NORTH COAST -- The IRS has proposed a resolution to a yearlong debate with accountants for more than two dozen North Coast wine companies caught in an audit sweep over common industry inventory valuation methods.
Some of the options could call for the larger vintners to pay hundreds of thousands of dollars each in adjustments for the tax years in question, according to CPAs representing the wineries. It comes at a time when a number of North Coast vintners have been rapidly trimming their budgets to match a dramatic shift in consumer spending on higher-end wines.
Some of the audited wine companies are considering entering a closing agreement with the IRS under one of the options to put the matter to rest rather than challenging the position, said Jeff Gutsch, a partner with Moss Adams, which is working with five of the audited wineries.
"A lot of wineries are backed into a corner on this thing," he said.
For three decades, many wineries have been using the dollar-value "last in, first out," or LIFO, cash-flow assumption to defer taxes as wine ages before sale.
In the past several years, the IRS has been looking for producers such as wineries to use specific inventory item definitions, rather than general ones such as "casegoods" or "bulk wine" that some have been using, or figure inflation by standard indexes. That would reduce the LIFO reserve, moving more inventory value back to the balance sheet from the income statement, reducing the cost of goods sold and raising taxable income.
The current resolution proposal from the IRS would give wineries three options for adjusting their accounting practices, according to Mr. Gutsch. Otherwise, they could challenge the new approach via discussions with auditor supervisors or an appellate conferee before taking the matter to U.S. Tax Court.
One option would be to figure the LIFO reserve from Bureau of Labor Statistics inflation indexes via the Industrial Price Index Computation, or IPIC, method going back to the first use of LIFO and paying an adjustment based on the difference. The winery could use IPIC or narrowly defined inventory pools going forward.
Another option would be to recalculate the reserve based on the narrower definitions going back to the first use of LIFO, pay the difference and use those new pools or the IPIC method going forward.
A third option would be for wineries to pay 27 percent of their LIFO reserve, 20 percent for the last open year and 7 percent for the current year, then use a standard price index or narrowly defined pool items afterward.
Mr. Gutsch said the last option would amount to a $640,000 adjustment for one client, which had a LIFO reserve of approximately $2.25 million at the end of 2007, and a $400,000 reserve increase in 2008, the wine company's last open year.
"For most of the clients we're working with the 27 percent is significant, but it is not worth going to Tax Court," he said.
The best defense, though, is to avoid an audit by filing for changed LIFO methods now with IRS Form 3115, according to Greg Scott, a partner of PricewaterhouseCoopers. He's been speaking at wine industry conferences on that tactic since the first winery LIFO audit in 2006.
Yet there could be another option, according to Mr. Scott.
"We've developed an alternative approach that we believe will be accepted at the appellate level that is related to the taxpayers' own numbers and not an arbitrary 27 percent," Mr. Scott said.
His alternate method, which would have to be taken up on appeal, would look at the impact of the item-definition change on the winery's LIFO reserve on a weighted-average basis for the prior three years. That would result in a cut-off adjustment percentage more closely based on the winery's actual LIFO reserve "distortion." For example, one client actually had its reserve increase by $300,000 rather than decrease.
The IRS has recognized LIFO for about 70 years in industries with big inflation in inputs, such as the automobile and petroleum industries. Yet there has been a move since 2006 to phase out LIFO to boost federal tax revenue.
Rep. Mike Thompson, D-St. Helena, brought the winery audit project, which started with a flurry of letters in April 2009, to light in federal budget hearings last June. At a budget hearing in Congress in early February of this year, he reportedly told Treasury Secretary Timothy Geithner that an end to LIFO would be a "big tax hit" to U.S. small companies.
According to the Bureau of National Affairs Daily Tax Report, Rep. Thompson noted that some industries have to hold their inventory for a long time. According to the report, Rep. Thompson told Mr. Geithner LIFO "is a fair and reasonable way to recognize that, and I would strongly urge you to go back and revisit that.”
An IRS chief counsel advice letter on the winery LIFO adjustment procedure is expected to be published in the next couple of months, according to Mr. Scott.
