14 1 T.C. No . 13

UNITED STAT ES TAX COURT
CITY LINE CANDY & TOBACCO CORP., Pet it io ne r v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No . 31 30 3- 08
. File d No ve m be r 19 , 20 13
. P, a co rp or at io n, i s a r es el le r an d l ic en se d wh ol es al e d eal er o f ci ga rette s i n New Yo rk . New Yorklaw p ro vi de s tha t al l ci ga rette s po ss es se d fo r sa le m

us t b ear ast am

p i ss ue d b y

th e New York t ax co m m is si on er. N.Y. Tax Law se c. 47 1( 1) (McKi nn ey 20 06 & Supp . 20 13 ). Pur su an t t o thi s l aw, P, a li cen se d c ig aret te st am pi ng ag en t fo r New York , purch as es cig aret te pa ck s fo r sa le , pu rch as es an d a ffi xe s ci ga rette tax st am

ps to th os e ci ga ret te pa ck s, an d s el ls th e st am pe d ci ga rette pa ck s t o s ub

job be rs an d re ta il ers inNew YorkCit y an d th ro ug ho utNew YorkSta te . Und er New Yo rk law, P i s re qu ire d t o in cl ud e, an d d idin cl ud e, th e co stof the cig aret te tax st am ps inth e sa le pri ce o f th e ci ga ret te s. P u se s the accrua l m etho d o f acc ount in g anda fi sc al y ear en di ng Oct. 3 1. Fo r al l re le va nty ears P co m pu te d i ts gro ss rece ip ts fro m cig aret te sal es forfin an ci al st at em en t p ur po se s b y to ta li ng th e gr os s s al e p ric es of the cig aret te s s ol d dur in g e ach y ear. Ho wev er, fo r in co m e ta x re po rti ng purp os es P ad jus te d i ts gro ss rece ip ts fro m- 2 -

ci ga rette sal es by sub tra ct in g the ap pr ox im at e co stof c ig arette tax st am ps pu rch as eddu rin g the fis cal y ear andrep orti ng as i ts gro ss rece ip ts th e res ul ti ng ne t am ou nt . P arg ue d tha t i ts av erag e an nu al gr os s re cei pt s (d et erm in edforin co m e ta x re po rti ng pu rp os es ) fo r th e th ree- ta xabl e-year pe rio d e nd in g wi thth e ta xabl e y ear p rece di ng each of th e y ears inis su e d idno t ex ceed$1 0 m il li on . P con te nd s tha t i t th eref or e qua li fie s fo r th e small re se ll er ex cep ti on un de r I.R.C. s ec. 26 3A( b) (2 )(B) foreach of the y ears inis su e an d c on se qu en tl y is no t requi redto co m

pl y with the un ifo rm

cap it al iz at io n (UNIC AP) ru le s o f I.R.C. s ec. 2 63 A with re sp ectto th e ci garet te s i t ac qu ire d fo r res al e. Held : R co rrec tl y

de te rmin edP’s gro ss rece ip ts foreach of the y ears inis su e o n the ba si s o f th e en ti re s al e p ric e o f th e ci ga ret te s i t so ld , in cl ud in g tha t p artof the sal e p ric e attri bu tabl e to th e co stof the ci ga rette tax st am

ps . Held , furth er, P i s s ub

ject t o the UNICAP ru le s o f I.R.C. s ec. 26 3A b ecau se P fai le d t o p ro ve th atit s av erag e an nu al gro ss rece ip ts fo r th e th ree- ta xabl e-year pe rio d e nd in g wi th th e ta xabl e y ear pr eced in g e ach of the y ears inis su e, co rrec tl y cal cu la te d t o i nc lu de th e en ti re s al e p ric e o f th e ci ga rette s i t s ol d, d idno t ex ceed$1 0 m il li on foran y

of the y ears inis su e. Held , furth er, the cig aret te tax st am p c os ts are i nd ire ctco st s th atm us t b e cap it al iz edun de r th e UNICAP ru le s. Held , furth er, the cig aret te tax st am p c os ts are h an dl in g c os ts th atR pr op erl y

all oc at ed , inpart, t o P ’s end in g i nv en to ry us in g the si m pl ifi edres al e m etho d.

Fel ip e E. Orne r, fo r pe ti ti on er. Mi m i M . W on g, fo r res po nd en t.- 3 -

MARVEL, Ju dg e: In ano ti ce o f de fic ie nc y res po nd en t d et erm in ed de fic ie nc ie s i n p et it io ne r’s Fed eral in co m e ta x o f $9 6,9 08 an d $ 9,9 01 forth e ta xabl e y ears en di ng (TYE) Octo be r 31 , 20 04 an d 2 00 6, re sp ect iv el y . After 1
co nc es si on s, th e is su es forde ci si on are: (1) whet he r pe ti ti on er qua li fie s fo r th e

2
sm al l re se ll er ex cep ti on to th e uni fo rm cap it al iz at io n (UNIC AP) ru le s o f se ct io n 26 3A; if n ot , (2) whet he r th e New York c ig aret te st am p t ax pe ti ti on er i nc urredis 3
Res po nd en t d et erm in edanov erp aym en t o f $8 61 forTYE O ct ob er 3 1, 1 20 05
. W ith the ex cep ti on of c os ts rel at edto th e ci garet te tax st am ps , th e p art ie s 2 st ip ul at edth e al lo cat io n o f pe ti ti on er’s co st s as fol lo ws:

Hand li ng & Gen eral & Ind ire ctco st s- - TYE st or ag e Purch as in g adm in
. no na ll oc ab le 10 /3 1/ 04 $3 5,0 68 $4 4,8 56 $12 8,0 14 $29 2,0 34 10 /3 1/ 05 28 ,13 5 36 ,33 4 11 6,8 18 25 4,3 31 10 /3 1/ 06 28 ,01 9 40 ,06 4 12 1,3 54 28 9,8 56 The parti es als o s ti pu la te d a dju st m en ts forin su ran ce ex pe ns es an d fo r pe ti ti on er’s “ co stof g oo ds so ld --p ur ch as es ” as fol lo ws: Cos t o f go od s s ol d-
- TYE Ins ur an ce ex pe ns es pu rch as es 10/ 31 /0 4 $3 3,1 64 $6 ,36 2,6 50 10/ 31 /0 5 24 ,55 7 5,8 52 ,50 8 Unl es s o th erwi se in di cat ed , all sec ti on refe ren ces are t o the Int ern al 3 Rev enue Co de (Co de ) ineffe ctforth e y ears inis su e, an d a ll Ru le refe ren ces are t o (co nt in ue d...)- 4 -

anin di rectco stth atitm

us t capi ta li ze u nd er the UNICAP ru le s; an d, i f so , (3) whe th er re sp on de ntpro pe rly all oc at eda po rti on of tha t co stto pe ti ti on er’s en di ng in ve nt ory us in g the si m

pl ifi edres al e m etho d. FINDINGS OF FACT So m e o f th e fac ts ha ve be enst ip ul at ed . The s ti pu la te d fa ct s an d fa ct s drawn fro m st ip ul at edex hi bi ts are i nc or po rat edhe rei n b y

th is refe ren ce. Whenpe ti ti on er fil edit s p et it io n, i ts pri nc ip al pl ace o f bu si ne ss was i n New Yo rk
. I. Bac kg ro un d New Yorklaw i m

po se s a t ax onall cig aret te s p os se ss edforsal e. N.Y. T ax Law sec . 47 1( 1) (McKi nn ey 20 06 & Supp . 20 13 ). Thattax is co ll ect edth ro ug h th e sa le of c ig aret te tax st am ps is su edby the New Yorktax co m m is si on er und er a pr ov is io n tha t re qu ire s tha t al l ci ga ret te s p os se ss edforsal e m us t b ear s uc h a st am p. Id . For the rel ev an t t ax y ears , New YorkSta te an d New Yo rkCit y each im po se d acig aret te st am

p t ax of $ 1.5 0 p er p ack , or $ 15 pe r carto n. As p artof i ts cig aret te tax co ll ect io n e ffo rts th e New York S ta te Depa rtment of Taxa ti on an d F in an ce l ic en se s ci ga ret te st am pi ng ag en ts (st am

pi ng ag en ts ). A st am pi ng ag en t p ur ch as es un st am pe d c ig aret te s fr om

to ba cco m anuf

actur ers an d (...co nt inue d) 3 th e Tax Co urt Ru le s o f Prac ti ce an d P ro cedur e. Mo ne tary am ou nt s h av e b een ro un de d t o the ne ares t d ol lar.- 5 -

pu rch as es cig aret te tax st am ps fro m eit he r New York S ta te or Ne w YorkCit y . 4 The st am pi ng ag en t af

fix es th e ap pr op ria te cig aret te tax st am p t o e ach cig aret te pa ck ag e in it s p os se ss io n a s ev id en ce tha t the cig aret te st am p t ax ha s b eenpa id
an d the n s el ls th e st am

pe d c ig aret te pa ck ag es to li cen se d re ta il ers , subjo bb ers , or ve nd in g m ach in e o pe rat or s fo r sa le to co ns um ers . The s ta m pi ng ag en t m

us t in cl ud e th e co stof the cig aret te tax st am p i n the sal e p ric e o f th e ci garet te s. Id
. se c. 47 1( 3)
. Pet it io ne r is a co rp or at io n e ng ag edinth e who le sa le tra di ng of t ob acco . Pet it io ne r pu rch as es to ba cco pro du ct s fr om vario us m anuf

actur ers an d re se ll s th em to subjo bb ers an d re ta il ers inNew YorkSta te , bo thinan d o utof Ne w York Ci ty. Pet it io ne r al so is a li cen se d c ig arette st am pi ng ag en t fo r New York. Pet it io ne r pu rch as edcig aret te tax st am ps , andth ereb y

pa idcig aret te st am

p t ax es , to ta li ng $5 ,82 3,3 94 , $4 ,84 2,9 12 , and$5 ,00 5,1 52 forTYE O ct ob er 3 1, 2 00 4 (2 00 4) , Octo be r 31 , 20 05 (20 05 ), an d Oct ob er 3 1, 2 00 6 (2 00 6) , res pe ct iv el y . II. Pet it io ne r’s Acco un ti ng Metho ds an d F in an ci al Sta te m en ts Fo r al l re le va nty ears pe ti ti on er u se d the accrua l m etho d o f acc ou nt in g fo r in co m e an d e xp en se s an d the fir st -in , firs t-o utm etho d o f acc ou nt in g fo r in ve nt ory . Dur in g the y ears inis su e ci ga ret te tax st am ps were s ol d i n ro ll s o f 30 ,00 0. 4 Pet it io ne r pu rch as eda ro ll of t ax st am ps fro m New YorkSta te as n eed ed , ap pr ox im at el y

ev ery th ree t o fo urday s.- 6 -

Pet it io ne r di d n otin tro du ce i ts fin an ci al st at em en ts foreach of the rel ev an t years in to ev id en ce. Howe ve r, th e p ro fitan d l os s s ta te m en t fo r 20 04 th atis inth e rec or d
co nf irms th atforfin an ci al st at em en t p ur po se s p et it io ne r cal cu late d i ts gro ss rece ip ts fro m

cig aret te sal es by tot al in g the gro ss sal e p ric es of c ig aret te s s ol d witho utan y

reduc ti on forth e co stof the cig aret te tax st am ps th atwas i nc lu de d i n th e sa le pri ces . III. Pet it io ne r’s Tax R ep orti ng an d the Not ic e o f Defi ci en cy Pet it io ne r ti m el y

fil edit s Fo rm s 1 12 0, U.S. Co rp or at io n In co m e Tax Return, fo r 20 04 -0 6. Pe ti ti on er re po rte d g ro ss rece ip ts of $ 6,9 19 ,78 9, $ 6,2 14 ,86 7, an d $6 ,42 0,8 23 , for20 04 , 20 05 , and20 06 , res pe ct iv el y . Peti ti on er ca lc ul at edit s g ro ss rece ip ts for

in co m e ta x p ur

po se s b y subtract in g fr om

it s g ro ss rece ip ts fro m ci ga ret te sal es th e ap pr ox im at e to ta l co stof the cig aret te tax st am ps itpu rch as ed du rin g e ach y ear. Fo ll owi ng anex am in at io n o f pe ti ti on er’s i nc om e ta x re tu rn s fo r 20 04 -0 6
res po nd en t m ai le d t o p et it io ne r th e n ot ic e o f de fic ie nc y for20 04 an d 2 00 6. Inth e no ti ce o f de fic ie nc y

res po nd en t d et erm in edth atpe ti ti on er h adun de rrep orte d i ts gr os s re cei pt s fo r eac h t ax ab le y ear i n an a m ou ntap pr ox im at el y equa l t o the co st- 7 -

of th e ci ga rette tax st am

ps pu rch as eddu rin g tha t t ax ab le y ear. Con se qu en tl y , 5
res po nd en t d et erm in edth atpe ti ti on er h adad di ti on al gro ss rece ip ts of $ 5,8 23 ,39 4, $4 ,84 2,9 12 , and$5 ,00 5,1 52 for20 04 , 20 05 , and20 06 , res pe ct iv el y . As a re su ltof the ad

jus tm en ts to pe ti ti on er’s g ro ss rece ip ts , res po nd en t al so de te rm in edth atpe ti ti on er’s av erag e an nu al gro ss rece ip ts forth e th ree- ta xabl ey ear p eri oden di ng with the tax ab le y ear p rece di ng each of 2 00 4- 06 ex ceed ed$1 0
m il li on an d the refo re i t was subjec t t o the UNICAP ru le s o f se ct io n 2 63 A. Und er 6 th e UNICAP ru le s, p et it io ne r was requi redto in cl ud e a p orti on of c ert ai n d ire ct
an d i nd ire ctco st s i n i nv en to ry co st s. Re sp on de ntcla ss ifi edth e ci ga ret te tax st am p co st s as ge ne ral an d a dm in is tra ti ve co st s an d d et erm in edth atpe ti ti on er’s i nd ire ct

The parti es st ip ul at edth atpe ti ti on er “pu rch as edcig aret te st am ps an d p ai d 5 to New Yorkst at e ci ga ret te st am p t ax es ” o f $5 ,82 3,3 94 , $4 ,84 2,9 12 , and $5 ,00 5,1 52 for20 04 , 20 05 , and20 06 , res pe ct iv el y . Und er N.Y. Tax Law s ec. 47 2( 1) (McKi nn ey

20 06 & Supp . 20 13 ), st am pi ng ag en ts m ay

ret ai n asp eci fie d pe rcen ta ge of c ol le ct edcig aret te st am p t ax es as c om

pe ns at io n fo r th ei r du ti es . Neit he r pa rty addres se d wh ethe r pe ti ti on er i nc lu de d s uc h c omm is si on s i n cal cu la ti ng it s g ro ss rece ip ts or i n c al cu la ti ng th e co stof c ig aret te tax st am ps it in curred
. Sec. 2 63 A(b )(2 )(B) pro vi de s tha t ce rta intax pay ers are ex cep te d fr om 6 co m pl y in g wi th th e UNICAP ru le s “ if the av erag e an nu al gro ss rece ip ts of the ta xp ay er (o r an y

pre de ces so r) fo r th e 3 -ta xabl e y ear p eri oden di ng with the tax ab le y ear p rece di ng su chtax ab le y ear d o n otex ceed$1 0,0 00 ,00 0.”- 8 -

co st s fo r ha nd li ng an d s to rag e, pu rch as in g, g en eral an d a dm in is tra ti ve , and in di rectco st s- -n on al lo cab le ex pe ns es were as fol lo ws: 7

Han dl in g & Gen eral & Ind ire ctco st s- - TYE st or ag e Purch as in g adm in
. no na ll oc ab le 10 /3 1/ 20 04 $8 0,2 51 $9 6,9 51 $5,9 59 ,47 1 $18 6,9 86 10 /3 1/ 20 05 65 ,03 8 81,0 90 4,9 62 ,09 2 15 1,2 46 10 /3 1/ 20 06 79 ,74 0 10 0,9 70 5,1 43 ,20 9 20 5,7 56 Usi ng th e si m

pl ifi edres al e m etho d wi th ou t h is to ric ab so rp ti on (si m pl ifi edres al e
m etho d) , res po nd en t d et erm in edth atpe ti ti on er h adad di ti on al sec ti on 26 3A cap it al iz ab le co st s fo r 20 04 , 20 05 , and20 06 of $ 6,2 82 , $3 ,96 3, an d $ 6,2 68 , res pe ct iv el y . Res po nd en t ca lc ul at edth e ad di ti on al sec ti on 26 3A capi ta li zab le
co st s as th e p ro du ctof the co m bi ne d abs or

pt io n ra ti o andpe ti ti on er’s p ur po rte d
se ct io n 4 71 co st s at the en d o f th e y ear. 8 9
Inth e n ot ic e o f de fic ie nc y res po nd en t d et erm in edth atth e ci ga ret te tax 7 st am p c os ts were g en eral an d a dm in is tra ti ve co st s an d re fere nc edsec . 1.2 63 A1( e)(4 )(i )(A), In co m e Tax Reg s., wh ic h d efi ne s s erv ic e co st s as “ in di rectco st s (e.g ., gen eral an d a dm in is tra ti ve co st s) th atcanbe id en ti fie d s pe ci fic al ly w ith a se rv ic e d ep artm en t o r func ti on or tha t d ire ct ly ben efi t o r are in curredby reaso n o f a se rv ic e d ep artm en t o r func ti on .” Res po nd en t ca lc ul at edpe ti ti on er’s s ec. 4 71 co st s as $2 46 ,30 4, $ 18 6,9 21 , 8 an d $ 23 9,8 23 for20 04 , 20 05 , and20 06 , res pe ct iv el y . Res po nd en t ap pe ars to ha ve cal cu la te d p et it io ne r’s se c. 47 1 c os ts as the su m of: (1) st or ag e an d h an dl in g co st s; (2) pu rch as in g c os ts ; an d (3 ) th e p ro du ctof p et it io ne r’s ge ne ral an d adm in is tra ti ve co st s an d the st or ag e an d h an dl in g c os t ab so rp ti on rat io forth e rel ev an t year. Howev er, i n c al cu la ti ng th e st or ag e an d h an dl in g c os t ab so rp ti on (co nt in ue d...)- 9 -

Inth e n ot ic e o f de fic ie nc y res po nd en t fu rth er d et erm in edth atpe ti ti on er (...co nt inue d) 8 rat io for each y ear, re sp on de ntus eda va lu e in th e num erat orth atdi ffer edfro m pe ti ti on er’s t ot al st or ag e an d h an dl in g c os ts forth e y ear. Re sp on de ntli ke wis e us eda va lu e in th e num erat orof the pu rch as in g c os t ab so rp ti on rat io th atdi ffer ed fro m pe ti ti on er’s t ot al pu rch as in g c os ts forth e y ear. Res po nd en t h as no t ad equa te ly exp la in ed , eithe r inth e n ot ic e o f de fic ie nc y orinhi s p os ttria l b rie fin g, h ow h e cam e up wi th th e num be rs us edinth e cal cu la ti on s at ta ch edto th e n ot ic e o f de fic ie nc y . It ap pe ars to th e Co urt tha t res po nd en t m ad e mis ta ke s i n a dju st in g p et it io ne r’s in ve nt ory inth e n ot ic e o f de fic ie nc y , andhe ap pe ars to have co nc ed edas m uc h. Ho wev er, o n b rie f res po nd en t ap pe ars to be equi vo cat in g o n h is po si ti on reg ard in g m is ta ke s i n the cal cu la ti on s at ta ch edto th e n ot ic e o f de fic ie nc y . W e ex pe ctres po nd en t i n h is Ru le 15 5 c om

pu ta ti on to expl ai n e ach of the va lu es us edan d t o i de nt ify clearly ho w he m ad e th e co m

pu ta ti on of any defi ci en ci es res ul ti ng fro m th is Opi ni on . Afte r fi li ng a pe ti ti on with thi s C ou rt p et it io ne r fi le d an app eal with the 9 In te rn al Rev enue Serv ic e App eal s Off ic e. App eal s Off

ic er Ma rco Mi ne rv in i (AO Mi ne rv in i) p rep areda nu m be r of sp read sh eet s p ur

po rti ng to cal cu la te pe ti ti on er’s in ve nt ory co st s und er the UNICAP ru le s. AO Mi ne rv in i al lo cat edpe ti ti on er’s ha nd li ng an d s to rag e, pu rch as in g, an d g en eral an d a dm in is tra ti ve co st s u si ng th e va lu es st ip ul at ed , see supr a n ot e 2 , rathe r th anus in g the va lu es inth e n ot ic e o f de fic ie nc y . In the fir stsp read sh eetAO Min erv in i d et erm in edth at10 0% o f th e ci ga ret te tax st am

p c os ts were i nd ire ctco st s n otall oc ab le to hand li ng an d s to rag e, pu rch as in g, o r ge ne ral an d a dm in is tra ti ve co st s, an d c al cu la te d tha t p et it io ne r ha d ad di ti on al sec . 26 3A capi ta li zab le co st s fo r 20 04 , 20 05 , and20 06 of $ 1,3 76 , $1 ,80 9, an d $ 2,2 28 , res pe ct iv el y . In the sec on d s pr ead sh eetAO Min erv in i al lo cat ed50 % of the cig aret te tax st am p c os ts to hand li ng co st s an d 5 0% t o in di rectco st s n otall oc ab le to hand li ng an d s to rag e, pu rch as in g, o r ge ne ral an d adm in is tra ti ve co st s an d c al cu la te d tha t p et it io ne r ha d a dd it io na l s ec. 2 63 A cap it al iz ab le co st s fo r 20 04 , 20 05 , and20 06 of $ 53 ,42 3, $ 71 ,83 6, an d $ 85 ,79 6, res pe ct iv el y . In b oth s pr ead sh eet s AO Mi ne rv in i u se d ava lu e fo r pe ti ti on er’s s ec. 47 1 c os ts forth e y ear tha t was equa l t o i ts en di ng in ve nt ory forth aty ear a s rep orte d o n i ts return.- 10 -

m us t i nc reas e it s i nv en to ry co st s fo r 20 04 , 20 05 , and20 06 by $25 2,5 86 , $1 90 ,88 4,
an d $ 24 6,0 91 , res pe ct iv el y . Res po nd en t arriv edat the se ad di ti on al am ou nt s b y ad di ng th e ad di ti on al sec ti on26 3A co st s fo r eac h year an d p et it io ne r’s purp orte d
se ct io n 4 71 co st s fo r eac h year. Res po nd en t the n a dd edth e am ou ntof the in crea se to pe ti ti on er’s en di ng in ve nt ory to cal cu la te it s ad

jus te d e nd in g i nv en to ry

foreach of th e ta xabl e y ears inis su e. 1 0 OPINION I. Burd enof P ro of Ord in ari ly, th e Co m

m is si on er’s d et erm in at io ns ina no ti ce o f de fic ie nc y are pr es um edco rrec t an d the tax pa y er b ears th e b ur de n o f pr ov in g that the y are in co rrec t. Ru le 14 2( a); W el chv. Hel ve rin g, 2 90 U.S. 11 1, 1 15 (19 33 ). Howev er, th e b ur de n o f pr oo f wil l s hi ft t o the Co m m is si on er i f th e ta xp ay er p ro ve s tha t the de te rm in at io ns are arbi tra ry , cap ric io us , or u nr eas on ab le . Paccar, In c. v. Co m m is si on er, 8 5 T.C. 7 54 , 78 7 (1 98 5) , aff’d, 8 49 F.2d39 3 (9 th Cir . 19 88 ). Co nc es si on s b y

th e Co m m is si on er ator dur in g the co ur se of tria l o rd in ari ly are in su ffi ci en t t o s hi ft the bu rd enof p ro of to th e Co m

m is si on er. Gob in s v . Inhi s s pr ead sh eet s AO Mi ne rv in i d et erm in edth atpe ti ti on er m us t i nc reas e 1 0 it s i nv en to ry

co st s fo r 20 04 , 20 05 , and20 06 by the am ou nt s o f ad di ti on al sec . 26 3A capi ta li zab le co st s, d es cri be d s up ra n ot e 9 . In ca lc ul at in g p et it io ne r’s ad jus te d e nd in g i nv en to ry

AO Min erv in i ad de d the ad di ti on al sec . 26 3A cap it al iz ab le co st s t o i ts en di ng in ve nt ory va lu e fo r eac h year.- 11 -

Co m m is si on er, 1 8 T.C. 1 15 9, 1 16 8- 11 69 (19 52 ), aff’d p er cu ria m , 21 7 F .2d95 2 (9 th Cir . 19 54 ); s ee al so Eng le s C oi n S ho p, In c. v. Co m m is si on er, T.C. Mem o. 19 83 -5 61
. Pet it io ne r ap pe ars to arg ue th atth e d et erm in at io ns inth e n ot ic e o f de fic ie nc y

are arbi tra ry , cap ric io us , or u nr eas on ab le an d the refo re the bu rd enof pr oo f is onres po nd en t. Pet it io ne r rel ie s o n the factth atdu rin g the se pro ceed in gs res po nd en t s ti pu la te d an a ll oc at io n o f ha nd li ng an d s to rag e, pu rch as in g, an d ge ne ral an d a dm in is tra ti ve co st s d iff eren t fr om

th e al lo cat io n i n the no ti ce o f de fic ie nc y . 1 1 The m ere f

actth atres po nd en t s ti pu la te d an a lt ern at iv e co stall oc at io n i s in su ffi ci en t t o s hi ft the bu rd enof p ro of to hi m . Whi le itap pe ars th atinth e n ot ic e of de fic ie nc y

res po nd en t m ay

ha ve m ad e so m e mis take s i n c al cu la ti ng th e requi red ad jus tm en ts un de r se ct io n 2 63 A, th os e m is ta ke s ar e n otsu ffi ci en t t o s up po rt a fin di ng th athi s d et erm in at io ns reg ard in g p et it io ne r’s gr os s re cei pt s an d i ts

Pet it io ne r al so co nt en ds th atth e d et erm in at io ns inth e n ot ic e o f de fic ie nc y 1 1 are arb itrary, capri ci ou s, o r un reas on ab le be cau se res po nd en t u se d an i nc orrect m etho do lo gy in c al cu la ti ng it s i nv en to ry co st s u nd er s ec. 2 63 A. Howev er, the pa rti es st ip ul at edth atinth e n ot ic e o f de fic ie nc y res po nd en t ap pl ie d the si m pl ifi ed res al e m etho d wi th ou t h is to ric ab so rp ti on , a m etho d e xp res sl y pe rm it te d u nd er s ec. 26 3A.- 12 -

ob li ga ti on to adhe re t o the rul es of s ect io n 2 63 A were arb itrary, capri ci ou s, o r un reas on ab le
. W e co nc lu de th atpe ti ti on er b ears th e b ur de n o f pr ov in g tha t re sp on de nt ’s de te rm in at io ns are i nc orrect . See Ru le 14 2( a). 1 2 II. App li cat io n o f Sec ti on 26 3A A. In tro du ct io n t o S ect io n 2 63 A Co ng res s en act edsec ti on 26 3A as part o f th e Tax Refo rm Act o f 19 86 , Pub
. L. No. 99 -5 14 , sec . 80 3( a), 1 00 Sta t. at23 50 . In en act in g s ect io n 2 63 A, Con gr es s in te nd edth ata si ng le , com pr eh en si ve setof rul es sh ou ldgo ve rncap it al iz at io n o f th e co st s o f pr oduc in g, ac qu iri ng , andho ld in g p ro pe rty for re sa le to m or e accu rat el y

refl ectin co m e an d c reat e a m or e n eu tra l t ax syste m . See Su zy ’s Zoo v. Co m m is si on er, 2 73 F.3d87 5, 8 79 (9t h C ir. 2 00 1) , aff’g 1 14 T.C. 1 (2 00 0) ; S. Rep t. No . 99 -3 13 , at 1 40 (19 86 ), 19 86 -3 C.B. (Vo l. 3 ) 1, 1 40 . Whe th er an

Und er s ec. 7 49 1( a) the bu rd enof p ro of sh ift s t o the Co m

m is si on er i f th e 1 2 ta xp ay er p ro du cedcred ib le ev id en ce t o s up po rt the de du ct io n o r po si ti on , th e ta xp ay er co m

pl ie d wi th th e subs tant ia ti on requi rem en ts , andth e ta xp ay er co op erat edwith the Secr et ary with re ga rdto all reas on ab le reque st s fo r in fo rm at io n. Pe ti ti on er d oe s n otco nt en d tha t s ec. 7 49 1( a) ap pl ie s, an d i t h as no t in tro du cedev id en ce t o p ro ve itsat is fie d the requi rem en ts of s ec. 7 49 1( a).- 13 -

ex pe nd itur e is de du ct ib le or m us t b e cap it al iz edis a qu es ti on of f act . INDOPCO, 1 3 In c. v. Co m

m is si on er, 5 03 U.S. 79 , 86 (19 92 ). Und er s ect io n 2 63 A a tax pa y er m us t capi ta li ze ce rta indi rectan d i nd ire ct
co st s al lo cab le to real or p ers on al pro pe rty tha t the tax pa y er h as acqui redfor
res al e. See al so sec . 1.2 63 A-3 (a)( 1) , Inc om e Tax Reg s. If the res al e p ro pe rty is in ve nt ory inth e ta xp ay er’s h an ds , th e ta xp ay er m us t i nc lu de th e d ire ctan d i nd ire ct
co st s i n i nv en to ry

co st s. Sec . 26 3A( a)(1 )(A). Dir ectco st s i nc lu de “ th e acqui si ti on co st s o f pr op erty

acqui redforres al e.” Sec . 1.2 63 A-1 (e)( 2) (ii ), In co m e Tax Reg s. In di rectco st s i nc lu de all co st s, o th er tha n d ire ctco st s, p ro pe rly all oc ab le to pr op erty acqui redforres al e. Sec. 1 .26 3A- 1( e)(3 )(i ), In co m e Tax Reg s. B. The Sm al l Re se ll er Ex cep ti on Und er s ect io n 2 63 A(b )(2 )(B) a ta xp ay er i s ex cep te d fr om co m pl y in g wi th th e UNICAP ru le s o f se ct io n 2 63 A with re sp ectto cert ai n p ro pe rty acqu ire d fo r res al e “ if the av erag e annu al gro ss rece ip ts of the tax pay er (o r an y pre de ces so r) fo r th e th ree- ta xabl e-year pe rio d e nd in g wi th th e ta xabl e y ear p rece di ng su chtax ab le
Sec. 1 62 (a) aut ho riz es a ta xp ay er t o d educ t o rd in ary an d n eces sary 1 3 bu si ne ss ex pe ns es pa idor i nc urreddu rin g the tax ab le y ear i n c arrying onth e ta xp ay er’s trad e o r bu si ne ss . Adv ert is in g andothe r se ll in g e xp en se s ar e de du ct ib le un de r se c. 16 2( a). See sec . 1.1 62 -1 (a), In co m e Tax Reg s. Ho wev er, n o de du ct io n i s av ai labl e fo r it em s u se d b y th e ta xp ay er i n c om

pu ti ng th e co stof in ve nt ory pro pe rty. See id
.- 14 -

y ear d o n otex ceed$1 0,0 00 ,00 0” (sm al l re se ll er ex cep ti on ). A rese ll er i s a 1 4 ta xp ay er wh o a cqui res forres al e (1 ) pr op erty th e ta xp ay er i nc lu de s i n i nv en to ry if
on handat the en d o f th e y ear, an d (2 ) pr op erty th e ta xp ay er h ol ds pri m ari ly for
sa le to cu st om ers inth e o rd in ary co ur se of b us in es s. See sec . 1.2 63 A-3 (a)( 1) , In co m e TaxReg s.

1. Part ie s’ Argu m en ts Pet it io ne r co nt en ds th atitqu al ifi es for th e small re se ll er ex cep ti on be cau se it s av erag e an nu al gro ss rece ip ts foreach of the y ears inis su e d idno t ex ceed$1 0
m il li on . Acco rd in g t o p et it io ne r, res po nd en t erredby inc lu di ng init s g ro ss

1 5
Two ty pe s o f res el le rs m

us t s at is fy

ad di ti on al requi rem en ts to qu al ify for 1 4 th e small re se ll er ex cep ti on . If th e res el le r pr oduc es pro pe rty, the res el le r qu al ifi es fo r th e ex cep ti on on ly if th e res el le r m eet s the gro ss rece ip ts tes t, s ee s ec. 26 3A( b) (2 )(B) , andth e res el le r’s pr oduc ti on act iv it ie s ar e d e m in im is , see sec . 1.2 63 A-3 (a)( 2) (ii ) an d (i ii ), In co m e Tax Reg s. If the res el le r is tre at edas pr oduc in g p ro pe rty becaus e p ro pe rty is p ro du cedun de r co ntractforth e res el le r, th e res el le r qu al ifi es forth e ex cep ti on on ly if th e res el le r m eet s the gro ss rece ip ts te st , see sec . 26 3A( b) (2 )(B) , and“ if the co nt ractis en te redin to in ci de ntto th e res al e act iv it ie s o f th e small re se ll er an d the pro pe rty is s ol d t o i ts cu st om ers ”, se e se c. 1.2 63 A-3 (a)( 3) , Inc om e TaxReg s.; see als o S uz y ’s Zoo v. Co m m is si on er, 2 73 F.3 d 8 75 , 88 0- 88 1 (9 th Cir . 20 01 ), aff’g 1 14 T.C. 1 (2 00 0)
. Pet it io ne r al so co nt en ds th atitqu al ifi es forth e small re se ll er ex cep ti on 1 5 be cau se itis a sm al l re se ll er wi th de m in im is pro du ct io n a ct iv ity . An an al y si s o f whe th er a re se ll er h as de m in im is pro du ct io n a ct iv ity is rel ev an t o nl y

if the res el le r sa ti sf ie s the gro ss rece ip ts tes t o f se c. 26 3A( b) (2 )(B) . If th e res el le r pr oduc es pr op erty , th e res el le r is ex cep te d fr om co m pl y in g wi th th e UNICAP ru le s o nl y if th e res el le r sa ti sf

ie s the gro ss rece ip ts tes t an d the de m in im is pro du ct io n a ct iv ity (co nt in ue d...)- 15 -

rece ip ts pro ceed s at tri bu tabl e to co ll ect io n o f th e New York c ig aret te st am p t ax . Pet it io ne r co nt en ds th atNew Yorklaw i m po se s the cig aret te st am

p t ax on co ns um ers , no t s ta m

pi ng ag en ts or wh ol es al ers ; the refo re, g ro ss rece ip ts do no t in cl ud e p ro ceed s at tri bu tabl e to co ll ect io n o f th e ci ga ret te st am p t ax . Peti ti on er furth er co nt en ds th atif i n c al cu la ti ng it s g ro ss rece ip ts for Fed eral in co m e ta x pu rp os es itpro pe rly subt ract edth e co stof the cig aret te tax st am ps itpu rch as ed , th enres po nd en t’s d et erm in at io ns th atpe ti ti on er und erre po rte d i ts gro ss rece ip ts
an d tha t p et it io ne r is subjec t t o the UNICAP ru le s o f se ct io n 2 63 A are erro ne ou s be cau se pe ti ti on er’s av erag e an nu al gro ss rece ip ts di d n otex ceedth e $ 10 m il li on th res ho ldforth e rel ev an t years. Res po nd en t co nt en ds th atpe ti ti on er d oe s n otqu al ify for the sm al l re se ll er ex cep ti on . Res po nd en t ex pl ai ns th atbe cau se New Yorklaw re qu ire s p et it io ne r to ad d the co stof the cig aret te tax st am ps to th e ci ga ret te sal e p ric e, itm us t i nc lu de ingro ss rece ip ts th e en ti re g ro ss sal e p ric e, in cl ud in g that p artof i ts gro ss sal e pr ic e ap pr ox im at el y

equa l t o the co stof c ig aret te tax st am ps itin curreddu rin g each tax ab le y ear. Re sp on de ntass ert s tha t af te r pe ti ti on er’s g ro ss rece ip ts are (...co nt in ue d) 1 5 requi rem en t. Sec . 1.2 63 A-3 (a)( 2) (ii ) an d (i ii ), In co m e Tax Reg s.; see als o S uz y ’s Zoo v. Co m

m is si on er, 2 73 F.3dat 8 80 -8 81 . Becau se we fin d tha t p et it io ne r’s av erag e an nu al gro ss rece ip ts forth e rel ev an t p eri od s ex ceed ed$1 0 m il li on , we ne edno t d eci de whet he r it s p ro du ct io n a ct iv ity was d e m in im is
.- 16 -

reco ns tru ct ed , it s av erag e an nu al gro ss rece ip ts for th e rel ev an t t es ti ng pe rio ds for each y ear i n i ss ue ex ceed$1 0 m il li on . Acco rd in gl y , we firs t m

us t d eci de whethe r fo r pu rp os es of d et erm in in g qu al ifi cat io n fo r th e small re se ll er ex cep ti on , pet it io ne r’s gr os s re cei pt s s ho ul d in cl ud e th e co stof the cig aret te tax st am ps itpu rch as eddu rin g e ach tax ab le y ear. 2. Cal cu la ti on of P et it io ne r’s Gros s R ecei pt s Un de r Sec ti on 26 3A( b) (2 )(B) Fo r pu rp os es of the sm al l re se ll er ex cep ti on , sec ti on 1.2 63 A-3 (b )(2 )(i ), In co m e TaxReg s., d efi ne s g ro ss rece ip ts as “ th e to ta l am ou nt , as d et erm in ed
un de r th e ta xp ay er’s m etho d o f acc ou nt in g, d eri ve d fr om all of the tax pa y er’s tra de s o r bu si ne ss es (e.g ., rev enue s d eri ve d fr om th e sa le of i nv en to ry

be fo re reduc ti on forco stof g oo ds so ld ).” Sect io n 1 .26 3A- 3( b) (2 )(i i), In co m e Tax 1 6 Reg s., h owe ve r, ex cl ud es cert ai n i te m s fr om th e d efi ni ti on of g ro ss rece ip ts for pu rp os es of the sm al l re se ll er ex cep ti on :

(ii ) Am ou nt s ex cl ud ed . * * * g ro ss rece ip ts do no t i nc lu de am ou nt s re pr es en ti ng --

(A) Returns or a ll owanc es ;

Thi s ca lc ul at io n i s co ns is te ntwith the cal cu la ti on of g ro ss in co m e in sec . 1 6 1.6 1- 3( a), In co m e TaxReg s. (g ro ss in co m e d eri ve d fr om a bu si ne ss is “ th e to ta l sa le s, l es s the co stof g oo ds so ld ”).- 17 - (B) In te res t, d iv id en ds , ren ts , royalt ie s, o r an nu it ie s, n otde riv edinth e o rd in ary co ur se of atra de or bu si ne ss ; (C) R ecei pt s fr om

th e sa le or e xc ha ng e o f cap it al as se ts , as d efi ne d i n s ect io n 1 22 1; (D) Rep aym en ts of l oa ns or s im il ar i ns tru m en ts * * *; (E) Rec ei pt s fr om

a sa le or e xc ha ng e n otinth e or di nary co ur se of b us in es s * * * , and (F) Re cei pt s fr om

an y act iv ity othe r th ana tr ad e o r bu si ne ss or an a ct iv ity

en ga ge d i n fo r pr of

it
. By reas on of the ab ov e, cal cu la ti ng pe ti ti on er’s g ro ss rece ip ts forpu rp os es of th e small re se ll er ex cep ti on requi res a two -s te p i nqui ry : (1 ) whe th er, und er i ts
accrua l m etho d o f acc ou nt in g, p et it io ne r’s gr os s re cei pt s fo r eac h t ax ab le y ear i n is su e in cl ud edth e en ti re s al e p ric e o f th e ci garet te s i t s ol d, i nc lu di ng th e am ou nt at tri bu tabl e to cig aret te tax st am ps itpu rch as eddu rin g the y ear; an d, i f we an swe r th e fi rs t i nqui ry

inth e aff irmativ e, (2 ) whe th er s ect io n 1 .26 3A- 3( b) (2 )(i i), In co m e Tax Reg s., ex cl ud es fro m gro ss rece ip ts th e ap pr ox im at e co stof c ig arette tax st am ps pu rch as eddu rin g e ach y ear.

a. Pet it io ne r’s Metho d o f Acco un ti ng Pet it io ne r us edth e acc ru al m etho d o f acc ou nt in g fo r th e y ears inis su e. Und er the accrua l m etho d o f acc ou nt in g, a t ax pa y er m us t re co gn iz e in co m e fo r th e- 18 -

y ear i n wh ic h the tax pay er ac cru es th e in co m e. See, e.g ., sec . 45 1( a). A tax pa y er accrue s i nc om e whe n the all -ev en ts tes t h as be enm et , m ean in g tha t the tax pa y er’s rig htto th e in co m e is fix edan d the tax pa y er can d et erm in e th e am ountof the in co m e with re as on ab le accuracy. Sec. 1 .45 1- 1( a), In co m e Tax Reg s. The on ly fina nc ia l s ta te m en t tha t p et it io ne r in tro du cedwas i ts 20 04 “ Pro fit
an d Lo ss ” st at em en t, wh ic h s ho ws t ot al sal es of $ 12 ,76 7,1 83 . W e in fer fr om th e pr of itan d l os s s ta te m en t tha t p et it io ne r de te rmin edit s t ot al sal es un de r it s ac cru al
m etho d o f acc ou nt in g fo r fi na nc ia l ac co un ti ng purp os es by tot al in g i ts gro ss rece ip ts fro m

cig aret te sal es du rin g the tax ab le y ear wi th ou t an y reduc ti onforth e co stof c ig arette tax st am ps purch as eddu rin g tha t year. Peti ti on er the n d educ te d
co stof g oo ds so ld , in cl ud in g the co stof the cig aret te tax st am ps , fro m it s g ro ss rece ip ts to arri ve at g ro ss pro fitbe fo re ex pe ns es . 1 7 Inco nt ras t, p et it io ne r cal cu la te d i ts gro ss rece ip ts for in co m e ta x re po rti ng pu rp os es by sub tra ct in g fr om it s g ro ss rece ip ts fro m

cig aret te sal es th e ap pr ox im at e co stof c ig aret te tax st am ps pu rch as eddu rin g the fis cal y ear and rep orti ng as i ts gro ss rece ip ts th e res ul ti ng ne t am ount . Mr. KunSan g R uy, one of Pet it io ne r di d n otin tro du ce i nt o e vi de nc e fi na nc ia l s tate m en ts foran y 1 7 ot he r ta xabl e y ears . In the ab se nc e o f an y pro of to th e co nt rary, w e in fer fr om th e pr of itan d l os s s ta te m en t i n the reco rdth atpe ti ti on er ca lc ul at edit s g ro ss rece ip ts fo r th e o th er y ears inis su e in a m an ne r si m il ar t o tha t u se d o n the pro fitan d l os s st at em en t fo r 20 04
.- 19 -

pe ti ti on er’s s ha reh ol de rs , tes ti fie d tha t the am ou ntrep orte d a s g ro ss rece ip ts onit s ta x re turn s re fle ct eda “ne t” am ou nt . Fo r ta x andfin an ci al acco un ti ng pu rp os es a ta xp ay er m us t fi rs t ca lc ul at e to ta l s al es rev enue de te rm in edinacco rd an ce wi th it s m etho d o f acc ou nt in g. Fo r fin an ci al acco un ti ng pu rp os es pe ti ti on er d idjus t tha t. Fo r in co m e ta x re po rti ng pu rp os es , ho wev er, p et it io ne r reduc edit s t ot al gro ss rece ip ts fro m cig aret te sal es by the co stof the cig aret te tax st am ps itpu rch as eddu rin g the tax ab le y ear t o arri ve at agro ss rece ip ts fig ur e th atwas s ub st an ti al ly lowerth anth e fi gu re u se d fo r fi na nc ia l ac co un ti ng pu rp os es . Pet it io ne r’s pr of

itan d l os s s ta te m en t fo r 20 04 co nf irms th atun de r it s accrua l m etho d o f acc ou nt in g i t i nc lu de d a ll of the gro ss rece ip ts ge ne rat edby its
sa le of c ig aret te s dur in g the tax ab le y ear, i nc lu di ng gro ss rece ip ts att rib ut ab le to th e ci ga ret te tax st am

ps affi xe d t o the cig aret te pa ck s b efo re s al e, incal cu la ti ng it s gr os s re cei pt s fr om

cig aret te sal es . This ap pr oa chis co ns is te ntwith New Yo rk law, whi chrequi res a st am pi ng ag en t t o i nc lu de th e co stof the cig aret te tax st am p inth e sa le pri ce o f th e ci ga ret te s. See N.Y. T ax Law sec . 47 1( 3) . Peti ti on er’s effo rts to sh ow tha t i t qua li fie d a s a s m al l re se ll er b y reduc in g i ts gro ss rece ip ts for each tax ab le y ear i n an am ou ntap pr ox im at el y equa l t o the co stof c ig aret te tax st am ps itpurch as eddu rin g the y ear wer e in co ns is te ntwith i ts accr ua l m etho d o f- 20 -

acco un ti ng an d wi th ap pl ic ab le New Yorklaw. Co ns eque nt ly, we fi ndth atth e sm al l re se ll er ex cep ti on do es no t ap pl y be cau se gro ss rece ip ts for each tax ab le y ear i n i ss ue sh ou ldno t b e reduc edby an am ountrep res en ti ng th e co stof c ig aret te ta x s ta m ps pu rch as eddu rin g tha t year.

b. Whe th er the Co stof C ig aret te Tax St am ps Is aTax Pro pe rly Excl ud edFro m

Gros s R ecei pt s Altho ug h p et it io ne r’s arg um en ts are n oten ti rel y cle ar, we i nt erp retth em

to be th atforpu rp os es of d et erm in in g e li gi bi li ty for the sm al l re se ll er ex cep ti on , th e co stof the cig aret te tax st am ps sh ou ldbe subt ract edincal cu la ti ng gro ss rece ip ts be cau se eithe r: (1 ) se ct io n 1 .26 3A- 3( b) (2 ), In co m e Tax Reg s., p erm it s o r requi res th e subt ract io n; or ( 2) sal es tax or o th er s im il ar St at e an d l oc al tax es are s ub tra ct ed inco m pu ti ng gro ss rece ip ts if, u nd er ap pl ic ab le Sta te or l oc al law, the tax leg al ly is im po se d o n the pu rch as er o f th e g oo d o r se rv ic e an d the tax pa y er m erel y co ll ect s an d re m it s the tax to th e ta xi ng au th or ity . W e ad dr es s ea chof the se arg um en ts be lo w. i. Effectof S ect io n 1 .26 3A- 3( b) (2 ) an d (3 ), In co m e Tax Reg s. Insp eci fy in g h ow g ro ss rece ip ts are ca lc ul at edforpurp os es of the sm al l
res el le r ex cep ti on , sec ti on1.2 63 A-3 (b )(2 ), In co m e TaxReg s., ex cl ud es sev eral
enum erat edit em s b utm ak es no refe ren ce t o t ax es . Becau se tax es are n ot- 21 -

sp eci fic al ly lis te d a s an ex cl us io n u nd er s ect io n 1 .26 3A- 3( b) (2 )(i i), In co m e Tax Reg s., the reg ul at io n p ro vi de s n o s up po rt f orpe ti ti on er’s arg um en t tha t the reg ul at io n re qu ire s the co stof the cig aret te tax st am ps itpu rch as eddu rin g the rel ev an t years t o b e ex cl ud edfro m th e cal cu la ti on of g ro ss rece ip ts forpu rp os es of th e small re se ll er ex cep ti on . Pet it io ne r po in ts ou t tha t s ect io n 2 63 A(b )(2 )(C) requi res gro ss rece ip ts to be cal cu la te d fo r pu rp os es of the sm al l re se ll er ex cep ti on us in g ru le s s im il ar t o tho se of parag rap hs (2) an d (3 ) of sec ti on 44 8( c). Res po nd en t d is ag rees be cau se sec ti on 26 3A( b) (2 )(C) pro vi de s tha t the sec ti on 44 8( c) ru le s ap pl y forag gr eg at io n pu rp os es on ly. Sect io n 1 .26 3A- 3( b) (3 ), In co m e Tax Reg s., d is cu ss es th e ag gr eg at io n o f gr os s re cei pt s fo r pu rp os es of the sm al l re se ll er ex cep ti on . The ag gr eg at io n co nc ep t em

bo di edth erei n, u nd er wh ic h m ul ti pl e p ers on s treat edas asi ng le
em pl oyer un de r se ct io n 5 2( a) o r (b ) orsec ti on 41 4( m) are tre at edas o ne tax pa y er fo r pu rp os es of the sm al l re se ll er ex cep ti on , si m pl y do es no t ap pl y

be cau se th ere i s on ly one tax pa y er i nv ol ve d i n thi s ca se . Con se qu en tl y , we rejectpe ti ti on er’s arg um en t tha t the ag gr eg at io n ru le s o f se ct io n 1 .26 3A- 3( b) (2 ) an d (3 ), In co m e Tax Reg s., s up po rt i ts cal cu la ti on of i ts gro ss rece ip ts .- 22 - ii
. The Ch arac te r of

th e New York C ig aret te Tax Init s o pe ni ng bri ef p et it io ne r ad dr es se s the is su e o f whe th er the cig aret te st am p t ax is im

po se d o n the st am

pi ng ag en ts , who le sa le rs , andres el le rs or o n the
co ns um ers . Peti ti on er co nt en ds th atth e ta x i s i m po se d o n the co ns um ers an d th eref or e is no t i nc lu dabl e in th e cal cu la ti on of i ts gro ss rece ip ts forpurp os es of th e small re se ll er ex cep ti on . In h is rep ly brie f res po nd en t co nt en ds th atth e ta x i s im po se d o n re se ll ers li ke pe ti ti on er. The parti es ap pe ar t o a gr ee tha t i f th e ci ga ret te st am p t axis im

po se d o n co ns um ers , rathe r th anonres el le rs , th ena res el le r m ay ex cl ud e fro m

gro ss rece ip ts th e sa le s p ro ceed s at tri bu tabl e to co ll ect io n o f th e ta x. Ho wev er, n ei th er p et it io ne r no r res po nd en t o ffer edan y leg al au th or ity

for su cha co nt en ti on , andwe are un ab le to fin d any sup po rt f orit
. In any even t, New Yo rkcas el aw ackno wled ge s 1 8 Two s ect io ns of the Co de ad dr es s the tax ab il ity of i m po se d v ers us 1 8 co ll ect edtax es , altho ug h n ei th er p arty cit es eit he r se ct io n t o s up po rt h is or i ts co nt en ti on . Sec. 1 64 (a) p ro vi de s tha t St at e, lo cal , andfor ei gn tax es are d educ ti bl e by the pe rs on onwho m

th e ta xe s ar e im

po se d. Se e se c. 1.1 64 -1 (a), In co m e Tax Reg s. Ho wev er, s ec. 1 64 (a) a ddres se s o nl y th e d educ ti bi li ty of ta xe s, n otwhet he r ta xe s s ho ul d b e in cl ud edingro ss rece ip ts . Con se qu en tl y , sec . 16 4( a) i s in ap pl ic ab le with re sp ectto th e is su e o f whe th er p et it io ne r m us t i nc lu de ingro ss rece ip ts pro ceed s at tri bu tabl e to th e ci ga ret te tax st am ps . Sec. 4 48 (c) p ro vi de s tha t a t axpa y er m ay us e th e cas h m etho d o f acc ou nt in g if the tax pa y er h as av erag e an nu al gro ss rece ip ts of l es s than $ 5 m il li on . See s ec. 1.4 48 -1 T(f)(2 )(i v) , Tem

po rary Inco m e Tax Reg s., 5 2 F ed . Reg . 22 77 2 (J un e 1 6, (co nt in ue d...)- 23 -

th atwhi le th e co ns um er b ears th e u lt im at e li ab il ity forth e ci ga ret te st am

p t ax , th e ta x i s i m po se d, atlea stto so m e d eg ree, o n the res el le r. Sch wart z v . Tax Ap pe al s Trib un al of N.Y., 64 3 N.Y.S.2 d 7 61 (App . Div . 19 96 ); M an de l To ba cco Co . v. St at e Tax Co m

m ’n, 39 7 N.Y.S.2 d 2 3 (Ap p. Di v. 1 97 7) . W e rejectpe ti ti on er’s
se co ndarg um en t, an d we h ol d tha t re sp on de ntpro pe rly det erm in edpe ti ti on er’s (...co nt in ue d) 1 8 19 87 ). Sec. 1 .44 8- 1T(f

)(2 )(i v) , Tem

po rary Inco m e Tax Reg s., s up ra, ad jus ts th e cal cu la ti on of g ro ss rece ip ts forpu rp os es of s ec. 4 48 sp eci fic al ly w ith re sp ectto am ount s at tri bu tabl e to th e co ll ect io n o f ta xe s as fol lo ws: [G]ros s re cei pt s d o n otin cl ud e am ou nt s re cei ve d b y th e ta xp ay er wi th res pe ctto sal es tax or o th er s im il ar s ta te an d l oc al tax es if, u nd er the ap pl ic ab le st at e o r lo cal law, the tax is leg al ly im po se d o n the pu rch as er o f th e g oo d o r se rv ic e, an d the tax pa y er m erel y co ll ect s an d rem it s the tax to th e ta xi ng au th or ity . If, inco nt ras t, the tax is im po se d o n the tax pa y er und er the ap pl ic ab le law, the n g ro ss rece ip ts sh al l i nc lu de th e am ou nt s re cei ve d tha t ar e al lo cab le to th e p aym en t of su chtax . Sec. 1 .26 3A- 3( b) (2 ), In co m e TaxReg s., p ro vi de s an ex pl ic itde fin it io n o f gr os s re cei pt s fo r pu rp os es of the sm al l re se ll er ex cep ti on , wher eas sec . 44 8( c) an d th e reg ul at io ns pro m

ul ga te d the reu nd er ad dr es s the cal cu la ti on of g ro ss rece ip ts fo r pu rp os es of d et erm in in g wh ethe r a t ax pa y er m ay us e th e cas h m etho d o f acco un ti ng . Peti ti on er u se s the accrua l m etho d o f acc ou nt in g andis no t h ere co nt en di ng th atitsh ou ldbe pe rm it te d t o u se th e cas h m etho d o f acc ou nt in g. In ad di ti on , th e d efi ni ti on s o f gr os s re cei pt s i n s ec. 1 .26 3A- 3( b) (2 ), In co m e Tax Reg s., an d s ec. 1 .44 8- 1T(f )(2 )(i v) , Tem

po rary Inco m e Tax Reg s., s up ra, are in co ns is te ntan d c an no t b e rea d t og ethe r. For ex am pl e, whi le sec . 1.4 48
- 1T(f )(2 )(i v) , Tem

po rary Inco m e Tax Reg s., s up ra, p ro vi de s tha t a t axpa y er m us t in cl ud e in gro ss rece ip ts in ci de nt al in co m e n otde riv edinth e o rd in ary co ur se of bu si ne ss , sec . 1.2 63 A-3 (b )(2 )(i i)( B), In co m e Tax Reg s., ex cl ud es su cham ou nt s fro m th e g ro ss rece ip ts cal cu la ti on .- 24 -

gr os s re cei pt s fo r pu rp os es of the sm al l re se ll er ex cep ti on us in g the rul es setforth insec ti on 1.2 63 A-3 (b )(2 )(i i)( B), In co m e Tax Reg s.

3. App li cat io n o f th e Sm al l Re se ll er Ex cep ti on The tes ti ng pe rio d fo r 20 04 in cl ud es TYE O ct ob er 3 1, 2 00 1, 2 00 2, an d 20 03 . The t es ti ng pe rio d fo r 20 05 in cl ud es TYE O ct ob er 3 1, 2 00 2, 2 00 3, an d 20 04 . Peti ti on er d idno t i ntro du ce an y cred ib le ev id en ce t o p ro ve th e co rrec t
am ount s o f it s g ro ss rece ip ts forTYE O ct ob er 3 1, 2 00 1 and20 02
. Fo r eac h o f th e ta xabl e y ears inis su e p et it io ne r be ars th e b ur de n o f pr ov in g th atit s av erag e g ro ss rece ip ts forth e th ree p rev io us tax ab le y ears di d n otex ceed $1 0 m il li on . Peti ti on er d idno t d o s o. Th e rec or d d oe s n otpe rm itus to cal cu la te pe ti ti on er’s actua l g ro ss rece ip ts forTYE O ct ob er 3 1, 2 00 1 and20 02 , two of the y ears inth e rel ev an t t es ti ng pe rio ds . Accor di ng ly, we co nc lu de th atpe ti ti on er h as fai le d t o p ro ve th atitm etth e requi rem en ts of the sm al l re se ll er ex cep ti onun de r se ct io n 2 63 A(b )(2 )(B) for20 04 an d 2 00 5. The tes ti ng pe rio d fo r 20 06 in cl ud es TYE O ct ob er 3 1, 2 00 3 (2 00 3) , 20 04 , an d 2 00 5. Durin g the tes ti ng pe rio d p et it io ne r ha d a ve rag e an nu al gro ss rece ip ts of $1 2,6 19 ,00 9. Pe ti ti on er d oe s n otqu al ify as a s m al l re se ll er b ecau se it s av erag e an nu al gro ss rece ip ts forth e te st in g p eri odex ceed ed$1 0 m il li on .- 25 -

Bec au se we co nc lu de th atres po nd en t co rrec tl y cal cu la te d p et it io ne r’s gr os s rece ip ts for

each tax ab le y ear i n i ss ue by inc lu di ng th e co stof c ig aret te tax st am ps itpurch as edan d i nc lu de d i n the cig aret te sal e p ric e an d b ecau se pe ti ti on er d idno t pr ov e th e am ou nt s o f it s av erag e an nu al gro ss rece ip ts forth e te st in g p eri od s ap pl ic ab le to 20 03 an d 2 00 4, we fi ndas f ol lo ws: Gros s re cei pt s Ci ga rette tax Tota l g ro ss TYE pe r return st am p c os ts recei pt s 10/ 31 /0 1 $9 ,43 2,8 11 Notinreco rd Unabl e to de te rm in e 10/ 31 /0 2 8,7 76 ,69 5 Notinreco rd Unabl e to de te rm in e 10/ 31 /0 3 7,6 04 ,92 3 $6 ,45 1,1 43 $1 4,0 56 ,06 6 10/ 31 /0 4 6,9 19 ,78 9 5,8 23 ,39 4 12 ,74 3,1 83 10/ 31 /0 5 6,2 14 ,86 7 4,8 42 ,91 2 11 ,05 7,7 79 On the ba si s o f th es e fi nd in gs we co nc lu de th atpe ti ti on er d oe s n otqu al ify for the
sm al l re se ll er ex cep ti on an d tha t i t i s s ub ject t o the UNICAP ru le s o f se ct io n 2 63 A fo r th e ta xabl e y ears inis su e. W e th eref or e m us t d eci de whet he r th e ci ga rette tax st am p c os ts pe ti ti on er i nc urredare capi ta li zab le co st s fo r pu rp os es of the UNICAP
ru le s an d i f so , ho w th os e co st s ar e ch arac te riz edan d a ll oc at edto th e ci ga ret te s pe ti ti on er ac qu ire d fo r res al e. III. Cap it al iz at io n o f Ci ga rette Tax St am p C os ts The UNICAP ru le s o f se ct io n 2 63 A requi re a t ax pa y er t o c ap it al iz e th e di rectan d i nd ire ctco st s o f rea l o r pe rs on al pro pe rty tha t a t ax pa y er ac qu ire s fo r- 26 -

res al e. Sec. 2 63 A(a), (b )(2 )(A). Fo r res el le rs , di rectco st s ar e acqui si ti on co st s. Sec. 1 .26 3A- 1( e)(2 )(i i), In co m e Tax Reg s. In di rectco st s ar e co st s al lo cab le to pr op erty acqui redforres al e “ whe n the co st s d ire ct ly ben efi t o r are in curredby
reas onof the pe rfo rm an ce o f * * * re sa le act iv it ie s.” Se c. 1.2 63 A-1 (e)( 3) (i) , In co m e TaxReg s. Capi ta li zab le in di rectco st s i nc lu de tax es “ othe rwis e al lo wab le
as a de du ct io n t o the ex te ntsu chtax es are at tri bu tabl e to lab or , m at eri al s, s up pl ie s, equi pm en t, l an d, o r fac il it ie s” us edinres al e act iv it ie s. Sec . 1.2 63 A-1 (e)( 3) (ii )(L), In co m e TaxReg s. Ho wev er, a t ax pa y er i s n otrequi redto cap it al iz e certa in in di rectco st s, i nc lu di ng “ m ark et in g, s el li ng , adv ert is in g, an d d is tri bu ti on co st s.” 1 9 Sec. 1 .26 3A- 1( e)(3 )(i ii )(A), In co m e Tax Reg s. Neit he r pa rty argu es th atth e ci ga ret te tax st am p c os ts are d ire ctco st s. Res po nd en t co nt en ds th atth e ci ga ret te tax st am p c os ts are i nd ire ctco st s tha t m us t be cap it al iz ed . Peti ti on er co nt en ds th atitis no t re qu ire d t o c ap it al iz e th e ci ga ret te ta x s ta m p c os ts be cau se th ey

are n ei th er co st s tha t d ire ct ly ben efi t o r are in curred by reaso n o f it s p erfo rm an ce o f res al e act iv it ie s n or tax es att rib ut ab le to lab or , m at eri al , or s up pl ie s. Pet it io ne r furth er co nt en ds th atth e ci ga ret te tax st am p c os ts
are c urren tl y

de du ct ib le sel li ng ex pe ns es . Accor di ng ly, we m us t d eci de whet he r Sec. 1 .26 3A- 1( e)(3 )(i ii )(F) , Inc om e Tax Reg s., p ro vi de s tha t a t ax pa y er 1 9 ne edno t capi ta li ze t ax es ass es se d o n the ba si s o f in co m e. Becaus e th e ci ga ret te st am p t ax is no t as se ss edonth e b as is of i nc om e, th is pro vi si on do es no t ap pl y .- 27 -

th e ci ga ret te tax st am

p c os ts are i nd ire ctco st s o r curren tl y de du ct ib le sel li ng ex pe ns es . A. In di rectCo st s: Gene ral Defi ni ti on As n ot edsupr a, in di rectco st s ar e co st s al lo cab le to pro pe rty acqu ire d fo r res al e “whe n the co st s d ire ct ly ben efi t o r are in curredby reaso n o f th e pe rfo rm an ce o f * * * re sa le act iv it ie s.” Se c. 1.2 63 A-1 (e)( 3) (i) , Inc om e Tax Reg s. The U.S. Court o f App eal s fo r th e Sec on d C irc ui t, t o wh ic h an app eal inth is cas e wou ldli e, ab se nta st ip ul at io n t o the co ntrary, see s ec. 7 48 2( b) (1 )(A), (2 ), ha s co ns id eredth e m ean in g o f th e p hr as es “ di rect ly ben efi t” or “ in curredby reaso n of ”, Ro bi ns on Kni fe Mf

g. Co . v. Co m

m is si on er, 6 00 F.3d12 1, 1 27 (2dCir . 20 10 ),
rev ’g T.C. Mem o. 2 00 9- 9. Atis su e in Ro bi ns on Kni fe was th e p ro pe r ta x tre atm en t o f ro y al ti es pa idforth e ta xp ay er’s u se of trad em ark s tha t i t p la cedon ki tc he n i te m s s ol d t o the publ ic . The ro y al ti es were p ay ab le when th e k it ch en it em s wer e so ld . The Co urt o f App eal s h el d tha t fo r a co stto be a cap it al iz ab le
co st , it“ m

us t b e a b ut -fo r cau se of the tax pa y er’s p ro du ct io n a ct iv it ie s” . Id. at 13 1- 13 2. Th e ta xp ay er co ul d h av e p ro du cedth e sa m e p ro pe rty, alb ei t wi th ou t a tra de m ark , andav oi de d p ay in g the royalty co st s. Id . at 1 31 . The Co urt o f App eal s he ldth atth e ro y al ty cos ts were n otcap it al iz ab le co st s b ecau se th e ro y al ty cos ts- 28 -

“ were ca lc ul at edas ape rcen ta ge of n etsal es ” an d “ were i nc urredon ly upo n the
sa le ”. Id . at 1 34
. Arti cl e 2 0 o f th e New York Tax Law pro vi de s tha t a s ta m pi ng ag en t m

us t pu rch as e ci ga ret te tax st am ps fro m th e co m m is si on er an d a ffi x tho se st am ps to th e ci ga ret te pa ck ag es itpo ss es se s fo r res al e. N.Y. T ax Law sec . 47 1( 2) . As bo th a st am pi ng ag en t an d aco rp or at io n e ng ag edinth e res al e o f ci ga ret te s, p et it io ne r
m us t p ur ch as e th e ci ga ret te tax st am ps . Butforth e p ur ch as e o f th e ci ga ret te tax 2 0 st am ps , pet it io ne r co ul d n oten ga ge init s b us in es s o f res el li ng cig aret te s. Th e ci ga ret te tax st am

p c os ts are i nc urredby reaso n o f pe ti ti on er’s res al e act iv ity . Furth erm or e, th e ci garet te tax st am p c os ts di ffer

fro m th e ro y al ty cos ts in Ro bi ns on Kni fe i n two i m po rta ntway s. Fi rs t, wh il e th e ta xp ay er i n R ob in so n Kni fe co ul d re fu se to pay royalty co st s wh il e co nt in ui ng to pro du ce an d s el l a
subs tant ia ll y

si m il ar p ro du ct , pet it io ne r co ul d n otrefu se to pu rch as e ci ga rette tax st am ps whi le co nt in ui ng to po ss es s ci ga ret te s fo r res al e. Seco nd , un li ke th e ro y al ty cos ts inRo bi ns on Kni fe, the cig aret te st am p t ax is ne ithe r cal cu la te d a s a pe rcen ta ge of n etsal es no r in curredon ly upo n the sal e o f th e ci ga ret te s. Whi le pe ti ti on er co ul d arg ue th atit s s ta m pi ng ag en t ac ti vi ty is s ep arat e 2 0 fro m it s re sa le act iv ity

an d the refo re the cig aret te st am p t ax is a co stall oc ab le so le ly to the st am

pi ng ag en t ac ti vi ty, th e rec or d s up po rts a fi nd in g tha t i ts st am pi ng ag en t ac ti vi ty w as part o f it s re sa le act iv ity . Con se qu en tl y , we fin d tha t th e st am pi ng ag en t ac ti vi ty is anin di vi si bl e p artof p et it io ne r’s res al e act iv ity .- 29 -

Und er New Yo rklaw p et it io ne r was requi redto pay th e ci ga ret te st am

p t ax whe n i t p os se ss edth e ci ga ret te s fo r res al e, no t upo n o ccu rren ce o f th e res al e. N.Y. Tax Law sec . 47 1( 1) . Peti ti on er was ob li gate d t o p ur ch as e th e ci ga ret te tax st am ps an d a ffi x the m

to th e ci ga ret te pa ck ag es as s oo n a s i t p ur ch as edan d t oo k po ss es si on of the cig arette s. Th e ci ga ret te s co ul d n otbe so ldwitho uta ta x s ta m p affi xe d t o the pa ck ag e. W e th eref or e fi ndth atth e ci ga ret te tax st am p c os ts are co st s i nc urredby reaso n o f pe ti ti on er’s res al e act iv it ie s. B. In di rectCo st s: Taxe s Cap it al iz ab le in di rectco st s i nc lu de tax es “ ot he rwis e al lo wab le as a de du ct io n t o the ex te ntsu chtax es are at tri bu tabl e to lab or , m at eri al s, s up pl ie s, equi pm en t, l an d, o r fac il it ie s” us edinres al e act iv it ie s. Sec . 1.2 63 A-1 (e)( 3) (ii )(L), In co m e TaxReg s. A ta xp ay er m ay de du ctord in ary an d n eces sary ex pe ns es pa id
orin curreddu rin g the tax ab le y ear i n c arrying onhi s trad e o r bu si ne ss . Sec. 1 62
. Cap it al iz ab le in di rectco st s d o n otin cl ud e ta xe s “ as se ss edonth e b as is of i nc om e”. Sec. 1 .26 3A- 1( e)(3 )(i ii )(F) , Inc om e Tax Reg s. If p et it io ne r di d n otpu rch as e th e ci ga rette tax st am ps an d a ffi x the m

to th e ci ga ret te pa ck ag es , itco ul d n otoff er the cig aret te s fo r sa le . There fo re the ci ga ret te tax st am

ps are m at eri al s an d s up pl ie s tha t p et it io ne r us es init s b us in es s- 30 -

of res el li ng cig aret te s. Furth erm or e, th e ci ga ret te tax st am p c os ts are o th erwi se 2 1 al lo wab le as ade du ct io n u nd er s ect io n 1 62
. Butforth e o pe rat io n o f th e 2 2 UNICAP ru le s o f se ct io n 2 63 A, a tax pa y er co ul d d educ t the cig aret te tax st am p co st s as ord in ary an d n eces sary bu si ne ss ex pe ns es un de r se ct io n 1 62
. The cig aret te st am

p t ax is no t a t ax ass es se d o n the ba si s o f th e ta xp ay er’s in co m e. New YorkSta te an d New Yo rk Cit y setth e p ric e o f th e ci ga rette tax st am ps . There fo re, co st s o f ci garet te tax st am ps are capi ta li zab le in di rectco st s as de fin edinsec ti on 1.2 63 A-1 (e)( 3) (ii )(L), In co m e Tax Reg s. C. Co stof C ig aret te Tax St am ps Nota Sel li ng Exp en se A tax pa y er n eedno t capi ta li ze ce rta inin di rectco st s, i nc lu di ng “ m ark et in g, se ll in g, ad ve rti si ng , anddi strib ut io n c os ts .” Sec. 1 .26 3A- 1( e)(3 )(i ii )(A), In co m e Tax Reg s. Whil e se ll in g e xp en se s ar e ex cep te d fr om th e UNICAP ru le s, s ee i d., a ta xp ay er cann otrech arac te riz e anenum erat edcap it al iz ab le in di rectco stas a

Pet it io ne r co nt en ds th atth e ci ga rette tax st am p c os ts are n otco st s 2 1 at tri bu tabl e to m at eri al s, s up pl ie s, o r labo r, be cau se th e ci garet te st am p t ax ul ti m at el y

is im po se d o n the co ns um er. Howe ve r, whe th er the cig aret te st am p t ax ul ti m at el y

is im po se d o n the co ns um er, the st am pi ng ag en t, o r th e who le sa le r is irr el ev an t. To b e a capi ta li zab le in di rectco st , th e ta x m us t b e at tri bu tabl e to m at eri al s, s up pl ie s, o r labo r; the re i s n o re qu ire m en t tha t the tax be im po se d o n the res el le r. See s ec. 1 .26 3A- 1( e)(3 )(i ii )(A), In co m e Tax Reg s. Whi le sec . 27 5 p ro hi bi ts a ta xp ay er fro m de du ct in g c ert ai n ty

pe s o f ta xe s, 2 2 se c. 27 5 d oe s n otad dr es s ci ga ret te st am p t ax es .- 31 -

se ll in g e xp en se , see LOAD, In c. v. Co m m is si on er, T.C. Mem o. 2 00 7- 51 , aff’d, 55 9 F .3d90 9 (9 thCir . 20 09 ). In LOAD, th e ta xp ay er ar gu edth atcert ai n S ta te ta xe s wer e m ark et in g, s el li ng , or d is tri bu ti on expe ns es ex cep te d fr om sec ti on 26 3A. Inreject in g the tax pa y er’s arg um en t, thi s C ou rt n ot edth atsec ti on 1.2 63 A1( e)(3 )(i i)( L), Inc om e Tax Reg s., s pe ci fic al ly dire ct edth e ta xp ay er t o i nc lu de su ch St at e ta xe s i n c ap it al iz ab le in di rectco st s. Id ., sl ip op . at 1 1- 13
. Si m il arl y , inRo bi ns on Kni fe Mf g. Co . v. Co m

m is si on er, 6 00 F.3d12 1, the U.S. Cou rt o f App eal s fo r th e Sec on d C irc ui t h el d tha t trad em arkfees are n ot
se ll in g e xp en se s ex cep te d fr om th e UNICAP ru le s. Th e Co urt o f App eal s n ot ed th atth e enum erat edli stof i nd ire ctco st s s pe ci fic al ly inc lu de s trad em arkfees . Id. at12 9. Th e tr ad em arkfees co ul d n otbe ch arac te riz edas s el li ng ex pe ns es be cau se animm ed ia te de du ct io n o f tr ad em arkfees wou ldde featth e p ur po se of the UNICAP ru le s t o e ns ur e “ th attra de m arkroyalt ie s ar e n otde du ct eddu rin g a ta xabl e y ear wh ic h p rece de s the y ear i n wh ic h the co rres po nd in g trad em ark ed it em s ar e so ld .” Id . at 1 30
. The cig aret te st am

p t ax is im

po se d o n “ al l ci ga ret te s p os se ss edinth e st at e by any pe rs on forsal e”. N.Y. Tax Law se c. 47 1( 1) . A resel le r be co m es li ab le for th e ci ga ret te st am

p t ax when itpu rch as es cig aret te s fo r res al e to cu st om ers an d n ot whe n i t ac tu al ly sell s the cig arette s t o c us to m ers . Alth ou gh th e res el le r is requi red- 32 -

by New Yorklaw t o i nc lu de th e co stof the cig aret te tax st am ps inth e sa le pri ce o f th e ci ga ret te s, s ee N.Y. Tax Law s ec. 4 71 (3 ), an d e ffec ti ve ly is re im burs edforth e ci ga ret te st am

p t ax itpa idwhen th e ci ga ret te s ar e so ld , a res el le r is no t en ti tl edto a ref un d o f th e ci garet te tax if the cig arette s ar e n otso ld , see Sch wart z, 64 3 N.Y.S.2d76 1, o r if

th e ci ga ret te tax st am

ps are s to le n b efo re the st am pi ng ag en t affi xe s the m

to th e ci garet te pa ck ag es , see Man de l To ba cco Co ., 39 7 N.Y.S.2 d 2 3. Und er thi s l eg al stru ctur e th e ci ga ret te st am p t ax canno t p ro pe rly be ch arac te riz ed
as a se ll in g e xp en se . 2 3 As thi s C ou rt n ot edinLOAD, se ct io n 1 .26 3A- 1( e)(3 )(i i)( L), Inc om e Tax Reg s., s pe ci fic al ly pro vi de s tha t ce rta intax es are i nd ire ctco st s tha t m us t b e cap it al iz ed . Und er s ect io n 1 .26 3A- 1( e)(3 )(i i)( L), Inc om e Tax Reg s., the cig aret te ta x s ta m p c os ts are i nd ire ctco st s tha t m us t b e cap it al iz ed . Peti ti on er cann ot rech arac te riz e a capi ta li zab le in di rectco stas asel li ng ex pe ns e.

Inarg ui ng th atcig aret te tax st am ps are s el li ng ex pe ns es , pet it io ne r rel ie s 2 3 so le ly on R ev . Rul . 79 -1 96 , 19 79 -1 C.B. 1 81 . Rev . Rul . 79 -1 96 , 19 79 -1 C.B. at 18 2, s ta te s that the co stof g oo ds so lddo es no t i nc lu de pro ceed s at tri bu tabl e to th e co ll ect io n o f St at e sa le s t ax es . Howev er, Rev . Rul . 79 -1 96 , supr a, is in ap pl ic ab le to th is cas e b ecau se : (1 ) itad dr es se s the de du ct ib il ity un de r se c. 16 4 o f St at e ge ne ral sal es tax es , no t ci ga ret te st am p t ax es , see sec . 16 4( b) (5 )(B) ; (2 ) it ad dr es se s i ns ta ll m en t s al e rep orti ng , no t i nv en to ry rep orti ng ; an d (3 ) itwas i ss ue d be fo re the en act m en t o f se c. 26 3A.- 33 -

Fi na ll y , pet it io ne r’s pr op os edrech arac te riz at io n wo ul d a ll ow i t an imm ed ia te de du ct io n fo r ex pe ns es rel at edto futur e sa le s. Whil e p et it io ne r typic al ly pur ch as edcig aret te tax st am ps an d s ol d the st am

pe d c ig aret te s wi th ina
m at te r of day s, i t h adso m e ci ga ret te s an d c ig aret te tax st am ps rem ai ni ng at the en d of th e ta xabl e y ear. If p et it io ne r de du ct edth e en ti re co stof the cig aret te tax st am ps pu rch as ediny ear 1 bu t d idno t s el l al l o f th e st am pe d c ig aret te pa ck ag es un ti l year 2, i t wo ul d d educ t co st s i n year 1 wi th res pe ctto cig aret te in ve nt ory th at
rem ai ne d u ns ol d a t the en d o f y ear 1
. Co ns is te ntwith thi s an al y si s, we co nc lu de th atth e ci ga ret te tax st am p c os ts
are n otsel li ng ex pe ns es ex cep te d fr om th e UNICAP ru le s b utin st eadare cap it al iz ab le in di rectco st s. We no w m us t d eci de ho w to all oc at e th os e co st s t o pe ti ti on er’s act iv it ie s an d h ow t o c al cu la te th e p orti on of tho se co st s that m us t b e cap it al iz ed
. IV. All oc at io n o f th e Ci ga ret te Tax St am p C os ts A. All oc at io n o f Ci ga ret te Tax St am p C os ts to Res al e Act iv it ie s Sect io n 2 63 A(a)(1 )(A) p ro vi de s tha t “ inth e cas e o f pr op erty whi chis in ve nt ory inth e h an ds of the tax pa y er”, the tax pa y er m us t i nc lu de cap it al iz ab le di rectan d i nd ire ctco st s i n i nv en to ry co st s. To cal cu late cap it al iz ab le co st s, a ta xp ay er fi rs t m

us t al lo cat e th e co st s t o v ari ou s ac ti vi ti es , su chas p ro du ct io n o r- 34 -

res al e act iv it ie s. See sec . 1.2 63 A-1 (c)( 1) , Inc om e Tax Reg s. Gen eral ly, res el le rs al lo cat e co st s t o fo urcat eg or ie s: (1) pu rch as in g c os ts , see sec . 1.2 63 A-3 (c)( 3) , In co m e TaxReg s.; (2) hand li ng co st s, s ee s ec. 1 .26 3A- 3( c)(4 ), In co m e Tax Reg s.; (3 ) st or ag e co st s, s ee s ec. 1 .26 3A- 3( c)(5 ), In co m e Tax Reg s.; an d (4 ) ge ne ral an d adm in is tra ti ve co st s re la ti ng to th e th ree p rio r cat eg or ie s, s ee s ec. 1 .26 3A- 3( c)(2 ), In co m e TaxReg s. Co st s at tri bu tabl e to pu rch as in g, h an dl in g, an d s to rag e act iv it ie s i nc lu de

“ di rectan d i nd ire ctlab orco st s * * * ; o ccupa nc y ex pe ns es * * *; m at eri al s an d
supp li es ; re nt , m ai nt en an ce, d ep reci at io n, an d i ns ur an ce o f ve hi cl es an d equi pm en t; to ol s; tel ep ho ne ;” an d trav el . Sec. 1 .26 3A- 3( c)(2 ), In co m e Tax Reg s. Han dl in g c os ts are “ co st s at tri bu tabl e to pro ces si ng , ass em bl in g, re pa ck ag in g, tra ns po rti ng , andothe r si mil ar ac ti vi ti es with re sp ectto pro pe rty acqu ire d fo r res al e”. Sec . 1.2 63 A-3 (c)( 4) (i) , Inc om e Tax Reg s. Pro ces si ng co st s ar e co st s a res el le r in curs inm ak in g m in orch an ge s t o apro du ctacqui redforres al e, su chas
m on og ramm in g o r al te rat io ns . See s ec. 1 .26 3A- 3( c)(4 )(i i), In co m e Tax Reg s. Ass em bl in g c os ts are co st s a r es el le r in curs inready in g p ro pe rty for re sa le , su chas at ta ch in g wh eel s t o abi cy cl e. See s ec. 1 .26 3A- 3( c)(4 )(i ii ), In co m e Tax Reg s. Rep ack ag in g c os ts in cl ud e co st s a r es el le r in curs to pa ck ag e p ro pe rty for re sa le to
cu st om ers . See s ec. 1 .26 3A( c)(4 )(i v) , Inc om e Tax Reg s.- 35 -

The parti es ’ arg um en ts reg ard in g the pro pe r al lo cat io n o f th e ci ga ret te tax st am p c os ts are n oten ti rel y

cle ar. Inth e n ot ic e o f de fic ie nc y res po nd en t de te rm in edth atth e ci ga ret te tax st am p c os ts were g en eral an d a dm in is tra ti ve co st s. Ho wev er, o n b rie f res po nd en t co nt en ds th atth e ci ga rette tax st am p c os ts
co ul d b e p ur ch as in g c os ts , han dl in g c os ts , or g en eral an d a dm in is tra ti ve co st s. Pet it io ne r ap pe ars to co nt en d tha t al th ou gh th e ci ga ret te st am p t ax co st s ar e a ge ne ral an d a dm in is tra ti ve co st s, the y ne edno t b e cap it al iz edbe cau se th ey can no t be all oc at edto pu rch as in g, h an dl in g, o r st or ag e co st s. Whil e we ag ree tha t the ci ga ret te tax st am

p c os ts co ul d b e ch arac te riz edas p ur ch as in g c os ts , han dl in g co st s, o r ge ne ral an d a dm in is tra ti ve co st s, fo r th e rea so ns setforth be lo w we fin d th atth e ci ga ret te tax st am p c os ts are m os t ap pr op ria te ly clas si fie d a s h an dl in g co st s. Whe n ast am

pi ng ag en t af

fix es a ci ga ret te tax st am

p t o acig aret te pa ck ag e, th e st am pi ng ag en t m ak es on ly a min or ch an ge to th e p ro du ct ; h owe ve r, New York law requi res th e st am

pi ng ag en t t o m ak e th is ch an ge be fo re s al e. See N.Y. Tax Law sec . 47 1( 2) . There fo re, the co stof the cig aret te tax st am ps is a co stth e res el le r in curs to ready

or p ack ag e th e ci ga ret te s fo r res al e. The c os ts rel at edto pu rch as in g andaffi xi ng th e ci ga ret te tax st am ps are s im il ar t o the pro ces si ng , as se m bl in g, an d re pa ck ag in g c os ts de sc rib edinth e reg ul at io ns as h an dl in g c os ts .- 36 -

Whi le th e h an dl in g a ct iv ity rel at edto th e ci ga ret te tax st am p d iff ers fro m th e sp eci fic ex am

pl es inth e reg ul at io ns , th e p ur ch as in g andaffi xi ng of the cig aret te ta x s ta m p i s s uf fic ie nt ly sim il ar t o the hand li ng act iv it ie s i n the ex am pl es to
supp ort a c on cl us io n tha t the cig aret te tax st am p c os t i s a h an dl in g c os t und er se ct io n 1 .26 3A- 3( c)(4 ), In co m e TaxReg s. We so ho ld
. B. Use of the Sim

pl ifi edRes al e Me th od 1. All oc at io n M etho ds Afte r a res el le r ha s al lo cat edco st s t o i ts vario us res al e act iv it ie s, the res el le r
m us t al lo cat e co st s t o e nd in g i nv en to ry . A resel le r subjec t t o the UNICAP ru le s
m ay us e th e fac ts -an d- ci rcu m st an ces m etho d, s ee s ec. 1 .26 3A- 1( f), In co m e Tax Reg s., o r th e si m

pl ifi edres al e m etho d, s ee s ec. 1 .26 3A- 3( d) , Inc om e TaxReg s. Bo th m etho ds en ab le th e res el le r to cal cu la te th e am ou ntof c os ts th atth e res el le r
m us t capi ta li ze und er the UNICAP ru le s.

2. The Co m

m is si on er’s Use of the Sim pl ifi edRes al e Me th od Sect io n 4 46 (b ) ve st s the Co m m is si on er wi th bro addi sc ret io n t o d et erm in e whe th er a p art ic ul ar m etho d o f acc ou nt in g c le arl y refl ect s i nc om e. See Kn ig ht
Ri dd er News pape rs , Inc . v. Un it edSta te s, 7 43 F.2d78 1, 7 88 (11 th Cir . 19 84 ); Ans le y -Sh ep pa rd -Burg es s C o. v . Comm is si on er, 1 04 T.C. 36 7, 3 70 (19 95 ); R LC In du s. Co . v. Co m

m is si on er, 9 8 T.C. 4 57 , 49 1 (1 99 2) , aff’d, 5 8 F .3d41 3 (9 th Cir
.- 37 -

19 95 ). If a t ax pa y er fa il s t o u se a m etho d o f acc ou nt in g that cl earl y refl ect s in co m e, th e Co m

m is si on er m ay

reco ns tru ctth e ta xp ay er’s i nc om e u si ng an y reas on ab le m etho d tha t cl earl y refl ect s i nc om e. Sec. 4 46 (b ). Pet it io ne r’s m etho d o f acc ou nt in g fo r in co m e an d e xp en se s, i nc lu di ng in ve nt ory co st s, d idno t ap pl y

th e UNICAP ru le s. Th eref or e, res po nd en t was
en ti tl edto reco ns tru ctpe ti ti on er’s i nc om e b y an y reas on ab le m etho d tha t cl earl y refl ect edin co m e. Becaus e se ct io n 1 .26 3A- 3( d) , Inc om e Tax Reg s., p ro vi de s tha t
res el le rs m ay

us e th e si m

pl ifi edres al e m etho d t o a ll oc at e co st s, we fi ndth at
res po nd en t ac te d p ro pe rly in u si ng th e si m pl ifi edres al e m etho d t o re de te rm in e pe ti ti on er’s i nc om e.

3. App li cat io n o f th e Si m pl ifi edRes al e Me th od Sect io n 1 .26 3A- 3( d) (3 ), In co m e Tax Reg s., p ro vi de s p ro cedur es for ap pl y in g the si m

pl ifi edres al e m etho d. Th e si m pl ifi edres al e m etho d u se s s ev eral fo rm ul as to cal cu late th e ad di ti on al cap it al iz ab le co st s fo r th e ta xabl e y ear. Id
. The ge ne ral form

ul a is : “ co m

bi ne d abs or

pt io n ra ti o × sec ti on 47 1 c os ts rem ai ni ng on handat year en d” . Sec. 1 .26 3A- 3( d) (3 )(i )(A), In co m e Tax Reg s. Th e p ro du ct of th is form ul a is equa l t o the am ou ntof a dd it io na l capi ta li zab le co st s tha t the- 38 -

ta xp ay er m

us t ad d t o i ts en di ng sec ti on 47 1 c os ts . Sec. 1 .26 3A- 3( d) (3 )(i )(B) , 2 4 In co m e TaxReg s. On ce the tax pa y er ad ds th e ad di ti on al cap it al iz ab le co st s t o i ts
en di ng sec ti on 47 1 c os ts , th e ta xp ay er ca lc ul at es to ta l en di ng in ve nt ory forth e ta xabl e y ear. 2 5 The co m bi ne d abs or

pt io n ra ti o i s the su m

of the st or ag e an d h an dl in g c os ts ab so rp ti on rat io an d the pu rch as in g c os ts ab so rp ti on rat io
. See s ec. 1 .26 3A- 2 6 3( d) (3 )(i )(C) (1 ), In co m e Tax Reg s. Sec ti on1.2 63 A-3 (d )(3 )(i )(D)(1 ), In co m e Tax

Sec. 4 71 pro vi de s the ge ne ral rul e fo r in ve nt or ie s. 2 4 Pet it io ne r co nt en ds th atinth e n ot ic e o f de fic ie nc y res po nd en t erro ne ou sl y 2 5 cal cu la te d e nd in g i nv en to ry as the pro du ctof: (1) th e ad di ti on al cap it al iz ab le co st s as de te rm in edus in g the si m pl ifi edres al e m etho d; (2) pe ti ti on er’s p ur po rte d se c. 47 1 c os ts forth e y ear, s ee s up ra n ot e 8 ; an d (3 ) pe ti ti on er’s en di ng in ve nt ory . Inhi s s pr ead sh eet s AO Mi ne rv in i d idno t i nc lu de pe ti ti on er’s s ec. 4 71 co st s fo r th e y ear i n c al cu la ti ng it s en di ng in ve nt ory . Res po nd en t b rie fly addres se d pe ti ti on er’s co nt en ti on inhi s re pl y bri ef. Neit he r pa rty adequa te ly exp la in edhi s o r it s p os it io n re ga rd in g the co rrec t ap pl ic at io n o f th e si m

pl ifi edres al e m etho d. As th e p art ie s fa il edto ad dr es s thi s is su e, we ha ve co nf

in edou r an al y si s t o tho se is su es m at eri al to th e res ol ut io n o f th is cas e. W e le av e fo r th e Ru le 15 5 c om pu ta ti on th e p ro pe r ap pl ic at io n o f th e si m pl ifi edres al e m etho d. If the parti es are u nabl e to reac h an a gr eem en t, we wi ll ad dr es s the is su e as ap pr op ria te ina Ru le 15 5 p ro ceed in g o r ina supp le m en ta l op in io n. The parti es st ip ul at edth e al lo cat io n o f al l co st s ex cep t fo r th e al lo cat io n o f 2 6 th e ci ga ret te tax st am

p c os ts . Becau se our de ci si on do es no t af fectth e p ur ch as in g co stab so rp ti on rat io , see sec . 1.2 63 A-3 (d )(3 )(i )(E), In co m e Tax Reg s., we d o n ot ad dr es s the cal cu la ti on of tha t ra ti o.- 39 -

Reg s., p ro vi de s that the st or ag e an d h an dl in g c os ts ab so rp ti onrat io is de te rm in ed
as fol lo ws: Curren t year’s st or ag e an d h an dl in g c os ts

Beg in ni ng in ve nt ory

pl us curren t year’s pu rch as es The curren t year’s st or ag e an d h an dl in g c os ts in cl ud e al l s to rag e co st s an d a ll ha nd li ng co st s i nc urreddu rin g the tax ab le y ear tha t re la te to pro pe rty the tax pa y er acqui redforres al e. Sec. 1 .26 3A- 3( d) (3 )(i )(D)(2 ), In co m e Tax Reg s. Th e be gi nn in g i nv en to ry

equa ls th e se ct io n 4 71 co st s o f pr op erty th e ta xp ay er ac qu ire d fo r res al e th atrem ai n uns ol d a s o f th e b eg in ni ng of the tax ab le y ear. Id . The
curren t year’s pu rch as es equa l the sec ti on 47 1 c os ts of p ro pe rty the tax pay er acqui redforres al e dur in g the tax ab le y ear. Id
. As n ot edsupr a p . 35 , th e ci ga ret te tax st am p c os ts are h an dl in g c os ts . Pet it io ne r m

us t i nc lu de th e ci ga ret te tax st am p c os ts in curreddu rin g the tax ab le y ear i n the nu m erat or of the rat io as p artof the curren t year’s st or ag e an d 2 7

Pet it io ne r co nt en ds th atth e an nu al cig aret te tax st am p c os t s ho ul d b e 2 7 in cl ud edinbo th th e num erat or an d d en om in at orof the st or ag e an d h an dl in g c os ts ab so rp ti on rat io . The d en om in at orin cl ud es th e se c. 47 1 c os ts fro m th e p rio r ta xabl e y ear a s wel l as th e cu rren t year’s pu rch as es . Alth ou gh pe ti ti on er pu rch as edcig aret te tax st am ps du rin g the tax ab le y ear, the cig aret te tax st am ps are no t i nc lu de d i n the curren t year’s pu rch as es be cau se th e ci ga ret te tax st am ps are no t p artof p et it io ne r’s in ve nt ory . Rath er, the cig aret te tax st am ps are i nd ire ct co st s al lo cab le to th e h an dl in g o f pe ti ti on er’s i nv en to ry . There fo re, the cig aret te ta x s ta m p c os t i s i nc lu de d i n the nu m erat oron ly.- 40 -

ha nd li ng co st s. Acco rd in gl y , we con cl ud e th atpe ti ti on er m us t i nc lu de th e cu rren t y ear’s ci ga rette tax st am

p c os ts inth e num erat orof the rat io
. V. Co nc lu si on Fo r pu rp os es of d et erm in in g e li gi bi li ty for the sm al l re se ll er ex cep ti on , pe ti ti on er m

us t i nc lu de ingro ss rece ip ts th e en ti re s al e p ro ceed s fr om th e sa le of ci ga ret te s, i nc lu di ng th e co st s o f th e ci ga rette tax st am ps . Peti ti on er fa il edto pr ov e th atitha d a ve rag e an nu al gro ss rece ip ts of l es s tha n $ 10 m il li on forth e te st in g p eri od s ap pl ic ab le to th e rel ev an t years, an d the refo re i t i s s ub ject t o the UNICAP ru le s o f se ct io n 2 63 A. The ci ga rette st am p t ax co st s ar e in di rectco st s pr op erl y ch arac te riz edas h an dl in g c os ts . Res po nd en t d idno t err inus in g the si m pl ifi edres al e m etho d t o d et erm in e th e am ou ntof c os ts pro pe rly all oc ab le to pe ti ti on er’s en di ng in ve nt ory un de r th e UNICAP ru le s. W e h av e co ns id eredall rem ai ni ng arg um en ts m ad e b y th e p art ie s for

2 8
res ul ts co nt rary to tho se expr es se d h erei n, an d t o the ex te ntno t d is cu ss edab ov e, we rejectth os e arg um en ts as i rrel ev an t, m oo t, o r witho utm eri t. Init s b rie f pe ti ti on er al so co nt en ds th atres po nd en t fa il edto ap pl y it s 2 00 5 2 8 ov erp aym en t t o an app ro pr ia te tax ab le y ear. As we un de rs tandpe ti ti on er’s arg um en t, i t i s cl ai m in g tha t the ov erp aym en t fo r 20 05 ha s n otbe enap pl ie d t o reduc e it s i nc om e ta x l iabi li ty for an ot he r y ear. Pe ti ti on er’s arg um en t ra is es a co m pu ta ti on al is su e o nl y , andwe ne edno t re so lv e ithe re. The im pa ctof the 20 05 ov erp aym en t o n the cal cu la ti onof the 20 04 an d 2 00 6 d efi ci en ci es , if an y , wil l b e co ns id eredinth e Ru le 15 5 p ro ces s.- 41 -

To re fle ctth e fo reg oi ng , Deci si on wil l b e en te red
un de r Ru le 15 5.