TTB Temporarily Fixes Problem with Fulfillment Warehouse Tax Credits - an “Alternate Procedure” for Paying Taxes & Reporting

By Erin Kelleher and Rob Tobiassen, Compliance Consultant and Former Chief Counsel (TTB)

On Friday, TTB issued an industry circular to help winery licensees struggling with an unintended consequence of the Tax Cuts and Jobs Act (the “Act”)  - - which became effective on January 1 of this year. The “fix” to the problem described below is only temporary and expires on June 30, 2018.  Hopefully that is enough time for a permanent solution to be adopted in a technical corrections bill, or by Rule change.

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The License Piggyback Dilemma – If it Sounds Too Good to be True, it Probably is

However one happens upon the wine industry (love of wine, retirement from a lucrative profession into the countryside to grow premium wine grapes or just good luck), the subject of doing business in a regulated space becomes an issue sooner rather than later. Wine production and sales are subject to a dizzying mix of regulation at the federal and state level, enough to frighten even the most dedicated and well-funded. While regulation cannot be avoided, many people figure there must be an easier way to get started than by locating a facility and applying for the complicated licenses and permits.

Unfortunately, it’s not that simple. This blog post explores the dangers inherent in many of the common work-around solutions brought to us. Do these questions sound familiar?

“I don’t have licenses of my own, but can’t I just use a winery’s licenses to make my wine and get the products to market?”
“I sell a winery my grapes and they make the wine and sell it. Can’t I just have them use my name on the bottle, sell the wine and we split the profits?”
“I have my grapes custom crushed. Can’t I just use the winery’s DTC permits to service the 30 plus states in which I may not legally sell wine?”

These questions all refer to “license piggyback” scenarios, where one winery’s licenses are being used to incubate a new wine brand, or leverage markets foreclosed to non-licensees.

The Problematic Relationship

The problem with any “license piggyback” solution is the same problem facing third party provider (TPP) marketing websites: you cannot “avail” yourself of the privileges of someone else’s license. Specifically, licensees cannot share profits with non-licensees, and unlicensed persons and entities cannot take title to, or sell, alcoholic beverages without a license appropriate to the relationship. This has been ruled on by the California ABC and the New York SLA, and the principle is universal throughout the US alcohol regulatory system. Combine these restrictions with the proliferation of new brands from people using the marketing power of their famous names, and wineries who blithely provide services to their grape growing friends and neighbors for a cut of the profits, and it is easy to see how problematic relationships are born from well-intentioned business deals.

Custom Crush Arrangements

Brand owners are sometimes new to the alcohol beverage industry and its morass of legal restrictions, and do not realize that they need a license to sell wine. They sign standard custom crush agreements with wineries, which mandate somewhere in the fine print (too long; didn’t read) that the brand owner have the licenses to take title to the product. The winery doesn’t follow up, the brand owner cuts a check and moves product to a warehouse, then sells it either direct to consumers, or to a distributor and back into the three tier-system. If the winery allows its license to be used, it has made an unlawful sale and the brand owner has engaged in the purchase and sale of wine without a license. Those are criminal acts under the express terms of the California ABC Act. That is not good for peace of mind or (maybe, we could be wrong about this) running for political office.

Wineries should make sure that their custom crush clients have licenses to take title to the product wineries manufacture for them as part of the vetting process during contract negotiations (either that or they intend to drink the wine themselves, or give it away).

For brand owners, custom crush agreements are necessary if the plan is to obtain licenses to sell the wine at wholesale, or direct to consumers such as with the Type 17/20 license combination in California. If the goal is ultimately to become an alternating proprietor (AP) with a winery license, or an actual winery, we recommend this approach for brand incubation before committing to production equipment and the costs and complexities of an AP or a facility.

For the scenario where a custom crush 17/20 intends to take advantage of the winery’s DTC permits, the relationships between the parties must be carefully structured to operate within the confines of the law, with the winery retaining title to the wine shipped under its permits, and the 17/20 acting as a TPP. This requires a good, clear, contract. A good contract provides a mechanism to not only resolve disputes between the parties, it prevents an aggrieved party in a later dispute from claiming that the underlying relationship was unlawful and therefore the contract between the parties is unenforceable.

Full Service Route to Market Contracts

Sometimes, wineries themselves are not aware of the limitations on their own license privileges and their relationships with non-licensees. We have seen well intentioned wineries offer their clients a full suite of services, including winemaking, brand consulting and turn-key route to market strategies for a cut of the profits from wine sales.

The tricky aspect of these relationships is that ABC has not drawn a clear line distinguishing lawful arrangements from unlawful ones. Wineries can provide services to licensees and non-licensees alike, including brand strategy and consulting services. Wineries cannot perform services that amount to renting out their licenses, and they cannot share profits with non-licensees. Therefore, the extent to which these contracts are lawful is fact specific, and depends on what exactly the contract terms specify.

Licensing/Marketing Agreements

Another approach for brand owners is to never take title to the product, and instead sign Licensing/Marketing Agreements with wineries. These agreements (variations of the TPP relationship) license the brand owner’s intellectual property to the winery, and the brand owners receive compensation for providing marketing services to the winery to facilitate distribution of the products. The arrangements are a good choice for those who cannot hold supplier/wholesale tier licenses, or those who don’t want to bother. There are, however, limitations with this approach. Principally, the prohibition on profit sharing with non-licensees necessitates careful structuring of the compensation portion of the agreements between brand owners and wineries to ensure they don’t cross the regulatory line.

Enforcement

And now the $64,000 question, is this an enforcement priority for ABC? What is the potential liability? Regarding the former question, we are seeing California ABC investigate these relationships with increasing frequency, and we expect more inquiries into these relationships as ABC and the federal authorities understand the number of problematic relationships out there.

The potential liability question is more complicated. ABC has jurisdiction over licensed wineries, and actions against winery licensees have taken the form of fines and license suspensions (revocation is on the table for egregious or deliberate violators). ABC, however, does not have jurisdiction over non-licensees, and would have to engage another agency such as the Attorney’ General’s office to prosecute non-licensees for the sale of alcohol without a license (a criminal misdemeanor in California). This makes it harder for ABC to follow-up on non-licensees, but they could find an example as a warning to the industry. No one wants to be that example.

The other form of liability is contractual responsibility for the failed relationship; and damages. While who a court would find liable if a dispute occurs is a fact specific exercise, that one party was licensed and the other wasn’t would probably resolve for the unlicensed party on the theory that the licensee (as the one responsible for compliance) should have known better.

Another complicated question arises if the unlicensed entity becomes licensed, or is seeking licenses, when the ABC comes knocking. ABC’s Trade Enforcement Unit could hold up license issuance pending an investigation, could ultimately deny licensure based on the unlawful relationship and could file an accusation after the license issues to seek fines and penalties short of revocation.

Best Practices

As with most business endeavors, there is no one-size fits all approach regarding contract winemaking, AP agreements, TPP agreements or brand development. Every situation is unique, and requires a different structure to best utilize the strengths of each party to the venture. Each relationship must be considered carefully in the context of the parties’ goals to comply with the regulations applicable to licensees, and to the prohibitions against selling alcohol without a license.

That all being true, if the new wine industry member takes the time to analyze the goals it has against properly structured relationships, the process will be relatively painless (lawyers and regulators notwithstanding), and should be a lot fun.

More on FDA Inspections - Breweries, Distilleries and Questions

BY:  Barbara Snider, Erin Kelleher and John Hinman

We received some great comments and questions regarding the recent (May 22, 2017) blog “Why the FDA is Inspecting Wineries.”

One of the most common questions was “does the FDA inspect breweries and distilleries?  The answer is a resounding yes. If you are a brewery or a distillery, revisit the original post for more detail.

Breweries and Distilleries.

The bottom line is that the rules are the same for all alcoholic beverages.  Most breweries and distilleries, like wineries, sell their products through general commerce and therefore, must register with the FDA and follow the same Good Manufacturing Practices.  All domestic companies must register unless they are considered a “retail food establishment” or “qualified facility” and are exempted from registering as described below in more detail.

Breweries and distilleries, like wineries, are also exempt from Subpart C (Hazard Analysis and Risk-based Preventative Controls) and Subpart G (Supply-Chain Program) but like wineries, must comply with Subparts A and B (related to sanitary conditions and training of employees in personal hygiene) and Subpart F (recordkeeping).

Breweries and distilleries are also subject to FDA inspections and the best practice is to be aware and prepared.  Therefore, the advice and brief checklists provided in the May 22nd blog apply equally to them. 

The one difference for breweries and distilleries is the disposal of spent grains from the manufacturing process.  In 2014 the FDA caused much consternation with its proposed rule that would require breweries and distilleries wishing to send the spent grain for animal feed to additionally comply with the hazard and risk analyses and a supply chain program under the Animal Food regulations.  (This would be in addition to complying with the human food regulations with which all alcoholic manufacturers must comply). 

The good news is that the FDA listened to the outcry against adding this additional regulatory burden and the current rule provides that processors already implementing human food safety requirements do not need to implement additional preventive controls when simply supplying a by-product (wet spent grains) for animal feed.  Breweries and distilleries are expected to assure that there is no physical contamination of the spent grain before shipping.  For example, contamination by placing trash or cleaning chemicals into the container holding the spent grain.  General sanitary conditions apply to transporting the spent grains for animal feed.

It is important to note, however, that any processor who further “processes” the spent grain for use as animal food (for example, drying, pelleting, heat-treatment) must additionally comply with the Animal Food Good Manufacturing Practices which include developing hazard and risk-analyses and developing preventative controls. 

The brewery or distillery may choose which path to take.

How does the FDA exemption for “Retail Food Establishments” apply to wineries, breweries and distilleries?  

We had many questions about how the exemption (which is not exactly a model of clarity) works.  The exemption as it applies to producers (such as wineries in the initial post but also including breweries and distilleries in this post) is very narrow.

The FDA exemption from the registration requirement is for producers that can demonstrate its primary purpose is to sell product directly to the consumer and that sells more than 51% of their product “out the front door” (“Retail Food Establishments”).  So, the question is whether a producer’s business operations are such that it meets the definition of “Retail Food Establishment.” 

First, even though the initial blog was written for wineries, because all alcoholic beverages are “food,” those breweries or distilleries that may qualify as a “retail food establishment” could possibly also fall under this narrow exception. 

As part of the implementation of the Food Safety Modernization Act (“FSMA”), the FDA amended and expanded the definition of “Retail Food Establishment”.  The official definition of a “retail food establishment” in the Code of Federal Regulations is:

“Retail food establishment means an establishment that sells food products directly to consumers as its primary function. The term “retail food establishment” includes facilities that manufacture, process, pack, or hold food if the establishment's primary function is to sell from that establishment food, including food that it manufactures, processes, packs, or holds, directly to consumers. A retail food establishment's primary function is to sell food directly to consumers if the annual monetary value of sales of food products directly to consumers exceeds the annual monetary value of sales of food products to all other buyers. The term “consumers” does not include businesses. A “retail food establishment” includes grocery stores, convenience stores, and vending machine locations.  A “retail food establishment” also includes certain farm-operated businesses selling food directly to consumers as their primary function.” (Highlighting and emphasis added.)

Therefore, any winery, brewery, distillery that can qualify as a “retail food establishment” demonstrating that its primary purpose is to sell its product directly to consumers will be exempted from the FDA registration requirement. 

This means that the annual monetary value of sales of food products directly to consumers must exceed the annual monetary value of sales of food products to all other buyers (at least 51% direct to consumer sales).  The term “consumers” does not include businesses unless (as discussed below) you operate within in a small local area in the same state (truly local businesses) and can be characterized a “Qualified Facility.” 

The FDA determined that all “direct-to-consumer sales” (DTC) including Internet and mail order sales are included as part of the calculation to determine whether the primary purpose is to sell directly to consumers.  The FDA stated that there is no requirement that DTC must be a face-to-face sale.  Therefore, sales proceeds from Internet and mail catalog DTC sales may be used in the calculation to determine that the primary function is to sell directly to consumers.  Sales made at farmers’ markets, consumer events, directly from tasting rooms and the like are also considered in the calculation. 

Further, while the earlier blog discussed the size requirement needed to qualify as a “retail food establishment” (less than 11 employees) in adopting the final rule, the FDA did away with any employee size requirement to qualify for the retail food establishment exemption stating:  “Even if some establishments that use mail, catalog, and Internet orders in determining their primary function are larger establishments and can reach consumers on a national level, we do not believe that is inconsistent with section 102(c) of FSMA, which does not specify that FDA’s amendment to the retail food establishment definition only pertains to establishments of a specific size.”  

The principal criteria the FDA will use in determining if an establishment qualifies as a “retail food establishment” is whether its primary purpose is to sell its product direct-to-consumer. The FDA’s basic test is whether an establishment’s annual monetary value of sales of food products directly to consumers exceeds the annual monetary value of sales of food products directly to all other buyers, i.e., more than 51% of its sales are direct-to-consumer.

This appears to be another benefit of the alcoholic beverage industry move to DTC (practically and legislatively) where possible. 

“Qualified Facilities”.

We did receive a comment asking us to explain what “Qualified Facilities” means.  This very narrow exemption from the FDA registration requirement applies only to very small businesses that principally operate locally.  Very briefly, a “qualified facility” status applies to those facilities that sell product to consumers, restaurants or “retail food establishments” located in the same state and not located further than 275 miles from the qualified facility.  There are also monetary limits on the value of product sold during the prior 3-year period (less than $500,000 adjusted for inflation).  Attestations and documentation are required.  Should anyone desire more information on this, please call the FDA, your trade association representative, or your attorney.

Recall Procedures.

We received some inquiries asking whether a winery (or brewery/distillery) needs to develop a “Recall Plan” in the case there is need for the recall of the product.  The first point to make is that the TTB has primary control over any recalls for alcoholic beverages and does not require a company under its jurisdiction to prepare a Recall Plan.  While it might be a good idea and a good business practice to have a plan of action regarding what to do if you need to recall a product from the market, know that it is not required by the TTB and the FDA cannot impose that requirement (at least not yet!). 

You should feel comfortable if the FDA inspector asks about your recall plan and you don’t have one (although we do encourage adoption of a recall plan as a basic best practice). 

Conclusion – Be Compliant!

We encourage our clients and friends to approach FDA compliance in the same orderly way that they approach all compliance topics.  There should be an officer or manager of the facility charged with the principal responsibility of compliance with operating regulations – whether labor and employee related, production facility related (use permits and equipment safety under OSHA for example), alcohol production and sales related (ABC, TTB and local state OSS permits) or food product related (FDA and local food service requirements for example). 

The smaller the enterprise of course the more the burden falls on fewer people.  That is also why we encourage checklists and spending quality time with your industry trade associations, who have a vested interest in making sure that their members know the rules.

This is a complex issue with many moving parts.  We encourage you to contact your trade association representative or your attorney with your questions before you get that call informing you that the FDA inspector is on the way.

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