Winery's dollar-value LIFO inventory item definitions are proper

Plain-English summary

Chief Counsel considered whether a winery properly divided its bulk and bottled wine into inventory items for its dollar-value, link-chain LIFO method. The advice concludes that the winery's definitions, which considered varietal, quality, production or aging stage, and bottle size, properly measured the inventory for computing the LIFO price index. Because the winery used grapes from the same growing region and bought grapes only to cover occasional vineyard shortfalls, it did not have to separate wine based solely on purchased versus estate-grown grapes. The analysis explains why combining goods with different characteristics or costs could distort the inflation measure used for LIFO accounting.

Ruling snapshot

• Question: Did the winery properly define its bulk and bottled wine items for its dollar-value LIFO pool?
• Outcome: Advice given
• Key authorities: IRC § 472; Treas. Reg. § 1.472-8; Amity Leather Products Co. v. Commissioner; Hamilton Industries, Inc. v. Commissioner

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201043029
       Release Date: 10/29/2010
       CC:ITA:B06:NMMulleneaux
       POSTF-138399-09

UILC: 472.08-00, 472.08-04

date: July 20, 2010

 to:   Associate Area Counsel, Large & Mid-Size Business (LMSB), Area 2
       (Heavy Manufacturing & Transportation)
       Attn: Elizabeth R. Edberg

from: Willie E. Armstrong, Jr.
Senior Technician Reviewer, Branch 7
Income Tax & Accounting (ITA)

subject: Definition of Dollar-Value LIFO Inventory Items

       This Chief Counsel Advice responds to your request for assistance. In accordance with
       6110(k)(3), this Chief Counsel advice should not be cited as precedent.

                                                     LEGEND

       Taxpayer            =      --------------------------------------------

       Region              =      ----------------

       Vineyard 1          =      -----------------------

       Vineyard 2          =      -----------------------

       a                   =      --

       b                   =      --

       c                   =      --

       d                   =      --

       e                   =      --

POSTF-138399-09 2

f = ---

g = ---
h = --

i = ----------

Grape 1 = -------------------------------------

Grape 2 = --------------------------------

Grape 3 = --------------------------

Grape 4 = ------------------

Reserve Varietal 1 = ----------------------------------------------

Estate Varietal 1 = --------------------------------------------

Varietal 1 = ----------------------------------

Varietal 2 = ------------------------------

Varietal 3 = -----------------------

Varietal 4 = ---------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

Month 1 = ------

Month 2 = ---------

POSTF-138399-09 3

                                      ISSUE

Whether Taxpayer properly defines items of inventory within its dollar-value, last-in,
first-out (LIFO) pool for purposes of computing the LIFO price index of the pool in
accordance with § 472 of the Internal Revenue Code and the Income Tax Regulations
thereunder.

                                  CONCLUSION

Taxpayer properly defines items within its dollar-value LIFO pool for purposes of
computing the LIFO price index of the pool in accordance with § 472 and the regulations
thereunder.

                                      FACTS

Taxpayer is a winery that produces several types of wine and owns and operates two
vineyards in Region: Vineyard 1 and Vineyard 2. Vineyard 1 contains a blocks of land,
including b for Reserve Grape 1, c for Estate Grape 1, c for Grape 2, b for Grape 3, and
b for Grape 4. Vineyard 2 contains d blocks of land, including e for Grape 3 and c for
Grape 4.

In Year 1, Taxpayer’s first vintage year, it produced Estate Varietal 1. In Year 2,
Taxpayer began producing Varietal 2, Varietal 3, and Reserve Varietal 1. In Year 3,
Taxpayer began producing Varietal 4 and continued to produce that varietal off and on
through Year 4.

Taxpayer uses grapes grown within the same grape-growing geographical region
(appellation) for its wine production and generally uses only estate-grown grapes. In
some years, however, Taxpayer may purchase a small amount of Grape 1, Grape 2,
Grape 3, and Grape 4 grapes to augment the estate-grown grapes if, and to the extent,
there is a shortfall in the yield from its vineyards due to weather, insects, diseases, or
other similar causes. Because the grape growing costs are expensed at the farming
division level, the grapes grown at Taxpayer’s vineyards are taken into inventory at a
zero basis. Taxpayer does not purchase wine for resale.

Taxpayer generally designates about f percent of the best of its Grape 1 production for
the Reserve Varietal 1 program. The vast majority of the grapes used in the program
come from the Reserve Grape 1 block although some blending may occur. Indeed, for
production years after Year 4, the bulk wine produced from Grape 4 grapes is used
solely for blending into the Varietal 1 programs at the time of bottling.

Although vineyard practices at the Reserve Grape 1 block may vary slightly from the
Estate Grape 1 blocks (timing of harvest, trellis systems, and canopy management may
differ), from a practical standpoint, there is no difference in production methods or costs
in the Reserve Varietal 1 program compared to the Estate Varietal 1 program. In this

POSTF-138399-09 4

regard, the grapes are crushed, fermented, and barrel aged using the same methods
and in the same location, up to the point of final blending decisions. At that point, the
best barrels are identified for the Reserve Varietal 1 program and are subject to further
barrel and/or bottle aging. The balance of the Varietal 1, along with any remaining
Varietal 4 from that vintage, goes into the Estate Varietal 1 program where they are
subject to the processes of blending, bottling, and bottle aging.

Traditionally, Taxpayer bottles its Varietal 2 in Month 1 of the year after harvest and
releases the wine for sale shortly thereafter. The majority of that bottling will sell out
within g months of bottling.

After a period of bulk aging, Taxpayer bottles its Varietal 3 in Month 2 of the year
following harvest. The wine is then bottle aged for a period of about h months before its
release for sale. Once released for sale, the majority of the bottled Varietal 3 is sold
within g months.

After a period of aging, the Estate Varietal 1 is bottled in Month 3 of the i year after
harvest, with a bottle aging period of about g months. The barrel and bottle aging
periods are slightly longer for the Reserve Varietal 1 program. Both Varietal 1 programs
generally sell out within g months of their respective releases.

Taxpayer defines items in its bulk wine by varietal: Varietal 1, Varietal 2, Varietal 3, and
Varietal 4. It further defines bulk wine by length of production, i.e., time, in months, from
the month the grapes are harvested (stage of production). Additionally, Taxpayer
defines bulk wine by quality. Once bulk wine is determined to be of sufficient quality to
be bottled as a “Reserve” (high quality) wine, Taxpayer treats such bulk wine as a
separate item from the bulk wine of the same varietal and production period.
In general, Taxpayer defines items of bottled wine in a similar manner as bulk wine. It
defines bottled wine by varietal, length of time it has been aged and stored, and the
quality of the wine (e.g., Estate Varietal 1, Reserve Varietal 1). Taxpayer further defines
items by the size of the bottle used, if the same item is bottled in containers of different
sizes. For example, some wines are further defined by 750mL and 1.5L bottles.

To value its bulk and bottled wine inventory, Taxpayer uses the dollar-value, link chain,
LIFO method. Taxpayer determines current-year cost using the latest acquisitions
method. Taxpayer maintains one natural business unit pool.

                                        LAW

Section 1.472-8(a) provides that any taxpayer may elect to determine the cost of its
LIFO inventories using the dollar-value LIFO method, provided such method is used
consistently and clearly reflects income. In order for Taxpayer’s dollar-value method to
clearly reflect income, Taxpayer must properly define each inventory item used to
calculate its LIFO index (inflation) and to measure increments and decrements in its
LIFO pool.

POSTF-138399-09 5

In order to determine whether Taxpayer properly defined its LIFO items and
consequently its LIFO index, it is helpful to first discuss the definition of the word “items”
and “goods” in the context of § 472 and the importance of a taxpayer properly defining
an inventory item within a pool for purposes of accurately measuring inflation and
calculating the LIFO index for the pool.

A. Definition of the Terms “Goods” and “Items”

Neither the Code nor the Regulations set forth a definition of the words “goods” and
“items.” Section 1.472-8, however, seems to use the terms “goods” and “items”
interchangeably when describing the dollar-value LIFO method. For example, § 1.472-
8(a) provides that “goods contained in the inventory are grouped into a pool or pools.”
Section 1.472-8(b)(1) states in part, “[a] pool shall consist of all items entering into the
entire inventory investment for a natural business unit of a business enterprise, unless
the taxpayer elects to use the multiple pooling method provided in subparagraph (3) of
this paragraph.” Section 1.472-8(e)(2)(i) also refers to an “item” in the pool.

In legislative interpretation, “…words are uniformly presumed, unless the contrary
appears, to be used in their ordinary and usual sense, and with the meaning commonly
attributed to them.” Caminetti v. United States, 242 U.S. 470, 485-486 (1917); see
Consumer Product Safety Commission v. GTE Sylvania, Inc., 447 U.S. 102, 108 (1980).
A similar presumption should be used with respect to words used in regulations. Thus,
the term “goods” should be used in its ordinary meaning. The term “goods” is defined in
Merriam-Webster’s Collegiate Dictionary, at 527 (9th ed. 1984) as “personal property
having intrinsic value . . . ; wares, commodities, merchandise . . . .” Therefore, using
common usage, goods or items can include a broad group of wares or commodities.

The Tax Court has established a basic principle for the term “item” in the context of
§ 472. The Tax Court stated, “[a] narrow definition of an item within a pool will
generally led to a more accurate measure of inflation (i.e., price index) and thereby lead
to a clearer reflection of income.” Amity Leather Products Co. v. Commissioner, 82 T.C.
726, 734 (1984). Thus, whether referencing “goods” or an “item,” the goods or item
placed in the inventory pool must provide an accurate measure of inflation.

Further, the cost of inventory items plays a significant role in defining an item. In Amity
Leather, the Tax Court agreed with the taxpayer that billfolds manufactured in Puerto
Rico should be treated for inventory purposes as different items from otherwise identical
billfolds produced in the United States. The billfolds produced in Puerto Rico were
substantially cheaper. See Hamilton Industries, Inc. v. Commissioner, 97 T. C. 120,
136 (1991) (goods may be placed in separate item categories because of their cost).

B. Importance of Defining Items Properly

POSTF-138399-09 6

Proper item definition is the foundation on which an accurate, reliable, and suitable
LIFO index must be built. The LIFO index is generally defined as the ratio of the current
cost of the goods in inventory to the base cost of those same goods. See § 1.472-8.
Since a LIFO reserve measures cumulative inflation in the ending inventory, it is
imperative that the LIFO index accurately measure inflation. In Amity Leather, the Tax
Court recognized the importance of defining inventory items properly:

  Because the change in the price of an item determines the price index and
  that index affects the computation of increments or decrements in the
  LIFO inventory, the definition and scope of an item are extremely
  important to the clear reflection of income. If factors other than inflation
  enter into the cost of inventory items, a reliable index cannot be computed.
  For example, if a taxpayer’s inventory experiences mix changes that result
  in the substitution of less expensive goods for more expensive goods, the
  treatment of those goods as a single item increases taxable income. . . .
  Conversely, if changes in mix of the inventory result in the substitution of
  more expensive goods for less expensive goods, the treatment of those
  goods as a single item decreases taxable income because the increase in
  inventory costs is eliminated from the LIFO cost of the goods as if such
  cost increase represented inflation.

Amity Leather, 82 T.C. at 733. This lengthy quotation emphasizes the importance of a
taxpayer defining its items properly and explains that distortions can occur when the
taxpayer does not properly define its items.

The Tax Court again emphasized this conclusion in Hamilton Industries when it stated:

  The proper grouping of goods into pools and items is central to the
  operation of the dollar-value method. Wendle Ford Sales, Inc. v.
  Commissioner, 72 T.C. 447, 452-453 (1979). In order to produce a clear
  reflection of income, the goods contained in a taxpayer’s pool and item
  categories must have similar characteristics, as determined under the
  standards applicable to each. Amity Leather Products Co. v.
  Commissioner, 82 T.C. at 734-735. A system which groups like goods
  together and separates dissimilar goods permits cost increases
  attributable to inflation to be isolated and accurately measured. Amity
  Leather Products Co. v. Commissioner, 82 T C. at 731-734. The more
  homogenous that each category can be made, the better it will screen out
  cost increases caused by non-inflationary factors, thus producing a clearer
  reflection of income than would be possible with categories containing
  heterogeneous agglomerations of goods.

Hamilton Industries, 97 T.C. at 132 (footnote omitted). The taxpayer in Hamilton had
elected the LIFO method and tried to include inventory purchased in two acquisitions in
the same inventory pool as inventory manufactured after the acquisition. The Tax Court

POSTF-138399-09 7

determined that the purchased inventory could be placed in the same pool as the later
manufactured inventory but, despite the taxpayer’s arguments, could not be treated as
the same item for LIFO purposes because the values of the purchased inventory were
too disparate from the costs of the manufactured inventory. Furthermore, the taxpayer
could identify the inventory in question and track it at the time of purchase. Id. at 139.

                                    ANALYSIS

A. Appropriate Criteria for Determining Item Definitions

If the inflation in Taxpayer’s LIFO inventory is to be correctly and consistently
measured, Taxpayer must properly define each item of wine in its inventory and the
change in cost of its various wines must be identified and measured at the item level.
The manner in which a winery should define “items” for LIFO purposes so that this goal
is met is factually dependent, and the resulting item definitions may vary depending on
the particular facts and circumstances of each winery.

Recognizing that not all criteria may be applicable to a particular winery, we believe that
the factors noted below should be considered in defining an inventory item for a winery
with regard to bulk wine, bottled wine, and cased goods.

Bulk Wine Item Definition Criteria

A winery should consider the following criteria when dividing the bulk wines that it
produces into LIFO inventory items:

   (1) Type of wine (e.g., varietal, appellation, or blend);
   (2) Source of grapes (e.g., purchased or grown);
   (3) Process, recipe, or formula used, or the program followed, to make the wine;
       and
   (4) Length of time the wine has been in production or aging at the end of the tax
       year, from the time the grapes are harvested (e.g., 3 months; 15 months; 27
       months).

Bottled Wine and Cased Goods Item Definition Criteria

A winery should consider the following criteria when dividing bottled wines and cased
goods into LIFO inventory items:

   (1) Type of wine (e.g., varietal, appellation, or blend);
   (2) Source of grapes (e g., purchased or grown);

POSTF-138399-09 8

   (3) Process, recipe, or formula used, or the program followed, to make the wine;
   (4) If the wine if aged in the bottle, the length of time the bottled wine has been
       aging when bottled;
   (5) Type and size of container, if a significant cost difference exists between
       types or sizes of containers; and
   (6) Length of time the wine has been stored after bottling.

Aside from these criteria, additional factors may be applicable to defining an item of
wine. The application of additional factors will depend on the facts and circumstances
related to a particular winery.

As to type of wine, each varietal, appellation, and blend should be defined as a separate
item. For this purpose, a blend generally is a wine made from mixing together two or
more wines or varietals. The term appellation refers to a defined viticultural growing
region, whereby specific grape varietals are grown, harvested, and made into wine.

Regarding source of grapes, wines made with purchased grapes and wines made with
estate-grown grapes should generally be treated as separate items due to their cost
differences. However, where a taxpayer purchases grapes if, and only to the extent,
there is a shortfall in the yield from its vineyard due to weather, insects, diseases, or
other similar causes, the taxpayer need not under such circumstances separate wines
into separate items on the basis that some of the grapes used to make wine, otherwise
made with estate grapes, were purchased.

For purposes of defining an item of wine, the terms “process,” “recipe,” “formula,” and
“program” mean a set of directions, techniques, or procedures regularly followed, as
well as a set of ingredients regularly used, to produce a distinct product (i.e., wine with
specific taste, quality or grade, cost, and price point). For example, if the taxpayer uses
different quality grapes of the same varietal to produce a high quality wine and a
medium quality wine, the two wines should be treated as separate items. On the other
hand, if the taxpayer uses the same quality grapes and some of the resulting wine has a
higher quality than, or will be marketed as a different wine from, the remainder of the
wine produced using these grapes, the taxpayer will not treat this wine as two items
based solely on the process, recipe, formula, or program criteria.

As to length of time wine has been aging or in production, wines with different ages or at
different stages of production such as the current year’s production, one-year bulk wine,
and two-year bulk wine, etc., should be separate items. This is because treating wines
that are at different stages of production as the same item would not create an accurate
measure of inflation or result in a correct LIFO index. For example, two-year bulk wine
would have more production and storage costs applied to it than the current year’s
production, or than one-year bulk wine. Therefore, if two-year bulk wine and one-year
bulk wine were treated as the same item for purposes of computing a LIFO index, the
LIFO index would be distorted as a result of the artificial inflation created by the two-
year bulk wine’s additional costs.

POSTF-138399-09 9

B. Application of Criteria to Taxpayer

Bulk Wine Item Definitions

Taxpayer properly applies the above criteria to bulk wine as follows:

    (1) Taxpayer properly defines its bulk wine by varietal. Taxpayer does not need

to distinguish its bulk wine by appellation because Taxpayer only uses grapes grown
within the same appellation.

   (2) Taxpayer properly defines bulk wine by source of grapes. Taxpayer primarily

uses estate-grown grapes. Taxpayer uses purchased grapes only if, and to the extent,
there is a shortfall in the yield of grapes from its vineyard due to weather, insects,
diseases, or other similar causes. Therefore, Taxpayer does not need to distinguish
wine on the basis of the use of purchased grapes versus estate-grown grapes.

   (3) Taxpayer properly defines bulk wine by process, recipe, or formula used.

Taxpayer also properly defines bulk wine by quality. Once Taxpayer‘s Varietal 1 is
determined to be of sufficient quality to be bottled as a “Reserve” wine, this higher-
quality bulk wine becomes a separate item.

   (4) Taxpayer properly defines its bulk wine by the stage of production or length

of time the bulk wine has been aging or in production.

Bottled Wine and Cased Goods Item Definitions

Taxpayer properly applies the above criteria to bottled wine as follows:

  (1) Taxpayer properly defines its bottled wine by varietal. Taxpayer does not

need to distinguish its bottled wine by appellation because Taxpayer only uses grapes
grown within the same appellation.

   (2) Taxpayer properly defines bottled wine by source of grapes. Taxpayer

primarily uses estate-grown grapes. Taxpayer uses purchased grapes only if, and to
the extent, there is a shortfall in the yield of grapes from its vineyard due to weather,
insects, diseases, or other similar causes. Therefore, Taxpayer does not need to
distinguish wine on the basis of the use of purchased grapes versus and estate-grown
grapes.

   (3) Taxpayer properly defines bottled wine by process, recipe, or formula used.

Taxpayer also properly defines bottled wine by quality. Once Taxpayer’s Varietal 1 is
determined to be of sufficient quality to be bottled as a “Reserve” wine, this higher-
quality bulk wine becomes a separate item.

POSTF-138399-09 10

  (4) Taxpayer properly defines bottled wine by length of time it has been aged

and stored.

   (5) Taxpayer properly defines bottled wine by the type and size of container

used. Taxpayer treats as separate items wine bottled in 750 mL containers and 1.5 L
containers.

Based on the facts presented, Taxpayer does not consider goods that do not have
similar characteristics as the same item. Rather, Taxpayer defines items of wine in a
manner that allows for an accurate measure of inflation. Taxpayer appropriately
subdivides bulk wine and bottled wine into inventory items based on factors such as
varietal, quality, length of time of aging, and other criteria noted. Therefore, Taxpayer
properly defines items within its dollar-value LIFO pool for purposes of computing the
LIFO price index of the pool in accordance with § 472 and the regulations thereunder.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 622-4970 if you have any further questions.