414

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) 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 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 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. 

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) 

416 141 UNITED STATES TAX COURT REPORTS (414) 

1 Respondent determined an overpayment of $861 for TYE October 31, 

2005. 2With 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 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 petitioner’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 references are to the Tax Court Rules of Practice and Procedure. Monetary 

amounts have been rounded to the nearest dollar. 

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 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 

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

4During 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. 

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 

purchases cigarette tax stamps 4 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, firstout 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 cigarettes sold without any reduction for the cost of the cigarette 

tax stamps that was included in the sale prices. 

418 141 UNITED STATES TAX COURT REPORTS (414) 

5The 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. 

6Sec. 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.’’ 

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 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 costs for handling and 

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

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 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 

Continued 

storage, purchasing, general and administrative, and indirect 

costs—nonallocable expenses were as follows: 7

TYE 10/31 

Handling 

& storage Purchasing 

General 

& admin. 

Indirect costs— 

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 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 costs 8 at the end 

of the year. 9

420 141 UNITED STATES TAX COURT REPORTS (414) 

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 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. 

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, 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 

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

11Petitioner 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 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). 

are insufficient to shift the burden of proof to the Commissioner. 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, 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 

422 141 UNITED STATES TAX COURT REPORTS (414) 

13Sec. 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. 14Two 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 

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 expenditure is deductible 13 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 year do not exceed $10,000,000’’ 

(small reseller exception). 14 A reseller is a taxpayer who 

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

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). 15Petitioner 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 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. 

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 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 

424 141 UNITED STATES TAX COURT REPORTS (414) 

16This 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’’). 

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 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; 

(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 

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

17Petitioner 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. 

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 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 petitioner’s shareholders, testified that the 

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 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 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 

(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 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. 

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 

428 141 UNITED STATES TAX COURT REPORTS (414) 

18Two 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, 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. 

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 that while the 

(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 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 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. 

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: 

430 141 UNITED STATES TAX COURT REPORTS (414) 

19Sec. 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. 

TYE 10/31 

Gross receipts 

per return 

Cigarette tax 

stamp costs 

Total gross 

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 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 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 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 cigaVerDate Mar 15 2010 09:06 Feb 03, 2015 Jkt 000000 PO 00000 Frm 00017 Fmt 3857 Sfmt 3857 V:\FILES\BOUNDV~1.WIT\BVACDB~1.141\CITYLI~1 JAMIE
(414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER 431

20While petitioner could argue that its stamping agent activity is sepaContinued 

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 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 ‘‘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 

432 141 UNITED STATES TAX COURT REPORTS (414) 

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 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. 

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. 

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 of 

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

21Petitioner 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. 22While sec. 275 prohibits a taxpayer from deducting certain types of 

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

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 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 tradeVerDate Mar 15 2010 09:06 Feb 03, 2015 Jkt 000000 PO 00000 Frm 00020 Fmt 3857 Sfmt 3857 V:\FILES\BOUNDV~1.WIT\BVACDB~1.141\CITYLI~1 JAMIE
434 141 UNITED STATES TAX COURT REPORTS (414) 

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. 

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 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 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. 

Finally, petitioner’s proposed recharacterization would 

allow it an immediate deduction for expenses related to 

future sales. While petitioner typically purchased cigarette 

(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 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 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 

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 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. 

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 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. 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. 

(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 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); AnsleySheppard-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 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– 

438 141 UNITED STATES TAX COURT REPORTS (414) 

24Sec. 471 provides the general rule for inventories. 

25Petitioner 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. 

26The 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. 

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 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 purVerDate Mar 15 2010 09:06 Feb 03, 2015 Jkt 000000 PO 00000 Frm 00025 Fmt 3857 Sfmt 3857 V:\FILES\BOUNDV~1.WIT\BVACDB~1.141\CITYLI~1 JAMIE
(414) CITY LINE CANDY & TOBACCO CORP. v. COMMISSIONER 439

27Petitioner 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 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. 

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. 

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 numerator 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 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 

parties 28 for results contrary to those expressed herein, and 

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 

.