The tax law is filled with artificial distinctions and deadlines that often don’t match up with the way businesses actually operate. One area where this is particularly true is in the realm of capitalization.
Capitalization rules allow taxpayers to calendar expenses and treat them differently depending on the phase of a project or manufacturing process. However, determining when certain costs should be capitalized can be complex and requires careful consideration of the relevant tax code provisions.
Chief Counsel Advice Memorandum 200713023, for example, provides guidance on when the actual preproductive period of a grape crop ends for tax purposes and which costs are subject to capitalization. This memo highlights the challenges taxpayers face in navigating the capitalization rules and underscores the importance of seeking expert advice to ensure compliance with the tax code.
Section 263A Capitalization
Section 263A is a tax law that governs how certain costs related to producing or acquiring property should be treated for tax purposes. This law applies to real or tangible personal property that is produced by the taxpayer, which includes property that is constructed, built, installed, manufactured, developed, improved, created, raised or grown.
The law requires that taxpayers subject to Section 263A include direct costs and a portion of indirect costs that directly benefit or are incurred because of the production of property in their inventory costs (if the property is inventory) or capitalize them (if the property is not inventory). Direct material costs include the cost of materials that become part of the property produced or that are consumed during production, while direct labor costs include labor costs associated with producing specific units of property.
Indirect costs include all other costs that are not direct material or direct labor costs, such as overhead, interest, and taxes (excluding state and federal income taxes). Taxpayers must allocate indirect costs between production, resale, and other activities in a reasonable manner.
Preproductive Period Costs
Section 263A also includes provisions related to preproductive periods and preproductive period costs. The law does not apply to the production of any animal or plant with a preproductive period of two years or less, provided the taxpayer is not required to use an accrual method of accounting. Preproductive period costs include all costs incurred before a plant becomes productive in marketable quantities and include preparatory costs, such as the cost of acquiring the seed, seedling, or plant, and costs associated with cultivating, maintaining, or developing the plant.
The actual preproductive period of a plant is used to determine the period during which a taxpayer must capitalize preproductive period costs, and field costs incurred after the harvest of a crop or yield but before it is sold or disposed of are not included in preproductive period costs.
Finally, the law defines what constitutes a farming business for purposes of Section 263A. A farming business involves the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity. Processing activities that are normally incidental to the growing, raising, or harvesting of these products are included in a farming business, while processing activities beyond these incidental activities are not.
Capitalization of Grapes for a Winery
This brings us back to the question at hand. When is a grape no longer a grape?
According to the IRS, the first issue in answering this is determining when the “actual preproductive period” (“APP”) of the grape crop ends for tax purposes. The APP is the period during which costs associated with producing the crop must be capitalized rather than immediately expensed.
The IRS guidance explains that while the tax code states that the APP ends when the crop is “sold or otherwise disposed of,” the IRS believes that for grapes grown for self-use, the APP should end at the point of “the crush.” The crush is when the grapes are turned into juice and marc for winemaking and marks the end of the grape crop and the beginning of wine production. The IRS argues that extending the APP beyond the crush would result in inappropriate capitalization of costs into a crop that no longer exists.
The IRS says the second issue is to identify costs incurred between the harvest of a grape crop and the blossoming of the subsequent crop, as these costs are subject to capitalization. The IRS explains that preparatory costs and preproductive period costs of the grape vine must be capitalized during the APP, which ends when the vine first becomes productive in marketable quantities. After the end of the APP, preproductive period costs are generally capitalized to a crop during the preproductive period of the crop and are deducted as a cost of maintaining the vine when incurred between the end of the APP of one crop and the beginning of the APP of the subsequent crop.
However, the IRS notes that there is a special exception that applies to the period between the harvesting of a crop and the sale or other disposition of the crop. Field costs, such as irrigating, fertilizing, spraying, and pruning, are not required to be capitalized into the harvested crop because they do not benefit or are unrelated to the harvested crop or yield. The cost of the harvest itself is a preproductive cost that is capitalized into the crop if it is incurred during the APP of the crop. The IRS guidance concludes that the field cost exception ends when the APP of the crop ends, which, in the case of grapes grown for self-use, is the onset of the crush.
So there you have it. That is when a grape is no longer a grape.
The IRS guidance on Section 263A capitalization provides clarity on when the “actual preproductive period” of a grape crop ends for tax purposes, which is at the point of “the crush” for grapes grown for self-use. The guidance also explains which costs are subject to capitalization during the preproductive period and which costs are exceptions. This guidance can be helpful for wineries, farmers, and manufacturers for planning, tracking expenses, and advance tax planning.