R&D Tax Credit for Vineyards and Wineries Affected by Smoke Exposure

A version of this article was previously published on Wine Business.

For vineyards and wineries, 2020 has witnessed unprecedented wildfires. In California, a record was set with more than 3.7 million acres burned. Similar devastation occurred in Oregon and Washington with over 1.6 million combined acres burned. Unfortunately, wildfires still continue to ravage the West.

With fire comes smoke bringing an imminent threat of smoke exposure to grapes. Some vineyards and wineries will forego their 2020 vintage altogether due to smoke exposure; others will attempt to produce wine using new methods or techniques to mitigate smoke exposure.

Those who attempt to produce a 2020 vintage should consider the potential of research and development (R&D) tax credits.

Effects of Smoke Exposure

While a vineyard or winery may not be directly impacted by a wildfire, smoke exposure to grapes is still a concern. Smoke exposure can cause a substantial increase in volatile phenols—such as guaiacol and 4-methylguaiacol—which are absorbed through grape skins and can result in wine characterized by overwhelming smoke and ash traits. It’s unknown how much smoke exposure is considered causal for unwanted traits, but the risk increases with continual or multiple exposures.

Testing Issues

Further complicating the issue, assessing whether grapes have been affected by smoke exposure isn’t measurable by the naked eye.

Lab testing is one method to measure the levels of volatile phenols, but labs are currently inundated and have backlogs of samples to test—leaving many vineyards and wineries in limbo as they make decisions to harvest and produce wine.

Small-scale fermentations and sensory and chemical analysis can also help assess for smoke-exposure characteristics.

Neither method is fool-proof; when determining the impact on the resulting wine, there’s still uncertainty in how to treat grapes with smoke-exposure defects.

R&D Tax Credit & Deduction

The R&D tax credit provides companies a dollar-for-dollar tax savings that directly reduces a company’s tax liability—in general, this includes approximately 10% of qualified expenses. If the R&D credit can’t be used immediately or completely, any unused federal credit can be carried forward for up to 20 years—or indefinitely for California R&D tax credits.

Amounts eligible for the R&D tax credit are also eligible for immediate deduction in 2020 as an Internal Revenue Code (IRC) Section 174 research and experimental expenditure, accelerating the realized tax benefit for expenses that may have been otherwise deferred or depreciated.

Qualified Research

Qualified R&D ultimately depends on whether the activity meets each element of the four-part test established in the tax code.

Elimination of Uncertainty

The activity is undertaken to discover information intended to eliminate uncertainty about the capability, method, or design of a new or improved product or process.

Process of Experimentation

The activity involves one or more alternatives—intended to eliminate uncertainty—and conducts a process of evaluating the alternatives through modeling, simulation, or a systematic trial and error methodology.

Technological in Nature

The process of experimentation must rely on hard sciences such as engineering, physics, chemistry, biology, or computer science.

Qualified Purpose

The activity relates to a new or improved function, performance, reliability, or quality of a product or process.

Examples of Smoke-Exposure Research

Given the vast uncertainty and risk due to smoke exposure—and the lack of specific and effective solutions—wineries that attempt to produce a 2020 vintage with smoke-exposed grapes will likely conduct R&D activities that meet the four-part test criteria.

The types of activities that might qualify include:

  • New or improved pressing methods or equipment—for example, press-fraction trials
  • New or improved fermentation methods, processes, or techniques such as yeast strain tests, skin-contact trials, and fermentation temperature trials
  • New or improved clarification methods or techniques, including improvements to fining and filtration processes—for example, activated carbon, reverse osmosis, or solid phase extraction
  • New or improved product formulations for desired flavor or aroma profiles such as dilution or blend trials
  • New or improved aging methods such as barrel and toast trials

Qualified Expenses

If a company determines the work it conducts likely qualifies for the R&D tax credit, identifying related expenses is the next consideration. Most expenses fall into three categories: wages, supplies, and contractors.

Wages

Qualifying employee wages are determined in proportion to the percentage of time an employee spends on R&D in that year.

Wages can include the following:

  • Form W-2
  • Box 1 wages
  • Pass-through income subject to self-employment tax

Qualified employees include individuals performing qualified research as well as those that directly support or supervise the research.

The rules further specify that if an employee spends at least 80% of their time performing qualified R&D activities, 100% of their wages can be included to calculate the credit.

Job titles that might conduct smoke exposure R&D activity include the following:

  • Winemakers
  • Viticulturists
  • Cellar workers
  • Lab technicians

Supplies

Qualifying equipment and materials related to the research process can include prototype equipment or processing systems as well as other tangible property such as:

  • Grapes
  • Yeast
  • Fining agents
  • Barrels and barrel alternatives
  • Testing supplies
  • Bulk wine used in experiments

Contractors

Payments to contractors may also be eligible, but subject to some restrictions. Qualified contractor expenses typically include:

  • Consulting winemakers
  • Outside lab testing
  • Subject-matter-expert consultants
  • Temporary labor

Documentation

Like many other aspects of tax compliance, documentation is important. There are two primary categories of documentation for R&D purposes—quantitative support and qualitative support.

Quantitative Support

Taxpayers will want to clearly track costs spent on the R&D projects in their financials—ideally through specific general ledger accounts or tagged memo entries. Taxpayers should also maintain employee wage information, specifically Form W-2 data.

Qualitative Support

Taxpayers will need to retain all documentation—formal or informal—developed over the course of the R&D project.

Examples include the following:

  • Project descriptions or plans
  • Trial designs
  • Test logs and reports
  • Sensory and organoleptic evaluations
  • Chemical analysis
  • Notes, presentations, and emails

We’re Here to Help

As your vineyard or winery is determining whether or not to produce a 2020 vintage, it is worth exploring the R&D tax credit to mitigate some of the risk.

If you need assistance determining whether your winery or vineyard qualifies for the R&D tax credit, please contact your Moss Adams professional.