Wine Industry CPAs Seek Solution to LIFO Challenge by IRS

CPAs serving the wine industry start meeting one-on-one with IRS field agents this week in an attempt to find an industry-wide solution about the use of an accounting inventory method that sparked audits of 28 wineries in Sonoma and Napa counties.

The IRS is investigating wineries' use of the last in, first out (LIFO) inventory method, which, in essence, matches today's costs of production with today's revenues. LIFO, in use for 70 years, has been widely used by the wine industry since the 1970s.

The IRS' challenge to a method that many wineries thought was acceptable could result in hefty past-due tax bills for some wineries and higher tax rates in the future for wineries. Furthermore, some wineries previously audited are undergoing audits again.

Greg Scott, partner, PricewaterhouseCoopers, San Francisco, said the IRS has been resisting holding an industry-wide, broad-based meeting with national IRS representatives, opting instead for individual meetings. "This seems to be an inefficient approach," he said. "We need to reach the right answer for the industry as a whole." In addition to scheduling meetings with IRS representatives, CPAs also contacted Congressman Mike Thompson (D-CA) with their concerns. On June 4, Thompson submitted questions to the Commissioner of Internal Revenue Douglas Shulman (see PDF here). Responses were received in late July (see PDF here).

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 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 not under audit may consider filing Form 3115, Application for Change in Accounting Method (www.irs.gov/pub/irs-pdf/f3115.pdf), 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. Once the form is filed, said an IRS media spokesperson, businesses must receive approval from the IRS before changing their method of accounting.

Scott 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,'" he said. Also, the IRS had previously audited several wineries with LIFO as a focus.

According to that Office of Chief Counsel IRS Memorandum (www.irs.gov/pub/irs-lafa/064301f.pdf ), 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."

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 Dave Brotemarkle of Brotemarkle, Davis & Co. "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.

LIFO has been in the spotlight recently for two other reasons: various proposals to repeal LIFO on the national level, although no current legislation has been introduced, plus the accounting method's link to International Financial Reporting Standards (for more information, see the October issue of Wine Business Monthly).

Meanwhile, the Wine Institute has joined with about 100 other associations and businesses in opposing repeal of LIFO through the LIFO Coalition.

The Wine Institute said, in a statement, it is working with its member companies, its Congressional delegation and the executive branch to "make sure that the negative impact of repeal is fully understood. This includes the IRS audits of some of our members. Congressman Mike Thompson (D-CA1), who serves on the House Committee on Ways and Means, has been a key player in trying to get to the bottom of this."