Here are more key wine business tax changes for 2018

JEFF QUACKENBUSH,

NORTH BAY BUSINESS JOURNAL

While financial experts expect to be pouring over the ramifications of the new federal tax law for years to come, those that serve the wine business are seeing several key changes so far. A few key changes are permanent, but a number of important modifications are to sunset by 2026 or 2027.

At the top of the list of improvements for the wine industry from the hundreds of pages in House Resolution 1, called the Tax Cuts and Jobs Act, are temporary relief from the estate tax and big changes to depreciation calculations, particularly for viticulture. Other significant changes in the law passed by Congress on Dec. 20 and signed by President Trump on Dec. 22 are lower corporate tax rates, which is causing conversations on how businesses are organized, as well as changes to accounting for profits, losses and costs.

But these and other nuances in the law come are making advisers caution clients to watch for clarifications from Congress and regulators over the next few years. Upcoming elections and the delicate majority in the Senate could also change things in the new tax law.

“If the midterms do not go well (for Republicans) and Democrats take control in 2020, they could overturn a lot of these tax laws,” said Jeff Gutsch, partner in the wine practice of Moss Adams. He is based in Santa Rosa.

ESTATE TAX

A big improvement in the new law is the doubling of the lifetime exemption for the estate tax, according to David Pardes, a tax partner who leads PwC’s wine industry tax group based in San Francisco. (Here is PwC analysis of H.R. 1.) The rate for estate, gift and generation-skipping transfer taxes remains at 40 percent upon death or gifting, but the lifetime exemption that can be claimed upon death or gifts from 2018 through 2025 doubles to $11 million per person or $22 million for a couple.

"For most taxpayers, they will never end up in a position where they will have to pay estate tax," Pardes said.

But the 2025 sunset for the exemption has him and other analysts worried about "clawbacks" after that time. That's what could happen if a donor gifts up to the lifetime exemption while it's higher then dies when it lower, and the IRS claws back the gift amounts for a transfer tax. Accountants will be looking for legislative, regulatory and court guidance on this, Pardes said.

"It puts pressure on people in the industry to decide what they will do in the next seven years," he said.

Estate taxes have been a challenging hurdle for family businesses in the North Coast, as the company value may have risen to a level requiring various succession-planning methods over several years to avoid a big financial and tax hit on new owners in the next generation. Strategies include gifts to family members and to trusts.

APPRECIATING MORE DEPRECIATION

Another big boost for business is the move of bonus depreciation for certain property from 50 percent of cost back up to 100 percent of the cost for equipment and non-building assets, Pardes said. It's available for assets acquired and put into service from the fourth quarter of 2017 through 2022. Then it generally phases down 20 percent per year 2023–2026 from 80 percent to 20 percent.

What's key for the wine business in the new federal law is full expensing on the cost of vines in the year vines are planted rather than the year the vines are placed in service, up from 50 percent, which was placed into law a couple of years ago, Pardes said. That includes the cost of the vine plus the various preplanting and planting costs, which are capitalized into the vine.

"Before, you had to wait three years," he said, noting the standard metric for when wine-grape vines are considered to be bearing salable fruit. "I think that will be a good benefit for the farmers we work with."

But this new bonus comes with a minus: interest-expense limitations.

"Congress needed to find ways to raise revenue to offset the variety of new tax benefits, and this was one way they did it," Pardes said. Staff from the Joint Committee on Taxation estimated that the new tax law all together will increase federal deficit by $1.456 trillion over a decade.

For tax years through 2021, companies with gross receipts that exceed $25 million will have to figure their earnings before interest, taxes, depreciation and amortization (EBITDA) then multiply them by 30 percent, and any interest expense above that will have to be deferred to the next year. Then starting in 2022 the calculation is based on EBIT, and that shift will need to be watched, Pardes said.

But there is a carveout in the interest-expense limitation for farming operations, he noted. Wine companies with farming and winemaking divisions will have to allocate their interest expense between those two activities.

Another benefit for farming in the tax law is faster depreciation for farming equipment, from seven years to five years, Gutsch said.

GOING WITH THE FLOW-THROUGH

One of the more talked-about matters in the tax law is relief for small businesses via a new deduction and lower tax rates. The law permanently lowers the federal corporate tax rate from 35 percent to 21 percent.

And in addition to lowering the top individual tax rate from 39.6 percent to 37 percent for tax years in 2018–2025, there's a new 20 percent deduction during that period for qualified business income that is reported on the individual tax returns of the principals. Such pass-through or flow-through businesses include sole proprietorships, partnerships or S corporations.

That's different from the C corporation entity form recognized by the IRS. Rather than taxing business income on the individual returns, C corp income is double-taxed, first at corporate rates then at individual rates after distributions to shareholders, not taking into account tax-mitigation strategies for C corps.

But the "vast majority" of wine businesses in the North Coast are some form of pass-through entity, according to Gutsch. With the new pass-through deduction and lower tax rates, Gutsch and Pardes have been fielding calls from clients wanting to know whether changing their entity type makes sense.

With the 20 percent pass-through deduction and the new top federal tax rate of 37 percent for individuals (income over $500,000) and couples (over $600,000), the effective tax rate ultimately can work out to be 29.8 percent, barring other limitations.

"Essentially, it drops the pass-through rate down a little closer to the rate for C corps, which makes value of a C corp a little less than it otherwise would be," Gutsch said.

Something to keep in mind with a switch to a C corp, though, is revocation of an S corp election can't be easily reversed for five years, he said. So significant planned events such as the tax impact from the sale of assets and an overturning of the new tax changes with any change in Congressional party majority have to be considered, he said.

UPPING THE CAP ON UNICAP

Among the carveouts buried in the tax law is a higher cap on the gross-receipts exemption from uniform capitalization (UNICAP) of costs into inventory. Under Sections 471 and 263A of the Internal Revenue Code, wine producers must capitalize certain direct as well as indirect costs into inventory. Among the few exceptions for wine producers from these rules have been the $1 million gross receipts and the $200,000 de minimis exceptions.

The new tax law lifts the UNICAP-exemption cap for such gross receipts to $25 million. That opens the exception to wineries with gross receipts of $25 million a year, Pardes said.

"Other than purchased raw materials such as grapes, bottles and corks, (no other) costs will be capitalized into inventory," he said. "It will allow a substantial number of wineries to significantly benefit from a simplified inventory-costing approach. They will be able to accelerate deductions in ways they were never able to do before."

With the new provision, a wine company that grows grapes, produces wine, ages it then bottles and sells it will be able to deduct related costs along the way, Pardes noted. Before, such a business wouldn't be able to deduct those costs until the wine was sold.

"That's a big win for wineries," he said.

DOWNSIZE THE EXCISE

Worked into the federal tax bill was the Craft Beverage Modernization and Tax Reform Act (H.R. 747/S. 236), which had been in the works since 2015 and has its origins with the Small Producer Tax Credit of 1991, according to trade groups Wine Institute and WineAmerica. That credit came the same year as a big hike in the federal excise tax on wine, but the latest tax-reform bill has the first reduction in federal excise taxes for wine in eight decades, according to the Wine Institute.

The new version of the credit, effective just for 2018 and 2019, expands it to all sizes of wineries (for the first 750,000 gallons produced, or 315,000 standard 9-liter cases), adds sparkling wine to the eligibility list, ups the alcohol-content cap to 16 percent by volume from 14 percent, and allows more bubbles in low-alcohol wines.

Savings on the federal excise tax for small- to medium-sized wineries are projected to be 55 percent–70 percent, according to the Wine Institute. The group analyzed savings for vintners making 14 percent-alcohol wines, so the benefit would be even better for makers of higher-alcohol wines, such as a number of luxury-tier Napa Valley cabernet sauvignon labels. Under that scenario, the credit would peak at about 250,000 gallons (105,000 cases), reducing that tax down to $83,300, a drop of $184,200, or 69 percent. A vintner producing 30,000 gallons (12,600 cases) would get a 59 percent reduction, to $2,100. The maximum credit value at 750,000 gallons would be $451,000.

STAY TUNED

The slim margin of votes held by the Republican majority in the U.S. has Pardes, Gutsch and other financial experts worried about the advice they are giving clients for coming years. With midterm elections coming in 2020 and the Democratic Party against a number of provisions in the new tax law, the prospect for changes to key features is present.

But regardless of changes in the makeup of Congress, the ambiguity in the new tax law could require legislative technical corrections, which call for a high threshold of 60 votes in the Senate to pass. Alternatives are guidance letters and policy statements from federal regulators, outcomes of IRS audits and rulings in U.S. Tax Court.

"People will try to find ways to plan around this, and the IRS may have created something it didn't intend," Pardes said. "This will keep (tax professionals) like me fully employed."

Jeff Quackenbush (jquackenbush@busjrnl.com, 707-521-4256) covers the wine business and commercial construction and real estate.