ICYMI | From the Vine to the Bottle

Cash or accrual basis.

Both cash and accrual accounting methods have advantages that depend largely on the winery owner’s goals. Because wineries produce inventory, they generally must use the accrual method; however, Revenue Procedure 2001-10 requires only direct material costs to be included in determining inventory value. It also allows the winery to use the cash method if the winery’s average annual gross receipts for the prior three tax years are less than $1 million.

If the winery is vertically integrated and the vineyard portion qualifies to use the cash method, some additional tax planning opportunities may be considered. For example, under accrual accounting rules, ordinary and necessary farm operating costs are considered to be production costs and, as such, are included in determining inventory cost. Under cash basis rules [based on Agro-Jal Farming Enterprises v. Comm’r., 145 T.C. 145 (2015)], such farming costs may be deducted in the year paid rather than waiting until the wine inventory is sold, which could be up to four years later (Paul Neiffer, “Cash Basis Farmers Allowed to Deduct all Costs!” The Farm CPA, July 31, 2015, http://bit.ly/2IyzObJ).

Inventory.

Winemaking costs vary considerably because of the variations in varietal production processes and aging requirements. Determining the applicable costs to include in inventory can be challenging, but tracking such costs is crucial for both proper winery management and proper tax reporting.

The various processes (grape crushing, fermentation, product storage and aging, bottling) may be classified as cost centers relative to the allocation of general and administrative (G&A) costs. Allocating such costs to products through cost centers may be easy or complex; some allocations may be made simply on the basis of wine volume, as more intricate allocations may not be cost-beneficial. For example, spikes in electricity cost often occur during the crush process and the beginning stages of fermentation; however, often only white grapes are pressed and cold fermented, so it “may not be reasonable or material to go beyond the allocation of the utility bill by square footage of the facility” (IRS 2011). Cost allocation can be simplified by applying Internal Revenue Code (IRC) section 263A, which uses ratios to compute the allocated G&A costs included in ending inventory and cost of goods sold.

If a winery qualifies as small (i.e., it averages less than $1 million in gross revenues over three years), it may qualify to value inventories by using only direct costs of materials and supplies under Revenue Procedure 2001-10. These direct costs would include items such as corks, grapes, bulk wine, and bottles; all other traditional inventory, such as direct labor and manufacturing overhead, can be written off as a period cost in the year of production. When the wine is sold, the direct materials costs are expensed to the income statement as cost of goods sold (Joyce Jakubiak, “Inventory Accounting for Wineries,” Buckley Law PC, June 22, 2010; Michael Ricioli, “Tax Opportunities for Wineries and Vineyards,” Moss Adams, March 2016). Similarly, small producers with less than $200,000 of indirect costs may be able to write those costs off as a cost of the current period, rather than including them in inventory (Jakubiak).

International markets.

Many U.S. wineries have expanded their markets to include international sales. If products are exported, there may be a benefit from forming an interest charge domestic international sales corporation (IC-DISC), which can result in lower taxes on export income. An IC-DISC is a “tax-exempt domestic corporation set up as a brother/sister of a C or an S corporation” to provide distinct tax opportunities (Paul Franson, “Hidden Deductions for Wineries and Growers,” Wines & Vines, July 20, 2012, http://bit.ly/2NZmLG3).

IC-DISCs do not have employees or offices and are not taxed at the federal level; instead, they charge a sales commission from the exporting winery. This revenue is then distributed to the shareholders, who tend to be the same individuals or entities that own the exporter, as qualified dividends. Currently, qualified dividends are taxed at a lower rate than ordinary income, so the resulting tax bill can be significantly lower than if the export income was taxed at ordinary income rates (Ricioli).

Internal fraud issues.

For wineries, as for many organizations, small size may limit the ability to implement important internal control measures like proper separation of duties. Wineries with owners who are not involved in day-to-day operations, or family-owned operations with limited resources, may be particularly susceptible to fraud (Jennifer Huffman, “Fraud Experts Tell Wineries to Wise Up,” Napa Valley Register, Sep. 22, 2015, http://bit.ly/2NWbMNI). As in other organizations, when duties cannot be adequately separated, compensating controls should be put in place.

As in many industries, asset misappropriation is the most common type of insider fraud in wineries. Given the high dollar value of many bottles of wine, it is not a surprise that many asset misappropriation schemes in the wine industry involve inventory theft. One such larceny example involved Kendall-Jackson’s distribution center. Jordan Crass, a former customer service representative at Kendall-Jackson, and two accomplices stole thousands of bottles of wine priced at approximately $150 per bottle. Crass and his accomplices recorded wine shipments to fake customers, which shipments were subsequently found to have been “lost”; in reality, Crass delivered the shipments to online wine retailers and others and pocketed the proceeds. The bottles were sold on the Internet or were traded for sporting event tickets. The crime came to light when Kendall-Jackson’s VP for Marketing found bottles of cabernet sauvignon, merlot, and cabernet franc blends for sale on the internet—even though those vintages had not yet been released for sale (L.A. Carter, “3 Admit Guilt in Theft of $200,000 in Jackson Wines,” Press Democrat, Oct. 30, 2008, http://bit.ly/2DO0TZx; Marsha Dorgan, “Napa Man Accused in $200,000 Wine Theft,” Napa Valley Register, Jan. 30, 2008, http://bit.ly/2QkpIhk).

Many internal controls utilized in other industries to protect against and detect asset misappropriation are relevant to wineries as well. For example, carefully vetting applicants for sensitive positions in the winery, including background and credit checks, can help to ensure an honest workforce. Inventory counts are important controls in wineries because they help determine if there has been any misappropriation and comply with TTB recordkeeping requirements. To help dissuade employees from inventory theft, some wineries have instituted a “paycheck bottle” policy, in which employees are given a specified number of bottles of wine per month to both reward employees and to help dissuade them from wine theft. These bottles, of course, must be properly accounted for with respect to TTB and excise tax purposes.

External fraud risk.

In small wineries, as in many small businesses, the use of outsourced service providers for back office support functions (e.g., payroll processing, product design, human resources, information technology) is common. As with any business using such services, careful vetting of support personnel and companies is needed.

Raw materials fraud. The quality of raw material input is significant in any type of manufacturing, but for a winery, the grapes completely make or break product output. Jeffry James Hill, a former Napa Valley winemaker and vineyard manager, created false records to misrepresent wine and grapes as being Napa Valley cabernet sauvignon when, in actuality, the grapes were from other parts of California and were, in part, cheaper merlot and malbec grapes. Hill intercepted trucks hauling grapes and diverted them to his own winery; he also falsified the underlying TTB’s Form 5120s paperwork that tracks the grape origin under appellation designations. Hill also instructed employees who picked grapes to mislabel the origin and varietal, allowing him to charge higher prices for his own wine products, as well as for grapes he sold to other wineries. Because of Hill’s fraud, the Don Sebastiani & Sons winery had to recall mislabeled wine and claimed $3 million in damages. As is the case in many frauds, Hill’s scheme was uncovered through a whistleblower tip: a truck driver alerted his vineyard manager that Hill had made the driver deliver several tons of grapes to Hill’s winery rather than the actual customer. The vineyard manager was fired and decided to call the TTB and report a complaint (Mark Scaramella, “Feds Indict Napa Wine Scammer,” Anderson Valley Advertiser, Nov. 9, 2016, http://bit.ly/2DRBm1X).

Another type of fraud committed against wineries is related to cooperage. Two companies lied to wineries about the origin of the oak used to produce barrels and casks; instead of being from the forest of Tronçais in central France, the oak was from lower-quality forests in Lorraine and Eastern Europe (“French Cooperage Firms Convicted of Fraud,” Wine Business Blog,Dec.15, 2010, http://bit.ly/2P5je5I). Whether such a difference in location would make a difference in wine taste is hard to know, but it would have made a difference in the cost of the barrels to the wineries making the purchases.

Even the big players in the wine industry can be caught unaware. E&J Gallo bought over 18 million bottles of mislabeled wine from French winemakers that were to be marketed under the Red Bicyclette Pinot Noir label. The difference in price (£39 per 100 liters for “ordinary wine” versus £84 for pinot noir) earned the scammers about £7 million. Suspicion arose when French customs officials realized that “the amount of Pinot Noir being sold to Gallo was far more than the region had ever produced” (“Gallo Caught in Fraud over 18 Million Bottles of Cheap French Wine,” Daily Mail, Feb. 18, 2010, https://dailym.ai/2NhBlDG). The Sieur d’Arques region suppliers grow a total of 15,000 hectoliters of Pinot Noir grapes (approximately 396,300 gallons’ worth of wine) annually, but Gallo bought 135,000 hectoliters (approximately 3,566,000 gallons’ worth) from those suppliers between 2006 and 2008 (Nadia Arumugam, “Wine Scams: The Ultimate Hall of Fame,” Forbes, Jan. 8, 2013, http://bit.ly/2zN4x21).

Protecting against raw materials fraud can be challenging, but being aware of the possible types of frauds possible is a good start. The best internal control is to only do business with reliable and known suppliers and to have a contractual arrangement that allows for retribution if lower quality or mislabeled goods are provided. Employees and nonemployees alike should be trained about the benefits of sharing information about any irregularities of which they are aware.

Bonded warehouses and fraud. Wineries often use bonded warehouses to store their wine until sold; at that point, the warehouse will pay the winery’s excise taxes and then invoice the storage client. In a 2014 case, the owner of Monterey Wine Services was found to have not paid approximately $900,000 in excise taxes that were due when wine was sold for storage customers, although those customers were billed for and paid the tax amounts. The wineries in this case committed no fraud but were affected by the tax evasion (Ana Ceballos, “Monterey Wine Services Owner Owed $877k in Taxes,” Monterey Herald,Sept. 18, 2014, http://bit.ly/2zN9RCv).

Arson is another problem that has arisen with bonded warehouses. In 2005, Mark Anderson, the owner of Wines Central, a wine storage facility housed in an old naval munitions facility, was stealing his clients’ merchandise. After over 5,700 bottles belonging to one client went missing, embezzlement charges were filed against Anderson; however, the charges were not widely publicized, so some clients stayed with his company (Frances Dinkelspiel, “As Trial Opens, Wine Collectors Seek Solace,” New York Times, Nov. 14, 2009, https://nyti.ms/2P6kIga). To conceal his crime from these other clients, Anderson took a blowtorch and gasoline to the facility and destroyed 6 million bottles of wine worth approximately $200 million that belonged to 95 wineries and up to 60 collectors; the disaster nearly caused scores of small wineries to go out of business (Rachel Raskin-Zrihen, “North Bay Wine Warehouse Arsonist Subject of TV Show,” Mercury News, Aug. 9, 2013, https://bayareane.ws/2xUK5el; Alisha Wyman, “Mare Island Winery Warehouse Arson Trial Begins,” Napa Valley Register, Nov. 16, 2009, http://bit.ly/2zN3Tlc). Furthermore, the fire eliminated the stock of entire vintages from highly regarded Napa Valley wineries, a loss that was felt for years (Dinkelspiel).

Care should be exercised when wineries contract with bonded warehouses. Verification of the warehouse’s bond should be supplemented by an inspection of physical controls, such as fire suppression systems and burglary alarms. Although preventive controls are essential, detective controls can also be helpful for wineries storing wine in bonded warehouses. For example, if the bonded warehouse is responsible for paying excise taxes, winery personnel should follow up with the tax authorities to make certain that taxes have been paid. Periodic physical inventory counts of bottles stored at bonded warehouses can also help to detect inventory theft.