City Line Candy & Tobacco Corp. v. Commissioner

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

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

414

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

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

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

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 416 141 UNITED STATES TAX COURT REPORTS (414)

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

FINDINGS OF FACT

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

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

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

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

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

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

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

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

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

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

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 418 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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

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

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

the Internal Revenue Service Appeals Office. Appeals Officer Marco
Continued

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 420 141 UNITED STATES TAX COURT REPORTS (414)

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

OPINION

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

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

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

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

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

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

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 422 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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

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

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 424 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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

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 426 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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 428 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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 430 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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 432 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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

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 434 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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 436 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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 438 141 UNITED STATES TAX COURT REPORTS (414)

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

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

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

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

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

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

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

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 440 141 UNITED STATES TAX COURT REPORTS (414)

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

f

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