NORTH BAY - More than 30 wineries mostly in Napa and Sonoma counties have been targeted in a wave of IRS audits of common inventory accounting methods in the industry for three decades.

IRS auditors are claiming that some wineries are defining their inventory pool "items" under the dollar-value last-in, first-out (LIFO) cost-flow assumption too broadly, resulting in an inaccurate internal inflation index for a given vintner and a "distorted" reflection of income to be taxed, according to a nationally known wine accounting expert.

"If you have a regular cab and you have a reserve cab with longer aging and more expensive packaging, but you treat them as the same wine, you will overstate your LIFO tax benefit," said Greg Scott, a partner with PricewaterhouseCoopers in San Francisco.

LIFO first was accepted seven decades ago for most accurately reflecting net income for industries with rapid inflation in pricing for inputs, and the wine business started using it three decades back.

For businesses heavily affected by inflation, such as the cost of choice winegrapes in recent years, LIFO provides a way to defer taxes.

Trouble is, if a winery that defines its pool items too broadly - common items can be as general as "bulk wine" and "case goods" - the IRS can require use of the Bureau of Labor Statistics inflation index for wineries, which is usually a few percentage points and based on cost bases for large wineries, according to Wendy Petersen, senior tax manager in Moss Adams' wine practice in Santa Rosa.

"If a high-end winery calculates a $5 million reserve and the [bureau] index calls for a $1 million reserve, then the winery would have to recognize $4 million as income, unless an alternate calculation was settled upon," she said. "That would be a huge hit in bad economic times."

And such a tax adjustment could topple some wineries, according to Kevin Alfaro, a partner in the St. Helena office of G&J Seiberlich & Company.

"It could actually bankrupt some wineries at a time when there already is financial pressure," he said.

On top of this would be added record-keeping requirements for the more specific cost items.

These accountants are part of a group of more than 30 wine-focused and other accountants from about a half-dozen firms seeking an industry resolution on LIFO with the IRS, similar to what was brokered for the automobile and oil industries, without big audit adjustments. The local network of wine accountants started discussing options when it became clear that the IRS audit notices that went out April 10 to wineries were the same approach.

The group also has sought help from the Washington, D.C., office of the IRS through Rep. Mike Thompson, D-St. Helena, and Leslie Schneider, who consulted with the oil and auto industries on LIFO.

Mr. Scott of PricewaterhouseCoopers has been warning of a coming focus on LIFO item definition for nearly three years. A legal audit field advice document from the IRS' San Francisco office in October 2006 on an audit of LIFO reserves at a large winery highlighted that the IRS was looking for specificity in LIFO items. It can be possible to lock in a winery's LIFO reserve before an audit.

"A half dozen of the wineries being audited took my advice and filed an account-method change," Mr. Scott said. "A method change is the cheapest insurance policy you can get."

 Rather than just bulk wine and case goods items, the IRS area counsel quoted a 1996 U.S. Tax Court decision in Richardson vs. Commissioner regarding use of LIFO by vehicle dealerships that goods in a LIFO pool must be treated as separate items if they are substantially different in form and cost. Under that concept there would be cost-accounting items for differing grapes, bottles, labels, length of aging, closures, labels and other packaging.

The year 2006 also was a time of national attention on LIFO with talks of repealing the method to raise tax revenue for programs. That discussion has begun again with Obama administration proposals to phase out LIFO through 2011 to help fund new programs. Yet the House of Representatives version of the bill, introduced last week, didn't have LIFO repeal in it.

Still, local accountants say LIFO may be extinct in a few years if international accounting standards, which don't recognize it, are adopted.