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Saving Grapes – How R&D Credits Can Lessen the Pain of Smoke Taint

The year 2020 will be remembered for a lot of things. Many of them are bad. The COVID-19 pandemic forced people to stay home, led to millions being infected and over a million deaths globally. In California, wildfires ravaged the state, with more than 9,600 fires burning more than 4.3 million acres. The blazes destroyed homes, offices, and many agricultural businesses.

California’s multibillion-dollar wine industry was not spared any pain. A pair of wildfires destroyed or damaged around 30 vineyards in Napa and Sonoma counties, and even those wineries lucky enough to have escaped direct damage from the flames still face uncertainty. As we know, a wine vintage is, among other things, a sort of time capsule. The perfect amount of sun and rain produce the best grapes and the best tasting wines.

However, the wildfire produced a tremendous amount of heavy smoke, which releases phenols that absorbed into grapes. Once absorbed, the phenols can bind to molecules in the grape through a process knowns as glycosylation. This affect creates problems during the winemaking and wine ageing process, which can give the wine an ash flavor that is very hard to predict. A smoky taste, while enjoyable in bourbon and whisky, is not typically valued in wine.

Smoke taint has hurt the industry. The USDA’s preliminary grape crush report for 2020 shows a 14 percent drop in the number of tons compared to 2019. That is the lowest tonnage reported in over a decade. The price per ton also fell nearly 17 percent. Many vineyards made the difficult decision that harvesting the grape crop was not worth the time or expense, figuring salvaging the crop was impossible.

But not all went down this path. Many wineries pumped in significant resources into combating the effects of smoke taint in their wines. Some are applying cutting-edge science to salvage smoke-tainted grapes; others are pivoting to novel products like brandy.

For the brave winemakers who explored new processes and products to overcome the tainted grapes, there may be a silver lining from the IRS: a credit on their 2020 tax return.

Many winemakers may already be familiar with the research and development (R&D) credit, but here are the basics for those who are not. The R&D Credit is an incentive program providing a dollar-for-dollar reduction on a company’s tax burden for qualifying research and development expenses. The Reagan administration introduced the credit in 1981, as a way to encourage businesses to invest in innovation.

The credit does not need to be used immediately. Companies can carry it forward for up to 20 years.

Putting money towards innovation is never wrong, but how do you know if your investment in fighting smoke-taint qualifies for the R&D Credit? The IRS uses this four-part test to ensure a given expense passes its criteria:

  1. The Technological in Nature Test. Essentially, this means the research and development must rely on the hard sciences, like engineering, oenology, biology, chemistry, computer science, physics, etc.
  2. The New or Improved Business Component Test. The purpose of the research is to attempt to develop or improve a new or existing business component. A business component can be “any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer.” However, to qualify, the improvement cannot be superficial; it needs to be new or improved functionality, performance, reliability or quality.
  3. The Technical Uncertainty Test. The activities meant to develop or improve a business component need to show an attempt to overcome or eliminate a technical uncertainty or obstacle. There are three types of uncertainty: capability (being able to accomplish the objective), methods (how to get from concept to finished product/design) and final design (how the end product will work/look).
  4. The Process of Experimentation Test. While working to overcome technical uncertainties, there must be evidence there was experimentation to evaluate alternative solutions. This can be accomplished through trial and error, systemic testing, refining, prototyping and other methods. Having successful experiments is not a requirement for the credit. The IRS says failures still qualify.

As you might have guessed, a good many activities directed towards fixing smoke taint would likely pass these four tests. Examples of activities likely to qualify include:

  • Evaluating new techniques to minimize smoke exposure
  • Employing new methods for salvaging fermentations
  • Exploring new product developments or alternatives
  • Lab testing
  • Bringing on new equipment or tools
  • Evaluating clarification methods
  • Evaluating aging methods

It is essential to know there are eight activities the IRS expressly excludes from the R&D Tax Credit. They are:

  1. Research after commercial production. Once the business component is developed to the point where it is ready for use, companies cannot claim further tax credit research.
  2. Adaptation. A business cannot claim the tax credit by merely tailoring the activities to a customer’s requirements.
  3. Duplication. Companies cannot reproduce (either whole or in part) an existing business component previously developed.
  4. Surveys, studies, research relating to management functions. Things like market research, employee training, customer satisfaction surveys, etc., do not qualify for the tax credit.
  5. Software for internal use.
  6. Foreign research. The research must be done in the United States or any of its possession (like Puerto Rico or the U.S. Virgin Islands).
  7. Social science research. As mentioned above, research must be in the hard sciences, not in things like economics, business management, behavioral science, etc.
  8. Funded research. Research funded by contract, grants or a person/government entity does not qualify.

Winemakers can take advantage of the R&D Tax Credit to lower their tax burden. However, determining whether a given activity qualifies for the credit requires a highly specialized tax expert. To minimize the possibility of potentially costly audits, consult a reputable R&D tax specialist before making any critical decisions about your crop. – By Andre Shevchuck, BPM Partner

Andre Shevchuck is a Partner in BPM LLP’s Specialized Tax Services Practice. As a leader of BPM’s Research and Development (R&D) Tax Credit Consulting practice, Andre helps his clients to identify, document, and defend their R&D tax credit claims. He can be reached at AShevchuck@bpmcpa.com.

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