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Cigarette Reseller Not Eligible for Small Reseller Exception; UNICAP Rules Apply.

(Parker Tax Publishing October 22, 2015)

A company could not exclude from its cigarette gross receipts the part of the sale price attributable to the cost of the cigarette stamp tax. As a result, the company failed to prove that it was eligible for a small reseller exception to Code Sec. 263A and thus was subject to the uniform capitalization rules. City Line Candy & Tobacco Corporation, 2015 PTC 349 (2nd Cir. 2015).


City Line Candy & Tobacco Corporation (City Line), an accrual method taxpayer, is a reseller and licensed wholesale dealer of cigarettes in New York. Under New York law, all cigarettes possessed for sale must bear a stamp issued by the New York tax commissioner. Pursuant to this law, City Line, a licensed cigarette stamping agent for New York, buys 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. Under New York law, City Line is required to include, and did include, the cost of the cigarette tax stamps in the sale price of the cigarettes.

In computing its gross receipts from cigarette sales for financial statement purposes, City Line totaled the gross sale prices of the cigarettes sold during each year. However, for income tax reporting purposes, City Line 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.

In a notice of deficiency, the IRS determined that City Line had underreported its gross receipts for each of its 2004 through 2006 fiscal years in an amount approximately equal to the cost of the cigarette tax stamps purchased during that tax year. Consequently, the IRS determined that City Line had additional gross receipts of almost $6 million, $5 million, and $5 million for 2004, 2005, and 2006, respectively. As a result of the adjustments to City Line's gross receipts, the IRS also determined that the company's average annual gross receipts for the three-taxable year period ending with the tax year preceding each of the 2004-06 tax years exceeded $10 million; therefore the company was not eligible for the "small retailer" exception in Code Sec. 263A(b)(2)(B) and was subject to the UNICAP rules.

Tax Court Decision

The Tax Court held that the IRS correctly determined City Line Candy & Tobacco's gross receipts 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. As a result, the court said that City Line was subject to the UNICAP rules of Code Sec. 263A because it failed to prove that its average annual gross receipts for the three-taxable-year period ending with the tax year preceding each of the years in issue, when correctly calculated to include the entire sale price of the cigarettes it sold, did not exceed $10 million for any of those years (the threshold for the small retailer exception). The court also concluded that the cigarette tax stamp costs were indirect costs that had to be capitalized under the UNICAP rules and such costs are handling costs that the IRS properly allocated, in part, to City Line's ending inventory using the simplified resale method.

Second Circuit Appeal

On appeal, the Second Circuit affirmed the Tax Court. City Line argued it qualified for the "small reseller" exception to the Code Sec. 263A uniform capitalization rules and that its tax stamp purchases were deductible selling expenses. According to City Line, the Tax Court erred by calculating its gross receipts based on its total revenue, including the part attributable to tax stamps, and not solely based on the price of the cigarettes themselves.

The Circuit Court noted that whether it included the stamps' value determined whether City Line's gross receipts exceed the threshold for the "small reseller" exception in Code Sec. 263A(b)(2)(B). The court found that City Line's own financial accounting included the stamps in its gross receipts, and determined the Tax Court rightly found that City Line has failed to show why its tax accounting should differ.

Having determined that the uniform capitalization rules applied to City Line, the court turned to whether they permitted City Line to deduct the cost of stamps as an expense or required City Line to capitalize them as an indirect cost.

City Line offered three arguments for treating its stamp costs as deductible, which the court said contradicted each other and failed independently. City Line first suggested that the stamps were actually a direct cost, but the court stated that would not change the outcome, since direct costs must also be capitalized pursuant to Code Sec. 263A(a)(2)(A). Alternatively, City Line argued that the stamps qualified as a deductible selling expense, but the court noted that Reg. Sec. 1.263A-1(e)(3) specifically list taxes as an example of indirect costs that must be capitalized to the extent they are properly allocable to property acquired for resale.

Finally, City Line argued that Robinson Knife Mfg. Co. v. Comm'r, 600 F.3d 121 (2d Cir. 2010) limits the capitalization requirement and permits the deduction of indirect costs tied directly to sales. Robinson Knife, the Second Circuit observed, interpreted Reg. Sec. 1.263A-1(e)(3) as including two limitations on the requirement that indirect costs be capitalized. First, the court noted, that case required capitalization only of costs that are a "but-for cause" of the taxpayer's production or sales activity. The court said this causation test was easily satisfied in the instant case, since City Line's cigarette sales would have been illegal but for the stamps, and the Tax Court found that City Line's stamping activity was an integral part of its resale activity. Second, Robinson Knife permitted the deduction of costs that are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory. The court determined City Line's situation failed the second prong because, under New York law, City Line became liable for the cigarette tax as soon as it offered the cigarettes for sale, not when it sold them. The court stated that accepting City Line's reading would permit it to take an immediate deduction for costs associated with future sales, precisely the kind of temporal mismatch Code Sec. 263A seeks to avoid.

OBSERVATION: The IRS amended Reg. Sec. 1.263A-1(e)(3) after Robinson Knife to include the capitalization of indirect costs that are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. The revised regulations were not effective during the years at issue.

For a discussion of the uniform capitalization rules, see Parker Tax ¶242,380. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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