                                               CITY LINE CANDY & TOBACCO CORP., PETITIONER v.
                                                     COMMISSIONER OF INTERNAL REVENUE,
                                                                RESPONDENT
                                                    Docket No. 31303–08.                  Filed November 19, 2013.

                                                P, a corporation, is a reseller and licensed wholesale dealer
                                              of cigarettes in New York. New York law provides that all
                                              cigarettes possessed for sale must bear a stamp issued by the
                                              New York tax commissioner. N.Y. Tax Law sec. 471(1)
                                              (McKinney 2006 & Supp. 2013). Pursuant to this law, P, a

                                     414




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         415


                                              licensed cigarette stamping agent for New York, purchases
                                              cigarette packs for sale, purchases and affixes cigarette tax
                                              stamps to those cigarette packs, and sells the stamped ciga-
                                              rette packs to subjobbers and retailers in New York City and
                                              throughout New York State. Under New York law, P is
                                              required to include, and did include, the cost of the cigarette
                                              tax stamps in the sale price of the cigarettes. P uses the
                                              accrual method of accounting and a fiscal year ending Oct. 31.
                                              For all relevant years P computed its gross receipts from ciga-
                                              rette sales for financial statement purposes by totaling the
                                              gross sale prices of the cigarettes sold during each year. How-
                                              ever, for income tax reporting purposes P adjusted its gross
                                              receipts from cigarette sales by subtracting the approximate
                                              cost of cigarette tax stamps purchased during the fiscal year
                                              and reporting as its gross receipts the resulting net amount.
                                              P argued that its average annual gross receipts (determined
                                              for income tax reporting purposes) for the three-taxable-year
                                              period ending with the taxable year preceding each of the
                                              years in issue did not exceed $10 million. P contends that it
                                              therefore qualifies for the small reseller exception under
                                              I.R.C. sec. 263A(b)(2)(B) for each of the years in issue and con-
                                              sequently is not required to comply with the uniform capital-
                                              ization (UNICAP) rules of I.R.C. sec. 263A with respect to the
                                              cigarettes it acquired for resale. Held: R correctly determined
                                              P’s gross receipts for each of the years in issue on the basis
                                              of the entire sale price of the cigarettes it sold, including that
                                              part of the sale price attributable to the cost of the cigarette
                                              tax stamps. Held, further, P is subject to the UNICAP rules
                                              of I.R.C. sec. 263A because P failed to prove that its average
                                              annual gross receipts for the three-taxable-year period ending
                                              with the taxable year preceding each of the years in issue,
                                              correctly calculated to include the entire sale price of the ciga-
                                              rettes it sold, did not exceed $10 million for any of the years
                                              in issue. Held, further, the cigarette tax stamp costs are
                                              indirect costs that must be capitalized under the UNICAP
                                              rules. Held, further, the cigarette tax stamp costs are han-
                                              dling costs that R properly allocated, in part, to P’s ending
                                              inventory using the simplified resale method.

                                           Felipe E. Orner, for petitioner.
                                           Mimi M. Wong, for respondent.
                                       MARVEL, Judge: In a notice of deficiency respondent deter-
                                     mined deficiencies in petitioner’s Federal income tax of
                                     $96,908 and $9,901 for the taxable years ending (TYE)




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                                     416                 141 UNITED STATES TAX COURT REPORTS                                      (414)


                                     October 31, 2004 and 2006, respectively. 1 After concessions, 2
                                     the issues for decision are: (1) whether petitioner qualifies for
                                     the small reseller exception to the uniform capitalization
                                     (UNICAP) rules of section 263A; 3 if not, (2) whether the New
                                     York cigarette stamp tax petitioner incurred is an indirect
                                     cost that it must capitalize under the UNICAP rules; and, if
                                     so, (3) whether respondent properly allocated a portion of
                                     that cost to petitioner’s ending inventory using the simplified
                                     resale method.

                                                                          FINDINGS OF FACT

                                       Some of the facts have been stipulated. The stipulated
                                     facts and facts drawn from stipulated exhibits are incor-
                                     porated herein by this reference. When petitioner filed its
                                     petition, its principal place of business was in New York.
                                     I. Background
                                       New York law imposes a tax on all cigarettes possessed for
                                     sale. N.Y. Tax Law sec. 471(1) (McKinney 2006 & Supp.
                                     2013). That tax is collected through the sale of cigarette tax
                                     stamps issued by the New York tax commissioner under a
                                     provision that requires that all cigarettes possessed for sale
                                        1 Respondent determined an overpayment of $861 for TYE October 31,

                                     2005.
                                        2 With the exception of costs related to the cigarette tax stamps, the par-

                                     ties stipulated the allocation of petitioner’s costs as follows:

                                                               Handling                                 General      Indirect costs—
                                           TYE 10/31           & storage           Purchasing          & admin.       nonallocable
                                             2004                  $35,068           $44,856           $128,014          $292,034
                                             2005                   28,135            36,334            116,818           254,331
                                             2006                   28,019            40,064            121,354           289,856

                                     The parties also stipulated adjustments for insurance expenses and for pe-
                                     titioner’s ‘‘cost of goods sold—purchases’’ as follows:

                                                                         Insurance                        Cost of goods sold—
                                           TYE 10/31                      expenses                              purchases
                                          2004                 $33,164                      $6,362,650
                                          2005                  24,557                       5,852,508
                                       3 Unless otherwise indicated, all section references are to the Internal

                                     Revenue Code (Code) in effect for the years in issue, and all Rule ref-
                                     erences are to the Tax Court Rules of Practice and Procedure. Monetary
                                     amounts have been rounded to the nearest dollar.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         417


                                     must bear such a stamp. Id. For the relevant tax years, New
                                     York State and New York City each imposed a cigarette
                                     stamp tax of $1.50 per pack, or $15 per carton.
                                        As part of its cigarette tax collection efforts the New York
                                     State Department of Taxation and Finance licenses cigarette
                                     stamping agents (stamping agents). A stamping agent pur-
                                     chases unstamped cigarettes from tobacco manufacturers and
                                     purchases cigarette tax stamps 4 from either New York State
                                     or New York City. The stamping agent affixes the appro-
                                     priate cigarette tax stamp to each cigarette package in its
                                     possession as evidence that the cigarette stamp tax has been
                                     paid and then sells the stamped cigarette packages to
                                     licensed retailers, subjobbers, or vending machine operators
                                     for sale to consumers. The stamping agent must include the
                                     cost of the cigarette tax stamp in the sale price of the ciga-
                                     rettes. Id. sec. 471(3).
                                        Petitioner is a corporation engaged in the wholesale
                                     trading of tobacco. Petitioner purchases tobacco products
                                     from various manufacturers and resells them to subjobbers
                                     and retailers in New York State, both in and out of New
                                     York City. Petitioner also is a licensed cigarette stamping
                                     agent for New York. Petitioner purchased cigarette tax
                                     stamps, and thereby paid cigarette stamp taxes, totaling
                                     $5,823,394, $4,842,912, and $5,005,152 for TYE October 31,
                                     2004 (2004), October 31, 2005 (2005), and October 31, 2006
                                     (2006), respectively.
                                     II. Petitioner’s Accounting Methods and Financial Statements
                                       For all relevant years petitioner used the accrual method
                                     of accounting for income and expenses and the first-in, first-
                                     out method of accounting for inventory. Petitioner did not
                                     introduce its financial statements for each of the relevant
                                     years into evidence. However, the profit and loss statement
                                     for 2004 that is in the record confirms that for financial
                                     statement purposes petitioner calculated its gross receipts
                                     from cigarette sales by totaling the gross sale prices of ciga-
                                     rettes sold without any reduction for the cost of the cigarette
                                     tax stamps that was included in the sale prices.
                                       4 During the years in issue cigarette tax stamps were sold in rolls of

                                     30,000. Petitioner purchased a roll of tax stamps from New York State as
                                     needed, approximately every three to four days.




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                                     418                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     III. Petitioner’s Tax Reporting and the Notice of Deficiency
                                        Petitioner timely filed its Forms 1120, U.S. Corporation
                                     Income Tax Return, for 2004–06. Petitioner reported gross
                                     receipts of $6,919,789, $6,214,867, and $6,420,823 for 2004,
                                     2005, and 2006, respectively. Petitioner calculated its gross
                                     receipts for income tax purposes by subtracting from its gross
                                     receipts from cigarette sales the approximate total cost of the
                                     cigarette tax stamps it purchased during each year.
                                        Following an examination of petitioner’s income tax
                                     returns for 2004–06 respondent mailed to petitioner the
                                     notice of deficiency for 2004 and 2006. In the notice of defi-
                                     ciency respondent determined that petitioner had under-
                                     reported its gross receipts for each taxable year in an amount
                                     approximately equal to the cost of the cigarette tax stamps
                                     purchased during that taxable year. 5 Consequently,
                                     respondent determined that petitioner had additional gross
                                     receipts of $5,823,394, $4,842,912, and $5,005,152 for 2004,
                                     2005, and 2006, respectively.
                                        As a result of the adjustments to petitioner’s gross receipts,
                                     respondent also determined that petitioner’s average annual
                                     gross receipts for the three-taxable-year period ending with
                                     the taxable year preceding each of 2004–06 exceeded $10 mil-
                                     lion and therefore it was subject to the UNICAP rules of sec-
                                     tion 263A. 6 Under the UNICAP rules, petitioner was
                                     required to include a portion of certain direct and indirect
                                     costs in inventory costs. Respondent classified the cigarette
                                     tax stamp costs as general and administrative costs and
                                     determined that petitioner’s indirect costs for handling and

                                           5 The
                                               parties stipulated that petitioner ‘‘purchased cigarette stamps and
                                     paid to New York state cigarette stamp taxes’’ of $5,823,394, $4,842,912,
                                     and $5,005,152 for 2004, 2005, and 2006, respectively. Under N.Y. Tax
                                     Law sec. 472(1) (McKinney 2006 & Supp. 2013), stamping agents may re-
                                     tain a specified percentage of collected cigarette stamp taxes as compensa-
                                     tion for their duties. Neither party addressed whether petitioner included
                                     such commissions in calculating its gross receipts or in calculating the cost
                                     of cigarette tax stamps it incurred.
                                        6 Sec. 263A(b)(2)(B) provides that certain taxpayers are excepted from

                                     complying with the UNICAP rules ‘‘if the average annual gross receipts of
                                     the taxpayer (or any predecessor) for the 3-taxable year period ending with
                                     the taxable year preceding such taxable year do not exceed $10,000,000.’’




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                           419


                                     storage, purchasing, general and administrative, and indirect
                                     costs—nonallocable expenses were as follows: 7
                                                             Handling                                   General       Indirect costs—
                                       TYE 10/31             & storage          Purchasing             & admin.        nonallocable

                                             2004             $80,251             $96,951              $5,959,471          $186,986
                                             2005              65,038              81,090               4,962,092           151,246
                                             2006              79,740             100,970               5,143,209           205,756

                                     Using the simplified resale method without historic absorp-
                                     tion (simplified resale method), respondent determined that
                                     petitioner had additional section 263A capitalizable costs for
                                     2004, 2005, and 2006 of $6,282, $3,963, and $6,268, respec-
                                     tively. Respondent calculated the additional section 263A
                                     capitalizable costs as the product of the combined absorption
                                     ratio and petitioner’s purported section 471 costs 8 at the end
                                     of the year. 9
                                           7 In
                                            the notice of deficiency respondent determined that the cigarette tax
                                     stamp costs were general and administrative costs and referenced sec.
                                     1.263A–1(e)(4)(i)(A), Income Tax Regs., which defines service costs as ‘‘indi-
                                     rect costs (e.g., general and administrative costs) that can be identified
                                     specifically with a service department or function or that directly benefit
                                     or are incurred by reason of a service department or function.’’
                                       8 Respondent calculated petitioner’s sec. 471 costs as $246,304, $186,921,

                                     and $239,823 for 2004, 2005, and 2006, respectively. Respondent appears
                                     to have calculated petitioner’s sec. 471 costs as the sum of: (1) storage and
                                     handling costs; (2) purchasing costs; and (3) the product of petitioner’s gen-
                                     eral and administrative costs and the storage and handling cost absorption
                                     ratio for the relevant year. However, in calculating the storage and han-
                                     dling cost absorption ratio for each year, respondent used a value in the
                                     numerator that differed from petitioner’s total storage and handling costs
                                     for the year. Respondent likewise used a value in the numerator of the
                                     purchasing cost absorption ratio that differed from petitioner’s total pur-
                                     chasing costs for the year.
                                       Respondent has not adequately explained, either in the notice of defi-
                                     ciency or in his posttrial briefing, how he came up with the numbers used
                                     in the calculations attached to the notice of deficiency. It appears to the
                                     Court that respondent made mistakes in adjusting petitioner’s inventory in
                                     the notice of deficiency, and he appears to have conceded as much. How-
                                     ever, on brief respondent appears to be equivocating on his position regard-
                                     ing mistakes in the calculations attached to the notice of deficiency. We ex-
                                     pect respondent in his Rule 155 computation to explain each of the values
                                     used and to identify clearly how he made the computation of any defi-
                                     ciencies resulting from this Opinion.
                                       9 After filing a petition with this Court petitioner filed an appeal with

                                     the Internal Revenue Service Appeals Office. Appeals Officer Marco
                                                                                                        Continued




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                                     420                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                        In the notice of deficiency respondent further determined
                                     that petitioner must increase its inventory costs for 2004,
                                     2005, and 2006 by $252,586, $190,884, and $246,091, respec-
                                     tively. Respondent arrived at these additional amounts by
                                     adding the additional section 263A costs for each year and
                                     petitioner’s purported section 471 costs for each year.
                                     Respondent then added the amount of the increase to peti-
                                     tioner’s ending inventory to calculate its adjusted ending
                                     inventory for each of the taxable years in issue. 10

                                                                                 OPINION

                                     I. Burden of Proof
                                       Ordinarily, the Commissioner’s determinations in a notice
                                     of deficiency are presumed correct and the taxpayer bears
                                     the burden of proving that they are incorrect. Rule 142(a);
                                     Welch v. Helvering, 290 U.S. 111, 115 (1933). However, the
                                     burden of proof will shift to the Commissioner if the taxpayer
                                     proves that the determinations are arbitrary, capricious, or
                                     unreasonable. Paccar, Inc. v. Commissioner, 85 T.C. 754, 787
                                     (1985), aff ’d, 849 F.2d 393 (9th Cir. 1988). Concessions by
                                     the Commissioner at or during the course of trial ordinarily

                                     Minervini (AO Minervini) prepared a number of spreadsheets purporting
                                     to calculate petitioner’s inventory costs under the UNICAP rules. AO
                                     Minervini allocated petitioner’s handling and storage, purchasing, and gen-
                                     eral and administrative costs using the values stipulated, see supra note
                                     2, rather than using the values in the notice of deficiency. In the first
                                     spreadsheet AO Minervini determined that 100% of the cigarette tax
                                     stamp costs were indirect costs not allocable to handling and storage, pur-
                                     chasing, or general and administrative costs, and calculated that petitioner
                                     had additional sec. 263A capitalizable costs for 2004, 2005, and 2006 of
                                     $1,376, $1,809, and $2,228, respectively. In the second spreadsheet AO
                                     Minervini allocated 50% of the cigarette tax stamp costs to handling costs
                                     and 50% to indirect costs not allocable to handling and storage, pur-
                                     chasing, or general and administrative costs and calculated that petitioner
                                     had additional sec. 263A capitalizable costs for 2004, 2005, and 2006 of
                                     $53,423, $71,836, and $85,796, respectively. In both spreadsheets AO
                                     Minervini used a value for petitioner’s sec. 471 costs for the year that was
                                     equal to its ending inventory for that year as reported on its return.
                                        10 In his spreadsheets AO Minervini determined that petitioner must in-

                                     crease its inventory costs for 2004, 2005, and 2006 by the amounts of addi-
                                     tional sec. 263A capitalizable costs, described supra note 9. In calculating
                                     petitioner’s adjusted ending inventory AO Minervini added the additional
                                     sec. 263A capitalizable costs to its ending inventory value for each year.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                          421


                                     are insufficient to shift the burden of proof to the Commis-
                                     sioner. Gobins v. Commissioner, 18 T.C. 1159, 1168–1169
                                     (1952), aff ’d per curiam, 217 F.2d 952 (9th Cir. 1954); see
                                     also Engles Coin Shop, Inc. v. Commissioner, T.C. Memo.
                                     1983–561.
                                       Petitioner appears to argue that the determinations in the
                                     notice of deficiency are arbitrary, capricious, or unreasonable
                                     and therefore the burden of proof is on respondent. Petitioner
                                     relies on the fact that during these proceedings respondent
                                     stipulated an allocation of handling and storage, purchasing,
                                     and general and administrative costs different from the
                                     allocation in the notice of deficiency. 11
                                       The mere fact that respondent stipulated an alternative
                                     cost allocation is insufficient to shift the burden of proof to
                                     him. While it appears that in the notice of deficiency
                                     respondent may have made some mistakes in calculating the
                                     required adjustments under section 263A, those mistakes are
                                     not sufficient to support a finding that his determinations
                                     regarding petitioner’s gross receipts and its obligation to
                                     adhere to the rules of section 263A were arbitrary, capri-
                                     cious, or unreasonable.
                                       We conclude that petitioner bears the burden of proving
                                     that respondent’s determinations are incorrect. See Rule
                                     142(a). 12
                                     II. Application of Section 263A
                                           A. Introduction to Section 263A
                                       Congress enacted section 263A as part of the Tax Reform
                                     Act of 1986, Pub. L. No. 99–514, sec. 803(a), 100 Stat. at
                                           11 Petitioner
                                                     also contends that the determinations in the notice of defi-
                                     ciency are arbitrary, capricious, or unreasonable because respondent used
                                     an incorrect methodology in calculating its inventory costs under sec.
                                     263A. However, the parties stipulated that in the notice of deficiency re-
                                     spondent applied the simplified resale method without historic absorption,
                                     a method expressly permitted under sec. 263A.
                                        12 Under sec. 7491(a) the burden of proof shifts to the Commissioner if

                                     the taxpayer produced credible evidence to support the deduction or posi-
                                     tion, the taxpayer complied with the substantiation requirements, and the
                                     taxpayer cooperated with the Secretary with regard to all reasonable re-
                                     quests for information. Petitioner does not contend that sec. 7491(a) ap-
                                     plies, and it has not introduced evidence to prove it satisfied the require-
                                     ments of sec. 7491(a).




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                                     422                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     2350. In enacting section 263A, Congress intended that a
                                     single, comprehensive set of rules should govern capitaliza-
                                     tion of the costs of producing, acquiring, and holding prop-
                                     erty for resale to more accurately reflect income and create
                                     a more neutral tax system. See Suzy’s Zoo v. Commissioner,
                                     273 F.3d 875, 879 (9th Cir. 2001), aff ’g 114 T.C. 1 (2000); S.
                                     Rept. No. 99–313, at 140 (1986), 1986–3 C.B. (Vol. 3) 1, 140.
                                     Whether an expenditure is deductible 13 or must be capital-
                                     ized is a question of fact. INDOPCO, Inc. v. Commissioner,
                                     503 U.S. 79, 86 (1992).
                                        Under section 263A a taxpayer must capitalize certain
                                     direct and indirect costs allocable to real or personal property
                                     that the taxpayer has acquired for resale. See also sec.
                                     1.263A–3(a)(1), Income Tax Regs. If the resale property is
                                     inventory in the taxpayer’s hands, the taxpayer must include
                                     the direct and indirect costs in inventory costs. Sec.
                                     263A(a)(1)(A). Direct costs include ‘‘the acquisition costs of
                                     property acquired for resale.’’ Sec. 1.263A–1(e)(2)(ii), Income
                                     Tax Regs. Indirect costs include all costs, other than direct
                                     costs, properly allocable to property acquired for resale. Sec.
                                     1.263A–1(e)(3)(i), Income Tax Regs.
                                           B. The Small Reseller Exception
                                       Under section 263A(b)(2)(B) a taxpayer is excepted from
                                     complying with the UNICAP rules of section 263A with
                                     respect to certain property acquired for resale ‘‘if the average
                                     annual gross receipts of the taxpayer (or any predecessor) for
                                     the three-taxable-year period ending with the taxable year
                                     preceding such taxable year do not exceed $10,000,000’’
                                     (small reseller exception). 14 A reseller is a taxpayer who
                                       13 Sec. 162(a) authorizes a taxpayer to deduct ordinary and necessary

                                     business expenses paid or incurred during the taxable year in carrying on
                                     the taxpayer’s trade or business. Advertising and other selling expenses
                                     are deductible under sec. 162(a). See sec. 1.162–1(a), Income Tax Regs.
                                     However, no deduction is available for items used by the taxpayer in com-
                                     puting the cost of inventory property. See id.
                                       14 Two types of resellers must satisfy additional requirements to qualify

                                     for the small reseller exception. If the reseller produces property, the re-
                                     seller qualifies for the exception only if the reseller meets the gross re-
                                     ceipts test, see sec. 263A(b)(2)(B), and the reseller’s production activities
                                     are de minimis, see sec. 1.263A–3(a)(2)(ii) and (iii), Income Tax Regs. If the
                                     reseller is treated as producing property because property is produced
                                     under contract for the reseller, the reseller qualifies for the exception only




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         423


                                     acquires for resale (1) property the taxpayer includes in
                                     inventory if on hand at the end of the year, and (2) property
                                     the taxpayer holds primarily for sale to customers in the
                                     ordinary course of business. See sec. 1.263A–3(a)(1), Income
                                     Tax Regs.
                                           1. Parties’ Arguments
                                       Petitioner contends that it qualifies for the small reseller
                                     exception because its average annual gross receipts for each
                                     of the years in issue did not exceed $10 million. 15 According
                                     to petitioner, respondent erred by including in its gross
                                     receipts proceeds attributable to collection of the New York
                                     cigarette stamp tax. Petitioner contends that New York law
                                     imposes the cigarette stamp tax on consumers, not stamping
                                     agents or wholesalers; therefore, gross receipts do not include
                                     proceeds attributable to collection of the cigarette stamp tax.
                                     Petitioner further contends that if in calculating its gross
                                     receipts for Federal income tax purposes it properly sub-
                                     tracted the cost of the cigarette tax stamps it purchased,
                                     then respondent’s determinations that petitioner under-
                                     reported its gross receipts and that petitioner is subject to
                                     the UNICAP rules of section 263A are erroneous because
                                     petitioner’s average annual gross receipts did not exceed the
                                     $10 million threshold for the relevant years.
                                       Respondent contends that petitioner does not qualify for
                                     the small reseller exception. Respondent explains that
                                     because New York law requires petitioner to add the cost of

                                     if the reseller meets the gross receipts test, see sec. 263A(b)(2)(B), and ‘‘if
                                     the contract is entered into incident to the resale activities of the small re-
                                     seller and the property is sold to its customers’’, see sec. 1.263A–3(a)(3), In-
                                     come Tax Regs.; see also Suzy’s Zoo v. Commissioner, 273 F.3d 875, 880–
                                     881 (9th Cir. 2001), aff ’g 114 T.C. 1 (2000).
                                        15 Petitioner also contends that it qualifies for the small reseller excep-

                                     tion because it is a small reseller with de minimis production activity. An
                                     analysis of whether a reseller has de minimis production activity is rel-
                                     evant only if the reseller satisfies the gross receipts test of sec.
                                     263A(b)(2)(B). If the reseller produces property, the reseller is excepted
                                     from complying with the UNICAP rules only if the reseller satisfies the
                                     gross receipts test and the de minimis production activity requirement.
                                     Sec. 1.263A–3(a)(2)(ii) and (iii), Income Tax Regs.; see also Suzy’s Zoo v.
                                     Commissioner, 273 F.3d at 880–881. Because we find that petitioner’s av-
                                     erage annual gross receipts for the relevant periods exceeded $10 million,
                                     we need not decide whether its production activity was de minimis.




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                                     424                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     the cigarette tax stamps to the cigarette sale price, it must
                                     include in gross receipts the entire gross sale price, including
                                     that part of its gross sale price approximately equal to the
                                     cost of cigarette tax stamps it incurred during each taxable
                                     year. Respondent asserts that after petitioner’s gross receipts
                                     are reconstructed, its average annual gross receipts for the
                                     relevant testing periods for each year in issue exceed $10
                                     million.
                                       Accordingly, we first must decide whether for purposes of
                                     determining qualification for the small reseller exception,
                                     petitioner’s gross receipts should include the cost of the ciga-
                                     rette tax stamps it purchased during each taxable year.
                                           2. Calculation of Petitioner’s Gross Receipts Under Section
                                              263A(b)(2)(B)
                                        For purposes of the small reseller exception, section
                                     1.263A–3(b)(2)(i), Income Tax Regs., defines gross receipts as
                                     ‘‘the total amount, as determined under the taxpayer’s
                                     method of accounting, derived from all of the taxpayer’s
                                     trades or businesses (e.g., revenues derived from the sale of
                                     inventory before reduction for cost of goods sold).’’ 16 Section
                                     1.263A–3(b)(2)(ii), Income Tax Regs., however, excludes cer-
                                     tain items from the definition of gross receipts for purposes
                                     of the small reseller exception:
                                             (ii) Amounts excluded. * * * gross receipts do not include amounts
                                           representing—
                                             (A) Returns or allowances;
                                             (B) Interest, dividends, rents, royalties, or annuities, not derived in the
                                           ordinary course of a trade or business;
                                             (C) Receipts from the sale or exchange of capital assets, as defined in
                                           section 1221;
                                             (D) Repayments of loans or similar instruments * * *;
                                             (E) Receipts from a sale or exchange not in the ordinary course of busi-
                                           ness * * *, and
                                             (F) Receipts from any activity other than a trade or business or an
                                           activity engaged in for profit.

                                       By reason of the above, calculating petitioner’s gross
                                     receipts for purposes of the small reseller exception requires
                                     a two-step inquiry: (1) whether, under its accrual method of
                                        16 This calculation is consistent with the calculation of gross income in

                                     sec. 1.61–3(a), Income Tax Regs. (gross income derived from a business is
                                     ‘‘the total sales, less the cost of goods sold’’).




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                          425


                                     accounting, petitioner’s gross receipts for each taxable year
                                     in issue included the entire sale price of the cigarettes it sold,
                                     including the amount attributable to cigarette tax stamps it
                                     purchased during the year; and, if we answer the first
                                     inquiry in the affirmative, (2) whether section 1.263A–
                                     3(b)(2)(ii), Income Tax Regs., excludes from gross receipts the
                                     approximate cost of cigarette tax stamps purchased during
                                     each year.
                                           a. Petitioner’s Method of Accounting
                                        Petitioner used the accrual method of accounting for the
                                     years in issue. Under the accrual method of accounting, a
                                     taxpayer must recognize income for the year in which the
                                     taxpayer accrues the income. See, e.g., sec. 451(a). A taxpayer
                                     accrues income when the all-events test has been met,
                                     meaning that the taxpayer’s right to the income is fixed and
                                     the taxpayer can determine the amount of the income with
                                     reasonable accuracy. Sec. 1.451–1(a), Income Tax Regs.
                                        The only financial statement that petitioner introduced
                                     was its 2004 ‘‘Profit and Loss’’ statement, which shows total
                                     sales of $12,767,183. We infer from the profit and loss state-
                                     ment that petitioner determined its total sales under its
                                     accrual method of accounting for financial accounting pur-
                                     poses by totaling its gross receipts from cigarette sales
                                     during the taxable year without any reduction for the cost of
                                     cigarette tax stamps purchased during that year. Petitioner
                                     then deducted cost of goods sold, including the cost of the
                                     cigarette tax stamps, from its gross receipts to arrive at gross
                                     profit before expenses. 17
                                        In contrast, petitioner calculated its gross receipts for
                                     income tax reporting purposes by subtracting from its gross
                                     receipts from cigarette sales the approximate cost of cigarette
                                     tax stamps purchased during the fiscal year and reporting as
                                     its gross receipts the resulting net amount. Mr. Kun Sang
                                     Ruy, one of petitioner’s shareholders, testified that the

                                           17 Petitioner
                                                     did not introduce into evidence financial statements for any
                                     other taxable years. In the absence of any proof to the contrary, we infer
                                     from the profit and loss statement in the record that petitioner calculated
                                     its gross receipts for the other years in issue in a manner similar to that
                                     used on the profit and loss statement for 2004.




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                                     426                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     amount reported as gross receipts on its tax returns reflected
                                     a ‘‘net’’ amount.
                                        For tax and financial accounting purposes a taxpayer must
                                     first calculate total sales revenue determined in accordance
                                     with its method of accounting. For financial accounting pur-
                                     poses petitioner did just that. For income tax reporting pur-
                                     poses, however, petitioner reduced its total gross receipts
                                     from cigarette sales by the cost of the cigarette tax stamps
                                     it purchased during the taxable year to arrive at a gross
                                     receipts figure that was substantially lower than the figure
                                     used for financial accounting purposes.
                                        Petitioner’s profit and loss statement for 2004 confirms
                                     that under its accrual method of accounting it included all of
                                     the gross receipts generated by its sale of cigarettes during
                                     the taxable year, including gross receipts attributable to the
                                     cigarette tax stamps affixed to the cigarette packs before
                                     sale, in calculating its gross receipts from cigarette sales.
                                     This approach is consistent with New York law, which
                                     requires a stamping agent to include the cost of the cigarette
                                     tax stamp in the sale price of the cigarettes. See N.Y. Tax
                                     Law sec. 471(3). Petitioner’s efforts to show that it qualified
                                     as a small reseller by reducing its gross receipts for each tax-
                                     able year in an amount approximately equal to the cost of
                                     cigarette tax stamps it purchased during the year were
                                     inconsistent with its accrual method of accounting and with
                                     applicable New York law. Consequently, we find that the
                                     small reseller exception does not apply because gross receipts
                                     for each taxable year in issue should not be reduced by an
                                     amount representing the cost of cigarette tax stamps pur-
                                     chased during that year.
                                           b. Whether the Cost of Cigarette Tax Stamps Is a Tax Pro-
                                              perly Excluded From Gross Receipts
                                       Although petitioner’s arguments are not entirely clear, we
                                     interpret them to be that for purposes of determining eligi-
                                     bility for the small reseller exception, the cost of the cigarette
                                     tax stamps should be subtracted in calculating gross receipts
                                     because either: (1) section 1.263A–3(b)(2), Income Tax Regs.,
                                     permits or requires the subtraction; or (2) sales tax or other
                                     similar State and local taxes are subtracted in computing
                                     gross receipts if, under applicable State or local law, the tax




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         427


                                     legally is imposed on the purchaser of the good or service and
                                     the taxpayer merely collects and remits the tax to the taxing
                                     authority. We address each of these arguments below.
                                           i. Effect of Section 1.263A–3(b)(2) and (3), Income Tax
                                              Regs.
                                        In specifying how gross receipts are calculated for purposes
                                     of the small reseller exception, section 1.263A–3(b)(2),
                                     Income Tax Regs., excludes several enumerated items but
                                     makes no reference to taxes. Because taxes are not specifi-
                                     cally listed as an exclusion under section 1.263A–3(b)(2)(ii),
                                     Income Tax Regs., the regulation provides no support for
                                     petitioner’s argument that the regulation requires the cost of
                                     the cigarette tax stamps it purchased during the relevant
                                     years to be excluded from the calculation of gross receipts for
                                     purposes of the small reseller exception.
                                        Petitioner points out that section 263A(b)(2)(C) requires
                                     gross receipts to be calculated for purposes of the small re-
                                     seller exception using rules similar to those of paragraphs (2)
                                     and (3) of section 448(c). Respondent disagrees because sec-
                                     tion 263A(b)(2)(C) provides that the section 448(c) rules apply
                                     for aggregation purposes only.
                                        Section 1.263A–3(b)(3), Income Tax Regs., discusses the
                                     aggregation of gross receipts for purposes of the small re-
                                     seller exception. The aggregation concept embodied therein,
                                     under which multiple persons treated as a single employer
                                     under section 52(a) or (b) or section 414(m) are treated as
                                     one taxpayer for purposes of the small reseller exception,
                                     simply does not apply because there is only one taxpayer
                                     involved in this case. Consequently, we reject petitioner’s
                                     argument that the aggregation rules of section 1.263A–
                                     3(b)(2) and (3), Income Tax Regs., support its calculation of
                                     its gross receipts.
                                           ii. The Character of the New York Cigarette Tax
                                        In its opening brief petitioner addresses the issue of
                                     whether the cigarette stamp tax is imposed on the stamping
                                     agents, wholesalers, and resellers or on the consumers. Peti-
                                     tioner contends that the tax is imposed on the consumers
                                     and therefore is not includable in the calculation of its gross
                                     receipts for purposes of the small reseller exception. In his




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                                     428                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     reply brief respondent contends that the tax is imposed on
                                     resellers like petitioner.
                                        The parties appear to agree that if the cigarette stamp tax
                                     is imposed on consumers, rather than on resellers, then a re-
                                     seller may exclude from gross receipts the sales proceeds
                                     attributable to collection of the tax. However, neither peti-
                                     tioner nor respondent offered any legal authority for such a
                                     contention, and we are unable to find any support for it. 18
                                     In any event, New York caselaw acknowledges that while the
                                           18 Two
                                               sections of the Code address the taxability of imposed versus col-
                                     lected taxes, although neither party cites either section to support his or
                                     its contention. Sec. 164(a) provides that State, local, and foreign taxes are
                                     deductible by the person on whom the taxes are imposed. See sec. 1.164–
                                     1(a), Income Tax Regs. However, sec. 164(a) addresses only the deduct-
                                     ibility of taxes, not whether taxes should be included in gross receipts.
                                     Consequently, sec. 164(a) is inapplicable with respect to the issue of
                                     whether petitioner must include in gross receipts proceeds attributable to
                                     the cigarette tax stamps.
                                        Sec. 448(c) provides that a taxpayer may use the cash method of ac-
                                     counting if the taxpayer has average annual gross receipts of less than $5
                                     million. See sec. 1.448–1T(f)(2)(iv), Temporary Income Tax Regs., 52 Fed.
                                     Reg. 22772 (June 16, 1987). Sec. 1.448–1T(f)(2)(iv), Temporary Income Tax
                                     Regs., supra, adjusts the calculation of gross receipts for purposes of sec.
                                     448 specifically with respect to amounts attributable to the collection of
                                     taxes as follows:
                                           [G]ross receipts do not include amounts received by the taxpayer with
                                           respect to sales tax or other similar state and local taxes if, under the
                                           applicable state or local law, the tax is legally imposed on the purchaser
                                           of the good or service, and the taxpayer merely collects and remits the
                                           tax to the taxing authority. If, in contrast, the tax is imposed on the tax-
                                           payer under the applicable law, then gross receipts shall include the
                                           amounts received that are allocable to the payment of such tax.
                                       Sec. 1.263A–3(b)(2), Income Tax Regs., provides an explicit definition of
                                     gross receipts for purposes of the small reseller exception, whereas sec.
                                     448(c) and the regulations promulgated thereunder address the calculation
                                     of gross receipts for purposes of determining whether a taxpayer may use
                                     the cash method of accounting. Petitioner uses the accrual method of ac-
                                     counting and is not here contending that it should be permitted to use the
                                     cash method of accounting. In addition, the definitions of gross receipts in
                                     sec. 1.263A–3(b)(2), Income Tax Regs., and sec. 1.448–1T(f)(2)(iv), Tem-
                                     porary Income Tax Regs., supra, are inconsistent and cannot be read to-
                                     gether. For example, while sec. 1.448–1T(f)(2)(iv), Temporary Income Tax
                                     Regs., supra, provides that a taxpayer must include in gross receipts inci-
                                     dental income not derived in the ordinary course of business, sec. 1.263A–
                                     3(b)(2)(ii)(B), Income Tax Regs., excludes such amounts from the gross re-
                                     ceipts calculation.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         429


                                     consumer bears the ultimate liability for the cigarette stamp
                                     tax, the tax is imposed, at least to some degree, on the re-
                                     seller. Schwartz v. Tax Appeals Tribunal of N.Y., 643
                                     N.Y.S.2d 761 (App. Div. 1996); Mandel Tobacco Co. v. State
                                     Tax Comm’n, 397 N.Y.S.2d 23 (App. Div. 1977). We reject
                                     petitioner’s second argument, and we hold that respondent
                                     properly determined petitioner’s gross receipts for purposes
                                     of the small reseller exception using the rules set forth in
                                     section 1.263A–3(b)(2)(ii)(B), Income Tax Regs.
                                           3. Application of the Small Reseller Exception
                                        The testing period for 2004 includes TYE October 31, 2001,
                                     2002, and 2003. The testing period for 2005 includes TYE
                                     October 31, 2002, 2003, and 2004. Petitioner did not intro-
                                     duce any credible evidence to prove the correct amounts of its
                                     gross receipts for TYE October 31, 2001 and 2002.
                                        For each of the taxable years in issue petitioner bears the
                                     burden of proving that its average gross receipts for the
                                     three previous taxable years did not exceed $10 million. Peti-
                                     tioner did not do so. The record does not permit us to cal-
                                     culate petitioner’s actual gross receipts for TYE October 31,
                                     2001 and 2002, two of the years in the relevant testing
                                     periods. Accordingly, we conclude that petitioner has failed to
                                     prove that it met the requirements of the small reseller
                                     exception under section 263A(b)(2)(B) for 2004 and 2005.
                                        The testing period for 2006 includes TYE October 31, 2003
                                     (2003), 2004, and 2005. During the testing period petitioner
                                     had average annual gross receipts of $12,619,009. Petitioner
                                     does not qualify as a small reseller because its average
                                     annual gross receipts for the testing period exceeded $10 mil-
                                     lion.
                                        Because we conclude that respondent correctly calculated
                                     petitioner’s gross receipts for each taxable year in issue by
                                     including the cost of cigarette tax stamps it purchased and
                                     included in the cigarette sale price and because petitioner did
                                     not prove the amounts of its average annual gross receipts
                                     for the testing periods applicable to 2003 and 2004, we find
                                     as follows:




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                                     430                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                                              Gross receipts         Cigarette tax                Total gross
                                           TYE 10/31           per return            stamp costs                   receipts

                                               2001            $9,432,811           Not in record           Unable to determine
                                               2002             8,776,695           Not in record           Unable to determine
                                               2003             7,604,923            $6,451,143                $14,056,066
                                               2004             6,919,789             5,823,394                 12,743,183
                                               2005             6,214,867             4,842,912                 11,057,779

                                     On the basis of these findings we conclude that petitioner
                                     does not qualify for the small reseller exception and that it
                                     is subject to the UNICAP rules of section 263A for the tax-
                                     able years in issue. We therefore must decide whether the
                                     cigarette tax stamp costs petitioner incurred are capitalizable
                                     costs for purposes of the UNICAP rules and if so, how those
                                     costs are characterized and allocated to the cigarettes peti-
                                     tioner acquired for resale.
                                     III. Capitalization of Cigarette Tax Stamp Costs
                                        The UNICAP rules of section 263A require a taxpayer to
                                     capitalize the direct and indirect costs of real or personal
                                     property that the taxpayer acquires for resale. Sec. 263A(a),
                                     (b)(2)(A). For resellers, direct costs are acquisition costs. Sec.
                                     1.263A–1(e)(2)(ii), Income Tax Regs. Indirect costs are costs
                                     allocable to property acquired for resale ‘‘when the costs
                                     directly benefit or are incurred by reason of the performance
                                     of * * * resale activities.’’ Sec. 1.263A–1(e)(3)(i), Income Tax
                                     Regs. Capitalizable indirect costs include taxes ‘‘otherwise
                                     allowable as a deduction to the extent such taxes are attrib-
                                     utable to labor, materials, supplies, equipment, land, or
                                     facilities’’ used in resale activities. Sec. 1.263A–1(e)(3)(ii)(L),
                                     Income Tax Regs. However, a taxpayer is not required to
                                     capitalize certain indirect costs, including ‘‘marketing,
                                     selling, advertising, and distribution costs.’’ 19 Sec. 1.263A–
                                     1(e)(3)(iii)(A), Income Tax Regs.
                                        Neither party argues that the cigarette tax stamp costs are
                                     direct costs. Respondent contends that the cigarette tax
                                     stamp costs are indirect costs that must be capitalized. Peti-
                                     tioner contends that it is not required to capitalize the ciga-
                                           19 Sec.
                                              1.263A–1(e)(3)(iii)(F), Income Tax Regs., provides that a taxpayer
                                     need not capitalize taxes assessed on the basis of income. Because the ciga-
                                     rette stamp tax is not assessed on the basis of income, this provision does
                                     not apply.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                           431


                                     rette tax stamp costs because they are neither costs that
                                     directly benefit or are incurred by reason of its performance
                                     of resale activities nor taxes attributable to labor, material,
                                     or supplies. Petitioner further contends that the cigarette tax
                                     stamp costs are currently deductible selling expenses.
                                     Accordingly, we must decide whether the cigarette tax stamp
                                     costs are indirect costs or currently deductible selling
                                     expenses.
                                           A. Indirect Costs: General Definition
                                       As noted supra, indirect costs are costs allocable to prop-
                                     erty acquired for resale ‘‘when the costs directly benefit or
                                     are incurred by reason of the performance of * * * resale
                                     activities.’’ Sec. 1.263A–1(e)(3)(i), Income Tax Regs. The U.S.
                                     Court of Appeals for the Second Circuit, to which an appeal
                                     in this case would lie, absent a stipulation to the contrary,
                                     see sec. 7482(b)(1)(A), (2), has considered the meaning of the
                                     phrases ‘‘directly benefit’’ or ‘‘incurred by reason of ’’, Robin-
                                     son Knife Mfg. Co. v. Commissioner, 600 F.3d 121, 127 (2d
                                     Cir. 2010), rev’g T.C. Memo. 2009–9. At issue in Robinson
                                     Knife was the proper tax treatment of royalties paid for the
                                     taxpayer’s use of trademarks that it placed on kitchen items
                                     sold to the public. The royalties were payable when the
                                     kitchen items were sold. The Court of Appeals held that for
                                     a cost to be a capitalizable cost, it ‘‘must be a but-for cause
                                     of the taxpayer’s production activities’’. Id. at 131–132. The
                                     taxpayer could have produced the same property, albeit with-
                                     out a trademark, and avoided paying the royalty costs. Id. at
                                     131. The Court of Appeals held that the royalty costs were
                                     not capitalizable costs because the royalty costs ‘‘were cal-
                                     culated as a percentage of net sales’’ and ‘‘were incurred only
                                     upon the sale’’. Id. at 134.
                                       Article 20 of the New York Tax Law provides that a
                                     stamping agent must purchase cigarette tax stamps from the
                                     commissioner and affix those stamps to the cigarette pack-
                                     ages it possesses for resale. N.Y. Tax Law sec. 471(2). As
                                     both a stamping agent and a corporation engaged in the
                                     resale of cigarettes, petitioner must purchase the cigarette
                                     tax stamps. 20 But for the purchase of the cigarette tax
                                           20 While      petitioner could argue that its stamping agent activity is sepa-
                                                                                                        Continued




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                                     432                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     stamps, petitioner could not engage in its business of
                                     reselling cigarettes. The cigarette tax stamp costs are
                                     incurred by reason of petitioner’s resale activity.
                                        Furthermore, the cigarette tax stamp costs differ from the
                                     royalty costs in Robinson Knife in two important ways. First,
                                     while the taxpayer in Robinson Knife could refuse to pay roy-
                                     alty costs while continuing to produce and sell a substan-
                                     tially similar product, petitioner could not refuse to purchase
                                     cigarette tax stamps while continuing to possess cigarettes
                                     for resale. Second, unlike the royalty costs in Robinson Knife,
                                     the cigarette stamp tax is neither calculated as a percentage
                                     of net sales nor incurred only upon the sale of the cigarettes.
                                        Under New York law petitioner was required to pay the
                                     cigarette stamp tax when it possessed the cigarettes for
                                     resale, not upon occurrence of the resale. N.Y. Tax Law sec.
                                     471(1). Petitioner was obligated to purchase the cigarette tax
                                     stamps and affix them to the cigarette packages as soon as
                                     it purchased and took possession of the cigarettes. The ciga-
                                     rettes could not be sold without a tax stamp affixed to the
                                     package. We therefore find that the cigarette tax stamp costs
                                     are costs incurred by reason of petitioner’s resale activities.
                                           B. Indirect Costs: Taxes
                                       Capitalizable indirect costs include taxes ‘‘otherwise allow-
                                     able as a deduction to the extent such taxes are attributable
                                     to labor, materials, supplies, equipment, land, or facilities’’
                                     used in resale activities. Sec. 1.263A–1(e)(3)(ii)(L), Income
                                     Tax Regs. A taxpayer may deduct ordinary and necessary
                                     expenses paid or incurred during the taxable year in carrying
                                     on his trade or business. Sec. 162. Capitalizable indirect
                                     costs do not include taxes ‘‘assessed on the basis of income’’.
                                     Sec. 1.263A–1(e)(3)(iii)(F), Income Tax Regs.
                                       If petitioner did not purchase the cigarette tax stamps and
                                     affix them to the cigarette packages, it could not offer the
                                     cigarettes for sale. Therefore the cigarette tax stamps are
                                     materials and supplies that petitioner uses in its business of

                                     rate from its resale activity and therefore the cigarette stamp tax is a cost
                                     allocable solely to the stamping agent activity, the record supports a find-
                                     ing that its stamping agent activity was part of its resale activity. Con-
                                     sequently, we find that the stamping agent activity is an indivisible part
                                     of petitioner’s resale activity.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         433


                                     reselling cigarettes. 21 Furthermore, the cigarette tax stamp
                                     costs are otherwise allowable as a deduction under section
                                     162. 22 But for the operation of the UNICAP rules of section
                                     263A, a taxpayer could deduct the cigarette tax stamp costs
                                     as ordinary and necessary business expenses under section
                                     162.
                                       The cigarette stamp tax is not a tax assessed on the basis
                                     of the taxpayer’s income. New York State and New York City
                                     set the price of the cigarette tax stamps. Therefore, costs of
                                     cigarette tax stamps are capitalizable indirect costs as
                                     defined in section 1.263A–1(e)(3)(ii)(L), Income Tax Regs.
                                           C. Cost of Cigarette Tax Stamps Not a Selling Expense
                                       A taxpayer need not capitalize certain indirect costs,
                                     including ‘‘marketing, selling, advertising, and distribution
                                     costs.’’ Sec. 1.263A–1(e)(3)(iii)(A), Income Tax Regs. While
                                     selling expenses are excepted from the UNICAP rules, see
                                     id., a taxpayer cannot recharacterize an enumerated
                                     capitalizable indirect cost as a selling expense, see LOAD,
                                     Inc. v. Commissioner, T.C. Memo. 2007–51, aff ’d, 559 F.3d
                                     909 (9th Cir. 2009). In LOAD, the taxpayer argued that cer-
                                     tain State taxes were marketing, selling, or distribution
                                     expenses excepted from section 263A. In rejecting the tax-
                                     payer’s argument, this Court noted that section 1.263A–
                                     1(e)(3)(ii)(L), Income Tax Regs., specifically directed the tax-
                                     payer to include such State taxes in capitalizable indirect
                                     costs. Id., slip op. at 11–13.
                                       Similarly, in Robinson Knife Mfg. Co. v. Commissioner, 600
                                     F.3d 121, the U.S. Court of Appeals for the Second Circuit
                                     held that trademark fees are not selling expenses excepted
                                     from the UNICAP rules. The Court of Appeals noted that the
                                     enumerated list of indirect costs specifically includes trade-
                                        21 Petitioner contends that the cigarette tax stamp costs are not costs at-

                                     tributable to materials, supplies, or labor, because the cigarette stamp tax
                                     ultimately is imposed on the consumer. However, whether the cigarette
                                     stamp tax ultimately is imposed on the consumer, the stamping agent, or
                                     the wholesaler is irrelevant. To be a capitalizable indirect cost, the tax
                                     must be attributable to materials, supplies, or labor; there is no require-
                                     ment that the tax be imposed on the reseller. See sec. 1.263A–
                                     1(e)(3)(iii)(A), Income Tax Regs.
                                        22 While sec. 275 prohibits a taxpayer from deducting certain types of

                                     taxes, sec. 275 does not address cigarette stamp taxes.




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                                     434                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     mark fees. Id. at 129. The trademark fees could not be
                                     characterized as selling expenses because an immediate
                                     deduction of trademark fees would defeat the purpose of the
                                     UNICAP rules to ensure ‘‘that trademark royalties are not
                                     deducted during a taxable year which precedes the year in
                                     which the corresponding trademarked items are sold.’’ Id. at
                                     130.
                                        The cigarette stamp tax is imposed on ‘‘all cigarettes pos-
                                     sessed in the state by any person for sale’’. N.Y. Tax Law sec.
                                     471(1). A reseller becomes liable for the cigarette stamp tax
                                     when it purchases cigarettes for resale to customers and not
                                     when it actually sells the cigarettes to customers. Although
                                     the reseller is required by New York law to include the cost
                                     of the cigarette tax stamps in the sale price of the cigarettes,
                                     see N.Y. Tax Law sec. 471(3), and effectively is reimbursed
                                     for the cigarette stamp tax it paid when the cigarettes are
                                     sold, a reseller is not entitled to a refund of the cigarette tax
                                     if the cigarettes are not sold, see Schwartz, 643 N.Y.S.2d 761,
                                     or if the cigarette tax stamps are stolen before the stamping
                                     agent affixes them to the cigarette packages, see Mandel
                                     Tobacco Co., 397 N.Y.S.2d 23. Under this legal structure the
                                     cigarette stamp tax cannot properly be characterized as a
                                     selling expense. 23
                                        As this Court noted in LOAD, section 1.263A–1(e)(3)(ii)(L),
                                     Income Tax Regs., specifically provides that certain taxes are
                                     indirect costs that must be capitalized. Under section
                                     1.263A–1(e)(3)(ii)(L), Income Tax Regs., the cigarette tax
                                     stamp costs are indirect costs that must be capitalized. Peti-
                                     tioner cannot recharacterize a capitalizable indirect cost as a
                                     selling expense.
                                        Finally, petitioner’s proposed recharacterization would
                                     allow it an immediate deduction for expenses related to
                                     future sales. While petitioner typically purchased cigarette
                                           23 In
                                             arguing that cigarette tax stamps are selling expenses, petitioner
                                     relies solely on Rev. Rul. 79–196, 1979–1 C.B. 181. Rev. Rul. 79–196,
                                     1979–1 C.B. at 182, states that the cost of goods sold does not include pro-
                                     ceeds attributable to the collection of State sales taxes. However, Rev. Rul.
                                     79–196, supra, is inapplicable to this case because: (1) it addresses the de-
                                     ductibility under sec. 164 of State general sales taxes, not cigarette stamp
                                     taxes, see sec. 164(b)(5)(B); (2) it addresses installment sale reporting, not
                                     inventory reporting; and (3) it was issued before the enactment of sec.
                                     263A.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         435


                                     tax stamps and sold the stamped cigarettes within a matter
                                     of days, it had some cigarettes and cigarette tax stamps
                                     remaining at the end of the taxable year. If petitioner
                                     deducted the entire cost of the cigarette tax stamps pur-
                                     chased in year 1 but did not sell all of the stamped cigarette
                                     packages until year 2, it would deduct costs in year 1 with
                                     respect to cigarette inventory that remained unsold at the
                                     end of year 1.
                                        Consistent with this analysis, we conclude that the ciga-
                                     rette tax stamp costs are not selling expenses excepted from
                                     the UNICAP rules but instead are capitalizable indirect
                                     costs. We now must decide how to allocate those costs to peti-
                                     tioner’s activities and how to calculate the portion of those
                                     costs that must be capitalized.
                                     IV. Allocation of the Cigarette Tax Stamp Costs
                                           A. Allocation of Cigarette Tax Stamp Costs to Resale Activi-
                                             ties
                                        Section 263A(a)(1)(A) provides that ‘‘in the case of property
                                     which is inventory in the hands of the taxpayer’’, the tax-
                                     payer must include capitalizable direct and indirect costs in
                                     inventory costs. To calculate capitalizable costs, a taxpayer
                                     first must allocate the costs to various activities, such as
                                     production or resale activities. See sec. 1.263A–1(c)(1),
                                     Income Tax Regs. Generally, resellers allocate costs to four
                                     categories: (1) purchasing costs, see sec. 1.263A–3(c)(3),
                                     Income Tax Regs.; (2) handling costs, see sec. 1.263A–
                                     3(c)(4), Income Tax Regs.; (3) storage costs, see sec.
                                     1.263A–3(c)(5), Income Tax Regs.; and (4) general and
                                     administrative costs relating to the three prior categories, see
                                     sec. 1.263A–3(c)(2), Income Tax Regs.
                                        Costs attributable to purchasing, handling, and storage
                                     activities include ‘‘direct and indirect labor costs * * *; occu-
                                     pancy expenses * * *; materials and supplies; rent, mainte-
                                     nance, depreciation, and insurance of vehicles and equip-
                                     ment; tools; telephone;’’ and travel. Sec. 1.263A–3(c)(2),
                                     Income Tax Regs. Handling costs are ‘‘costs attributable to
                                     processing, assembling, repackaging, transporting, and other
                                     similar activities with respect to property acquired for
                                     resale’’. Sec. 1.263A–3(c)(4)(i), Income Tax Regs. Processing
                                     costs are costs a reseller incurs in making minor changes to




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                                     436                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     a product acquired for resale, such as monogramming or
                                     alterations. See sec. 1.263A–3(c)(4)(ii), Income Tax Regs.
                                     Assembling costs are costs a reseller incurs in readying prop-
                                     erty for resale, such as attaching wheels to a bicycle. See sec.
                                     1.263A–3(c)(4)(iii), Income Tax Regs. Repackaging costs
                                     include costs a reseller incurs to package property for resale
                                     to customers. See sec. 1.263A(c)(4)(iv), Income Tax Regs.
                                       The parties’ arguments regarding the proper allocation of
                                     the cigarette tax stamp costs are not entirely clear. In the
                                     notice of deficiency respondent determined that the cigarette
                                     tax stamp costs were general and administrative costs. How-
                                     ever, on brief respondent contends that the cigarette tax
                                     stamp costs could be purchasing costs, handling costs, or gen-
                                     eral and administrative costs. Petitioner appears to contend
                                     that although the cigarette stamp tax costs are general and
                                     administrative costs, they need not be capitalized because
                                     they cannot be allocated to purchasing, handling, or storage
                                     costs. While we agree that the cigarette tax stamp costs
                                     could be characterized as purchasing costs, handling costs, or
                                     general and administrative costs, for the reasons set forth
                                     below we find that the cigarette tax stamp costs are most
                                     appropriately classified as handling costs.
                                       When a stamping agent affixes a cigarette tax stamp to a
                                     cigarette package, the stamping agent makes only a minor
                                     change to the product; however, New York law requires the
                                     stamping agent to make this change before sale. See N.Y.
                                     Tax Law sec. 471(2). Therefore, the cost of the cigarette tax
                                     stamps is a cost the reseller incurs to ready or package the
                                     cigarettes for resale. The costs related to purchasing and
                                     affixing the cigarette tax stamps are similar to the proc-
                                     essing, assembling, and repackaging costs described in the
                                     regulations as handling costs. While the handling activity
                                     related to the cigarette tax stamp differs from the specific
                                     examples in the regulations, the purchasing and affixing of
                                     the cigarette tax stamp is sufficiently similar to the handling
                                     activities in the examples to support a conclusion that the
                                     cigarette tax stamp cost is a handling cost under section
                                     1.263A–3(c)(4), Income Tax Regs. We so hold.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         437


                                           B. Use of the Simplified Resale Method
                                           1. Allocation Methods
                                        After a reseller has allocated costs to its various resale
                                     activities, the reseller must allocate costs to ending inven-
                                     tory. A reseller subject to the UNICAP rules may use the
                                     facts-and-circumstances method, see sec. 1.263A–1(f), Income
                                     Tax Regs., or the simplified resale method, see sec. 1.263A–
                                     3(d), Income Tax Regs. Both methods enable the reseller to
                                     calculate the amount of costs that the reseller must cap-
                                     italize under the UNICAP rules.
                                           2. The Commissioner’s Use of the Simplified Resale Method
                                        Section 446(b) vests the Commissioner with broad discre-
                                     tion to determine whether a particular method of accounting
                                     clearly reflects income. See Knight-Ridder Newspapers, Inc.
                                     v. United States, 743 F.2d 781, 788 (11th Cir. 1984); Ansley-
                                     Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 370
                                     (1995); RLC Indus. Co. v. Commissioner, 98 T.C. 457, 491
                                     (1992), aff ’d, 58 F.3d 413 (9th Cir. 1995). If a taxpayer fails
                                     to use a method of accounting that clearly reflects
                                     income, the Commissioner may reconstruct the tax-
                                     payer’s income using any reasonable method that
                                     clearly reflects income. Sec. 446(b).
                                        Petitioner’s method of accounting for income and expenses,
                                     including inventory costs, did not apply the UNICAP rules.
                                     Therefore, respondent was entitled to reconstruct petitioner’s
                                     income by any reasonable method that clearly reflected
                                     income. Because section 1.263A–3(d), Income Tax Regs., pro-
                                     vides that resellers may use the simplified resale method to
                                     allocate costs, we find that respondent acted properly in
                                     using the simplified resale method to redetermine peti-
                                     tioner’s income.
                                           3. Application of the Simplified Resale Method
                                       Section 1.263A–3(d)(3), Income Tax Regs., provides proce-
                                     dures for applying the simplified resale method. The sim-
                                     plified resale method uses several formulas to calculate the
                                     additional capitalizable costs for the taxable year. Id. The
                                     general formula is: ‘‘combined absorption ratio × section 471
                                     costs remaining on hand at year end’’. Sec. 1.263A–




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                                     438                  141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     3(d)(3)(i)(A), Income Tax Regs. The product of this formula is
                                     equal to the amount of additional capitalizable costs that the
                                     taxpayer must add to its ending section 471 costs. 24 Sec.
                                     1.263A–3(d)(3)(i)(B), Income Tax Regs. Once the taxpayer
                                     adds the additional capitalizable costs to its ending section
                                     471 costs, the taxpayer calculates total ending inventory for
                                     the taxable year. 25
                                        The combined absorption ratio is the sum of the storage
                                     and handling costs absorption ratio and the purchasing costs
                                     absorption ratio. 26 See sec. 1.263A–3(d)(3)(i)(C)(1), Income
                                     Tax Regs. Section 1.263A–3(d)(3)(i)(D)(1), Income Tax Regs.,
                                     provides that the storage and handling costs absorption ratio
                                     is determined as follows:
                                                         Current year’s storage and handling costs
                                                     Beginning inventory plus current year’s purchases

                                     The current year’s storage and handling costs include all
                                     storage costs and all handling costs incurred during the tax-
                                     able year that relate to property the taxpayer acquired for
                                     resale. Sec. 1.263A–3(d)(3)(i)(D)(2), Income Tax Regs. The
                                     beginning inventory equals the section 471 costs of property
                                     the taxpayer acquired for resale that remain unsold as of the
                                     beginning of the taxable year. Id. The current year’s pur-
                                           24 Sec.
                                               471 provides the general rule for inventories.
                                           25 Petitioner
                                                     contends that in the notice of deficiency respondent erro-
                                     neously calculated ending inventory as the product of: (1) the additional
                                     capitalizable costs as determined using the simplified resale method; (2)
                                     petitioner’s purported sec. 471 costs for the year, see supra note 8; and (3)
                                     petitioner’s ending inventory. In his spreadsheets AO Minervini did not in-
                                     clude petitioner’s sec. 471 costs for the year in calculating its ending inven-
                                     tory. Respondent briefly addressed petitioner’s contention in his reply
                                     brief.
                                        Neither party adequately explained his or its position regarding the cor-
                                     rect application of the simplified resale method. As the parties failed to ad-
                                     dress this issue, we have confined our analysis to those issues material to
                                     the resolution of this case. We leave for the Rule 155 computation the
                                     proper application of the simplified resale method. If the parties are un-
                                     able to reach an agreement, we will address the issue as appropriate in
                                     a Rule 155 proceeding or in a supplemental opinion.
                                        26 The parties stipulated the allocation of all costs except for the alloca-

                                     tion of the cigarette tax stamp costs. Because our decision does not affect
                                     the purchasing cost absorption ratio, see sec. 1.263A–3(d)(3)(i)(E), Income
                                     Tax Regs., we do not address the calculation of that ratio.




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                                     (414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER                                         439


                                     chases equal the section 471 costs of property the taxpayer
                                     acquired for resale during the taxable year. Id.
                                       As noted supra p. 436, the cigarette tax stamp costs are
                                     handling costs. Petitioner must include the cigarette tax
                                     stamp costs incurred during the taxable year in the numer-
                                     ator 27 of the ratio as part of the current year’s storage and
                                     handling costs. Accordingly, we conclude that petitioner must
                                     include the current year’s cigarette tax stamp costs in the
                                     numerator of the ratio.
                                     V. Conclusion
                                        For purposes of determining eligibility for the small re-
                                     seller exception, petitioner must include in gross receipts the
                                     entire sale proceeds from the sale of cigarettes, including the
                                     costs of the cigarette tax stamps. Petitioner failed to prove
                                     that it had average annual gross receipts of less than $10
                                     million for the testing periods applicable to the relevant
                                     years, and therefore it is subject to the UNICAP rules of sec-
                                     tion 263A. The cigarette stamp tax costs are indirect costs
                                     properly characterized as handling costs. Respondent did not
                                     err in using the simplified resale method to determine the
                                     amount of costs properly allocable to petitioner’s ending
                                     inventory under the UNICAP rules.
                                        We have considered all remaining arguments made by the
                                     parties 28 for results contrary to those expressed herein, and
                                        27 Petitioner contends that the annual cigarette tax stamp cost should be

                                     included in both the numerator and the denominator of the storage and
                                     handling costs absorption ratio. The denominator includes the sec. 471
                                     costs from the prior taxable year as well as the current year’s purchases.
                                     Although petitioner purchased cigarette tax stamps during the taxable
                                     year, the cigarette tax stamps are not included in the current year’s pur-
                                     chases because the cigarette tax stamps are not part of petitioner’s inven-
                                     tory. Rather, the cigarette tax stamps are indirect costs allocable to the
                                     handling of petitioner’s inventory. Therefore, the cigarette tax stamp cost
                                     is included in the numerator only.
                                        28 In its brief petitioner also contends that respondent failed to apply its

                                     2005 overpayment to an appropriate taxable year. As we understand peti-
                                     tioner’s argument, it is claiming that the overpayment for 2005 has not
                                     been applied to reduce its income tax liability for another year. Petitioner’s
                                     argument raises a computational issue only, and we need not resolve it
                                     here. The impact of the 2005 overpayment on the calculation of the 2004
                                     and 2006 deficiencies, if any, will be considered in the Rule 155 process.




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                                     440                 141 UNITED STATES TAX COURT REPORTS                                     (414)


                                     to the extent not discussed above, we reject those arguments
                                     as irrelevant, moot, or without merit.
                                       To reflect the foregoing,
                                                                         Decision will be entered under Rule 155.

                                                                               f




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