A version of this article ran in the Wine Business Monthly March 2019 edition
Tax reform, commonly referred to as the Tax Cuts and Jobs Act (TCJA), provides several tax-planning opportunities for wineries and vineyards.
Below are some of the key federal tax changes impacting these industries as well the potential impact on business owners. While these are federal tax changes, it’s also important to consider state tax rules, which don’t always conform to federal changes.
C Corporation Tax Rate
The C corporation tax rate decreased to a flat rate of 21% from a maximum rate of 35%. With this change, business owners may want to evaluate if their current entity structure is still the most beneficial.
Determining the appropriate entity structure for a business is a complicated process with a variety of tax and other points to consider, such as:
- Double taxation
- Impact of owning appreciating assets—for example, vineyards
- Estate planning and exit strategy
Converting to a C corporation is a relatively simple process that can often be done on a tax-free basis if structured correctly. However, it can be difficult to convert from a C corporation to another entity type without triggering significant tax consequences. Regardless of the ease of changing your entity structure, careful analysis should be completed prior to any change to mitigate any unintended consequences.
Qualified Business Income (QBI) Deduction
If you’re a winery or vineyard taxpayer that isn’t structured as a C corporation, there’s a new 20% QBI deduction available through 2025 for the owners of flow-through entities and sole proprietorships. Generally, owners of winemaking or farming businesses should qualify for this deduction.
For example, if a pass-through winery with one owner generates $500,000 in taxable income and all of that income is considered QBI, its owner could be eligible for a $100,000—or 20%—deduction. The owner would then only pay tax on the remaining $400,000 of income from the business.
Some restrictions could limit the ability for a vineyard or winery owner to take this deduction, including limitations on overall income as well as limitations based on the amount of W-2 wages within the applicable business.
Some vineyard taxpayers don’t have any W-2 wages within their farming business because they contract all their vineyard work with managers or independent contractors. Given the new 20% deduction, these taxpayers may want to re-evaluate their relationships and seek strategies that would enable them to utilize the deduction.
Cash Method of Accounting
One of the biggest changes under TCJA is the expanded availability of the cash method of accounting for winery businesses. In general, winery businesses with average annual gross receipts of $25 million or less in the prior three-year period are now eligible to use the cash method of accounting.
Prior to tax reform, this method was only available for winery businesses with average annual gross receipts less than $1 million. There are other limitations on the availability of the cash method for certain taxpayers with losses and for taxpayers who own or control multiple businesses, so these rules will also need to be considered.
Considerations for Wineries
Simplifying the accounting of the overall business isn’t the only advantage for a winery using the cash method of accounting. Certain rules also allow taxpayers to use simplified methods to account for inventory from a tax perspective.
A winery eligible to use the cash method of accounting is eligible to use the non-incidental materials and supplies method provided by Treasury Regulation Section 1.162-3. This method generally requires the costs of raw materials to be capitalized to inventory and allows a taxpayer to deduct costs such as overhead, depreciation, custom crush and winemaking or production wages in the year in which those amounts are paid. Typically, the costs that are required to be capitalized will include purchased grapes and bulk wine, glass, corks, bottles, and other bottling supply costs.
Qualified wineries are able to change to these methods effective for tax years beginning in 2018. When adopting these methods, taxpayers are required to recalculate their inventory as of the end of the prior tax year under the new, simplified method.
This cost is then compared to inventory originally calculated under their old method. The difference between the two amounts is a tax deduction in 2018, assuming the cost computed under the new method is lower. The taxpayer would need to file for an accounting method change to formally change to these new accounting methods.
For example, consider a winery with inventory costs of $2 million at December 31, 2017, calculated using their old accounting method. Using the simplified method referenced above, assume that the inventory costs are $800,000 at December 31, 2017.
The difference of $1.2 million between the $2 million from the old method and the $800,000 of the new method would be taken as a deduction on the 2018 return. In addition, the 2018 production costs and cost of goods sold would all be accounted for in accordance with the new method.
Wineries typically have multiple vintages of inventory on hand, so multiple years of production costs are trapped in inventory. For eligible taxpayers, this new method could generate significant deductions in the year of change because they’ll be able to deduct those prior year production costs that remain in inventory.
Considerations for Vineyards
Prior to tax reform, most vineyards were eligible to use the cash method of accounting, but new changes further expand eligibility for vineyards. Under the revised rules, two main limitations prohibit a vineyard from using the cash method:
- It’s held in a C Corporation with more than $25 million in average gross receipts in the prior three years.
- Its activity generates a taxable loss in a flow-through entity that’s considered a tax shelter. The definition of a tax shelter is broad-reaching and therefore it’s important to consult with a tax advisor to determine whether these limits apply to your business activity.
Section 179 Deduction
Tax reform included significant changes to Internal Revenue Code Section 179, Election to Expense Certain Depreciable Business Assets. Beginning January 1, 2018, these changes include:
- Expensing limit doubled to $1 million
- Phase-out threshold increased to $2.5 million
Once a taxpayer has eligible asset additions in excess of $2.5 million, the allowed Section 179 expense is reduced dollar for dollar. This means a taxpayer with $3.5 million in eligible asset additions wouldn’t be able to take a Section 179 deduction.
Tax reform also included significant changes to bonus depreciation with rules becoming effective for assets acquired and placed into service after September 27, 2017.
Percentages are now doubled to 100% and, unlike with the Section 179 deduction, a taxpayer can take bonus depreciation on all eligible asset additions with no limit on the deduction or amount taken. Taxpayers can also claim bonus depreciation on used assets, which prior to tax reform, only applied to new assets.
These changes will have a significant impact on business acquisitions in the wine industry. If a taxpayer acquires an existing business in a qualified asset acquisition, he or she may be able to take 100% bonus depreciation on all assets that have a tax life of 20 years or less and recognize that deduction entirely in the year of purchase.
However, the taxpayer will need to consider whether any of the bonus depreciation expense would need to be capitalized under another section of the Internal Revenue Code, such as production costs or UNICAP.
Additional Depreciation on Specified Plants
Under pre-reform rules, a taxpayer who planted or grafted specified plants, including vines, was allowed 50% additional depreciation in the first year that the vine was planted or grafted. TCJA increased the additional depreciation to 100%.
When determining the benefits of this election, taxpayers should consider their method of accounting for pre-productive costs and the availability of bonus depreciation when the vine becomes productive.
The availability of bonus depreciation for a winery is pretty widespread, but depending on how a taxpayer accounts for pre-productive costs, bonus depreciation may not be available for vineyard assets.
Pre-productive costs are the farming costs incurred between the time a vine is planted through the harvest date of the first commercially harvestable crop, typically three crop years. An eligible vineyard taxpayer has the option to expense or capitalize these costs into the basis of the vine. However, there’s a trade-off for accelerating these deductions.
Taxpayers that elect to expense pre-productive costs are required to use the Alternative Depreciation System (ADS) method, which is a straight-line method of calculating depreciation and requires longer lives to depreciate farming assets.
For example, a taxpayer who capitalizes pre-productive costs would depreciate vines over a 10-year life. However, a taxpayer who expenses pre-productive costs would depreciate vines over a 20-year life. In addition to the slower depreciation method and longer lives, bonus depreciation isn’t available for vineyard assets that are depreciated using the ADS method.
It’s important to note that the requirement to use ADS will apply to all vineyard or farming assets for a specific taxpayer who’s elected to expense their pre-productive farming costs. If a taxpayer has a majority interest in an LLC that owns a vineyard and elected to expense the pre-productive costs for that vineyard, all other current or subsequent vineyards controlled by that taxpayer would also be required to use the ADS method.
Given that a taxpayer’s method of accounting for pre-productive costs will impact their ability to take bonus depreciation, it’s important for a taxpayer to understand his or her method of accounting for pre-productive costs. Note that while bonus depreciation isn’t available to taxpayers who expense pre-productive costs, the ability to take Section 179 on vineyard assets isn’t affected by a taxpayer’s method of accounting for pre-productive farming costs.
For vineyard businesses that capitalize their pre-productive farming costs, bonus depreciation is allowed on eligible farming assets. This means that bonus depreciation can be taken on vineyard development costs when the vineyard goes into production as well as assets acquired in a vineyard acquisition, including, for example, vines, trellis, and above-ground irrigation.
Increasing a Loss
Some of these changes focus on the ability to accelerate losses and deductions beginning with the 2018 year. However, it’s important to note that due to other changes under TCJA, losses from active trades or business could be limited.
Under TCJA, active losses from pass-through businesses can offset other active business income plus a maximum of $500,000 if taxpayers are married filing jointly (MFJ) or $250,000 for all other taxpayers.
For example, consider a taxpayer (MFJ) with $1 million of income that consists of W-2 wages, interest, and dividends for 2018. The same taxpayer also has a flow-through loss from their winery of $1 million for 2018 and has basis to deduct this loss in full.
Under the pre-tax reform rules, the taxpayer would be able to offset the $1 million winery loss against his or her other sources of income and bring his or her taxable income to zero. However, under TCJA, only $500,000 of the $1 million loss will be able to offset other income and the taxpayer will pay tax on the remaining $500,000 of income that couldn’t be offset by the winery loss. The excess $500,000 of loss from the winery that was limited will be carried to future years until utilized.
Included in the TCJA were changes related to excise taxes. These changes include an expansion of the availability of the excise tax credit which was previously only available to small producers. In addition, there were changes to the calculation of the excise tax credit and the amount of excise tax that is assessed on wines with alcohol content above 14% and below 16%. These new provisions only apply to wine removed from bond for the period after December 31, 2017, and before January 1, 2020.
We’re Here to Help
Winery and vineyard business owners can benefit from performing a detailed analysis of their company’s specific situation to determine which, if any, actions to take. For more information on how tax reform may affect your planning through the year, contact your Moss Adams professional or view our tax-planning guide.