Sales-Related Expenses Remove Taxpayers From “Small Reseller” Exception of Sec. 263A

By Brenna MacDonald, CPA, Milwaukee, and Tom Stockdale, CPA, Chicago

Editor: Greg A. Fairbanks, J.D., LL.M.

Recent appellate court rulings unfavorable to taxpayers and their application of Sec. 263A provide additional guidance regarding the required capitalization of certain indirect costs and the interpretation of Robinson Knife Mfg. Co.,600 F.3d 121 (2d Cir. 2010), nonacq. 2011-1 C.B., for the exclusion of sales-related expenses. In September 2015, the Second and Fifth Circuits affirmed two 2013 Tax Court decisions regarding the application of Sec. 263A to inventory produced and acquired for resale by taxpayers that had considered themselves to be exempt from Sec. 263A.

The uniform capitalization (UNICAP) rules of Sec. 263A require capitalization of direct costs and indirect costs that directly benefit or are incurred by reason of production or resale activities. Under Sec. 263A and Regs. Sec. 1.263A-1(e), capitalizable indirect costs include purchasing costs, storage and handling costs, and general and administrative-type "service" costs that support or partially support production or resale activities. Capitalizable indirect costs specifically exclude sales- and marketing-related costs and service costs that do not support production or resale activities. However, Sec. 263A(b)(2)(B) provides a "small reseller" exception for taxpayers engaged in resale activities with average annual gross receipts of $10 million or less based on the prior three tax years. Taxpayers qualifying for the small reseller exception are exempt from the UNICAP rules.

In City Line Candy & Tobacco Corp., No. 14-3793-ag (2d Cir. 9/30/15), aff'g 141 T.C. 414 (2013), the Second Circuit affirmed the Tax Court's decision that a wholesale cigarette dealer was required to recognize tax stamp revenue in gross receipts and was therefore subject to Sec. 263A as a result of not meeting the small reseller exclusion. In addition, the court upheld the Tax Court's decision that the taxpayer was required under Sec. 263A to capitalize purchased cigarette tax stamps as an indirect storage and handling cost.

City Line, a wholesale cigarette dealer, was licensed as a stamping agent in the state of New York, which provided the company a commission for stamping services. New York state law imposes an excise tax on cigarettes by requiring a state-issued tax stamp on cigarettes packaged for sale. As a licensed stamping agent, City Line purchased tax stamps and applied the stamps to packages of cigarettes before selling them to retailers or wholesalers.

As required by state law, the taxpayer included the cost of the cigarette tax stamps in the wholesale sales price of the cigarettes. City Line's financial accounting included the stamps as gross receipts, but for income tax reporting purposes, the company adjusted its gross receipts to exclude the cost of the purchased cigarette tax stamps. Based on the gross receipts reported for tax purposes, City Line qualified as a small reseller exempt from UNICAP. The taxpayer supported this position by citing Regs. Sec. 1.263A-3(b)(2)(ii)(F), which allows an exclusion of receipts from activities that are not part of the trade or business or not engaged in for profit. City Line argued that it was responsible for collecting the cigarette tax as a fiduciary of the state under New York law, and therefore it was not entering into the activity for profit as part of its active trade or business.

The Second Circuit affirmed the Tax Court's ruling that the tax stamps should be recognized as gross revenues, as Regs. Sec. 1.263A-3(b)(2)(i) defines gross receipts as "the total amount, as determined under the taxpayer's method of accounting, derived from all of the taxpayer's . . . businesses." Additionally, since the taxpayer chose to become a licensed stamping agent for New York and received a commission for the services, the activity was a source of revenue in itself and should be included in gross revenue, the court said.

Increasing City Line's gross receipts to appropriately include the tax stamp revenue resulted in the taxpayer's not meeting the small reseller exception and therefore being subject to the UNICAP rules.

The Second Circuit next addressed the issue of which costs were required to be capitalized. In its 2013 ruling, the Tax Court determined that purchased tax stamps were capitalizable indirect costs. City Line primarily argued that the tax stamps should be treated as a deductible selling expense for the resale of cigarettes, citing Robinson Knife. In Robinson Knife, the Second Circuit ruled that trademark royalties contingent on sales were not allocable to ending inventory. City Line further relied on Robinson Knife to argue that the tax stamps were deductible because they related directly to the sale of cigarettes.

The Second Circuit affirmed the Tax Court's determination that the tax stamps were capitalizable indirect costs under Sec. 263A. The court first noted that the regulations under Sec. 263A specifically list taxes as a capitalizable indirect cost. Regarding City Line's argument based on Robinson Knife, the court found that City Line's cigarette sales would have been illegal but for the stamps and that its stamping activity was an integral part of its resale activity. Thus, the court concluded that the taxpayer failed Robinson Knife's "but-for cause" test because it could not sell cigarettes but for the purchase of the stamps. Further, under New York state law, City Line was liable for the stamp taxes at the point at which it offered the cigarettes for sale to customers, not when the cigarettes were sold to the customers. Thus, City Line did not fulfill the second Robinson Knife requirement because the taxes were not sales-based—while they were calculated as a percentage of sales revenue from certain inventory, they were not incurred only upon the sale of that inventory. Thus, the Second Circuit agreed with the Tax Court that the tax stamps should correctly be treated as indirect costs incurred for the resale of the cigarettes and, therefore, were capitalizable under Sec. 263A.

In another case, Frontier Custom Builders, Inc.,No. 14-60518 (5th Cir. 9/16/15), aff'g T.C. Memo. 2013-231, the Fifth Circuit affirmed the Tax Court's decision that a custom homebuilder was a producer subject to the UNICAP rules and was required to capitalize officers' compensation and other costs as indirect costs incurred related to production activities.

Frontier is a custom homebuilder based in Houston that designs and sells custom homes, but it engages subcontractors to build the structures. For tax purposes, Frontier followed the inventory methods used for financial reporting to capitalize direct materials, labor, and post-production-period carrying costs. However, Frontier deducted the cost of salaries, year-end bonuses, and other expenses, including the compensation of its president, and did not compute an adjustment to capitalize additional costs under Sec. 263A. The Tax Court ruled that Frontier was subject to Sec. 263A and upheld the adjustment to income assessed by the IRS for the capitalization of the president's compensation and other costs related to the production of inventory.

Frontier argued that it was exempt from the UNICAP rules because it was a custom homebuilder rather than a speculation homebuilder. As such, the company was in the business of sales and marketing, not production-related services, as custom homebuilding is centered on marketing strategy and the creativity of sales personnel, designers, and decorators, not on tradesmen, as used by speculation homebuilders. The company contended that the actual production activities were contracted out by Frontier and not performed by Frontier employees.

Frontier further argued that the compensation paid to its president was deductible because the president was an executive engaged in the company's overall management and policy and strategic business planning. The Tax Court held that although Frontier subcontracted the construction of custom homes, this fact alone did not preclude it from having to comply with Sec. 263A. Additionally, designing custom homes is a necessary step in their construction, and, therefore, part of Frontier's production activities were subject to Sec. 263A. The Tax Court determined that Frontier's compensation to employees, including its president, constituted allocable mixed service costs under Sec. 263A, as Frontier could not provide contemporaneous support for the deduction of those expenses. The Fifth Circuit agreed with the Tax Court's determination that a substantial portion of the president's activities directly benefited, or were incurred by reason of, production activities.

Frontier also argued for the deduction of year-end bonuses, as the company determined the bonuses based on profits from the sale of homes and contended that the bonuses therefore should be allocated to homes sold by year. The Fifth Circuit affirmed the Tax Court's decision that this method of accounting would not clearly reflect income, and, furthermore, if the proposed cost allocation method were allowed, all of a taxpayer's production costs could be excluded from capitalization under Sec. 263A on the basis that payments came from profits.

The conclusions in both cases provide additional guidance on the IRS's interpretation of sales-based expenses and its narrow application of Robinson Knife. Determining whether an expense is deductible as related to the sale of inventory or capitalizable under Sec. 263A to production or resale activities continues to be subjective but appears to be less favorable to taxpayers following the decisions in Frontier and City Line.


Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503202-521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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