                           141 T.C. No. 13



                  UNITED STATES TAX COURT



     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 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
cigarette 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 cigarette sales for financial statement purposes by totaling the
gross sale prices of the cigarettes sold during each year. However, for
income tax reporting purposes P adjusted its gross receipts from
                                   -2-

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 consequently is not
required to comply with the uniform capitalization (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 cigarettes 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 handling 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.
                                          -3-

        MARVEL, Judge: In a notice of deficiency respondent determined

deficiencies in petitioner’s Federal income tax of $96,908 and $9,901 for the

taxable years ending (TYE) 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


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

                   Handling &                      General &        Indirect costs--
    TYE             storage       Purchasing        admin.           nonallocable

 10/31/04          $35,068         $44,856        $128,014            $292,034
 10/31/05           28,135          36,334         116,818             254,331
 10/31/06           28,019          40,064         121,354             289,856

The parties also stipulated adjustments for insurance expenses and for petitioner’s
“cost of goods sold--purchases” as follows:

                                                        Cost of goods sold--
        TYE               Insurance expenses                 purchases

   10/31/04                     $33,164                     $6,362,650
   10/31/05                      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 references are to
                                                                       (continued...)
                                        -4-

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 incorporated 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 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 purchases unstamped cigarettes from tobacco manufacturers and

      3
       (...continued)
the Tax Court Rules of Practice and Procedure. Monetary amounts have been
rounded to the nearest dollar.
                                         -5-

purchases cigarette tax stamps4 from either New York State or New York City.

The stamping agent affixes the appropriate 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 cigarettes. 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.

      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.
                                         -6-

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 cigarettes sold

without any reduction for the cost of the cigarette tax stamps that was included in

the sale prices.

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 deficiency respondent determined that petitioner had underreported its

gross receipts for each taxable year in an amount approximately equal to the cost
                                        -7-

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

million and therefore it was subject to the UNICAP rules of section 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




      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 retain a specified
percentage of collected cigarette stamp taxes as compensation 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.”
                                         -8-

costs for handling and storage, purchasing, general and administrative, and

indirect costs--nonallocable expenses were as follows:7

                  Handling &                      General &        Indirect costs--
     TYE           storage        Purchasing       admin.           nonallocable

 10/31/2004        $80,251          $96,951       $5,959,471         $186,986
 10/31/2005         65,038           81,090        4,962,092          151,246
 10/31/2006         79,740          100,970        5,143,209          205,756

Using the simplified resale method without historic absorption (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,

respectively. Respondent calculated the additional section 263A capitalizable

costs as the product of the combined absorption ratio and petitioner’s purported

section 471 costs8 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 “indirect 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 general and
administrative costs and the storage and handling cost absorption ratio for the
relevant year. However, in calculating the storage and handling cost absorption
                                                                        (continued...)
                                        -9-

      In the notice of deficiency respondent further determined that petitioner



      8
        (...continued)
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 purchasing costs for the year.

       Respondent has not adequately explained, either in the notice of deficiency
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. However, on brief
respondent appears to be equivocating on his position regarding mistakes in the
calculations attached to the notice of deficiency. We expect respondent in his
Rule 155 computation to explain each of the values used and to identify clearly
how he made the computation of any deficiencies 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 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 general 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,
purchasing, 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, purchasing, 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 -

must increase its inventory costs for 2004, 2005, and 2006 by $252,586, $190,884,

and $246,091, respectively. 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 petitioner’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 are

insufficient to shift the burden of proof to the Commissioner. Gobins v.

      10
        In his spreadsheets AO Minervini determined that petitioner must increase
its inventory costs for 2004, 2005, and 2006 by the amounts of additional 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.
                                        - 11 -

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




      11
         Petitioner also contends that the determinations in the notice of deficiency
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 respondent applied the simplified
resale method without historic absorption, a method expressly permitted under sec.
263A.
                                       - 12 -

obligation to adhere to the rules of section 263A were arbitrary, capricious, 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 2350. In enacting section 263A, Congress

intended that a single, comprehensive set of rules should govern capitalization of

the costs of producing, acquiring, and holding property 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




      12
        Under sec. 7491(a) the burden of proof shifts to the Commissioner if the
taxpayer produced credible evidence to support the deduction or position, the
taxpayer complied with the substantiation requirements, and the taxpayer
cooperated with the Secretary with regard to all reasonable requests for
information. Petitioner does not contend that sec. 7491(a) applies, and it has not
introduced evidence to prove it satisfied the requirements of sec. 7491(a).
                                         - 13 -

expenditure is deductible13 or must be capitalized 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


      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 computing the cost of
inventory property. See id.
                                         - 14 -

year do not exceed $10,000,000” (small reseller exception).14 A reseller is a

taxpayer who 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


      14
         Two types of resellers must satisfy additional requirements to qualify for
the small reseller exception. If the reseller produces property, the reseller qualifies
for the exception only if the reseller meets the gross receipts 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 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 reseller and the property is sold to its customers”, see
sec. 1.263A-3(a)(3), Income 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 exception
because it is a small reseller with de minimis production activity. An analysis of
whether a reseller has de minimis production activity is relevant 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
                                                                           (continued...)
                                         - 15 -

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 subtracted the cost of the cigarette tax stamps it purchased,

then respondent’s determinations that petitioner underreported 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 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

      15
       (...continued)
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
average annual gross receipts for the relevant periods exceeded $10 million, we
need not decide whether its production activity was de minimis.
                                         - 16 -

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 cigarette 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 certain 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;




      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”).
                                        - 17 -

                   (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 business * * *, 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 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
                                         - 18 -

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 statement that petitioner determined its total sales under its accrual

method of accounting for financial accounting purposes 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

      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.
                                         - 19 -

petitioner’s shareholders, testified that the 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 purposes petitioner did just that. For income tax reporting

purposes, 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 taxable 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
                                         - 20 -

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 purchased during that year.

                    b.    Whether the Cost of Cigarette Tax Stamps Is a Tax
                          Properly Excluded From Gross Receipts

      Although petitioner’s arguments are not entirely clear, we interpret them to

be that for purposes of determining eligibility 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 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
                                         - 21 -

specifically 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 reseller exception using rules similar to those

of paragraphs (2) and (3) of section 448(c). Respondent disagrees because section

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 reseller 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.
                                        - 22 -

                          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. Petitioner 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 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 reseller may exclude from gross receipts

the sales proceeds attributable to collection of the tax. However, neither petitioner

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

      18
        Two sections of the Code address the taxability of imposed versus
collected 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 deductibility 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 accounting
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,
                                                                        (continued...)
                                        - 23 -

that while the consumer bears the ultimate liability for the cigarette stamp tax, the

tax is imposed, at least to some degree, on the reseller. 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

      18
        (...continued)
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 taxpayer 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 accounting 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), Temporary Income Tax Regs., supra, are
inconsistent and cannot be read together. For example, while sec. 1.448-
1T(f)(2)(iv), Temporary Income Tax Regs., supra, provides that a taxpayer must
include in gross receipts incidental 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 receipts calculation.
                                        - 24 -

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 introduce 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. Petitioner did not do so. The record does not permit us to calculate

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 million.
                                         - 25 -

         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:

                       Gross receipts        Cigarette tax           Total gross
         TYE             per return           stamp costs             receipts

       10/31/01         $9,432,811                Not in record   Unable to determine
       10/31/02          8,776,695                Not in record   Unable to determine
       10/31/03          7,604,923                 $6,451,143       $14,056,066
       10/31/04          6,919,789                  5,823,394        12,743,183
       10/31/05          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 taxable 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

petitioner 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 a taxpayer acquires for
                                         - 26 -

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 attributable 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. Petitioner contends that it is not required to capitalize the cigarette

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

      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 cigarette
stamp tax is not assessed on the basis of income, this provision does not apply.
                                        - 27 -

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 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.

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”, Robinson 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 without 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
                                        - 28 -

“were calculated 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 packages 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

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 royalty costs while continuing to produce and sell a

substantially 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.

      20
        While petitioner could argue that its stamping agent activity is separate
from its resale activity and therefore the cigarette stamp tax is a cost allocable
solely to the stamping agent activity, the record supports a finding that its
stamping agent activity was part of its resale activity. Consequently, we find that
the stamping agent activity is an indivisible part of petitioner’s resale activity.
                                         - 29 -

      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 cigarettes 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 allowable 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
                                       - 30 -

of 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



      21
         Petitioner contends that the cigarette tax stamp costs are not costs
attributable 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 requirement 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.
                                         - 31 -

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 certain State

taxes were marketing, selling, or distribution expenses excepted from section

263A. In rejecting the taxpayer’s argument, this Court noted that section 1.263A-

1(e)(3)(ii)(L), Income Tax Regs., specifically directed the taxpayer 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 trademark 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 possessed 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
                                         - 32 -

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. Petitioner cannot

recharacterize a capitalizable indirect cost as a selling expense.




      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 proceeds attributable to the
collection of State sales taxes. However, Rev. Rul. 79-196, supra, is inapplicable
to this case because: (1) it addresses the deductibility 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.
                                        - 33 -

      Finally, petitioner’s proposed recharacterization would allow it an

immediate deduction for expenses related to future sales. While petitioner

typically purchased cigarette 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 purchased 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 cigarette 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

petitioner’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 Activities

      Section 263A(a)(1)(A) provides that “in the case of property which is

inventory in the hands of the taxpayer”, the taxpayer 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
                                        - 34 -

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 * * *; occupancy expenses * * *; materials and

supplies; rent, maintenance, depreciation, and insurance of vehicles and

equipment; 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 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 property 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.
                                         - 35 -

         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. However, on brief respondent contends that the cigarette tax stamp costs

could be purchasing costs, handling costs, or general and administrative costs.

Petitioner appears to contend that although the cigarette stamp tax costs are a

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 processing,

assembling, and repackaging costs described in the regulations as handling costs.
                                         - 36 -

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.

      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 inventory. 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 capitalize under the UNICAP rules.

             2.     The Commissioner’s Use of the Simplified Resale Method

      Section 446(b) vests the Commissioner with broad discretion 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.
                                        - 37 -

1995). If a taxpayer fails to use a method of accounting that clearly reflects

income, the Commissioner may reconstruct the taxpayer’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., provides 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

petitioner’s income.

             3.    Application of the Simplified Resale Method

      Section 1.263A-3(d)(3), Income Tax Regs., provides procedures for

applying the simplified resale method. The simplified 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-3(d)(3)(i)(A), Income Tax Regs. The product

of this formula is equal to the amount of additional capitalizable costs that the
                                          - 38 -

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



      24
           Sec. 471 provides the general rule for inventories.
      25
         Petitioner contends that in the notice of deficiency respondent erroneously
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 include petitioner’s sec. 471 costs for
the year in calculating its ending inventory. Respondent briefly addressed
petitioner’s contention in his reply brief.

       Neither party adequately explained his or its position regarding the correct
application of the simplified resale method. As the parties failed to address 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 unable 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 allocation 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.
                                        - 39 -

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 taxable 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 purchases equal the section 471 costs of property the taxpayer

acquired for resale during the taxable year. Id.

      As noted supra p. 35, the cigarette tax stamp costs are handling costs.

Petitioner must include the cigarette tax stamp costs incurred during the taxable

year in the numerator27 of the ratio as part of the current year’s storage and


      27
         Petitioner contends that the annual cigarette tax stamp cost should be
included in both the numerator and 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 purchases because the cigarette tax stamps are
not part of petitioner’s inventory. 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.
                                         - 40 -

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 reseller 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 section 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 parties28 for

results contrary to those expressed herein, and to the extent not discussed above,

we reject those arguments as irrelevant, moot, or without merit.

      28
        In its brief petitioner also contends that respondent failed to apply its 2005
overpayment to an appropriate taxable year. As we understand petitioner’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.
                            - 41 -

To reflect the foregoing,


                                          Decision will be entered

                                     under Rule 155.
