National Wine & Spirits will have exclusive distribution rights in Indiana.
• Johnson Brothers Liquor Company will have exclusive distribution rights in Iowa.
The announcement caps an 18-month review process. “Our new go-to-market strategy, and its inherent emphasis on driving organic growth in a growing category, is the natural next step for us and our distributors,” Rob Sands, president and chief executive officer of Constellation said in a news release.
The move comes as Constellation reorganizes sales into a single sales and marketing structure and represents a new direction. Over the years Constellation has grown through acquisitions, and sometimes there have been distributor changes while many times there have not been. That is in part because the company previously operated four separate sales divisions, each with decentralized routes to market. Each of the four operating companies had responsibility for their wholesalers, making them decentralized and independent.
“As the world around us changed and consolidation continued to occur at the wholesaler and retailer tier, it became apparent to us that we weren’t leveraging our scale most effectively with our wholesalers and retail customers,” Constellation Wines U.S. president of sales Marty Birkel said. “To become more customer focused as a company, we had to realign and consolidate our wholesalers and had to streamline our organization into a single structure.”
Birkel said the number of employees in the sales force has been trimmed by less than 10 percent as a result of the internal restructuring. “It’s allowed us to have more focused responsibilities so we have less geographic area, but more focus on specific trade channels,” he said.
The company made the decision to move forward on the sales force restructuring and distributor realignment late last fall, an aggressive timeline which Birkel said made sense to do now rather after the holidays. wbm
