By Patricia M. Roth

The IRS offered settlements last week to Sonoma and Napa county wineries that came under audit in April for issues related to the last-in, first-out (LIFO) inventory costing method. This follows months of resolution-seeking meetings between wine industry CPAs and IRS representatives.

The IRS has given wineries four choices or options to resolve their audits as well as new inventory item definitions that IRS representatives indicated they would like to see become the industry standard, according to Moss Adams partner Jeff Gutsch.

The proposed definitions, not available at press time, could require “significantly more detail” in regard to tracking inventory and costs, said Moss Adams senior tax manager Michael Ricioli.

The new definitions address one of the issues seized upon by the IRS last spring: the definition of an inventory item for the purposes of determining inflation in a winery’s inventory. The question was whether the items the industry, in general, had been using were too broad for LIFO inventory purposes.

The new definitions outline how the IRS wants wineries to break down inventory items for the purpose of calculating LIFO. For example, it recommends that bulk wines, bottled wines and case goods be divided based on type of wine (varietal, appellation, blends of two or more varietals), source of grapes (purchased or grown) and length of time the wine has been aging at the end of the tax year.

The IRS resolution also mentions the use of a Consumer Price Index inflation indexing method, or IPIC, that bases a winery’s annual inflation for LIFO on an industry-wide inflation index. (For details, see October, WBM, “LIFO for Wineries: Here Today, Gone Tomorrow?”

“Up to now, the burden has been on the industry to determine how to group inventory items for purposes of LIFO. We had not been given any guidance from the IRS or the court system. At least now—for good, bad or indifferent—a recommendation has come out, and now the industry can begin evaluating this position,” said Ricioli.

Ricioli pointed out that the new inventory definitions are only a proposal by the IRS; they are not defined in the tax code nor supported through current case law. This is the position of the IRS, but taxpayers can still challenge the item definition through the appeals process and, if needed, the court system.

Wineries under audit have been in a “holding pattern” since springtime, Ricioli said. “The IRS met with us and other CPA firms to come up with what they believe is a reasonable method. Taxpayers under audit are now learning of the IRS' new item definitions and are evaluating the various options that have been proposed.”

Ricioli encouraged wineries to make sure they understood the ramifications of choosing one option over the other because a choice that was favorable this year may not necessarily be favorable going forward.

Industry-wide, the IRS recommendation means that LIFO is becoming more complicated, said Ricioli. “The amount of detail that may need to be tracked has increased so you have to look at the benefits and the burdens of being on LIFO,” he said.

Wineries that have not been audited 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. Ricioli said wineries currently using LIFO should “highly consider” discussing the matter with their CPAs.

Choices Offered to Audited Wineries

Each option (below) includes entering into a closing agreement with the IRS that would prevent it from later going back and revisiting the issue for all years up to and including the last year of the closing agreement, providing audit protection for a winery’s LIFO reserve up to the date of the closing agreement.

In the first choice, the IRS would reduce the winery’s LIFO reserve by 27 percent. This would be done on a cut-off method at 20 percent based on the earliest open year and 7 percent during the current year. The entire 27 percent would be currently due. The IRS would then require the winery to use the new item definitions, or the IPIC index method, going forward beginning with the current year under audit.

In the second choice, a winery could go back to the beginning of their use of LIFO and rerun the calculations using the new item definitions, and the difference between that method and the current method would be the audit adjustment. The tax on that difference would be due immediately.

In the third choice, a winery could go back to the beginning of the use of LIFO and rerun the calculations using the IPIC index method, and the difference between that method and the current method would be the audit adjustment. The tax on that difference would be due immediately.

There is also a fourth choice. A winery can disagree with the proposed item definition all together, appeal the IRS' position and, if warranted, challenge this position through the court system.

The LIFO inventory accounting method has been an accepted accounting method in the U.S. for 70 years and in the wine industry since the 1970s. Following a wave of audits that targeted Sonoma and Napa counties last spring, wine industry CPAs contacted Congressman Mike Thompson (D-Napa Valley), who submitted questions to the Commissioner of Internal Revenue in June. The IRS, through its responses, revealed that the audits were initiated as part of a Compliance Initiative Project on wineries in Napa and Sonoma counties.