by Roger McEowen, Leonard Dolezal Professor in Agricultural Law, Iowa State University, (515) 294-
4076, mceowen@iastate.edu

The Iowa wine industry has been reborn in recent years. About a century ago,
Iowa was the sixth largest grape producing state in the nation. With
Prohibition, the expanding market for corn and soybeans, damage to grapevines
due to chemical drift from row crops and a severe blizzard in 1940, the
industry declined significantly. However, in the last few years, the industry
has made a comeback. According to the Agricultural Marketing Resource Center
(AgMRC) at Iowa State University, there are now more than 70 wineries in Iowa
that produce more than 240,000 gallons annually. More than 600 acres are
planted to grapes in Iowa. So, while Iowa is not the Napa Valley, grape-
growing is becoming a bigger deal. That makes these two recent rulings, one by
the U.S. Tax Court, and the other by the IRS, important.

The Tax Court case was one that we have been talking about for several months
in anticipation of the court’s opinion. If you attended the ISU Tax Schools
last fall, we covered the case and its importance to agriculture and mentioned
that a decision was expected in early 2007.

The case involved a Sonoma County, California, vineyard and a dispute over the
appropriate depreciation of trellises and irrigation systems. The case had
been watched closely not only by the grape-growing industry, but by
agriculture in general. IRS had taken the position that vineyard trellises and
above-ground irrigation systems were depreciable land improvements rather than
depreciable agricultural equipment. Land improvements are depreciable over 15
years as property with a 20-year class life, while ag equipment is depreciable
over 7 years with a 10-year class life. The taxpayers treated all of the
property (trellises, drip irrigation systems and a well) as ag equipment, and
depreciated the property over seven years. The impact of the IRS position on
the taxpayer meant that they owed an additional $30,000 on their 2002 tax
return.

Both IRS and the taxpayer cited the same 1975 Tax Court case for the tests to
be utilized in determining whether an item is depreciable tangible personal
property. There are six factors for consideration - (1) whether the property
is capable of being moved; (2) whether the property is designed or constructed
to remain permanently in place; (3) whether there are circumstances that show
that the property may or will have to be moved; (4) how difficult and time-
consuming it is to move the property; (5) how much damage the property will
sustain if moved; and (6) how the property is affixed to the land. The
taxpayer argued that the trellises and above-ground irrigation systems are not
inherently permanent and are used as an integral part of the taxpayer’s
production activity. IRS argued that the trellises and irrigation systems, as
a whole, are not moveable and are, therefore, land improvements with the same
20-plus-year lifespan as the vines. IRS pointed to the industry-standard long-
term vineyard leases that protect the large investment in such systems and
describe them as land improvements. Key to the IRS argument was that to move
the system, the taxpayer had to take the entire system apart and, in the
process of taking it apart, pieces of the trellises and irrigation system are
destroyed.

The Tax Court agreed with the IRS as to the irrigation system and the well.
The evidence established that the well, which was permanently affixed to and
not readily removable from the earth, was a permanent land improvement that
could be expected to work for a long time ­ approximately 30 years. While some
of the irrigation system components were above-ground and could be removed,
repaired and maintained, land improvement categorization was overall supported
by the fact that the systems in great part were buried underground. As such,
the court viewed them as permanent structures that were not readily movable.
So, the entire irrigation system, including the above-ground drip lines were
held to be land improvements that are depreciable over 15 years.

However, the court held that the trellises were depreciable ag equipment. The
court reasoned that trellises are synonymous with fencing (fencing is ag
equipment) in that they use posts that are not affixed in concrete (even posts
affixed in concrete have been held to not be land improvements). The trellises
could also be dismantled and moved, the court noted, and the taxpayer had
actually done so in the past. The court also reasoned that the trellises were
like machines inasmuch as the posts, stakes and wires could be adjusted to
train grapevines to produce high-quality grapes. 

The court’s holding that trellises can be depreciated as farm equipment is a
big win for the wine industry. Indeed, that was the most expensive part of the
case for the taxpayers. The case might be appealed. In that event, the main
focus of the case may be on the proper classification of the above-ground
irrigation drip lines. Also, the appellate court may address the potential
application of a 1974 U.S. Court of Claims opinion where the court held that
something as permanent as a whiskey maturation facility (warehouse), when
integral to the production of the product, is tangible personal property. The
Tax Court didn’t address the potential application of that case (it was raised
in the taxpayer’s brief). If it were deemed applicable, that could mean that
all of the items at issue are depreciable as ag equipment. Now, that would
really be big news. Trentadue v. Comr., 128 T.C. No. 8 (2007).

The second development is an IRS ruling involving the uniform capitalization
rules as applied to grapes. Those rules apply to taxpayers that have a long-
term crop with more than a two-year pre-productive period, and operate to bar
deductions for the costs associated with that crop during the pre-productive
period. Instead, the taxpayer has to add the associated costs to their tax
basis in the crop. Production costs can include everything from direct labor
and material costs to indirect rents, taxes and other costs.

The rule is a big deal for farmers in the nursery business, and almost all
tree, vine or bush crops that require at least two years to reach production.
For plants, the pre-productive period begins when the seed is planted or the
plant is first acquired by the taxpayer. The pre-productive period ends when
the plant is ready to be produced in marketable quantities or when the plant
can reasonably be expected to be sold or otherwise disposed of. The pre-
productive period, however, is determined not in light of the taxpayer’s
personal experience but in light of the weighted average pre-productive period
determined on a nationwide basis. The IRS has provided a list of plants grown
in commercial quantities in the U.S. that have a nationwide weighted average
pre-productive period in excess of two years.

The rule is particularly problematic for grape growers. One question has been
whether they have to capitalize all of their expenses up until the time the
wine is sold. That would be a really tough rule for wineries because the wine-
making process can take many years. But, a recent IRS ruling softens the blow.
The ruling says that the IRS will treat grape growing and winery functions as
separate businesses. That’s the case, even though (1) the grapes are never
subject to sale or other disposition (as those terms are used in tax law); and
(2) the taxpayer does not operate their business as two separate and distinct
businesses.

In conjunction with that reasoning, the IRS ruled that the actual pre-
productive period of a grape crop grown for self-use ends no later than the
crushing of the grapes. Extending the pre-productive period beyond crushing
would result in the capitalization of inappropriate costs into a crop that no
longer exists.

As for the costs incurred between the harvest of the grapes and blossoming of
a later crop, IRS ruled that a taxpayer must capitalize the direct costs and
an allocable portion of the indirect costs of producing the vine (such direct
and indirect costs would include, for example, administration costs,
depreciation and repairs on farm buildings and farm overhead). A special
exception for “field costs” (irrigating, fertilizing, spraying and pruning)
applies to the period between harvesting and the sale of the crop. These costs
are not required to be capitalized because they don’t benefit, and are
unrelated to, the harvested crop. They merely maintain and improve the health
of the vines, but they don’t provide any benefits to the crop (which has
already been severed from the vines). That field crop exception, however, ends
when the pre-productive period of the crop ends, which is the onset of the
crush. So, IRS concluded that pre-productive period costs incurred between the
end of the pre-productive period and the blossoming of the later crop are
generally deductible as the cost of maintaining the vine.

The bottom line, therefore, is that costs incurred between the harvest of the
crop and the end of the pre-productive period must be capitalized unless they
are “field costs” that provide no benefit to the already severed crop. ILM
2007 13023 (Nov. 20, 2006).