Picture a winery in full swing during harvest – beautiful blue pinot noir – or alternatively, luminous green chardonnay grapes arriving at the winery on dusty trucks, destemmer-crushers processing those grapes at full but careful speed, the sweet smell of juice on the air. The juice ferments and ages, and is stored in stainless steel tanks and/or barrels until it has been converted into an aromatic, mouth filling, and satisfying wine.
That’s the fun part…
A winery is a manufacturing facility, and, like all manufacturers, must keep track of the costs of creating the products that it will eventually sell to generate revenues and (hopefully) profits. The general principle is that the costs of production are treated as inventory, which is only expensed when the wine is sold, rather than when incurred.
Without an understanding of those costs, it will be very difficult to properly manage those costs, and may be very difficult to price the wine, to plan for future production, or to even determine if the winery is making a profit.
Most manufacturing enterprises will use an accrual method of accounting to record the costs incurred. This means that the costs will be recorded on the books of the enterprise as they are incurred, which may well be before cash is actually paid. For example, grapes may be purchased and received by a winery in September, but the cash to pay for those grapes may not be paid until spring of the following year. Under the accrual method, the cost of the grapes will be recorded when the grapes are received.
There are several layers of costs that must be treated as inventory. The Internal Revenue Service provides guidance under IRC Sec. 471 for the inclusion in inventory of direct costs and certain indirect costs. Direct costs are the costs of grapes, bottles, corks, labels, and direct labor. Indirect costs that are required to be included in inventory are certain repairs, maintenance, utilities, rent, indirect and supervisory labor, indirect materials and supplies, tools and equipment, and inspection. These costs are basically the same costs that would be capitalized under GAAP (generally accepted accounting principles) if the winery kept its books and records on a GAAP basis.
For tax purposes, Section 263A of the Internal Revenue Code requires the inclusion in inventory of certain additional costs including depreciation of assets used in the production process, and a variety of general and administrative costs that directly benefit the wine making activity during the production period, which ends when the wine is released for sale. In some cases, it may even be necessary to include interest costs in inventory.
Each vintage and wine type will have different cost characteristics because wines have different production periods and processes. It can be quite a challenge to track these separate costs. Some wineries separate costs by department, including crush and ferment, cellar, bottling, and storage, and then allocate additional general and administrative costs based on a determination first of how much of a particular general and administrative cost is actually related to production, and then assigning that portion of the cost to the various products based on volume of wine produced. A winery that produces several different wines may have a chart of accounts that allows accumulation of costs to each wine through each step of the process.
There are a variety of methods available to simplify the calculation of additional costs included in inventory, including a “simplified production method” as described in the regulations under IRC 263A. This method involves comparing the additional general and administrative costs incurred during the year to the total direct and indirect costs incurred, and using that ratio to determine additional general and administrative costs to include in ending inventory.
Correct inclusion of costs in inventory can be a complicated accounting procedure. Fortunately, for tax purposes, small wineries may qualify to use a simplified method of inventory accounting. If the winery generates less than $1,000,000 in average gross revenues for a three year period preceding the year in question, the winery is only required to capitalize the direct costs of materials and supplies such as grapes, bottles, and corks. These costs would be placed on the balance sheet until the wine is sold, and would be considered cost of goods sold at that time.
The $1,000,000 small taxpayer exception is measured by including all the gross receipts of the taxpayer. For example, if the winery owner is an individual who also owns a restaurant, and that restaurant averages over $1,000,000 in sales for each of the preceding three years, the taxpayer will not qualify to use the simplified inventory method, even though the winery itself has no revenues.
Another helpful exception to the capitalization rules for small producers is the rule which states that small producers with less than $200,000 of indirect costs in a taxable year are not required to capitalize those costs into inventory.
While accounting for the costs of inventory can be complicated, such tracking is crucial to both proper tax reporting and to management of the winery. Consulting your tax advisor regarding these important inventory issues on an annual basis is highly recommended.
Joyce Jakubiak is a Senior Tax Manager at AKT LLP in Lake Oswego, Oregon. She has 20 years of public accounting experience in large local and regional firms and has expertise in a number of areas, including manufacturing, real estate, construction, and state and local tax. Joyce’s responsibilities at AKT include tax planning and compliance services to businesses and their owners. Joyce holds an MBA from the Univeristy of Portland and earned her undergraduate degree from Washington State University. To reach Joyce with additional questions or concerns, please email her at Joyce Jakubiakjjakubiak@aktcpa.com or visit the AKT website by clicking here.