INTRODUCTION

The goals of the study were:

1. To determine the nature and extent of noncompliance within the industry

2. To develop an audit techniques guide for the industry

3. To promote voluntary compliance within the industry through consistent treatment of issues and taxpayer education.

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successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay
the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver
premium service nearly anywhere...without premium pricing.  

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Chapter 1

OVERVIEW OF WINERY/VINEYARD OPERATIONS

FARMING

MANUFACTURING

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NOTE: TAM 9327007 is an example of the Service's position that the end of the

production period is the release date.

MARKETING/SALES

Once the product is ready for sale, the wineries have a variety of options on how to

sell their product. Some wineries have tasting rooms where visitors can purchase the

1-5

wine directly from the winery. The wineries may also sell directly to restaurants and

"bottle shops." More commonly, the wineries will work through a broker or a

distributor. A distributor will actually buy the product for resale. A broker, on the

other hand, may take possession but not ownership of the wine. The broker is paid a

commission based on sales. The wineries will still have their own sales force, even

though working through a broker or a distributor.

Wine making has progressed to such an extent that most of the wines produced today

are palatable. Few are of such consistently superior quality as to truly distinguish

themselves from the competition.

Therefore, the key to success in the wine industry has fallen on the

marketing/promotion side rather than that of production. To assist in marketing and

publicizing their wines, the winemaker or owner of the winery will attend tastings or

other promotional events. As will be discussed in Chapter 4 (Wine Industry Issues),

this can cause cost accounting problems when people "wear more than one hat." An

allocation of their salary, based on facts and circumstances, needs to be made.

1-6

Exhibit 1-1

Timing and Treatment of Vineyard Development Costs

Guidelines for capitalizing and expensing vineyard establishment costs when UNICAP does not

apply. If UNICAP applies, all costs are capitalized until the vineyard starts producing a crop.

1st 2nd 3rd

Cultural Costs Year Year Year

Pre-Plant Tillage: Man & Tractor C

Fumigation C

Layout and Mark C

Distribute and Set Stakes C

Stakes (7' – Treated) C

Rootstocks C

Plant Vines (Labor) C

Planting Supervision C

Bud and Cover, Including Rubber Ties C X X

Budwood (Certified) C X X

Uncover and Prune Rootstocks C X

Cut Rubbers & Tops, Place Collars C X

End Posts (Treated) C C C

End Post Set (Labor) C C C

String Trellis Wire (Labor) C C C

Trellis Wire C C C

Train & Prune (Labor) X X

Mildew Control X X

Irrigation Labor (After Planting) X X X

Water & Pumping Power (After Planting) X X X

Repairs on Irrigation Equipment X X X

Cultivation C X X

Frost Protection (Labor) X X

T-Budding (Conversion) C C C

C = Capitalize

X = Expense

1-7

Exhibit 1-2 (1 of 22)

Sample Costs to Establish a Vineyard

and Produce Wine Grapes in

Sonoma County

1992

University of California

Cooperative Extension

Revised 12-9-93

Exhibit 1-2 (2 of 22)

This is page intentionally left blank..

1-9

Exhibit 1-2 (3 of 22)

U.C. COOPERATIVE EXTENSION

SAMPLE COSTS TO

ESTABLISH A VINEYARD AND PRODUCE

WINE GRAPES

IN SONOMA COUNTY — 1992

by

Rhonda Smith, Farm Advisor, Sonoma County

Karen Klonsky, Extension Economist, U.C. Davis

Pete Livingston, Staff Research Associate, U.C. Davis

and

Laura Tourte, Post Graduate Researcher, U.C. Davis

The detailed costs for vineyard establishment and wine grape production in Sonoma County are presented in

this study. The hypothetical farm used in this report consists of a total of 35 acres, 30 of which are in

production each year.

The practices described in this cost study are considered typical for this crop and area. Sample costs given

for labor, materials, equipment and contract services are based on current figures. Some costs and practices

detailed in this study may not be applicable to your situation. The use of trade names is not an endorsement

or a recommendation. A blank Your Cost column is also provided to enter your actual costs on Tables 2 and

3, Costs Per Acre To Produce Wine Grapes and Costs And Returns Per Acre To Produce Wine Grapes. This

study is only intended as a guide and can be used in making production decisions, determining potential

returns, preparing budgets and evaluating production loans.

This study consists of General Assumptions for Establishing a Vineyard and Producing Wine Grapes and

eight tables.

Table 1. Costs Per Acre To Establish A Vineyard.

Table 2. Costs Per Acre To Produce Wine Grapes

Table 3. Costs And Returns Per Acre To Produce Wine Grapes

Table 4. Monthly Cash Costs Per Acre To Produce Wine Grapes

Table 5. Whole Farm Annual Equipment, Investment And Business Overhead Costs

Table 6. Hourly Equipment Costs

Table 7. Ranging Analysis

Table 8. Costs And Returns / Breakeven Analysis

For an explanation of calculations used for the study refer to the attached General Assumptions, call the

Department of Agricultural Economics, Cooperative Extension, University of California, Davis, California,

(916) 752-3589 or call the Sonoma County Viticulture Farm Advisor.

Two companion studies entitled, "Sample Costs to Produce Organic Wine Grapes in The North Coast, With

Annually Sown Cover Crop" and "Sample Costs to Produce Organic Wine Grapes in The North Coast, With

Resident Vegetation" are available for those interested in organic wine grape production or as a comparison

between the two systems.

The University of California Extension in compliance with the Civil Rights Act of 1964, Title IX of the Education Amendments of 1972, and the Rehabilitation Act of 1973 does not

discriminate on the basis of race, creed, religion, color, national origins, or mental or physical handicaps in any of its programs or activities, or with respect to any of its employment

practices or procedures. The University of California does not discriminate on the basis of age, ancestry, sexual orientation, marital status, citizenship, medical conditions (as defined in

section 12926 of the California Government Code) or because the individuals are disabled or Vietnam era veterans. Inquiries regarding this policy may be directed to the Personnel

Studies and Affirmative Action Manager, Agriculture and Natural Resources, 2120 University Avenue, University of California, Berkley, California 94720, (510) 644-4270.

University of California and the United States Department of Agriculture cooperating.

1-10

Exhibit 1-2 (4 of 22)

GENERAL ASSUMPTIONS FOR

ESTABLISHING A VINEYARD AND PRODUCING WINE GRAPES

Sonoma County — 1992

U.C. Cooperative Extension

The following is a description of some general assumptions pertaining to sample costs of vineyard

establishment and wine grape production in Sonoma County. The costs are based on typical practices used

by many growers in this county, some of which may not be used during every production year. The costs are

represented on an annual per acre basis. The use of trade names in this report does not constitute an

endorsement or recommendation nor is any criticism implied by omission of other similar products by the

University of California:

1. LAND:

The vineyard is owned and not leased. It is managed and operated by the owner except where noted.

The vineyard is located on a valley floor with very deep, well drained soil. Land is valued at $15,000

per acre. The farm is composed of 35 acres, 30 of which are planted with wine grapes. The other 5

acres are used for the farmstead, roads, reservoir and well. Since only 30 of the 35 total acres are in

production, the land value per vineyard acre is shown as $17,500. Land is not depreciated.

2. VINEYARD CONVERSION:

The land used in this study is assumed to have an existing vineyard on it. The existing grapevines will

be removed following the land purchase. After the vines have been removed and burned the land will

be ripped 3 times to a depth of 5 feet by a custom tillage company. The 30 acres used for the vineyard

are then fumigated and tarped. This is done under contract by a fumigation company. The reservoir

for frost protection will be excavated at this time. The well from the previous vineyard will be

refurbished and a new pump and motor will be installed along with the drip irrigation system and the

overhead sprinkler frost protection system, before the vineyard is planted.

3. VINES:

Bench grafts of a certified chardonnay clone on a phylloxera resistant rootstock are planted on a 7' ×

11' spacing with 566 vines per acre during the first year. In the second year, 2% or 11 vines per acre

will be replanted. Vines will be trained to a bilateral cordon at 36 inches and spur pruned. The

grapevines are expected to become mature in 3 years and then be productive for an additional 22 years.

4. TRELLIS SYSTEM:

The trellis system is designed to support a bilateral cordon trained and spur pruned vineyard. The

trellis system in this study utilizes tomato stakes, metal stakes for the sprinkler system and in-line

lodgepole posts. A permanent cordon wire is attached to all stakes and posts and 2 pair of movable

wires are hung on J nails attached to the lodgepoles. The trellis system is installed during the first 2

years of the vineyard establishment and is detailed as follows:

1-11

Islip + Company CPAs are here with personalized service to help you with these issues.  Since 1958, we have successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver premium service nearly anywhere...without premium pricing.  Give us a call or send us an email 916-488-1900 or  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .www.Islip.net

Exhibit 1-2 (5 of 22)

First Year: After the previous vineyard has been removed and the ground has been ripped and

fumigated, sugar beet lime is applied at rate of 10 tons per acre and incorporated by discing. The

entire vineyard is then laid out and the row ends and stake location within the rows are marked. Both

the drip irrigation and frost protection systems are installed. Eight foot roll formed metal stakes are set

at each sprinkler rise location and 4' tomato stakes are pounded into the ground where remaining

grapevines are to be planted. Initially drip irrigation line is laid out on the ground along the vine row

and turned on to make the ground soft for digging. After the holes are dug, the vines are then planted.

Second Year: The in-line lodgepoles and end posts are installed. The 4-5 inch diameter, 8 foot inline

posts are spaced 21 feet apart, but are not placed where a vine is sited. The end assembly consists

of a 48 inch long screw anchor 6 with a 6 inch metal plate and a 6-7 inch diameter, 9 foot end post.

Ten gauge anchor wires are strung from the screw anchor to the end post. A permanent, 12 gauge,

high tensile, cordon wire is attached with a clamp to each tomato and metal stake. It is from this

cordon wire that the drip irrigation line is suspended by short lengths of 14 gauge wire. A 14 gauge,

high tensile wire is permanently attached to the tops of the in-line posts. Two pairs of movable, 14

gauge, high tensile wire are secured to each end post. J nails are tacked into the lodgepoles, above the

cordon wire. The 4 movable wires are moved up the posts and held in position by the J nails.

5. IRRIGATION SYSTEM:

Water for the drip irrigation system is pumped from a depth of 150 feet in a 200 foot well using a 10

horsepower (HP) pump. Pressure at the discharge head is 35 pounds per square inch (psi) and

produces a flow of 125 gallons per minute (gpm). The well, 10 HP pump, filtration station, drip line,

fertilizer injector system and the labor to install each of these components is included in the irrigation

system cost.

The irrigation system has a 25 year lifespan. The drip irrigation system is installed before the

grapevines are planted in the first year, but is not shown as a cash establishment cost. It is instead

treated as an improvement to the property and therefore, an investment and can be found in Table 5

under Annual Investment Costs.

Pumping costs for irrigation water vary during the establishment years due to the total volume of water

pumped and electrical rates, some of which are flat rate fees. Starting in the fourth year the irrigations

begin in May and end in August. An additional postharvest irrigation of 3 acre inches occurs in

October. Irrigation rates and pumped water costs for the establishment and production years are

shown in Table A.

1-12

Exhibit 1-2 (6 of 22)

Table A.

Year Gal/Vine Acft/Year Cost/Acft

1 300 .51 $32.04

2 300 .51 $32.04

3 200 .34 $26.52

4+ 100 .17 $29.04

6. FROST PROTECTION SYSTEM:

The frost protection system consists of a 12 acre foot reservoir, a 1500 gpm pump powered by a diesel

engine, a permanent, underground pipeline and sprinklers. Water for frost protection is pumped from

the well into the reservoir and stored there until needed. Though the frost protection system is installed

during vineyard conversion and planting in the first year, it is not shown as a cash cost in vineyard

establishment, but rather is considered as an improvement to the land. The cost for the frost protection

system can be found in Table 5. under Annual Investment Costs. This system has an expected life of

2.5 years.

In this study, it is assumed that frost protection will be required for 6 hours per night for 6 nights in all

years, except the first. Annual use of 9.9 acre feet of water for frost protection is presumed to occur

throughout the life of the vineyard. In actual practice the amount of water used to protect the vineyard

from frost will vary from year to year. The water for frost protection purposes costs $17.40 per acre

foot in addition to the cost of pumped irrigation water as shown in Table A. The cost difference

between water used for irrigation and frost protection purposes, is due to the extra pumping of water

required from the reservoir through the overhead sprinklers.

7. ESTABLISHMENT CULTURAL PRACTICES:

The removal of the old vineyard, the planting of the new one and installation of the trellis system occur

during the first and second year of vineyard establishment and are described, in the Trellis System

section. The practices described below represent only the hypothetical vineyard in this study. These

are typical practices for many vineyards in Sonoma County, but may not be appropriate to your

circumstance.

A number of similar, but different cultural operations are performed during pruning, training vines and

hand vine care operations. In the first year, the pruning operation starts by removing the dirt mounded

over the vine and cutting off high rootstock roots. The vine is then pruned to a 2 bud spur, pulled over

to the stake and secured. A milk carton is placed over the trunk for protection. All prunings are left in

between the vine rows and are chopped by the tractor and mower.

The second year begins with training the vine and tying 1 shoot up the stake. The vine is topped and

the lowest laterals are removed. During dormancy weaker vines are cut back while pruning. Any

remaining lower laterals would also be pruned off and cordons cut back to the appropriate girth.

1-13

Exhibit 1-2 (7 of 22)

Training vines in the third year leads off by extending the cordons along the permanent cordon wire.

Spur positions are selected at this time. Slower growing vines continue to be trained; however year 3

is the last year that the vines are trained in this study. Spur position selection may continue with this

year's pruning operations. Canes from spurs are pruned appropriately.

After vines are trained, hand vine care activities such as shoot thinning and suckering trunks and

cordons start in years 4 and 5. The number of hours per acre needed to prune declines from the

previous year, but remains constant in the years thereafter.

The 2 pair of movable wires are not shifted during the first 2 years. Starting in the third year, 3 hours

per acre are necessary to move the wires once; however, by the fourth year 9 hours per acre are needed

to raise the wires up the lodgepoles on three separate occasions.

Insects and diseases are managed by using several different pesticides and management techniques

beginning in the second year. Leafhoppers and mites can be controlled by various insecticides. The

insecticide spray used in this study reflects an average of costs for either dimethoate or a mix of an

insecticidal soap and Pyreflin EC (which does not contain piperonyl butoxide).

There are many pathogens that attack grapevines, but the two major diseases that are assumed to occur

in this study are botrytis bunch rot and powdery mildew. Bunch rot would be controlled starting in the

fourth year solely on the practice of leaf removal in the grape cluster area. A fungicide spray and

dusting program for powdery mildew control would begin the second year. Thiolux, or another

wettable sulfur, is applied once early in the season, followed by 4 applications of sulfur dust made up

until bloom. After that time Rubigan, or another D.M.I. (demethylation inhibiting) fungicide is used to

control powdery mildew until fruit ripening begins.

Weeds present in the vine row the year the vines are planted are controlled by a hand hoeing. The row

centers between the vine rows are cultivated during spring and summer throughout the establishment

years. The vineyard is stripped sprayed with a combination of preemergence and/or contact herbicides

registered for young vines beginning in the late fall of the second year. Summer weed control from the

second year on switches from hand hoeing the weeds in the vine row to spot spraying with Roundup.

A liquid nitrogen fertilizer is applied in all years of vineyard establishment. Both 6-3-9 and 2-4-10 are

used in the first 3 years to apply 40 pounds of nitrogen, 35 pounds phosphorus and 95 pounds of

potassium per acre through the drip line. Beginning in year 4, 6-3-9 alone is applied to deliver 30

pounds nitrogen, 15 pounds phosphorus and 45 pounds potassium per acre. Pounds of fertilizer are

calculated assuming 10 pounds of material per gallon.

An establishment cost is the sum of the costs for land preparation, trellis system, planting, vines, cash

overhead and production expenses for growing the vines through the first year that grapes are

harvested. It is used to determine the non-cash overhead expenses, depreciation and interest on

investment, during the production years. The Total Accumulated Net Cash Cost on Table 1, in the

third year represents the establishment cost. For this

1-14

Exhibit 1-2 (8 of 22)

study, this cost is $11,039 per acre or $331,170 for the 30 acre vineyard. The establishment cost is

spread over the remaining 22 years of the 25 years the vineyard is in production.

8. PRODUCTION CULTURAL PRACTICES:

Pruning is done during the winter months and the prunings are chopped using the mower. Hand vine

care activities such as shoot thinning and suckering trunks and cordons continue through all production

years. Moving the wire pairs requires 9 hours per acre in order to make 3 relocations a year.

Nitrogen is applied at a rate of 30 pounds per acre during the production years, by injecting a total of

50 gallons of 6-3-9 through the drip irrigation system. Additionally, 15 pounds of phosphorus and 45

pounds of potassium is applied at this fertilization rate.

In practice, herbicide choice is a function of weed pressure which can change over time. In this

vineyard, vine row weeds are controlled with a mix of Princep, Goal and Roundup and are applied as a

strip spray during December. Resident vegetation in the row centers is managed with 4 mowings per

year which includes chopping the prunings. A spot herbicide spray of Roundup is used to treat 5% of

the acreage, primarily for field bindweed control.

Pest management techniques used to Control insect and disease problems in the last 2 years in

establishing the vineyard are the same practices used in the production years. Leafhoppers and mites

are controlled by a spray mix of either dimethoate or a mix of an insecticidal soap plus Pyrellin EC.

The cost of the insecticide reflects an average of the two different treatments. Powdery mildew is

treated in March with an application of Thiolux followed by 4 applications of dusting sulfur starting in

April and continuing through mid-May. Rubigan is substituted for sulfur and 4 sprays occur from

mid-May through early-July. Botrytis bunch rot is managed only by leaf removal around the grape

clusters. Leaf removal usually starts in June.

The pesticides and rates mentioned in this cost study are a few of those that are listed in the UC IPM

Grape Pest Management Guidelines. Cultural practices for the production of wine grapes vary from

grower to grower and region to region. The practices and inputs used in this cost study serve only as a

sample or guide. Variations can be significant. For additional information contact the Sonoma County

Viticulture Farm Advisor.

9. YIELDS & RETURNS:

Grapes begin bearing an economic crop in the third year after planting. The annual yields are

measured in tons as shown in Table B. These assumed yields are from the third year of vineyard

establishment to maturity.

1-15

Exhibit 1-2 (9 of 22)

Table B.

Year Yield (tons/ac)

3 1.5

4 3.5

5 5.0

6+ 6.0

An estimated price of a $1250 per ton of chardonnay wine grapes is used in this study. Returns will

vary and the yields and prices used in this cost study are an estimate taking into consideration current

situations.

10. HARVEST:

Harvesting starts in the third year. As the yield increases the cost to harvest also increases until

vineyard maturity is reached in the sixth year. In this cost study the vineyard contracts to have the

grape crop custom harvested. The harvesting is done by hand. If growers do their own mechanical

harvesting, then the equipment for harvest operations should be inventoried in Investment costs on

Table 5, and operation costs would be calculated and placed in Harvesting costs in Tables 1 and 2. All

custom charges would be subtracted from Harvesting costs in Tables 1 and 2.

11. LABOR:

Basic hourly wages for workers are $8.00 and $6.00 per hour for machine operators and field workers,

respectively. Adding 34% for SDI, FICA, insurance and other benefits increases the labor rates shown

to $10.72 per hour for machine labor and $8.04 per hour for non-machine labor. The labor hours for

operations involving machinery are 20% higher than the operation time to account for extra labor

involved in equipment set-up, moving, maintenance and repair. Wages for managers are not included

as a cash cost. Any returns above total costs are considered returns to management and investment.

12. INVESTMENT:

The investments shown in Table 7 are those that are allocated to the vineyard. Annual investments

shown in Tables 1 and 5 represent depreciation and opportunity cost for each investment on an annual

per acre basis.

13. OVERHEAD:

County taxes are calculated as 1.1% of the average value of equipment, buildings, value of the

grapevines and improvements. Insurance is charged at 0.5 % of the average value of the equipment

over its useful life. Office and business costs are estimated at $180 per acre for the farm. These

expenses include, but are not limited to office supplies, telephones, bookkeeping, accounting, legal

fees, road preparation and maintenance. Consultant fees for pest, tissue and sod analyses are included

at $20 per acre.

1-16

Exhibit 1-2 (10 of 22)

14. INTEREST:

Interest on operating capital is based on a short term interest rate charged against cash costs and is

calculated monthly until harvest at the nominal rate of 9% per year. Interest is also charged on

investment at a real interest rate of 4% per year to account for income foregone that could be received

from an alternative investment (opportunity cost) and is calculated using a long term interest rate

charged on the average value of the land, improvements to the property and equipment. A real interest

rate indicates the return for the use of capital and does not include any adjustment for inflation. A

nominal interest rate would include an inflation factor.

15. EQUIPMENT COSTS:

In allocating the equipment costs per acre, the following calculations were made and shown in Table 7:

(a) Original Cost of equipment is the cost of the new equipment plus sales tax. (b) Depreciation is

straight line with a 10% salvage value. (c) Interest on investment is calculated as the average value per

acre of the equipment during its useful life multiplied by a real interest rate of 4%. Average value

equals new cost plus salvage value divided by 2 divided by the number of acres. (d) The Total

Investment Costs are calculated as 60% of the depreciation and the interest costs for all new equipment

to reflect a mix of the new and used equipment. These values are also used in Tables 1 and 5. All of

this equipment is used on the entire 30 acre vineyard.

16. FUEL & REPAIR:

The fuel and repair cost per acre for each operation in Tables 1 and 5 is determined by multiplying the

total hourly operating cost for each piece of equipment in Table 8 by the number of hours per acre for

that operation. Prices for on-farm delivery of gasoline and diesel are $0.98 and $0.71 per gallon,

respectively.

17. ACKNOWLEDGEMENT:

Several Sonoma County wine grape producers assisted in furnishing information for this study.

Appreciation is expressed to those growers and other individuals who provided assistance.

1-17

Islip + Company CPAs are here with personalized service to help you with these issues.  Since 1958, we have successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver premium service nearly anywhere...without premium pricing.  Give us a call or send us an email 916-488-1900 or  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .www.Islip.net

Exhibit 1-2 (11 of 22)

Table 1. U.C. COOPERATIVE EXTENSION

COSTS PER ACRE TO ESTABLISH A WINE GRAPE VINEYARD

SONOMA COUNTY — 1992

Labor Rate: $10.72/Hr. machine labor Interest rate: 9%

$8.04/Hr. non-machine labor Vine per Acre: $66.00

Costs per Vineyard Acre

YEAR 1st 2nd 3rd 4th 5th

YIELD (Tons/acre) 1.5 3.5 6.0

Planting Costs

Vine Removal and Ripping — Contract $ 550

Fumigation — Custom Methyl Bromide Application

Apply Soil Amendments 1,400

Preplant Discing 406

Mark and Layout Vineyard 19

Install Tomato Stakes 150

Trim and Store Vines 220

Plant Vines — 566 Vines (+11 replants in year 2) 80 2

Layout and Install Trellis System

2313 45

2,393

TOTAL PLANTING COSTS $5,138 $2,440

Cultural Costs:

Hand Vine Care $322 $322

Pruning $150 $161 $240 161 161

Train Vine 281 375

Chop Brush 6 6 6 6 6

Winter Weed Control 95 95 53 53 53

Hand Hoe Weeds 16

Summer Weed Control on 5% of Acreage 12 12 12 12

Cultivation of Row Centers 38 38 38 38 38

Frost Protection 23 24 25 25

Mildew Control 103 103 103 103

Insect and Mite Management 35 35 35 35

Move Wires 24 72 72

Leaf Removal 217 217

Irrigate 49 49 42 38 38

Fertilize 90 90 90 48 48

Pickup Truck Use 165 165 165 165 165

TOTAL CULTURAL COSTS $609 $1,058 $1,207 $1,295 $1,295

Harvest Costs:

Harvest — Custom @ $120/Ton 180 420 720

TOTAL HARVEST COSTS $180 $420 $720

Interest on Operating Capital @ 9% 220 129 47 45 47

1-18

Exhibit 1-2 (12 of 22)

U.C. COOPERATIVE EXTENSION

Table 1. continued

Costs per Vineyard Acre

YEAR 1st 2nd 3rd 4th 5th

Overhead Costs:

Office Expense $180 $180 $180 $180 $180

Pest Management Consultant Fees 20 20 20 20 20

Liability Insurance 8 8 8 8 8

Property Taxes 286 286 306 362 382

Equipment Insurance 105 105 105 105 105

Investment Repairs 23 23 23 23 23

TOTAL OVERHEAD COSTS $622 $622 $642 $698 $718

TOTAL CASH COSTS $6,589 $4,249 $2,076 $2,458 $2,780

INCOME FROM PRODUCTION $1,875 $4,375 $7,500

NET CASH COSTS FOR THE YEAR $6,589 $4,249 $201

PROFIT ABOVE CASH COSTS $1,917 $4,720

TOTAL ACCUMULATED NET CASH COSTS $6,589 $10,838 $11,039 $9,122 $4,402

Depreciation:

Buildings $16 $16 $16 $16 $16

Drip Irrigation system 63 63 63 63 63

Frost Protection system 50 50 50 50 50

Reservoir — 12 Acre Feet 33 33 33 33 33

Pruning Equipment 4 4 4 4 4

ATV 39 39 39 39 39

Shop Tools 20 20 20 20 20

Equipment 118 118 118 118 118

TOTAL DEPRECIATION $343 $343 $343 $343 $343

Interest on Investment @ 4%: $700 $700 $700 $700 $700

Land @ $17,500/Acre 12 12 12 12 12

Buildings 38 38 38 38 38

Drip Irrigation system 31 31 31 31 31

Frost Protection system 20 20 20 20 20

Reservoir — 12 Acre Feet 1 1 1 1 1

Pruning Equipment 5 5 5 5 5

ATV 7 7 7 7 7

Shop Tools 30 30 30 30 30

Equipment

TOTAL INTEREST ON INVESTMENT $844 $844 $844 $844 $844

TOTAL COST FOR THE YEAR $7,776 $5,436 $3,263 $3,645 $3,967

INCOME FROM PRODUCTION $1,875 $4,375 $7,500

NET COST FOR THE YEAR $7,776 $5,436 $1,388

NET PROFIT FOR THE YEAR $730 $3,533

TOTAL ACCUMULATED NET COST $7,776 $13,212 $14,600 $13,870 $10,337

1-19

Exhibit 1-2 (13 of 22)

Table 2. U.C. COOPERATIVE EXTENSION

COSTS PER ACRE TO PRODUCE WINE GRAPES

SONOMA COUNTY — 1992

Labor Rate: $10.72/Hr. machine labor Interest rate: 9.00%

$8.04/Hr. non-machine labor Yield per Acre: 6.00 ton

Operation

time Labor Fuel,Lube Material Custom/ Total Your

Operation (Hrs/A) Cost & Repairs Costs Rent Cost Cost

Cash and Labor Costs per Acre

Cultural:

Pruning 20.01 160.88 0.00 0.00 0.00 160.88

Winter Weed Control 0.15 1.93 0.79 48.07 0.00 50.79

Chop Brush and Mow Centers 0.65 8.36 3.82 0.00 0.00 12.18

Frost Protection — 6× 1.20 9.65 0.00 16.48 0.00 26.13

Mildew Control 2.24 28.82 13.76 56.91 0.00 99.49

Hand Vine Care 40.00 321.60 0.00 0.00 0.00 321.60

Move Wires — 3× 9.00 72.36 0.00 0.00 0.00 72.36

Mow Row Centers — 3× 1.50 19.30 8.82 0.00 0.00 28.11

Irrigate — 100 Gal/Vine/Year — 2× 4.00 32.16 0.00 2.80 0.00 34.96

Fertigation — 30 lbs of W/Acre/Year — 2× 1.60 12.86 0.00 47.40 0.00 60.26

Leaf Removal 27.00 217.08 0.00 0.00 0.00 217.08

Summer Weed Control — 5% of Acreage 0.04 0.48 0.20 10.85 0.00 11.53

Insect/Mite Pest Management 0.50 6.43 3.29 33.50 0.00 43.22

Pickup Truck Use 9.50 122.21 42.98 0.00 0.00 165.19

TOTAL CULTURAL COSTS 117.39 1014.12 73.66 216.01 0.00 1303.79

--------- --------- -------- --------- --------- ---------

Harvest:

Harvest — Contract 6 Tons/Acre 0.00 0.00 0.00 0.00 720.00 720.00

TOTAL HARVEST COSTS 0.00 0.00 0.00 0.00 720.00 720.00

--------- --------- --------- --------- --------- ---------

Postharvest:

Irrigate — Postharvest 0.40 3.22 0.00 8.01 0.00 11.23

TOTAL POSTHARVEST COSTS 0.40 3.22 0.00 8.01 0.00 11.23

--------- --------- --------- --------- --------- ---------

Interest on operating capital @ 9.00% 48.06

TOTAL OPERATING COSTS/ACRE 1017.33 73.66 224.02 720.00 2083.08

TOTAL OPERATING COSTS/TON 347.18

CASH OVERHEAD:

Office Expense 180.00

Pest Management Fee 20.00

Liability Insurance 8.33

Property Taxes 104.40

Property Taxes 291.60

Property Insurance 132.54

Investment Repairs 24.17

TOTAL CASH OVERHEAD COSTS 761.04

---------

TOTAL CASH COSTS/ACRE 2844.11

TOTAL CASH COST/TON 474.02

1-20

Exhibit 1-2 (14 of 22)

U.C. COOPERATIVE EXTENSION

Table 2. continued

NON-CASH OVERHEAD

Per producing Annual Cost

Acre

Investment Depreciation Interest @ 4.00%

Land 17500.00 700.00 700.00

Buildings 525.00 15.75 11.55 27.30

Drip Irrigation System 1746.67 62.88 38.43 101.31

Frost Protection System 1343.33 48.34 29.55 77.91

Pruning Equipment 40.00 3.60 0.88 4.48

Shop Tools 333.33 20.00 7.33 27.33

ATV — 4wd 216.67 39.00 4.77 43.77

Vineyard Establishment 11039.00 501.77 220.78 722.55

Reservoir — 12 Acre Foot 1000.00 33.33 20.00 53.33

Equipment 1229.88 105.48 27.06 132.54

TOTAL NON-CASH OVERHEAD 34973.88 830.17 1060.35 1890.52

COSTS

--------- --------- --------- ---------

TOTAL COSTS/ACRE 4734.63

TOTAL COSTS/TON 789.11

1-21

Exhibit 1-2 (15 of 22)

Table 3. U.C. COOPERATIVE EXTENSION

COSTS AND RETURNS PER ACRE TO PRODUCE WINE GRAPES

SONOMA COUNTY — 1992

Labor Rate: $10.72/Hr. machine labor Interest rate: 9.00%

$8.04/Hr. non-machine labor

Quantity/Acre Unit Price or Value or Your

Cost/Unit Cost/Acre Cost

GROSS RETURNS

Wine Grapes 6.00 ton 1250.00 7500.00

TOTAL GROSS RETURNS FOR WINE GRAPE 7500.00

--------

OPERATING COSTS

Herbicide:

Roundup 2.00 qt 10.85 21.70

Princep 4L 2.00 qt 5.09 10.18

Goal 16E 1.25 qt 21.63 27.04

Water:

Water Frost Protection 4.00 acin 4.12 16.48

Water 4.05 acin 2.67 10.81

Fungicide:

Thiolux 6.00 lb 0.85 5.10

Dusting Sulfur 60.00 lb 0.17 10.20

Rubigan EC 19.00 oz 2.19 41.61

Fertilizer:

6-3-9 30.00 lb of M 1.58 47.40

Pesticide:

Pesticide Mix 1.00 appl 33.50 33.50

Contract:

Harvest 6.00 ton 120.00 720.00

Labor (machine) 6.09 hrs 10.72 187.52

Labor (non-machine) 103.21 hrs 8.04 829.81

Fuel Diesel 34.24 gal 0.71 24.31

Lube 3.65

Machinery repair 45.67

Interest on operating capital @ 9.00% 48.06

TOTAL OPERATING COSTS/ACRE 2083.08

TOTAL OPERATING COSTS/TON 347.18

---------

NET RETURNS ABOVE OPERATING COSTS 5416.92

CASH OVERHEAD COSTS:

Office Expense 180.00

Pest Management Fee 20.00

Liability Insurance 8.33

Property Taxes 104.40

Property Taxes 291.60

Property Insurance 132.54

Investment Repairs 24.17

TOTAL CASH OVERHEAD COSTS/ACRE 761.04

---------

TOTAL CASH COSTS/ACRE 2844.11

TOTAL CASH COSTS/TON 474.02

1-22

Exhibit 1-2 (16 of 22)

U.C. COOPERATIVE EXTENSION

Table 3. continued

Quantity/Acre Unit Price or Value or Your

Cost/Unit Cost/Acre Cost

NON-CASH OVERHEAD COSTS

(DEPRECIATION & INTEREST)

Land 700.00

Buildings 27.30

Drip Irrigation System 101.31

Frost Protection System 77.91

Pruning Equipment 4.48

Shop Tools 27.33

ATV — 4wd 43.77

Vineyard Establishment 722.55

Reservoir — 12 Acre Foot 53.33

Equipment 132.54

TOTAL NON-CASH OVERHEAD COSTS/ACRE 1890.52

---------

TOTAL COSTS/ACRE 4734.43

TOTAL COSTS/TON 789.11

NET RETURNS ABOVE TOTAL COSTS 2765.37

1-23

Exhibit 1-2 (17 of 22)

Table 4. U.C. COOPERATIVE EXTENSION

MONTHLY CASH COSTS PER ACRE TO PRODUCE WINE GRAPES

SONOMA COUNTY — 1992

Beginning DEC 91 DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV

Ending NOV 92 91 92 92 92 92 92 92 92 92 92 92 92 TOTAL

Cultural:

Pruning 53.63 53.63 53.63 160.88

Winter Weed Control 50.79 50.79

Chop Brush and Mow Center 12.18 12.18

Frost Protection — 6× 13.06 13.06 26.13

Mildew Control 11.32 25.59 18.21 28.12 16.25 99.49

Hand Vine Care 53.63 107.17 107.17 53.63 321.60

Move Wires — 3× 48.24 24.12 72.36

Mow Row Centers — 3× 9.37 9.37 9.37 28.11

Irrigate — 5× 6.99 6.99 13.99 6.99 34.96

Fertigation — 2× 30.13 30.13 60.26

Leaf Removal 217.08 217.08

Summer Weed Control 11.53 11.53

Insect/Mite Pest Management 43.22 43.22

Pickup Truck Use

TOTAL CULTURAL COSTS ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ ------

16.52 16.52 16.52 16.52 16.52 16.52 16.52 16.52 16.52 16.52 165.19

120.94 70.15 82.33 40.90 108.79 236.64 494.26 109.75 23.51 16.52 1303.79

Harvest:

Harvest Contract 6 Tons 720.00 720.00

TOTAL HARVEST COSTS 720.00 720.00

------ ------

Postharvest:

Irrigate — Postharvest 11.23 11.23

TOTAL POSTHARVEST COSTS 11.23 11.23

------ ------

Interest on oper. capital 0.91 1.43 2.05 2.36 3.17 4.95 8.66 9.48 15.05 48.06

TOTAL OPERATING COSTS/ACRE 121.84 71.58 84.38 43.26 111.97 241.59 502.92 119.23 758.57 27.74 2083.08

TOTAL OPERATING COSTS/TON 20.31 11.93 14.06 7.21 18.66 40.26 83.82 19.87 126.43 4.62 347.18

OVERHEAD:

Office Expense 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 180.00

Pest Management Fee 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 20.00

Liability Insurance 8.33 8.33

Property Taxes 250.20 145.80 396.00

Property Taxes 250.20 145.80 396.00

Property Insurance 132.54 132.54

Investment Repairs 2.42 2.42 2.42 2.42 2.42 2.42 2.42 2.42 2.42 2.42 24.17

TOTAL CASH OVERHEAD COSTS 272.61 163.29 22.42 22.42 168.21 22.42 22.42 22.42 22.42 22.42 761.04

------ ------ ------ ------ ------ ------ ------ ------ ------ ------ -------

TOTAL CASH COSTS/ACRE 394.46 234.87 106.80 65.68 280.18 264.00 525.33 141.65 780.98 50.16 2844.11

TOTAL CASH COSTS/TON 65.74 39.14 17.80 10.95 46.70 44.00 87.56 23.61 130.16 8.36 474.02

1-24

Exhibit 1-2 (18 of 22)

Table 5. U.C. COOPERATIVE EXTENSION

WHOLE FARM ANNUAL EQUIPMENT, INVESTMENT, AND BUSINESS OVERHEAD COSTS

SONOMA COUNTY — 1992

ANNUAL EQUIPMENT COSTS

Non-Cash Over. Cash Overhead

Yr Description Price Life Depreciation Interest ance Taxes Total

Yrs. Insur-

92 60 hp 4wd Tractor 29900 15 1794.00 657.80 82.23 180.90 2714.93

92 Duster 3035 10 273.20 66.76 8.35 18.36 366.67

92 Flail Mower — 8' 5500 10 495.00 121.00 15.13 33.28 664.41

92 Orchard Sprayer 4560 10 410.40 100.32 12.54 27.59 550.85

92 Pickup Truck — ½ Ton 16500 7 2121.43 363.00 45.37 99.82 2629.62

92 Weed Sprayer — 50 Gal 2000 10 180.00 44.00 5.50 12.10 241.60

TOTAL 61495 5274.03 1352.88 169.12 372.05 7168.08

60% of New Cost* 36897 3164.42 811.73 101.47 223.23 4300.85

* Used to reflect a mix of new and used equipment

ANNUAL INVESTMENT COSTS

Non-Cash Over. Cash Overhead

Yr Description Price Life Depreciation Interest ance Taxes Repairs Total

Yrs. Insur-

INVESTMENT

ATV — 4wd 6500 5 1170.00 143.00 17.88 39.33 50.00 1420.21

Buildings 15750 30 472.50 346.50 43.31 95.29 100.00 1057.60

Drip Irrigation System 52400 25 1886.40 1152.80 144.10 317.02 300.00 3800.32

Frost Protection System 40300 25 1450.80 886.60 110.83 243.82 150.00 2842.05

Land 525000 21000.00 2625.00 5775.00 0.00 29400.00

Pruning Equipment 1200 10 108.00 26.40 3.30 7.26 25.00 169.96

Reservoir — 12 Acre Foot 30000 30 1000.00 600.00 75.00 165.00 0.00 1840.00

Shop Tools 10000 15 600.00 220.00 27.50 60.50 100.00 1008.00

Vineyard Establishment 331170 22 15053.10 6623.40 827.92 1821.43 0.00 24325.85

TOTAL INVESTMENT 1012320 21740.80 30998.70 3874.84 8524.65 725.00 65863.99

ANNUAL BUSINESS OVERHEAD COSTS

Description Farm Unit Unit Cost

Units/ Price/ Total

Liability Insurance 30.00 acre 8.33 249.90

Office Expense 30.00 acre 180.00 5400.00

Pest Management Fee 30.00 acre 20.00 600.00

Property Taxes 30.00 acre 104.40 3132.00

1-25

Exhibit 1-2 (19 of 22)

Table 6. U.C. COOPERATIVE EXTENSION

HOURLY EQUIPMENT COSTS

SONOMA COUNTY — 1992

COSTS PER HOUR

Actual Non-Cash Over. Cash Overhead Operating

Hours

Used

Yr Description ciation Interest ance Taxes Repairs Lube Oper. Costs/Hr.

Depre- Insur- Fuel & Total Total

92 60 hp 4wd Tractor 167.6 6.42 2.36 0.29 0.65 1.49 2.41 3.90 13.63

92 Duster 38.4 4.27 1.04 0.13 0.29 1.52 0.00 1.52 7.25

92 Flail Mower — 8' 64.5 4.60 1.13 0.14 0.31 1.58 0.00 1.58 7.76

92 Orchard Sprayer 43.8 5.62 1.37 0.17 0.38 2.29 0.00 2.29 9.83

92 Pickup Truck — ½ Ton 285.0 4.47 0.76 0.10 0.21 2.99 1.53 4.52 10.06

92 Weed Sprayer — 50 Gal 5.6 19.18 4.69 0.59 1.29 1.00 0.00 1.00 26.75

1-26

Exhibit 1-2 (20 of 22)

Table 7. U.C. COOPERATIVE EXTENSION

RANGING ANALYSIS

SONOMA COUNTY — 1992

COSTS PER ACRE AT VARYING YIELDS TO PRODUCE WINE GRAPE

YIELD (TON/ACRE)

3 4 5 6 7 8 9

OPERATING COSTS/ACRE:

Cultural Cost 1304 1304 1304 1304 1304 1304 1304

Harvest Cost 360 480 600 720 840 960 1080

Postharvest Cost 11 11 11 11 11 11 11

Interest on operating capital 45 46 47 48 49 50 51

TOTAL OPERATING COSTS/ACRE 1720 1841 1962 2083 2204 2325 2446

TOTAL OPERATING COSTS/TON 573 460 392 347 315 291 272

CASH OVERHEAD COSTS/ACRE 761 761 761 761 761 761 761

TOTAL CASH COSTS/ACRE 2481 2602 2723 2844 2965 3086 3207

TOTAL CASH COSTS/TON 827 651 545 474 424 386 356

NON-CASH OVERHEAD COSTS/ACRE 1891 1891 1891 1891 1891 1891 1891

TOTAL COSTS/ACRE 4372 4493 4614 4735 4856 4976 5097

TOTAL COSTS/TON 1457 1123 923 789 694 622 566

NET RETURNS PER ACRE ABOVE OPERATING COSTS FOR WINE GRAPES

PRICE

(DOLLARS PER TON) 3 4 5 6 7 8 9

YIELD (TON/ACRE)

950.00 1130 1959 2788 3617 4446 5275 6104

1050.00 1430 2359 3288 4217 5146 6075 7004

1150.00 1730 2759 3788 4817 5846 6875 7904

1250.00 2030 3159 4288 5417 6546 7675 8804

1350.00 2330 3559 4788 6017 7246 8475 9704

1450.00 2630 3959 5288 6617 7946 9275 10604

1550.00 2930 4359 5788 7217 8646 10075 11504

1-27

Exhibit 1-2 (21 of 22)

U.C. COOPERATIVE EXTENSION

Table 7. continued

NET RETURNS PER ACRE ABOVE CASH COSTS FOR WINE GRAPES

PRICE

(DOLLARS PER TON) 3 4 5 6 7 8 9

YIELD (TON/ACRE)

950.00 369 1198 2027 2856 3685 4514 5343

1050.00 669 1598 2527 3456 4385 5314 6243

1150.00 969 1998 3027 4056 5085 6114 7143

1250.00 1269 2398 3527 4656 5785 6914 8043

1350.00 1569 2798 4027 5256 6485 7714 8943

1450.00 1869 3198 4527 5856 7185 8514 9843

1550.00 2169 3598 5027 6456 7885 9314 10743

NET RETURNS PER ACRE ABOVE TOTAL COSTS FOR WINE GRAPES

PRICE

(DOLLARS PER TON) 3 4 5 6 7 8 9

YIELD (TON/ACRE)

950.00 -1522 -693 136 965 1794 2624 3453

1050.00 -1222 -293 636 1565 2494 3424 4353

1150.00 -922 107 1136 2165 3194 4224 5253

1250.00 -622 507 1636 2765 3894 5024 6153

1350.00 -322 907 2136 3365 4594 5824 7053

1450.00 -22 1307 2636 3965 5294 6624 7953

1550.00 278 1707 3126 4565 5994 7424 8853

1-28

Exhibit 1-2 (22 of 22)

Table 8. U.C. COOPERATIVE EXTENSION

COSTS AND RETURNS / BREAKEVEN ANALYSIS

SONOMA COUNTY — 1992

COSTS AND RETURNS — PER ACRE BASIS

Crop 1. Gross Returns 2. Operating Costs Costs (1-2) 4. Cash Costs (1-4) 6. Total Costs (1-6)

3. Net Returns 5. Net Returns 7. Net Returns

Above Oper. Above Cash Costs Above Cash Costs

Wine Grapes 7500 2083 5417 2844 4656 4735 2765

COSTS AND RETURNS — TOTAL ACREAGE

Crop 1. Gross Returns 2. Operating Costs Costs (1-2) 4. Cash Costs (1-4) 6. Total Costs (1-6)

3. Net Returns 5. Net Returns 7. Net Returns

Above Oper. Above Cash Costs Above Cash Costs

Wine Grapes 225000 62492 162508 85323 139677 142039 82961

BREAKEVEN PRICES PER YIELD UNIT

Breakeven Price to Cover

CROP (Units/Acre) Units Costs Costs Costs

Base Yield Yield Operating Cash Total

$ per Yield Unit

Wine Grapes 6.0 ton 347.18 474.02 789.11

BREAKEVEN YIELD PER ACRE

Breakeven Price to Cover

CROP Units ($/Unit) Costs Costs Costs

Yield Base Price Operating Cash Total

$ per Yield Unit

Wine Grapes ton 1250.00 1.7 2.3 3.8

This page intentionally left blank.

2-1

Chapter 2

SELECTION AND CLASSIFICATION OF RETURNS

SELECTION OF RETURNS

There are several publications and trade journals which list wineries at the national,

state and local levels. Starting with The Wines and Vines Buyers Guide/Annual

Directory (see Sources of Information), an annual publication listing by state,

provided virtually all wineries in business at the time of publication. The publication

also provided additional information that is useful in securing returns. This

information include:

1. the name, address, and telephone number of the winery

2. when the winery was founded

3. who the principals are, such as the owner, CFO, winemaker, etc.

4. vineyard holdings

5. crush and storage capacity

6. types of products (still wine, sparkling wine, brandy)

7. brand names (if different from the winery name)

8. bonded winery number — useful if requesting information from the Bureau of

Alcohol, Tobacco and Firearms (BATF)

9. in some cases, the type of entity (proprietorship, partnership, corporate)

10. areas and methods of distribution.

With the names of wineries, the local BATF office should be able to supply Employer

Identification Numbers (EIN) for almost all the wineries in that district, along with

more information as to the wineries entity status. Utilizing transcripts to confirm the

tax year and filing status, the returns should be requested through the Planning and

Special Programs Branch.

Many wineries are subsidiaries of larger entities and file as part of the consolidated

return. In addition, some entities may have been acquired by foreign parents.

2-2

Although tracking ownership can be difficult, the ownership of the various entities

can be established. Research of industry periodicals may be required to assist in

determining the parent company and where they are located. For wineries who

underwent a recent change in ownership, information may be obtained directly from

the winery, including a copy of their return.

CLASSIFICATION OF RETURNS

Selecting returns with high audit potential has always been a priority with the Service.

Proper screening of winery returns is vital to the success of the program. Winery cost

accounting systems are complex and require a significant amount of audit time for

proper evaluation.

There are several factors to consider when evaluating a return for potential.

1. Find out as much information on that winery as you can. The Wines and Vines

Buyer's Guide provides information such as type of products, annual

production, and acres of vineyards owned or controlled by the winery. Industry

periodicals provide a wealth of information. Details on sales of wineries,

acquisitions of certain assets, introductions of new labels or products, etc. can

all be useful in determining audit potential.

2. Who prepared the return? There are a handful of local CPA firms that

specialize in the wine industry. A possible "flag" is a return prepared by anyone

not specializing in wineries. A significant rate of substantial errors had been

found in examinations of those returns.

3. Look for obvious omissions in the cost accounting system. Was all

depreciation expensed? Was all interest expensed? In reviewing the Cost of

Goods Sold section, does it appear that indirect costs, such as payroll tax

expense, insurance, repairs, general and administrative costs, etc., have been

included?

3-1

Chapter 3

AUDIT COMMENTS

SCOPE

This chapter provides information in conducting the pre-audit, initial interview, and

comparative analysis of the balance sheet and income and expense statements.

INITIAL DOCUMENT REQUEST

The following is a pro forma initial Document Request that may be used for

examination of wineries.

3-2

Form 4564 Internal Revenue Service

Rev. Jan. 1984 Information Document Request

Department of the Treasury Request Number

TO: (Name of Taxpayer and Co. Div. or Branch Subject

SAIN No. Submitted to:

Dates of Previous Requests

Description of Documents Requested

In addition to the general, common requests such as related party tax

returns, employment tax returns, and other package audit items:

(1) Inventory costing workpapers, including

– physical inventory count sheets

– breakdown of vintages and varietals

– notes or discussion on application of UNICAP

– how do they allocate indirect costs such as officer's salary, depreciation, interest, G&A, etc.?

– did they restate inventory in the first year of UNICAP?

– did they recognize the Section 481(a) amount in income?

– what is their definition of "production period"?

(2) Release date history

(3) Forms 702 and 2050 (BATF) for the period —

(4) Prior BATF audits/reports

(5) Depreciation Schedule

– looking for buildings at 5 year life and depreciation on production assets being expensed rather than

capitalized to inventory.

– allocation of purchase price on vineyard properties

– vineyards being depreciated prior to first crop?

From:

Name and Title of Requester Date

Office Location

3-3

INITIAL INTERVIEW AND WALK THROUGH

As with any examination, the initial interview can be crucial. One of the most difficult

aspects of UNICAP is the allocation of certain costs, especially officer's and

employee's salaries. The walk through of the facilities should be viewed as an

opportunity to verify the overhead allocations made. Since the overhead allocations

may be made asset by asset or by square footage, getting a firm understanding of the

layout of the facility is essential.

The walk through is an excellent time for the taxpayer to tell you about their product

line, what varietals they produce, what processes they use, and what the different

assets are used for.

In addition to all your other standard questions, including those about internal

control, you may wish to ask about:

Vineyard Operations:

1. Do you grow your own grapes? If so, do you sell any to outside parties? How

do you account for grape growing costs (expensed versus capitalized to

inventory)?

2. Do you purchase grapes from related parties? If so, what are the terms? FMV?

Payment made in the year of sale or when the wine made from those grapes is

sold?

3. Did you buy any vineyard properties recently? (Purchase price allocations —

placed in service dates.)

4. Did you plant or convert (t-bud) any vineyards recently? (T-budding is the

grafting in of a different type of wine grape to the trunk of an existing vine.

The issues involve the capitalization of development costs, including

fumigation, cost of vines and trellises, labor, etc.) See Exhibit 1-1.

5. How do you keep track of vineyard labor? (Expensed versus Capitalized)

6. Did you have any losses due to phylloxera disease? (Phylloxera is a root louse

that feeds on the roots of vines. The disease kills the vines and the only

effective treatment is to replace the vineyard.) See Chapter 4, Vineyard

Operations, for discussion of this issue.

3-4

Manufacturing Operations:

1. Where are the production facilities? (Some wineries may have several crushing,

bottling/warehousing locations.)

2. How do you account for winery labor? (How do they keep track of capitalized

vs. expensed costs.)

3. What facilities are used for crush/ferment versus barrel/bottle aging versus postproduction

warehousing? (Some wineries have limited storage space and may

use a coop of some sort for bottle aging — these costs should be capitalized.)

4. Do you do any custom crush or have any custom crush work done? (Custom

crush refers to a winery, who has the idle production capacity doing the

crush/ferment and even bottling/aging for someone who has grapes but not the

equipment available. This should be reflected in other income, with an

offsetting allocation of costs, by the winery doing the work. The amounts paid

would be capitalized as part of the cost of the wine by the owner of the grapes.)

5. What exactly are the tasks of the highly compensated employees? (Since

UNICAP requires officers' salaries to be capitalized if related to production, it

seems that more and more of their time is accounted for in marketing!)

Cost Accounting System:

1. What method do you use? (Are they on UNICAP? Have they tried to avoid

UNICAP by using lower of cost or market? Some wineries have used bulk

wine spot prices or other estimates of fair market value?)

2. Did you have any write-downs of your inventory? (Sometimes a particular tank

of wine might in fact go wrong, and the actual sales price might drop below

cost. In other situations, a particular varietal may not be well received, but the

sales price may not be reduced. It just takes longer to move the product.)

3. Is there a narrative or other documentation available that discusses how the cost

accounting system works? (Often the larger wineries, who have adopted

UNICAP will have a detailed analysis of how they implemented UNICAP —

how they allocated the various costs between the cost centers.)

3-5

4. When UNICAP became applicable, was beginning inventory restated?

5. How do you account for interest expense? (UNICAP requires that interest

expense be allocated to inventory having a production period in excess of

2 years, such as most red wines, sparkling wines and brandy, and to inventory

with a production period of between 1 and 2 years if the value of the inventory

exceeds $1 million. National Office has indicated that the $1 million limit

applies to a salable unit. Since cases of wine do not cost more than the limit,

interest will not be capitalized if the production period is less than 2 years.)

Marketing/Sales

1. Do you do direct sales, use a broker or a distributor or a combination thereof?

Are sales limited to your state or do you sell nationwide or export?

2. Do you maintain your own sales force? Are shareholder/employees or owners

involved? (Again, as it relates to UNICAP, the costs involved in marketing and

sales are currently deductible. A principal shareholder/owner might wear the

title of "winemaker" when in reality he or she spends a significant amount of

time on the road promoting the wine, leaving the actual production process in

the hands of an assistant. Conversely, a guest appearance at a promotional

event does not turn a winemaker into a Vice President of Marketing.

3. Do you sell any of your wines on futures? (This was a common practice. A

customer would buy wine half way through its production period at a set price

and take delivery of the wine on release. The customary terms were half down,

and the balance upon delivery. The customers would forfeit their deposit if they

didn't complete their transaction within a short period of time after the release.

The wineries invariably treated the down payments as a liability, rather than

income. While this seems to have been a fad that quickly faded, you may still

see substantial futures sales and wish to pursue the issue of recognition of

income.)

3-6

BALANCE SHEET ACCOUNTS

During the pre-audit a comparison of the pre-UNICAP return to the return where

UNICAP is first applicable should be performed to review the changes. There should

be significant changes in certain expense items being capitalized for UNICAP.

Depreciation, interest expense, officers' salaries, and an allocation of general and

administrative expenses were not required to be capitalized under full absorption.

Beginning inventory should be restated in the first year of UNICAP.

Inventories

Compare the balance sheet amounts with prior and subsequent year returns, Schedule

A (Computation of Cost of Goods Sold) and the financial statements if available. Are

there any discrepancies? In one examination, tasting room inventory was included per

the financial statements but excluded from the tax returns. Has the taxpayer changed

the inventory calculations between returns without making the necessary

amendments? Compare the balance sheet amounts with the inventory workpapers.

They do not always agree.

Other Assets

Does the taxpayer have construction in progress? This can be an indication that

vineyards in the development stage are being properly accounted for.

Buildings and Other Depreciable Assets (Fixed Assets)

This industry is one of the most capital intensive industries in the United States. The

assets to sales ratios normally run about 2 to 1. A lack of assets could be an

indication that the taxpayer is renting assets from a related party. If production assets

are being rented, this rent should be capitalized to inventory. The depreciation

schedule should be scrutinized for (1) adequate capitalization of depreciation to

inventory, (2) useful lives on buildings (sometimes claimed to be essentially

equipment), (3) personal residences being depreciated, (4) all development costs

being capitalized, and (5) placed in service dates. (Are the vineyards producing a

crop?)

3-7

Land

Review the land/depreciable assets in the vineyard allocation. Did the taxpayer

purchase the land with the vineyard already planted?

Interest Bearing Debt in General

Compare the amount of debt with the amount of interest expense. Is it reasonable? If

the taxpayer produces products with a long production period (most red wines,

sparkling wines and brandy), is a portion of the interest being capitalized? Under

UNICAP, interest should be capitalized under the avoided cost method.

Other Liabilities

Sometimes the breakdown of this amount will indicate that there is an amount "due to

affiliates" or "due on grape purchases" or some similar description. This should be

investigated to determine if an accrual basis winery is purchasing grapes from a

related cash basis vineyard. Often, the terms will state that the winery will voluntarily

withhold payment to the vineyard until the wine produced from those grapes is sold.

This can result in an unwarranted deferral of the recognition of income (at the

vineyard level) for a period of up to 5 years. See Chapter 4 for further discussion.

INCOME AND EXPENSE ACCOUNTS

Other Income

Taxpayer was required to restate (increase) beginning inventory for the first year of

UNICAP. This increase will be taken into income, generally, over a period of 4 years.

Does the other income account include the IRC section 481(a) amount? Does the

taxpayer do any custom crushing? Does the taxpayer sell any by-products? Some of

the larger producers will sell their solid waste (skins, seeds, stems, and leaves) as a

soil conditioner.

Compensation of Officers

Is any amount capitalized to inventory?

3-8

Salaries and Wages

Due to the changes required by UNICAP, a higher percentage of wages should be

capitalized (reflected in the Cost of Goods Sold computation) than expensed directly.

If you have the return prior to UNICAP, compare the percentages.

Repairs

Under UNICAP, repairs to production assets must be capitalized to inventory.

Rent

Under UNICAP or full-absorption, rent on production assets must be capitalized to

inventory.

Taxes

There are four main categories of taxes for wineries. They are: Payroll taxes, real

estate taxes, wine (excise) taxes, and income and miscellaneous other taxes. Payroll

taxes should be capitalized to inventory in the same ratio as the wages to which they

relate. Real estate taxes on production assets should be capitalized to inventory per

UNICAP. The wine excise tax is administered by the BATF and is filed using a Form

ATFF 5000.24. This tax is paid when the wine is transferred "out-of-bond." The

term "bonded facility" means a specific geographic location that is under bond to the

BATF. When alcoholic beverages are produced, excise tax must be paid when the

product is transferred from that location, unless the new location is also a bonded

facility. Generally, the wine is not transferred until the year of sale. Therefore,

whether it is treated as an expense item or directly attached to the wine sold, the

effect would be an allowance in the year of sale. However, if the wine is transferred

in years prior to sale, and the excise tax is paid upon transfer, the tax should be

included in the ending inventory calculation for UNICAP. Income taxes are

specifically excluded from capitalization under UNICAP.

Interest Expense

Again, per UNICAP, interest expense needs to be capitalized to inventory if the

production period exceeds 2 years, or, if the value (cost) exceeds $1 million and the

production period exceeds 1 year.

3-9

Depreciation

See Buildings and Other Depreciable Assets section above.

Advertising

Generally, amounts expended for advertising and promotion are currently deductible.

However, the account should be reviewed for label development costs and, in closely

held entities, for personal expenses.

Pension/Profit Sharing Plans and Employee Benefits

These costs should be capitalized in the same ratio as the wages from which they

came.

Other Deductions

Some preparers use this section to show the total capitalization of expenses to

inventory, including amounts capitalized on the expenses listed above. In some cases,

the amount of capitalization exceeds the total of "other expenses," resulting in a

negative amount. Since this total amount of capitalization cannot be traced to any

specific account, it is difficult to isolate any expenses in the pre-audit that appear to

warrant attention. If that is the case, you will need to wait until you receive a

breakdown from the taxpayer. Some preparers provide a schedule of capitalized

costs, as an attachment to the return. This schedule shows the total amount of an

expense, and an individual breakdown of the amount capitalized and the amount

expensed. This type of schedule can be very helpful in your pre-audit to determine

the scope of your review of the taxpayer's application of UNICAP.

In addition, this account should be reviewed for other items that should be capitalized

to inventory, such as supplies, utilities, insurance, contract labor, production related

consulting/professional fees, storage or warehousing costs, and other indirect

production costs.

Professional fees should be reviewed for items such as label development costs and

trademark costs (no longer deductible), legal fees associated with the acquisition of

assets, and any other capitalizable costs.

Costs that would generally be currently deductible include indirect costs of the

sales/marketing department, sales commissions to distributors, and other advertising,

promotion, or marketing costs.

3-10

Exhibit 3-1

Department of the Treasury

Bureau of Alcohol, Tobacco and Firearms

Islip + Company CPAs are here with personalized service to help you with these issues.  Since 1958, we have successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver premium service nearly anywhere...without premium pricing.  Give us a call or send us an email 916-488-1900 or  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .www.Islip.net

WINE

Bottle Size Ounces Per Case Case Per Case Corresponds To

Equivalent Fluid Bottles Liters Per U.S Gallons

3 liters 101 Fl. Oz. 4 12.00 3.17004 4/5 Gallon

1.5 liters 50.7 Fl. Oz. 6 9.00 2.37753 2/5 Gallon

1 liter 33.8 Fl. Oz. 12 12.00 3.17004 1 Quart

750 milliliters 25.4 Fl. Oz. 12 9.00 2.37753 4/5 Quart

375 milliliters 12.7 Fl. Oz. 24 9.00 2.37753 4/5 Pint

187 milliliters 6.3 Fl. Oz. 48 8.976 2.37119 2/5 Pint

100 milliliters 3.4 Fl. Oz. 60 6.00 1.58502 2, 3, & 4 Oz.

Official Conversion Factor: 1 Liter = 0.26417 U.S. Gallon

Mandatory date for conversion: January 1, 1979

U.S. Government Printing Office: 1985 — 491-840/46360 ATF F 5100.10 (8-85)

Department of the Treasury

Bureau of Alcohol, Tobacco and Firearms

DISTILLED SPIRITS

Bottle Size Ounces Per Case Case Per Case Corresponds To

Equivalent Fluid Bottles Liters Per U.S Gallons

1.75 liters 59.2 Fl. Oz. 6 10.50 2.773806 ½ Gallon

1.00 liters 33.8 Fl. Oz. 12 12.00 3.170064 1 Quart

750 milliliters 25.4 Fl. Oz. 12 9.00 2.377548 4/5 Quart

500 milliliters 16.9 Fl. Oz. 24 12.00 3.170064 1 Pint

375 milliliters 12.7 Fl. Oz. 24 9.00 2.377548 4/5 Pint

200 milliliters 6.8 Fl. Oz. 48 9.60 2.536051 ½ Pint

100 milliliters 3.4 Fl. Oz. 60 6.00 1.585032 ¼ Pint

50 milliliters 7.7 Fl. Oz 120 6.00 1.585032 1, 1.6, & 2 Oz.

Official Conversion Factor: 1 Liter = 0.264172 U.S. Gallon

Mandatory date for conversion: January 1, 1980

ATF F 5100.10 (8-85)

This page intentionally left blank.

4-1

Chapter 4

WINE INDUSTRY ISSUES

INVENTORY COSTING

For information on Full Absorption, see IRC section 471.

For information on Uniform Capitalization, see IRC section 263A.

General Discussion

Wineries are manufacturers and as such, must use the accrual method of accounting

for their inventory using a cost method. Prior to the adoption of IRC section 263A

(UNICAP), manufacturers were required to account for their inventories using the

full-absorption rules under IRC section 471. Full-absorption required allocation of

direct costs (grapes, bottles, corks, labels, direct labor) and certain indirect costs to

inventory.

Indirect costs that were required to be allocated included certain repairs, maintenance,

utilities, rent, indirect and supervisory labor, indirect materials and supplies, tools and

equipment, and quality control, and inspection.

A second category of costs were specifically excluded from allocation to inventory

and were allowed as current expenses. Examples of these costs included marketing,

advertising, selling, distributing, the excess of tax depreciation over book, income

taxes, and general and administrative costs, including officers' salaries attributable to

the operation of the business as whole, rather than directly to the production activity.

A third category of costs was only allocated to inventory if these costs were allocated

to inventory for financial accounting purposes. These items included taxes, book

depreciation, employee benefits, scrap losses, rework, factory administrative costs,

certain officers' salaries, and insurance.

Prior to UNICAP, some wineries used various interpretations of the practical capacity

method, citing the Heaven Hill case, claiming that most of the winery assets were

only used "for production" during the crush/fermentation process. The operations

after turning the grape juice into wine were merely "storage." Therefore, the indirect

costs (such as utilities, rents, etc.) attributable to that period were expensed, rather

than allocated to inventory. However, any direct costs incurred were still capitalized.

An example of this would be bottling costs.

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The New Law

UNICAP became effective for returns whose fiscal year began after December 31,

1986. Therefore, the earliest returns to which UNICAP applies are calendar year

1987. Any fiscal year returns ending prior to that would have begun in 1986 and

UNICAP would not apply. UNICAP is applicable for all manufacturers (including

wineries) and vineyard operations. However, most vineyard operations can (and do)

elect out of UNICAP. See Notice 88-24 as listed in Exhibit 4-1.

Two major changes were instituted by UNICAP. First, several new categories of

costs are now required to be allocated, in part or in whole, to inventory. These

additional costs to be allocated include all depreciation on production assets,

insurance, certain taxes, employee benefits, officers' salaries, and general and

administrative costs. Second, the definition of "production period" (that time frame

during which appropriate costs must be allocated) was broadened and strengthened.

See Exhibit 4-2. The Senate Finance Committee Report specifically addressed the

Heaven Hill decision. The report indicates that in the case of the property such as

wine that is aged before it is sold, the production period includes the aging period.

The Service is taking the position that the aging period ends when the wine is

"released for sale." Many wineries have a published release schedule, while others

may have an informal arrangement.

Restatement of Beginning Inventory in the Year of Change

For Change of Accounting Methods see Rev. Proc. 92-20.

The change from full-absorption to UNICAP is a change in method of accounting.

The legislative history of IRC section 263A makes it clear that the taxpayer must

compute an IRC section 481(a) adjustment in the first year UNICAP applies and that

the IRC section 481(a) adjustment will generally be taken into income over 4 years.

See Conf. Rep. No. 841, 99th Cong., 2d Sess. II-308 (1986) reprinted in 1986-3

1986-3 C.B. (Vol. 4), p. 308; Temp. Treas. Reg. section 1.263A-1T(e)(2) and Temp.

Treas. Reg. section 1.263A(e)(3). If the taxpayer should have been on UNICAP but

was not, this constitutes a "Category A" method change. See Notice 88-78, 1988-2

C.B. 394.

Taxpayers have a choice in applying UNICAP. They can painstakingly review their

prior years' costs to determine which specific items were previously treated as period

costs that under UNICAP should have been capitalized. This difference, to the

degree that those items are still in inventory, makes up the IRC section 481(a)

amount. While this system is the most accurate (if the information is even available),

it can be very time consuming and costly. A "simplified production method" is

available. Essentially, the taxpayer would continue to use their pre-UNICAP

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accounting system, specifically identify additional UNICAP costs only for the current

year, and then apply the percentage difference to the beginning year's inventory figure

to calculate the IRC section 481(a) amount. For example, if a taxpayer calculated its

ending inventory under full-absorption at $1,000 and determined that the additional

costs to be capitalized for UNICAP totalled $250, then the percentage increase due to

UNICAP is presumed to be 25 percent. Therefore, the beginning inventory would be

increased by 25 percent to restate the inventory per UNICAP. This method, though

decidedly easier, will result, in most circumstances, in a larger increase to beginning

inventory than a specific identification method.

Definition of Production Period

As previously mentioned, production costs are only allocated to inventory during the

production period. Generally, the production period will begin when the grapes are

crushed. This date can be tied to the "weight tickets" the wineries are required to fill

out for the BATF. The production period ends when the wine is "released for sale."

Exactly when the wine is released for sale is a determination that will vary depending

on the facts and circumstances unique to each winery. Some wineries regularly and

routinely produce wine for sale as bulk wine. This product can be sold immediately

after the fermentation process. If this is the case, the production period would end

when that vintage/varietal is offered for sale. Conversely, if the winery routinely ages

the wine in tanks, barrels and/or bottles, the production period would not end until

the winery decides that the wine has aged sufficiently and is ready to be sold. An

actual "releasing" of the wine for sale to the customer would show the release date.

Some wineries can verify this date by a printed schedule of release dates that they

provide to their distributors. If this type of information is not available, ask for the

earliest shipping tag for a vintage/varietal.

While every winery is going to differ, most premium white wines are released within

24 months. Most premium red wines are released after 24 months, with the possible

exception of Pinot Noir. Bulk wine is normally sold within 12 months to free up the

fermenting tanks for the next year's harvest.

Specific Allocation of Expenses/Departments to Inventory

When various costs are allocated to inventory, the deduction of those costs is delayed

until the wine is sold. Since this delay can be several years, you may find some

taxpayers trying to categorize costs as non-allocable, thereby gaining current

deductibility. Under UNICAP, many costs are allocable in part or in full to inventory.

The taxpayer's workpapers on the actual calculation of ending inventory should be

reviewed to determine if costs were properly allocated and capitalized. The examiner

4-4

should ensure that the ending inventory on Schedule A (calculation of cost of goods

sold) includes an appropriate amount of allocable costs. If these costs are excluded in

the calculation of ending inventory, the result is a current expensing of the costs.

The total direct and indirect costs (service costs) of an administrative, service, or

support department or function (service department) that directly benefit particular

production activities are allocable to those activities. The direct costs of a service

department are the costs that are specifically identified with the services provided.

The indirect costs of a service department are those costs that can't be identified, but

are incurred because of a service department's direct costs. For example, a

"purchases" department would be a service department to the extent that it purchased

grapes and other supplies for the production process. The purchasing representative's

salary would be a direct cost. Utilities associated with the purchasing office would be

an indirect cost.

Mixed service costs (costs that benefit production activities as well as other functions)

must be allocated to the particular activities.

With UNICAP, sales and marketing expenses are not allocable to inventory.

Similarly, the tax and financial accounting departments are not part of inventory

costing. Conversely, all direct costs and other costs associated with production (such

as repairs to production assets, real estate taxes, insurance, depreciation, etc., on

production assets, etc.) must be capitalized. While most of these costs are easily

identifiable, the proper treatment of these costs is often an issue. Many of these costs

require an allocation between production and other cost centers. For example, the

winery building would have depreciation, utilities, insurance, real estate and various

other expenses associated with it. If that building was used solely for the

crushing/fermenting of grapes and the aging of wine in barrels, then all the associated

costs would be allocated to inventory. This is rarely the case. Usually, the winery

assets might house and/or serve several functions. There might be a tasting room,

general and administrative office, sales office, and post-aging (post production

period) storage facility. An allocation of the costs must be made to the various

functions. The methodology used by the taxpayer should be reviewed. Some costs,

such as those of a building, can be allocated easily by using square footage. Other

costs, such as labor, might be most accurately allocated by reviewing the time spent.

For example, the winemaker may spend 75 percent of his or her time actually in the

cellar, while the other 25 percent may be spent in the tasting room, marketing the

wine to customers. In such a case, the salary should be allocated between production

and marketing, based on the relative time spent on each. Other costs, such as security

services, might be most easily allocated based on relative value of the assets

protected. See Exhibit 4-2.

4-5

Interest Expense — Avoided Cost Method

Interest expense must be allocated to inventory if the production period exceeds 2

years. The over 1 year and over $1 million definition applies to each salable unit.

Therefore, interest will only be capitalized to wine that has a production period

exceeding 2 years.

Interest is to be allocated to inventory using the avoided cost method. See Notice 88-

99, as listed in Exhibit 4-1. The calculation is essentially a two-step process. First,

interest expense is traced to its source. Interest that is directly attributable to

production assets is allocated to inventory. Second, a calculation is made to

determine the amount of interest expense that would have been avoided if debt would

have been reduced (paid-off) rather than the funds expended on the costs of

production. Note, the interest capitalization requirements will usually not apply to all

the items in a winery's inventory, as not all items will have the requisite production

period. Therefore, once the total amount of interest expense to be allocated to

inventory is determined (based on the avoided cost method), a secondary

determination must be made as to which items of inventory require interest

capitalization.

LIFO

Many wineries have elected LIFO to enjoy the tax benefits of increasing inventory

costs. When UNICAP came into effect, the LIFO layers were required to be restated

as if UNICAP had been in effect since the time of election. There is also a simplified

method available to restate the layers.

Most taxpayers use a dollar-value method, with double extension being the most

popular. It is preferred because it will more accurately reflect income. Barring any

compelling argument from the taxpayer, double extension should be used.

New Issue:

An issue has been raised, with concurrence from National Office, where the definition

of an item has been expanded. In order to clearly reflect income, the grouping of like

goods and the separation of dissimilar goods must be accomplished. Per Amity

Leather Products Co. v. Commissioner, 82 T.C. 726, the more homogeneous each

category is, the better it will screen out cost increases caused by non-inflationary

factors, thus producing a clearer reflection of income. The LIFO method was not

intended to permit taxpayers to include in cost of goods sold increases attributable to

the replacement of goods with low cost characteristics with goods possessing higher

cost characteristics. Hamilton Industries, Inc. v. Commissioner, 97 T.C. 120 (1991).

4-6

Wineries in general have been moving from generic/jug wines to more costly premium

varietals. The cost differentials can be substantial, without considering inflation. If a

taxpayer has changed their mix of product over the years and does not differentiate

between low and high cost items, consider requiring a change in segregate items by

varietal. This should more accurately reflect increases due to changing production

methods and costs, rather than inflation.

Note: This type of change would be a change in method of accounting. Generally,

Rev. Proc. 92-20 governs voluntary changes in methods of accounting.

Lower of Cost or Market

Manufacturers are allowed to elect to use the Lower of Cost or Market method

(LCM) of determining their ending inventory. The intention of this method is to

properly match a distinct loss in the value or utility of an inventory item with the

period in which the loss is realized.

Some wineries have attempted to use LCM to accelerate cost of goods sold

deductions by valuing their ending inventory at a market value that is substantially

lower than cost.

The most common valuation is to use bulk wine spot prices, as quoted by a dealer in

bulk wine. This method is used, even though the wines are often never sold as bulk

wines, and never even offered for sale at the quoted prices. Other valuations have

been noted, including using the county tax assessor's personal property tax valuation.

It is the Service's position that, except for a few specific instances, the taxpayer must

use cost to value their ending inventory.

There are times when a specific vintage/varietal of the taxpayer's wine may be

unsuitable for sale at a price higher than cost. In those instances, whether because of

spoilage, change in consumer demand, etc., where the taxpayer has attempted to sell

the wine at a price lower than cost, a writedown to "market" should be allowed.

However, an arbitrary writedown to a value lower than cost should not be allowed

when the product has not been offered for sale at that lower price. See Thor Power

Tool Co. v. Commissioner, 439 U.S. 522 (1979). TAM 9121003 is an example of the

Service's position.

Under certain circumstances, a taxpayer can use replacement cost to value its

inventory. However, the taxpayer has the burden of establishing a valuation below

cost by presenting sufficient, objective evidence of prices of comparable goods in the

same quantities the taxpayer would purchase if it were engaged in purchasing bulk

wine rather than producing it.

4-7

VINEYARD OPERATIONS

Cash Basis Vineyards, Capitalized Costs, and Phylloxera Disease are discussed below.

Cash Basis Vineyards

These areas discussed under Cash Basis Vineyards are: 1) Deferring Recognition of

Income; 2) Expensing of Grape Growing Cost; and 3) Consolidated Returns.

Deferring Recognition of Income

Issue: Sales to Related Winery -- Payments Deferred/Wineries Expensing

Grapes.

It is a standard practice within the industry for a winery to own or control its own

grape supply. This insures not only supply but quality control of grapes. In fact,

many of the wineries started from vineyard operations.

It is also a standard practice that the form of ownership of the winery and vineyard

might be different, even though controlled and owned by the same person(s). We

have seen consolidated returns with both the vineyard and winery operations being

corporations, and any combination of corporate, partnership, S-Corporation and

individual ownership of the two operations. Another more extreme version is to

expense growing costs and transfer the grapes to the winery at no cost or basis. (See

the following section for discussion of single entity issue.)

The issue that should be addressed is the use of the cash method of accounting at the

vineyard level and the voluntary deferral of payment on the grape purchases by the

winery. Since wineries, as a manufacturer, must use the accrual basis of accounting

the deferral of payment should make no tax difference at the winery level, since no

deductions are claimed at the winery level until the wine is sold. However, if the

payments by the winery are withheld for a period of time, this creates an unwarranted

deferral of the recognition of income at the vineyard level.

The terms of payment in the grape purchase arrangements can vary greatly. In

interviewing an independent grape grower, it was disclosed that the standard practice

of most larger wineries is to make full payment within 30 days of the last harvest for

white grapes and by mid-December for red grapes. Payment arrangements with

smaller wineries are individually negotiated but range from 25-50 percent

4-8

downpayment with full payment by March to May of the subsequent year, with

possibly interest charged on any amounts unpaid as of the beginning of the calendar

year. This appears to be the industry standard between unrelated vineyards selling

grapes to wineries. Of course, price is set based on demand and quality, negotiated at

arm's length.

The terms between related parties sometimes deviate from the above mentioned

industry practices. The prices to be paid have ranged from cost to using the

"Berryhill" report (the State Agriculture Department Grape Price Report) or other

published prices for location and variety to using the "Berryhill" plus an additional

percentage to account for higher quality grapes. There have been few issues raised

regarding pricing policies as prices appear to be negotiated at arm's length and in

accordance with IRC section 482. The terms (timing) of payment is what needs to be

addressed.

Several vineyards have made arrangements to sell their grapes to the related winery

and not receive payment until the wine made from those grapes is sold (or at least

some derivative of this type of arrangement). The time frame of deferral can be up to

3 years for white grapes and 5 years for red grapes. In this way, the vineyard

recognizes expenses up to 5 years prior to the recognition of income. The terms of

such arrangements are sometimes formalized in fixed sales contracts that spell out

purchase price and payment schedules and interest bearing notes for the unpaid

balances. However, more often the terms are evidenced only by bookkeeping entries

and flexible verbal agreements.

These arrangements, in conjunction with the cash basis method of accounting, distort,

rather than clearly reflect the income of the vineyard operations. This creates artificial

losses with which to offset other income of the vineyard owner.

Law and Argument. IRC section 446(c)(1) specifically allows for the cash receipts

and disbursements method. IRC section 447 disbursements method. IRC section 447

requires the accrual method of accounting for determining taxable income for certain

C-Corporations and partnerships engaged in the trade or business of farming (unless

there is inadequate gross receipts or the C-Corporations are family corporations).

IRC section 448 does not affect vineyard operations in that they are "farming

businesses."

IRC section 446(b) indicates that a method of accounting must clearly reflect income.

IRC section 451(a) provides that income shall be included in the taxable year in which

received, unless under the taxpayer's method of accounting, such income is includible

in another period. In the case of a taxpayer using the cash receipts and disbursements

method of accounting, Treas. Reg. section 1.451-2(a) provides, in pertinent part, that

income although not actually reduced to a taxpayer's possession is constructively

received by him or her in the taxable year during which it is credited to his or her

account, set apart for him or her, otherwise made available so that he or she may

4-9

draw upon it at any time, or so that he or she could have drawn upon it during the

taxable year if notice of intention to withdraw had been given.

Various court cases and revenue rulings have addressed the issue of deferred payment

arrangements similar to the types in question, but none were found that deal with

vineyards. The court cases have found for both sides of this issue.

The main factor that runs through all of the cases and rulings seem to be that of the

"arm's length transaction." The deferred payment arrangements are not at "arm's

length," are volunteered on the part of the payee, and do not conform to industry

practices for unrelated parties.

Revenue Ruling 58-162, 1958-1, 234; J.B. Banek, 56-1 U.S.T.C. 9175; Kenneth

McIntyre v. United States, 58-1 U.S.T.C. 9355; and Levno v. United States, 77-2

U.S.T.C. 9687 dealt with grain farmers and cattle ranchers who entered into payment

deferrals with unrelated parties. All allowed the deferral of income from the year of

actual sale to the subsequent year when the sales contract legally bound the parties to

such treatment in an arm's length transaction. In Levno, it was stated that the intent

of the parties was to provide average income in any given year. In each case, the

payee lost all control as to the timing of payment, the deferrals were standard industry

practices, and appear reasonable.

In Martin Malmberg v. Lamb, 53-2 U.S.T.C. 9472, and Mary Hineman v. Broderick,

51-2 U.S.T.C. 9403, the courts found that the taxpayer constructively received

income in the year of sale (not receipt) when the payment was voluntarily postponed.

In Hineman, the deferral period was 2 years, while in Malmberg it was only one.

Revenue Ruling 72-317, 1972-1, 128, addresses the negative implications that

"control" has when dealing with constructive receipt. This ruling cites several court

cases that indicate due to the control of the taxpayer, constructive receipt was

concluded.

Various arguments have been forwarded by taxpayers using these arrangements that

include "the winery did not have the funds available" or that "it was a financing

arrangement for the winery." No doubt these are valid in their own right, but funds in

every case would have become available (either by winery borrowings or owner

capital contributions), if the winery was forced to purchase grapes from unrelated

parties. In fact, it is a wonderful financing arrangement for the winery to be awarded

low interest or interest free loans. It makes perfect economic sense for the winery to

never make payments on its grape purchases. But that shouldn't alter the tax

treatment of sales at the vineyard level.

For constructive receipt to be successfully raised as an issue, there has to be funds

available at the winery level to make the required payments. In some cases, the funds

for vineyard operations were advanced by the winery and booked as intercompany

accounts payable/ receivable. This shows that not only was the money available, it

4-10

was actually released to the vineyard, but not recognized as income. If the winery

actually has the funds available, but does not advance them to the vineyard, this still

indicates availability. If the winery's cash reserves would not cover the required

payment, constructive receipt cannot be used. However, looking to the financial

position of the winery owner and the borrowing power of the winery can show that

funds could have been available and thus add to the "substance over form" issue. In

cases where constructive receipt is not appropriate, consider requiring a change of

accounting method to the accrual method or consider whether the vineyard must use

the installment method. A vineyard must use the installment method where a

disposition occurs and at least one payment is to be received after the close of the

taxable year of the disposition. Note, however, that a vineyard can elect out of the

installment method under IRC section 453 (d).

Using the accrual method of accounting would require the recognition of the gross

receipts in the year of sale (the same as constructive receipt). The installment method

would delay the recognition of expenses until the income is received.

In the cases where actual notes have been drawn up, A. Hurwitz, 23 Tax Ct. Memo

2011, and R.R. Ellis v. Commissioner, 39-2 U.S.T.C. 9757, both address the issue of

the FMV of the notes received being income if they are unrestricted as to use,

disposition, or enjoyment. In the cases where no notes were received, this

strengthens the argument that the sales were not at arm' s length.

In any case, whether the eventual sales proceeds are considered to be "constructively

received," the accrual or installment methods of accounting are utilized, or the FMV

of notes received are used to recognize income in the year of sale, the taxpayer should

recognize income and expenses as if selling to an unrelated party. In no case should

the deferral extend beyond the year subsequent to the sale.

In cases where constructive receipt cannot be raised, IRC section 482 can be

employed. In Central Bank of the South v. United States, 88-1 U.S.T.C. 9114,

income recognition was forced where no payment was made, in order to clearly

reflect income in transactions between related parties. The goal of IRC section 482 is

to put related taxpayers on the same footing as unrelated taxpayers.

Issue:

Expensing of Grape Growing Costs by the Winery -- taking the grapes into inventory

at no basis.

When a winery owns its own vineyards, another issue may exist. Whether the winery

is a sole-proprietorship, a partnership, or a corporation, the costs of growing grapes

4-11

are expensed and the grapes are transferred from the vineyard to the winery at no

basis.

Apparently, the rationale presented by the taxpayer has been that the vineyard part of

the operation is a farming business. As such, the vineyard should be allowed to use

the cash receipts method of accounting. The vineyard operations would then be

reflected on the return using a Schedule F. Since there was no sale in this transaction,

only expenses are listed and a loss results, which is used to offset other income.

The winery operation, since it paid nothing for the grapes, take them into inventory at

$0 basis. The result of this transaction is that the taxpayer enjoys the recognition of

the expenses in the year incurred, but does not recognize the income until the wine is

sold. As such, the net effect is the same to the vineyard owner in the previous issue.

Taxpayers have argued that the winery facility is ancillary to the vineyard farming

operation and cited Maple Leaf Farms, 64 T.C. 428 (1977). In that case, the

taxpayer raised, slaughtered, and processed ducks. Some of the ducks were raised

but a majority were purchased for slaughter. The taxpayer was significantly involved

in the growing process of the purchased ducks. The court held that the taxpayer's

business, as a whole, was significantly near the "grower" end of the spectrum (as

compared to a processor/manufacturer) to be considered a farmer.

Several factors in the winery/vineyard scenario are distinguishable from Maple Leaf

Farms. First, the wine processing operation can take up to several years as opposed

to one week for the duck processing operation. Second, a substantial amount of time,

expense and capital are expended on the wine processing operation as compared to

the vineyard operation. It is the Service's position that the winery operation is in fact

a manufacturing operation. When the grapes produced by the same entity are not

sold, but rather used in the manufacturing process, the grape growing operations

become part of the overall manufacturing cycle. See also Rev. Ruls. 64-148 and 58-

581.

In two cases with this issue that have been resolved, the taxpayers agreed to the

Service's position. The problem in settling the cases has been dealing with Rev. Proc.

84-74. Rev. Proc. 84-74 and now Rev. Proc. 92-20 provide various procedures

regarding changes of accounting method and various spread forward periods. The

Rev. Procs. indicate how to treat "Category A" changes (changes from a clearly

unallowable method) and "Category B" changes (all other changes other than

Category A). At the winery level, it can be argued that this would be a Category A

method because the taxpayer does not include all direct costs in its inventory. At the

vineyard level, it could be considered a Category B change because the cash basis is

clearly available to farmers. Note, however, the for involuntary changes in methods

of accounting, the taxpayer is not entitled to any spread and the full IRC section

481(a) adjustment should be included in the year of change.

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Rev. Proc. 92-20 provides for different treatment during a "transition period" through

September 18, 1992. The Industry Specialist for Motor Vehicles produced an

analysis of Rev. Proc. 92-20 for the Motor Vehicle Industry. These charts listing the

different treatments for Category A, B, and LIFO items during the various time

frames have been included as Exhibit 4-2.

Consolidated Returns

IRC section 263A applies to vineyards. Although a "farmer" is generally not required

to use the accrual method of accounting or to keep inventories (unless the provisions

of IRC section 447 apply), the costs to produce the grapes sold must be included in

determining the amount of gain to be deferred. Therefore, the cost of growing the

grapes, as determined with reference to IRC section 263A, must be deferred along

with the gross proceeds. TAM 9134001 is an example of Service position on this

issue.

A similar issue was identified in a consolidated return setting. One of the subs, the

vineyard, was selling grapes to another consolidated member. The taxpayer argued

that all expenses at the vineyard level were period costs and should be currently

expensed. Only the gross receipts should be part of the computation of deferred gain.

Therefore, the taxpayer effectively deferred all the income and expensed all the costs.

However, as noted above, the cost of growing the grapes must be deferred along with

the income under IRC section 263A. Additionally, the gain or loss in an

intercompany transaction must be deferred under Treas. Reg. section 1.502-13(c)(2).

Capitalized Costs

Issue: Capitalization of T-budding Expense.

"T-budding" is a popular method of converting a vineyard of an existing varietal

grape to produce a different, more marketable type of varietal. The process is to cut

off an existing vine at about 4 feet high and graft in two "buds" or branches from

another type of grape in the shape of a T. This allows for a quick conversion from an

unmarketable grape to a desired variety at minimal cost and loss of production. A

minimal crop is often attained in the year of the conversion and maximum yields are

attained in 2 or 3 years. "T-budding" is especially popular with growers wanting to

convert to zinfandel grapes, which have been in short supply. The costs of converting

a vineyard should be capitalized, as the "new" vines have a substantial useful life.

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Issue: Capitalization of Development Costs.

See Exhibit 1-2 for a reference chart on the costs to develop a vineyard, when the

costs are incurred, and the tax treatment of those costs.

Generally speaking, the direct costs of the vines (rootstock and trellis) as well as the

labor and indirect costs to plant should be capitalized and depreciated when the vines

start producing grapes. The cost of the irrigation system (including the labor to install

it) should be depreciated starting when it first delivers water to the vines.

Issue: Capitalization of Fumigation.

Several soil-borne diseases and pests may be present at a proposed vineyard site.

These diseases and pests can substantially reduce crop yield and quality. Prior to

planting, the soil is tested to determine the extent of infestation. If the problem is

severe enough, the soil may need to be sterilized prior to planting. This process

(fumigation) entails injecting the soil with liquid chemicals, which then turn into a gas

and permeate the soil. The soil is covered with plastic to trap the gas. The cost can

range from a few hundred dollars per acre on up depending on the soil conditions.

This process is only done prior to planting. While the benefits from fumigation will

slowly wane over the life of the vineyard, it does provide benefit for a period longer

than the ACRS useful life of the vineyard.

This cost is not deductible under IRC section 175 as a soil conservation expense,

under IRC section 182 (repealed as of December 31, 1985) as a land clearing

expense, or under IRC section 180 as a soil treatment expense. Treas. Reg. section

1.180-1(b) denies a deduction for costs incurred in the initial treatment of land. The

intent of IRC section 180 was to allow a deduction for recurring soil treatments such

as fertilizers and the like. Therefore, the Service has taken the position that the cost

of fumigation should be capitalized. Since the benefits of fumigation are limited, it is

reasonable that the costs be added to the cost of the vines and similarly depreciated.

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Issue: Phylloxera -- Vine Replacement.

Phylloxera is a disease (a root louse) that attacks vineyards. This disease destroyed

the American and European grape growing operations at the turn of the century, and

it's back. Several positions have been promoted by individuals in the wine industry as

to how to treat the $10,000 to $15,000 per acre costs to replace infected vineyards.

A Napa Valley winery requested a Private Letter Ruling (PLR), and asked that they

be allowed to 1) expense the basis of the old vineyard and the costs to remove it as an

abandonment loss, and 2) expense all the costs associated with developing the new

vineyard.

National Office indicated that the Service's position would be to capitalize certain

costs, including:

1. The engineering and design of the new vineyard

2. Preparation of the land for replanting, including fumigation

3. Purchase of vines, irrigation equipment and trellis system

4. Planting and installation costs

5. Budding (grafting on varietal vines to rootstock).

Based on this response, the taxpayer withdrew their request.

DEPRECIATION/AMORTIZATION

Issue: Five Year Life on Buildings.

Winery operations require buildings for various phases of their operations. Generally,

the fermenting tanks, aging barrels, and bottling lines are housed within buildings. In

most cases, the aging facilities are temperature controlled. In many cases, white wine

is fermented in temperature controlled tanks. In some cases, the facility might be

humidity controlled. In some rare cases, the building housing the fermenting tanks

might literally be built around the tank.

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A number of years ago, when Investment Tax Credit (ITC) was allowed, it was

popular to claim that certain tangible assets were not buildings, but were in fact

"equipment." This equipment not only qualified for ITC, but as 5 year property for

purposes of calculating depreciation. Wineries have been known to claim this

treatment for the winery building as well as separate aging facilities. Since ITC is no

longer allowable, and several court cases have more narrowly defined what type of

property warrants the preferred treatment, this practice is no longer as prevalent as it

once was. However, it still comes up from time to time.

Special Type Buildings versus Special Purpose Structures. Only Special Purpose

Structures can qualify for the preferential treatment. There are many buildings built

for special purposes. Almost all buildings are built in some way for a special purpose,

that is, factory building, hotel, apartment house, restaurant, warehouse, office

building, etc. However, a special purpose building is not a special purpose structure.

Special purpose structures are structures (as defined in Rev. Proc. 62-21) which are

an integral part of the production process and which, under normal practice, are

replaced contemporaneously with the equipment that they house, support, or move.

(Rev. Rul. 66-29 clarifies and supports this position.) General purpose buildings,

such as warehouses, storage facilities, general factory buildings, and commercial

buildings are not special purpose structures.

Bulk Storage Structures. Some taxpayers have attempted to classify their buildings

as bulk storage structures. The Revenue Act of 1971 clearly states that, to qualify,

the property must be used for bulk storage of fungible commodities. Bulk storage

refers to the keeping of a commodity of a large mass prior to consumption or

utilization. Commodities that are fungible in nature are of such nature that one part

can be used in place of another. The tanks and barrels hold the commodity, not the

building. The building holds the tanks and barrels, not a commodity. Refer also to

Rev. Rul. 74-3 and Treas. Reg. section 1.48-1(d)(5).

Issue: Purchase Price Allocations.

When a going concern is purchased by a taxpayer, a common area of dispute is the

allocation of purchase price between land, buildings and equipment for wineries and

land, vines and other equipment for vineyards. These allocations are occasionally

based on appraisals but more frequently are based on informal estimates.

These allocations need to be reviewed for reasonableness. Industry publications are

available that reflect costs to develop vineyards. Information on the cost of planted

vs. unplanted land is also generally available. If information is not available, or if the

dollar amounts are significant, an engineering referral is recommended. In one

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examination, an engineering referral resulted in a significant adjustment in the

allocation of purchase price to goodwill rather than depreciable assets (buildings).

Issue: Trade and Label Development.

Wineries incur substantial costs in the development of trademarks for their winery

name. They will also procure a trademark to protect a proprietary wine name. They

may also receive trademarks on label designs, vineyard designations, and unique

manufacturing processes.

Prior to 1987, the costs incurred for the acquisition, protection, expansion,

registration or defense of a trademark or trade name had to be capitalized. The

taxpayer could elect, under IRC section 177, to amortize these costs over a not less

than 60 month period. Generally, for costs incurred after 1986, this election has been

repealed. Therefore, the taxpayer cannot expense directly or capitalize and then

amortize these costs.

Since these costs generally show up as legal fees, the professional fees or legal fees

account should be reviewed to see if any of these type of expenditures are present.

Wineries also incur substantial costs in the designing or developing of their labels and

packaging designs. Usually this work is contracted out to a graphic arts company,

but on occasion, wineries have connected with a well-known artist to do a label

design. As mentioned above, these label designs, once developed, are trademarked.

The costs can range from a few thousand dollars for a simple label, to over $200,000

for a complete line of label, case, box, corkscrew, T-shirt, etc. designs.

Rev. Rul. 89-23 was published and was applicable to costs incurred after 1986.

These expenditures must be capitalized. This ruling originally stated that the cost of

package designs may not be amortized under Treas. Reg. section 1.167(a)-3 because

a useful life cannot be ascertained.

Rev. Proc. 90-63 was released December 31, 1990, and revokes Rev. Proc. 89-16

and Rev. Proc. 89-17, 1989-1 C.B. 827. Essentially, it provides the taxpayer with

one of two options for capitalization and amortization. A design-by-design method

will provide a 60 month amortization period, but a specific write-off of any design

that ceases to be used. The pooling method allows for a 48 month amortization

period, but no write-off for designs that are no longer being used.

These costs may show up in product development, promotion, advertising, purchases,

or other accounts. Ask about these types of costs in your initial interview. Also,

4-17

when touring the tasting room or wine library, keep an eye out for label changes. The

costs may have been incurred in your year.

MISCELLANEOUS ISSUES

Issue: Personal Residence on Winery/Vineyard Property.

In the smaller, family owned and operated corporate enterprises, it is not uncommon

for the owner to reside on or adjacent to the property. If the residence is owned by

the shareholder, and no deductions for business use are claimed, no issue exists.

However, if title is held by the corporation, depreciation and other associated

deductions may have been claimed, while the shareholder/employee is allowed to live

in the residence without recognizing any income from the transaction.

We have seen similar arrangements with partnerships and individuals having title to

the property with the associated deductions being claimed. If the expenses are truly

personal in nature, they should be disallowed under IRC section 262. The following

discussion addresses the additional factors involved when a corporation furnishes

lodging to its shareholder/employee.

IRC section 119 addresses lodging furnished by an employer. Three major factors are

required:

1. The lodging must be on the business premises

2. The lodging must be furnished for the convenience of the employer

3. The employee is required to accept such lodging as a condition of his or her

employment.

There are many valid reasons for having an employee "on the premises." Where

vineyards are present, someone must be available to operate the frost protection

systems. Another argument is that having someone on the premises is a deterrent to

trespassers and vandals. In cases where the employee is involved in the entertainment

aspect of marketing, many "off-hour" activities are conveniently arranged.

Cataran v. Commissioner, 442 F.2d 606 (1969) and DL Johnson v. Commissioner,

Tax Ct. Memo 1985-175, are two cases addressing this issue. Both support the

taxpayer, finding that the taxpayer met all three requirements of IRC section 119.

Usually there will be no issue of the lodging being on the business premises. The

taxpayer must have an employment contract that specifies that he or she will live on

4-18

the property. The source of argument will be the "for the convenience of the

employer" requirement. The major factor that the courts considered was the necessity

for the employee to be available at all times. If the employee is away from the

property for substantial periods of time (for business or personal reasons), this

substantially weakens the taxpayer's arguments.

Other factors to look at include:

1. Does the employee actually do the work specified in the employment contract?

Do they hire someone else to actually perform the tasks?

2. Is the residence one that would be provided to a non-shareholder employee? In

some instances, the residences have been rather small, old farmhouses,

substantially beneath the means of the taxpayer. This is an indication that it is

for the convenience of the employer. In another case, the residence was a

tremendous stonewalled mansion, valued in excess of $1 million. It is unlikely

that a residence of this type would be made available to a non-shareholder.

While the court cases cited above indicate the court's willingness to allow this type of

arrangement, the examiner must still pursue abuses of this Code section. Remember

that there can be a substantial cost to the shareholder. Interest deductions on the

residence are not deductible at the individual level and, further, neither the

shareholder not the corporation would be able to avail themselves of the deferral and

non-recognition provisions of IRC sections 1034 and 121.

Issue: Recognition of Income from Futures Sales.

There has been an active market for futures on prestigious French wines for many

years. These futures are offered by retailers to the general public and are seen as a

hedge against price increases.

Beginning in the mid-1980s, several California wineries with premium and ultrapremium

red wines started offering futures directly to the public. The general terms

of the agreements called for a 50 percent down payment on a guaranteed price, with

the balance to be paid upon delivery when the wine is released. If the buyer failed to

complete the transaction, he or she would forfeit the down payment. The time frame

between the initial offering and the delivery date is usually 18-24 months.

In some cases, the potential investors have the opportunity to taste the wine while it is

still in the barrel. However, this is a rare instance of being invited to relatively

exclusive "barrel tasting" parties. Most of the futures are purchased solely on the

basis of the quality of prior years' vintages. The wineries make no guarantees of the

4-19

superior quality of a particular vintage being bought on a futures contract. Their only

obligation is to deliver the wine at the release date.

Through future sales, the wineries enjoy an improved cash flow and can forecast their

sales with greater reliability. Additionally, when the wineries make the sales directly,

they avoid the revenue sharing with the distributors and retailers.

The wineries invariably treat the down payment as a deposit, booking the entry as a

liability rather than revenue.

When a taxpayer receives an advance payment for goods or services or other income

items over which the taxpayer has a present right and complete and unreduced

control, the advance payment constitutes income. Van Wagoner v. United States,

368 F.2d 95, 98 (1966), and Husch Improvement Co. v. Commissioner, 143 F.2d

912, 915 (1944).

On the other hand, where the amount paid is intended to secure property of the

taxpayer against damages or loss, or to secure the performance of a condition or

other non-income producing covenants or a contract, and the sum is to be returned to

the payor, the payment is a nontaxable security deposit, notwithstanding the fact that

the taxpayer had temporary use of the money. Commissioner v. Indianapolis Power

& Light, 439 U.S. 203 (1990), Mantell v. Commissioner, 17 T.C. at 1143, 1148

(1952), Clinton Hotel Realty Corp. v. Commissioner, 128 F.2d 968,969 (1952). An

example would be where a lessor requires a lessee to deposit a sum to secure against

damage to the rented premises and agrees to refund the deposit in full if no such

damage occurs.

Treas. Reg. section 1.451-5 discusses the tax treatment for advance payments for

goods and long-term contracts.

Treas. Reg. section 1.451-5(a)(1) defines an advance payment as any amount which is

received in a taxable year by a taxpayer using an accrual method of accounting for

purchases and sales or a long-term contract method of accounting (described in

Treas. Reg. section 1-451-3) pursuant to and to be applied against an agreement for

the sale or other disposition in a future taxable year of goods held by the taxpayer

primarily for sale to customers in the ordinary course of his or her trade or business.

Under the conditions in most futures contracts, it appears these future contracts and

the payments made under them constitute "advance payments" as defined above in the

Treasury Regulations. The monies paid by the purchaser were made pursuant to the

futures contract as part of their promise to take delivery of specific quantities of wine

and were to be applied against the purchase price of the wine and their future

delivery.

4-20

Extract

Treas. Reg. section 1.451-5(b)

*** Advance payments must be included in income either--

(i) In the taxable year of receipt or,

(ii) Except as provided in paragraph (c) of this section.

(a) In the taxable year in which properly accruable under

the taxpayer's method of accounting for tax purposes if such method

results in including advance payments into gross receipts no later than the

time such advance payments are included in gross receipts for purposes of

all his reports (including consolidated financial statements) to

shareholders, partners, beneficiaries, other proprietors, and for credit

purposes or,

(b) If the taxpayer's method of accounting for purposes of

such reports results in advance payments (or any portion of such payments)

being included in gross receipts earlier than for tax purposes, in the taxable year

in which includible in gross receipts pursuant to his method of accounting for

purposes of such reports.

* * * * * * *

The exception noted above in paragraph (c)(1)(i) of the Treas. Reg. section 1.451-5

provides an exception for inventoriable goods.

Extract

Treas. Reg. section 1.451-5(c)(1)(i)

*** If a taxpayer receives an advance payment in a taxable year with

respect to an agreement for the sale of goods properly includible in his

inventory, or with respect to an agreement (such as a gift certificate)

which can be satisfied with goods or a type of goods that cannot be

identified in such taxable year, and on the last day of such taxable year the

taxpayer --

(a) Is accounting for advance payments pursuant to a method

described in paragraph (b)(1)(ii) of this section for tax purposes,

(b) Has received "substantial advance payments" (as defined in

subparagraph (3) of this paragraph) with respect to such agreement, and

(c) Has on hand (or available to him in such year through his

normal source of supply) goods of substantially similar kind and in

sufficient quantity to satisfy the agreement in such year, then all advance

payments received with respect to such agreement by the last day of the

4-21

second taxable year following the year in which such substantial advance

payments are received, and not previously included in income in

accordance with the taxpayer's accrual method of accounting, must be

included in income in such second taxable year.

It appears that the wine futures are sold during the period in which the wine is being

aged in the winery. The vintage of the wines being sold are several years prior to the

release date and are not yet bottled or in a form to be sold. Thus, it would appear

these goods are not "on hand."

Furthermore, it is the Service's position that each vintage of wine is a unique product

and would not meet the definition of "substantially similar kind." Therefore, the wine

futures would not come under the exception for inventoriable goods under Treas.

Reg. section 1.451-5(c)(1)(i).

It is the Service's position that the advance payments are treated under the general

provision of Treas. Reg. section 1.451-5(b). Treas. Reg. section 1.451-5(b) provides

that advance payments are includible in income in the year of receipt or in the earlier

of the taxable year the advance payments are recognized under the taxpayer's method

of accounting for tax purposes or the taxable year the advanced receipts are

recognized under the taxpayer's method of accounting for book purposes. Thus, the

advance payments may be deferred by the wineries under Treas. Reg. section 1.451-

5(b).

As a practical matter, the futures method of marketing appears to be limited, and for

the most part has been terminated by the wineries. Some wineries still offer futures,

but the majority of wineries do not. To the degree that a winery has ceased offering

futures, and the amount still on the books is not material, it may not be an issue that

warrants development.

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4-23

Exhibit 4-1

STATUTORY AUTHORITY REGARDING UNICAP (SECTION 263A)

IRC SECTION 263A

REGULATIONS 1.263-1T (TEMPORARY)

REV. PROC. 92-20 CHANGES IN METHODS OF ACCOUNTING

NOTICE # DESCRIPTION

88-24 PROPERTY PRODUCED BY FARMERS

– COSTS TO BE CAPITALIZED

– ELECTING OUT OF THIS PROVISION

88-86 OTHER ISSUES IN THE FINAL REGULATIONS

– SIMPLIFIED PRODUCTION COST METHOD

– SIMPLIFIED SERVICE COST METHOD

– ON-SITE STORAGE

– DEFERRED INTERCOMPANY TRANSACTIONS

– LIFO TAXPAYERS

– STORAGE COSTS

– LOWER OF COST OR MARKET

88-92 AUTOMATIC CHANGE IN METHOD TO COMPLY WITH 263A

– PROCEDURE TO COMPLY

– CHECKLIST & QUESTIONS TO ANSWER

88-99 INTEREST CAPITALIZATION

– TRACING AND AVOIDED COST RULES

– MECHANICS OF INTEREST CAPITALIZATION

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Islip + Company CPAs are here with personalized service to help you with these issues.  Since 1958, we have successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver premium service nearly anywhere...without premium pricing.  Give us a call or send us an email 916-488-1900 or  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .www.Islip.net

Exhibit 4-2

UNICAP GUIDELINES — CAPITALIZATION v. EXPENSE

The following listing reviews common indirect costs and the treatment required under UNICAP

for costs directly associated with the production activities. Mixed Service Costs benefit the

operation as a whole and must be allocated between the cost centers to which they apply.

Description Capitalized Not Capitalized Cost

Mixed Service

Repairs/Maintenance — Production

Repairs — not production

Utilities

Rent

Indirect Labor

Material & Supplies

Small Tools & Equipment

Quality Control

Excise Tax (Paid Prior to Sale)

Income Taxes

Real Estate Taxes

Depreciation

Amortization

Allocable Administration Costs

Officer's Salary (Production)

Insurance

Pension Plans

Employee Benefits

Bottling & Packaging Labor

Rework Labor (scrap, spoilage)

Warehousing

Purchasing Dept.

Shipping (Purchases)

Shipping (Sales)

Marketing & Promotion

Selling Expenses

Strikes

G&A — Directly for Production

Mixed Service Costs

Personnel

Data Processing

Accounting

Security Services

Management — Overall Policy

Tax Department

Internal Audit

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4-27

Exhibit 4-3 (1 of 7)

CHART I

March 23, 1992 – September 18, 1992

Non-LIFO

Category A Category B

Except for LIFO Except for LIFO

I. Under Examination on March 23, 1992 and No 3115 can be filed (See rules for issue pending

issue is pending on March 2, 1992 Sec. 14.02(1) before Form 3115 is filed.)

II. Under Examination and Taxpayer files 3115

before September 18, 1992:

A. Regardless whether the issue is pending:

1) Positive 481(a):

a) Year of Change

b) 481(a) Spread

2) Negative 481(a)

a) Year of Change

b) 481(a) Spread

B. Issue is pending when filed:

1) Year of change

2) 481(a) Spread

First year of exam

Sec. 14.02(2)(a) and 6.02(2)(a)

3 years

Sec. 14.02(2)(a) and

6.02(2)(b)(1)

Current year

Sec. 14.02(2)(a) and 6.02(2)(a)

No Spread

Sec. 14.02(2)(a) and

6.02(2)(b)(ii)

Last year

Under Exam Except *

Sec. 14.02(2)(b)(i)

6 years

Sec. 1402(2)(b)(ii)

* But not later than the last year filed as of the date the examination in which the issue is pending began.

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Exhibit 4-3 (2 of 7)

CHART I (continued)

March 23, 1992 – September 18, 1992

Non-LIFO

Category A Category B

Except for LIFO Except for LIFO

C. No Issue Pending:

1) Year of change Current Year

2) 481(a) Spread 6 years

III. Contracted for Examination after March 23,

1992 and before September 19, 1992 and

taxpayer files Form 3115 within the first 90

days of Examination and after September 18,

1992:

A. Positive 481(a):

1) Year of Change First year of exam Current Year

2) 481(a) Spread 3 years No Spread

B. Negative 481(a):

1) Year of Change Current Year Current Year

2) 481(a) Spread No Spread 6 years

IV. No 3115 filed before September 19, 1992 or

within first 90 days of Examination.

Year of Change First year of Exam

481(a) Spread No Spread

Sec. 14.02(1) and 6.02(2)(a) Sec. 1402(1) and 6.02(3)(a)

Sec. 14.02(1) and 6.02(2)(b)(1) Sec. 1402(1) and 6.02(3)(b)(i)

Sec. 14.02(1) and 6.02(2)(a) Sec. 1402(1) and 6.02(3)(a)

Sec. 14.02(1) and 6.02(2)(b)(ii) Sec. 1402(1) and 6.02(3)(b)(ii)

Sec. 1402(2)(b)(i)

Sec. 1402(2)(b)(ii)

First year of Exam

No Spread

4-29

Exhibit 4-3 (3 of 7)

CHART II

March 23, 1992 – September 18, 1992

LIFO

LIFO Category A LIFO Category B

I. Under Examination on March 23, 1992

A. Issue pending on March 2, 1992

B. Issue not pending on March 2, 1992.

1) 3115 filed before September 19,

1992 and issue is pending when

3115 is filed.

a) Year of Change

b) 481(a) Spread

2) 3115 filed before September 19,

1992 and issue is not pending

when 3115 is filed:

a) Year of Change

b) 481(a) Spread

II. Contacted for Examination after March 23,

1992 and before September 19, 1992 and

taxpayer files a Form 3115 before September

19, 1992.

No 3115 can be filed (See rules for II.A. below.)

Sec. 14.02(1)

Latest year under exam Latest year under exam

except ** except **

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Cut-off* Cut-off*

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Current Year Current Year

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Cut-off* Cut-off*

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

* Except for Hamilton type issues. See Sec. 9.01.

** But not later than the last year filed as of the date the examination in which the issue is pending began.

4-30

Exhibit 4-3 (4 of 7)

CHART II (continued)

March 23, 1992 – September 18, 1992

LIFO

LIFO Category A LIFO Category B

A. Issue pending when Form 3115 is filed.

1) Year of Change

2) 481(a) Spread

B. Issue not pending when Form 3115 is

filed.

1) Year of Change

2) 481(a) Spread

III. Contacted for Examination March 23, 1992

and before September 19, 1992 and taxpayer

files a Form 3115 after September 19, 1992

and within 90 days of examination.

A. Positive 481(a)

1) Year of Change

2) 481(a) Spread

Latest year under exam Latest year under exam

except ** except **

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Cut-off* Cut-off*

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Current Year Current Year

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

Cut-off* Cut-off*

Sec. 14.02(2)(c) Sec. 14.02(2)(c)

First year of Exam First year of Exam

Sec. 1402(1) and 6.02(4)(a) Sec. 1402(1) and 6.02(4)(a)

6 Years 6 Years

Sec. 1402(1) and 6.02(4)(b) Sec. 1402(1) and 6.02(4)(b)

10 year lookback * 10 year lookback *

Sec. 1402(1) and 6.02(4)(c) Sec. 1402(1) and 6.02(4)(c)

* Except for Hamilton type issues. See Sec. 9.01.

4-31

Exhibit 4-3 (5 of 7)

CHART II (continued)

March 23, 1992 – September 18, 1992

LIFO

LIFO Category A LIFO Category B

B. Negative 481(a)

1) Year of Change Current Year Current Year

2) 481(a) Spread Sec. 14.02(1), 6.02(4)(b) and Sec. 14.02(1), 6.02(4)(b) and

III. Contacted for Examination after March 23,

1992 and before September 19, 1992 and

taxpayer does not file a Form 3115 before

September 19, 1992 or within the first 90 days

of the Examination.

A. Year of Change

B. 481(a) Spread

Sec. 14.02(1) and 6.02(4)(a) Sec. 14.02(1) and 6.02(4)(a)

Cut-off* Cut-off*

5.03(3) 5.03(3)

First year under Exam First year under Exam

No Spread No Spread

* Except for Hamilton type issues. See Sec. 9.01.

4-32

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4-33

Exhibit 4-3 (6 of 7)

CHART III

New Rules

Category A Category B LIFO

I. Not under examination — taxpayer

files Form 3115

A. Year of Change: Current Year Current Year Current Year

B. 481(a) Spread: Positive 3 Years 6 Years Cut-Off*

II. Examination — taxpayer files Form

3115 in first 90 days.

A. Positive 481(a)

1) Year of Change 1st year of exam Current Year 1st year of exam

2) 481(a) Spread 3 Years No Spread 6 years, 10 year lookback *

B. Negative 481(a)

1) Year of Change Current Year Current Year Current Year

2) 481(a) Spread No Spread No Spread Cut-off*

Sec. 5.02 Sec. 5.02 Sec. 5.02

Sec. 5.03(1)(a) Sec. 5.03(2) Sec. 5.03(3)

Negative No Spread

Sec. 503(1)(b)

Sec. 6.02(2)(a) Sec. 6.02(3)(a) Sec. 6.02(4)(a)

Sec. 6.02(2)(b)(i) Sec. 6.03(3)(b)(i) Sec. 6.02(4)(b)

Sec. 6.02(2)(a) Sec. 6.02(3)(a) Sec. 6.02(4)(a)

Sec. 6.02(2)(b)(ii) Sec. 6.03(b)(ii) Sec. 6.02(4)(b)

& Sec. 6.02(4)(c)

and 502(3)

* Except for Hamilton type issues. See Sec. 9.01.

4-34

Exhibit 4-3 (7 of 7)

CHART III (continued)

New Rules

Category A Category B LIFO

III. Under examination — taxpayer

does not file 3115 in first 90 days.

A. Year of Change

B. 481(a) Spread

1st Year of Exam 1st Year of Exam 1st Year of Exam

No Spread No Spread No Spread

Does not cover the following situations:

120 day window

60 day window

30 day window

Filed with the consent of the District Director

Newly affiliated corporations

Generally, the rules for taxpayers not under examination apply to these situations.

For Taxpayers not under examination, they must file Form 3115 within the First 180 days of the year, or the first 270

days with good cause. After the first 180 days the 3115 is considered filed early for the next year.

Cut-off: The LIFO cut-off method is a change made with no 481(a) adjustment for any year prior to the year of change

and applies only to LIFO method changes.

G-1

GLOSSARY

Acid — A component of grape juice and wines. The most important acids present are malic, tartaric,

succinic, lactic, and citric.

Aging — The final process in wine making of holding wines for a period of time to allow some of the

components to mature and change beneficially.

Alcohol by Volume — The percentage of alcohol contained in a wine by volume, declared by law on

the label. Table wines cannot contain more than 14 percent; dessert and fortified wines (legally

the same) contain more than 14 percent but not more than 24 percent, although wines of more

than 21 percent are not normally found on the market.

Amelioration — The legal addition of sugar, water, and/or acid to balance deficiencies in wine.

Appellation of Origin — In the United States, a general term for the label designations that indicate

geographic origins of bottled wines that meet specific requirements. Any wine, at least 75 percent

of which is made of grapes grown in the area designated on its label and conforms to the laws and

regulations relevant there, is entitled to a country, state, or county appellation.

BATF — The Bureau of Alcohol, Tobacco, and Firearms (also ATF).

Balling — A system for measuring the sugar content of juice or wine, expressed as degrees Balling.

Called after the man who devised it, the name is pronounced as in "balance." For all purposes, the

same as Brix.

Barrel-Fermented — Wine that has undergone fermentation in small casks as opposed to very large

tanks.

Bench-Crafted — Vines grafted to rootstock, then developed in greenhouses and field nurseries, and

planted while still dormant.

Binning — Storing premium bottled wine (before its release for sale) for 6 months to several years to

obtain the benefits of aging in the bottle.

Blanc de Blancs — Usually sparkling wine made entirely of Chardonnay (occasionally of other whites)

rather than the more traditional blend of black and white grapes.

Blanc de Noirs — A white wine made from black grapes, with a blush, or deeper tone than a white

wine from white grapes. Frequently used for sparkling wines.

Blend — To combine wines of different varieties or lots to add interest or harmony to the finished

product; or a wine so made.

G-2

Bonded — Legal wine making or warehousing facilities under bond to the Government for payment of

taxes on the wine made or stored there.

Bottle Age — The mature characteristics of a wine attributable to the length of its stay in the bottle.

Bottle-Aging — Keeping bottled wines for a period of time to allow some of the components to

mature.

Bottle-Fermented — A champagne or sparkling wine made either by the method champenoise or the

transfer method.

Boutique Wineries — Those making premium, generally expensive, varietal wines, often from

designated vineyards, on a relatively small scale of production.

Brix — A measure of the sugar content. See Balling.

Brut — Champagne or sparkling wine that is very dry but may still contain a trace of sweetness.

Budwood — Well-developed canes bearing buds suitable for use in grafting or budding.

Bulk Process — In making sparkling wine, a technique (also called "Charmat process") that uses large,

covered containers for the secondary fermentation, a less expensive method for production of

large quantities.

Bulk Wine — Generally, less expensive wines sold in large containers or jugs. Some large producers

buy bulk wines from other wineries and blend, bottle, and distribute them under their own labels.

Bung — A plug for stoppering a wine cask.

Bung Hole — A small opening in a cask through which wine can be put in or taken out.

Butt — A wine barrel or cask of moderately large capacity.

Candle — To test the clarity of wine by looking at it with a candle or other light held behind the bottle.

Cane — The woody, mature state of the shoot (new growth) of the vine.

Canopy — The "umbrella" formed by the foliage of the vine.

Cap — The crust consisting of skins that forms on top of the juice during fermentation. To extract the

color and prevent spoilage, the cap must frequently be submerged by punching down or by

covering with juice pumped from the bottom.

Carbonated — Wines infused with carbon dioxide to make them bubbly.

G-3

Carbonic Maceration — The fermentation of uncrushed whole grapes, which takes place partly inside

the berries, some of which break down by their own weight, others by the action of the internal

fermentation. The resulting light, intensely fruity, low tannin wines are mildly effervescent, an

effect of the carbon dioxide produced in the process, and are meant for early drinking. Nouveaustyle

wines are made by this process.

Centrifuge — A machine used to clarify wine or must.

Chai(s) — A French term for above ground areas for wine storage.

Chapitalization — The addition of sugar to must, legal in such areas as Burgundy (France), but not

permitted in California.

Charmat Process — The same as bulk process for making sparkling wines.

Clone — (1) The propagation of a group of plants from a single source to perpetuate selected

characteristics or special attributes; (2) the variety so produced.

Cold-Fermented — White wines fermented in containers whose temperatures are controlled internally

or with jackets.

Cold Stabilization — A technique of chilling wine before bottling to cause the precipitation of

harmless potassium acid crystals or other sediment that might later cause haziness or deposits.

Concentrate — A reduction of grape juice by evaporation often used in home wine making or in areas

where fresh grapes are not obtainable.

Controlled Fermentation — A fermentation whose progress is altered by adjustment of temperature

or pressure.

Cooperage — Containers for storing wine, usually barrels, casks, and tanks of wood or steel.

Crush — The specific process of breaking the grape skins to begin fermentation. Used generally, as

"the crush," it designates the total procedure of wine making steps preceding fermentation.

Crusher — Usually a stemmer-crusher, a machine that macerates the grapes after destemming them.

Culture — A growth of organisms such as yeast that may be use to inoculate crushed grapes to aid

fermentation.

Cutting — A segment of a cane or shoot that will develop into a new plant when grown under

favorable conditions.

Cuvee — A specific blend of wines, often of different varieties, combined in the final lot; generally used

in making sparkling wine but occasionally also in producing table wine.

G-4

Dessert Wine — Wine of more than 14 percent but not more than 24 percent alcohol.

Diatomaceous Earth — A light, friable material derived from fossilized microscopic algae (diatoms)

used as a filter in clarifying wine.

Disgorge — In the making of sparkling wine, to eliminate the accumulated sediment in the neck of the

bottle by freezing it, uncorking the bottle, and using the pressure of the gas in the wine to eject

the sediment.

Dosage — In the making of sparkling wine, usually brandy and wine, mixed with sugar, used to replace

the wine lost in the disgorging of sediment.

Enology — The science of viniculture or wine making.

Estate Bottled — A wine produced solely from grapes grown on land owned or controlled by and in

the same viticultural area as the winery making it, as well as being made entirely on the premises.

Extraction — In wine making, drawing out and dissolving the pigments and other solubles in the skins,

seeds, pulp, and occasionally stems, which are kept in continuous contact with the juice.

Fermentation — The conversion by yeast enzymes of the grape sugar in the must or juice into alcohol

and carbon dioxide.

Fermentor — A large container in which fermentation takes place.

Field-Budded — See Field-grafted.

Field-Grafted — Budwood grafted to rootstock in the vineyard in late summer or early fall. Also

called field-budded.

Filter — To clarify wine after fermentation by removing suspended matter such as yeast cells with the

aid of porous membranes; also, the porous material used in the process. Filtration is the process

of clarifying wine with filters.

Fining — The process of clarifying wine by employing such agents as gelatin, egg whites, bentonite

(clay), or isinglass, that absorb or carry along most of the other suspended matter with them as

they settle to the bottom.

Finishing — The processes involved in clarifying wine before it is bottled.

Foil — The molded plastic or metallic material that fits over the cork and part of the neck of a wine

bottle.

Fortified — Any wine, but most frequently sherry, port, and so-called dessert wine, in which, by the

addition of spirits or brandy, the alcohol content has been increased to more than 14 percent and

G-5

not more than 24 percent and the fermentation halted before all of the sugar has been converted.

Normally, wines on the retail market are well below 24 percent.

Free-Run — In pressing, the crush juice that runs free from the press before force is used.

Fumigation — Chemically sterilizing the soil prior to planting.

Generic — wines named after general categories (red or while table wine) and place-names (Burgundy,

Rhine, Champagne).

Graft — To splice a varietal vine to a rootstock of another type, usually one that is resistant to

particular predators or diseases; sometimes used to change the variety. Also, the union or splice

portion of a plant so treated.

Hardening — When applied to canes, the state of dormancy.

Hybrid — A new grape variety developed by crossing two or more varieties or species.

Hydrometer — An instrument used to measure the amount of sugar in grape juice.

Inoculation — The addition of yeast starter to wine must to begin fermentation; or of a bacterium to

cause a malolactic fermentation.

Jug Wines — Generally less expensive, generic wines sold in large containers, although varietals are

more and more frequently included.

Lees — The yeast residue that settles to the bottom during fermentation. Wines that are left too long

before racking can pick up the odor of lees.

Made and Bottled By — Legally only designates that at least 10 percent of the wine in the bottle was

fermented at the winery.

Malic Acid — The acid in wine that converts to lactic acid during a secondary, or malolactic

fermentation.

Malolactic Fermentation — A secondary fermentation, often occurring naturally, that converts malic

to lactic acid and carbon dioxide, adding complexity to red wines and to some Chardonnays;

undesirable if it occurs or continues in the bottle, trapping gas and off-odors.

Marriage — A blending, or marrying, of two or more lots of still wine.

G-6

Methode Champenoise — The classic method of making Champagne by completing the second

fermentation, clarification, and other processes in the same bottle in which it is marketed.

Microclimate — The climate within a small area that differs from the climate in the larger area around

it.

Mildew — A fungus that is a major problem in quality vineyard control. The odor from heavily

mildewed grapes is often transmitted to the wine.

Mold — A fungus growth usually detrimental to grapes.

Must — The juice and pulp produced by crushing or pressing grapes before fermentation.

Negociant — A shipper of wine.

Nematodes — Vineyard pests that in their larval form attack vine roots, stunting the growth of the

plant. See Fumigation.

Overcropping — In viticulture, encouraging too large a yield per acre, thereby having a detrimental

effect on quality.

Oxidation — The changes in wine caused by exposure to air, sometimes beneficial, but often

undesirable, especially when excessive.

Phylloxera — A highly destructive root louse that infests Vitis Vinifera, but not some of the native

American stock, most of which is resistant to it.

Pomace — The solid residue after pressing.

Press — To exert pressure on crushed grapes to extract their juices. Also, a hand-operated or

mechanical device used in the process. The four common types are: 1) a vertical, hand-operated,

wooden basket press; 2) a horizontal, mechanical, metal basket press; 3) a horizontal, pneumatic

air-pressure (or bladder) press, including a lank press; and 4) a continuous press that allows

uninterrupted feeding and juice removal.

Press Wine — The wine obtained by pressing in a machine.

Private Reserve — Because there is no legal definition, this term on a label generally, but not

necessarily, indicates that the wine is of special quality, above the ordinary run. Same as Special

Select or Proprietor's Reserve.

Produced and Bottled By — Legally designates that 75 percent or more of the wine was fermented

and clarified at the winery named on the label.

G-7

Proprietary Wines — Those bearing fanciful names such as Rhine Castle, Rubion, or Ripple, usually

registered as a trademark by the brand owner.

Pruning — Cutting back the vegetative part of the vine after it has become dormant, a process that

affects the size, and, therefore, the quality of the next year's crop. In California, the three most

frequently used systems are head training (with spurs), cane pruning, and cordon pruning.

Pulp — The flesh of the grape or other fruit.

Puncheon — A large wooden cask for storing wine.

Punt — The indentation in the bottom of some wine bottles. Also called the kick.

Racking — Siphoning or pumping wine from one container to another to clarify it by leaving the

sediment behind.

Residual Sugar — Sugar that remains unconverted in the wine after fermentation.

Riddling — A method used at the end of the bottle fermentation of sparkling wine to encourage the

yeast sediment toward the cork for later disgorgement. The process, which can take between a

week and a month, consists of placing the bottles neck down in special racks and rotating them

individually about one-eighth of a turn daily. This historically has been done by hand, but now is

often done mechanically.

Rootstock — The part of the grapevine that is planted directly in the soil. A different bearing variety is

often later grafted to rootstock resistant to disease.

Scion — a cutting used in grafting, containing a bud of the desired vine.

Secondary Fermentation — A fermentation that takes place either spontaneously or by design after

the completion of the primary fermentation. In the making of sparkling wine, the gas produced

gives the wine its bubbles.

Sediment — Particulates that form deposits in some wines stored in containers, or, with age, in some

bottled wines.

Select — Generally implying something special about a wine, but meaningless since there is no precise

legal definition.

Settling — The natural precipitation of the solid matter in wine.

Shoot — A new growth of the vine.

Skin Contact — The process of holding grapes and juice together for a period of time before pressing

to obtain an extraction of color.

G-8

Sommelier — A wine steward.

Sparkling Wines — Wines whose effervescence is produced by carbon dioxide captured during a

second fermentation in the bottle or container in which it is made. The term applies to all

champagne-style wines made outside the Champagne district in France.

Split — A wine bottle containing 6.4 ounces.

Starter — Yeast used to start or ensure fermentation.

Stemmer — A machine that separates the stems from the grapes; when combined with a crusher, it is

called a stemmer-crusher.

Still Wines — All wines made without effervescence.

Stuck Fermentation — An incomplete fermentation that stops before all the sugar has been converted

to alcohol.

Sulfur — Used to dust vineyards as a control for powdery mildew.

Table Wine — In general, still, dry wine meant to accompany food, as opposed to special wines such

as sparkling, appetizer, or dessert wines.

Tannin — A polyphenolic compound derived from the skins, seeds, and stems of grapes which gives

young red wine an astringent, puckery quality, but contributes to its longevity and normally

ameliorates as the wine ages. In excess, it causes a bitter taste.

T-Budding — A method of grafting a new variety to an existing plant.

Tirage — In making sparkling wine, the mixture of still or cuvee wine, yeast culture, and sugar drawn

off into bottles or larger containers to undergo the secondary fermentation and allow the spent

yeasts to settle out.

Topping — A technique to control oxidation in containers by replacing wine lost through evaporation.

Transfer Process — A champagne and sparkling wine process that removes the wine from the bottle

after fermentation for filtering in pressurized tanks before rebottling. Such wines are labeled

"bottle fermented" or "fermented in the bottle" as opposed to "fermented in this bottle," often

used on the more expensive methode champenoise wines.

Ullage — Leakage or evaporation of wine from its container, resulting in oxidation and often spoilage.

Varietal Wine — Since January 1, 1983, any wine named after and containing 75 percent or more of a

Vitis vinifera grape variety, and grown in the appellation of origin appearing on the label.

G-9

Vigneron — A French term for a vineyardist.

Vintage — Applied in the United States to wine in which at least 95 percent of the grapes come from

the harvest of the year designated on the label. A vintage year is also one worthy of being

specified on the label.

Vintner — A person who makes or sells wine.

Viticultural Area — Since January 1, 1983, a region described as having distinguishable geographic

features and Governmentally recognized and defined boundaries. Wines bearing a viticultural area

designation on their labels must contain 85 percent grapes grown from that area.

Viticulture — The science of growing grapes.

Vitis Vinifera — The European-Middle Eastern grapevine from which most of the world's fine table

wine are made.

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IS-1

INFORMATION SOURCES

The following is a non-inclusive listing of various sources of information found useful by the

Sacramento Wine Industry Study group in conducting wine industry examinations. Consult with the

state and local agencies/resources in your area for assistance.

GOVERNMENT AGENCIES

BATF Bureau of Alcohol, Tobacco and Firearms

ABC Department of Alcoholic Beverage Control

California Department of Food and Agriculture

Napa County Agricultural Commissioner

Napa County Agriculture Extension Advisor

University Extension -- University of California — Davis

UC Davis — Department of Viticulture & Enology

University of California

INDUSTRY PUBLICATIONS

Books

Book of California Wine

Authors — Muscatine, Amerine & Thompson

Publisher — University of California Press/Sotheby

Wines & Vines' Buyer's Guide/Annual Directory

1800 Lincoln Ave.

San Rafael, CA 94901-1298

(415) 453-9700

UC Davis — Department of Viticulture & Enology

Annual Report

University of California

IS-2

Magazines

Wines & Vines

1800 Lincoln Ave.

San Rafael, CA 94901-1298

(415) 453-9700

The Wine Spectator

P.O. Box 1960

Marion, Ohio 43306-4060

(800) 347-6969

Wine Times

404 Irvington Street

P.O. Box 39

Pleasantville, NY 10570-0039

(800) 356-VINO

Wine & Spirits

P.O. Box 1548

Princeton, NJ 08540

(609) 921-2196

Islip + Company CPAs are here with personalized service to help you with these issues.  Since 1958, we have successfully worked with the IRS and the FTB helping our clients stay in compliance of the tax laws and pay the minimum amount due.  With Offices in Sacramento and Auburn as well as internet we are able to deliver premium service nearly anywhere...without premium pricing.  Give us a call or send us an email 916-488-1900 or  This e-mail address is being protected from spambots. You need JavaScript enabled to view it .www.Islip.net