DOJ Argues Greeting Card Company Is Not Exempt From UNICAP Rules

Suzy Spafford was the majority owner of Suzy's Zoo, which sold greeting cards and other paper products bearing images of its licensed cartoon characters. As the company's principal artist, Spafford was personally responsible for developing and creating the cartoon characters. Suzy's Zoo did not sell its original cartoon drawings or any items that did not bear images of its cartoon characters.

The company used several independent printing companies to produce its products. Suzy's Zoo would send an original cartoon drawing to a printer, who would then photograph the drawing and create proofs of a particular paper product in accordance with Zoo's specifications. The printers were not allowed to sell any originals or reproductions of the company's cartoon characters, nor were they allowed to sell related paper products.

For the year ended June 30, 1994, Suzy's Zoo reported gross receipts of $5.9 million. The IRS determined that Suzy's Zoo was subject to the UNICAP rules under section 263A and, thus, that Zoo had overstated its cost of goods sold for the year because the company had not changed its accounting method to account for the UNICAP rules.

The Tax Court agreed with the IRS, holding that Suzy's Zoo did not qualify for any statutory exceptions because it actually produced its paper products. The court determined that the printers' reproduction process was merely mechanical in nature and that the company's ownership interest in the paper products attached at the first stage of their production -- when the cartoon characters were developed and created. The court also held that the year ended June 30, 1994 was the year in which Suzy's Zoo was required to change its accounting method to conform to the UNICAP rules for section 481 purposes. (For a summary of this opinion, see Tax Notes, Jan 17, 2000, p.360; for the full text, see Doc 2000-1101 (24 original pages) or 2000 TNT 5-9 .)

The Justice Department insists that the Tax Court correctly determined that Suzy's Zoo is a producer, rather than a reseller, of the products bearing its cartoon images for purposes of section 263A. The DOJ emphasizes that Suzy's Zoo cannot simultaneously be a "producer" and a "reseller" of the products at issue and that whether the cartoon images are independent artwork is irrelevant. The Justice Department further insists that the company is effectively a producer of the products at issue even though it does not "actually" fabricate them and even though the printers hold title to the products during the printing process. The Justice Department also argues that the regulatory exception for small resellers who also produce property under contract is inapplicable to Suzy's Zoo. Finally, the Justice Department contends that the Tax Court correctly held that the company's 1994 tax year was "the year of the change" under which the company was required to adjust for the change in its accounting method under section 481.

[1] On February 18, 1998, the Commissioner issued a notice of deficiency to Suzy's Zoo (taxpayer), determining an income tax deficiency with respect to its tax year ending June 30, 1994. (ER A, Ex. A.) ¹ On May 22, 1998, taxpayer timely filed a petition in the United States Tax Court, challenging the Commissioner's determinations. ² (ER A.) The Tax Court had jurisdiction pursuant to I.R.C. sections 6213, 6214, and 7442.

[2] On March 10, 2000, the Tax Court entered its decision, which is a final order that disposes of all claims of all parties. (ER G.) On April 11, 2000, taxpayers timely filed a notice of appeal. (ER H; see I.R.C. section 7483 and Fed. R. App. P. 13(a)(1).) This Court has jurisdiction over their appeal under I.R.C. section 7482.

STATEMENT OF THE ISSUES

[3] 1. Whether the Tax Court clearly erred in finding that taxpayer, which retains independent contractors to print its cartoon images on greeting cards and other items that it designs and sells, is a "producer" under I.R.C. section 263A.

[4] 2. Whether the Tax Court correctly held that "the year of change" for which taxpayer was required under I.R.C. section 481 to adjust for the change in its method of accounting was its 1994 tax year.

STATEMENT OF THE CASE

[5] Taxpayer petitioned the Tax Court, contesting the Commissioner's determination of an income tax deficiency for its tax year ending June 30, 1994. (ER A.) After concessions, the case was submitted for decision on the basis of fully stipulated facts pursuant to Tax Court Rule 122. (ER C; Supp. ER at 2.) On January 6, 2000, the Tax Court (Hon. David Laro) issued an opinion, published at 114 T.C. 1, sustaining the Commissioner's determination of a deficiency. (Supp. ER 1-24.) After a recomputation pursuant to Tax Court Rule 155 (ER F), the Tax Court entered its decision on March 10, 2000, determining an income tax deficiency of $131,077 for taxpayer's 1994 tax year (ER G). On April 11, 2000, taxpayer timely filed a notice of appeal. (ER H.)

STATEMENT OF FACTS

1. BACKGROUND

[6] Taxpayer is a California corporation with its principal place of business in California, and it is engaged in the business of "social expression" through the original drawing of licensed cartoon characters and the dissemination of those drawings on various paper products. During the tax year ending June 30, 1994, 84% of taxpayer's stock was owned by Suzy Spafford, and 16% was owned by two individuals who are not related to Ms. Spafford. (ER C at paragraphs 1, 11-19.)

[7] Ms. Spafford began developing cartoon characters in the 1960s, and she gradually developed taxpayer's business from those characters. She incorporated taxpayer's business in 1976, and she registered its name as a trademark. Taxpayer sells paper products, including greeting cards, stationery, Christmas cards, stickers, party products, notepads, calendars, blank recipe and address books, etc., that feature a copy of one or more of its cartoon drawings. (ER C at sections 6, 9-10, 13-16; ER D-4.)

[8] Taxpayer's creative work is done at its headquarters in San Diego. Ms. Spafford is taxpayer's principal artist, and she has personally drawn and painted most of its original cartoon characters, images, and scenes. During 1994, two other employees also drew original cartoon drawings which were reviewed, modified as necessary, and approved by Ms. Spafford. Taxpayer produces between 300 and 400 cartoon images a year; each drawing is numbered, and its use is thereby tracked. (ER C at paragraphs 45-51, 80-81.)

[9] Taxpayer uses several companies to print its products. Generally, taxpayer sends an original cartoon drawing to a printer, and the printer creates a "proof" of the product bearing that image in accordance with taxpayer's specifications. The printer sends the proof to taxpayer for approval, and taxpayer determines whether any changes need to be made, such as intensifying or changing a color. After a proof is approved, taxpayer sends a purchase order to the printer indicating the number of the product that it wants printed, and the printer prints the approximate number of products ordered. (ER C at paragraphs 53-58, 61-62, 65-66.)

[10] The printer does not print taxpayer's products until it receives an order from taxpayer, and it cannot sell taxpayer's products. The printer uses its own paper and ink, and it holds title to, and bears the risk of loss of, the supplies and printed goods until it ships them. (ER C at paragraphs 59-60, 68-69.)

[11] In the case of greeting cards and Christmas cards, the printer prepares an invoice with artist's adjustments noted and, pursuant to taxpayer's instructions, ships the printed sheets of cards to a bindery. Taxpayer employs various trucking companies to transport the items from the printer to the bindery. Taxpayer contracts with the bindery to cut and fold the sheets into individual cards, and the bindery bears the risk of loss if it damages the cards during that process. The bindery ships the finished cards to taxpayer's headquarters, where taxpayer stores all of its inventory, and taxpayer's employees package the finished cards in boxes for sale to retailers. (ER C at paragraphs 40, 67, 71-76.)

[12] At its headquarters, taxpayer offers for sale all currently available merchandise that features its cartoon images. It does not sell any products other than those bearing its cartoon images, and it does not sell any of its original cartoon drawings. Taxpayer's principal customers are card and gift shops and licensing partners, and its products are primarily sold by independent sales representatives who have specified sales territories and receive commissions. (ER C at paragraphs 31, 33-39, 77, 82.)

[13] In addition to selling products that bear its cartoon images, taxpayer enters into licensing agreements which give manufacturers of other products, such as rubber stamps, balloons, or needlepoint kits, the right to use a particular cartoon image. Under these agreements, taxpayer generally charges the licensee a fee for the use of each original cartoon drawing and a royalty equal to a certain percentage of the money generated by sales of the licensed products. The licensees sell and distribute the products that they create using taxpayer's cartoon images. Except for certain Mylar balloons made by one licensee, Classic Balloons, taxpayer does not sell its licensees' products through its independent sales representatives or catalogues, but it does sell such products at its headquarters. In its 1994 tax year, taxpayer's gross sales of Mylar balloons totaled $89,603, which was approximately 1.71% of taxpayer's total gross sales in that year. Taxpayer's showroom had gross sales of $84,248 in 1994, and this amount, which was approximately 1.61% of taxpayer's total gross sales in 1994, included both sales of products produced for taxpayer and sales of licensees' products. (ER C at paragraphs 17-27, 39.)

[14] Taxpayer never adjusted the value of its inventory to reflect I.R.C. section 263A. On its tax return for its year ending June 30, 1994, taxpayer reported ending inventory of $1,556,404, and its absorption ratio for that year would have been 42.87%. (ER C at paragraphs 90-93.)

[15] Taxpayer's total gross receipts during its 1994 tax year were $5,874,039. Of that amount, $5,241,830 was from sales, $623,469 was from royalties from licensing agreements, and $8,740 was from interest, discounts, and service charges. (ER C at paragraphs 26-29.) Taxpayer's gross receipts from sales were attributable to the following items (id. at paragraph 30):

Items                                         Gross Receipts  Percent

2. PROCEEDINGS IN THE TAX COURT

[17] The Commissioner issued a notice of deficiency to taxpayer for its 1994 tax year, determining that taxpayer was subject to the uniform capitalization rules of I.R.C. section 263A, and therefore was required to capitalize (rather than deduct) certain costs. (ER A, Ex. A at 11.) Taxpayer contested the Commissioner's determination in the Tax Court on several grounds. (ER A.) First, taxpayer argued that it did not produce its paper products, but instead resold them after buying them from producers (i.e., printers), and that it thus fell within the "small reseller" exception to section 263A. Second, taxpayer claimed that it qualified as an artistic business that was exempt from section 263A. Finally, taxpayer claimed that even if it were subject to section 263A, the "year of change" for which it was required under I.R.C. section 481 to account for the change in its method of accounting was its 1988 tax year rather than its 1994 tax year.

[18] The Tax Court found that taxpayer was subject to I.R.C. section 263A. (Supp. ER at 13.) It rejected taxpayer's argument that it was a reseller, rather than a producer, of its paper products. (Id.) The court concluded that, for purposes of section 263A, taxpayer was an "owner" and "producer" of its paper products. (Id.) It noted that taxpayer developed and drew its cartoon characters solely by itself, and that such development and drawing was "critical and indispensable to the paper products' production." (Id. at 13-14.) It further noted that the printer's reproduction of taxpayer's characters onto ordinary paper was merely one small step in taxpayer's process of exploiting its characters as sellable images, that such reproduction of the images was mechanical in nature and subject to taxpayer's control, close scrutiny, and approval, and that the printers had no right to sell the characters or reproductions thereof either alone or as part of a product. (Id. at 14-16.) Accordingly, the court concluded that "[t]he ink and characterless paperstock which the printers sell to [taxpayer] is sufficiently different from the character-filled paper products which [taxpayer] sells to its customers so as to characterize the latter products as sold initially by [taxpayer], rather than as sold first by the printers to [taxpayer] and then resold by [taxpayer] to its customers." (Id. at 16.)

[19] The Tax Court also rejected taxpayer's argument that it qualified as an artistic business that was exempt from I.R.C. section 263A. (Supp. ER at 17.) The court noted that a personal service corporation could qualify for the exemption for artists only if substantially all of its stock were owned by a qualified employee- owner and members of his family, and that the pertinent legislative history explained that "substantially all" in this context means 95% or more of the value of the corporation's stock. (Id. at 18-19.) Because none of taxpayer's shareholders owned the requisite percentage of stock, the Tax Court held that taxpayer did not qualify for the exemption for artists. (Id. at 20.)

[20] Finally, the Tax Court determined that "the year of change" for which taxpayer was required under I.R.C. section 481 to account for the change in its method of accounting to reflect section 263A was its 1994 tax year. (Supp. ER at 20-24.) The court noted that the year of change in which a taxpayer must take into account certain adjustments to reflect a change in its method of accounting is the first taxable year in which it computes income under a method of accounting that is different from the method used in the prior year. (Id. at 22.) Because taxpayer's 1994 tax year was the first taxable year in which its taxable income was computed under a method of accounting different from the method used in the prior year, the Tax Court concluded that 1994 was the year of change for purposes of section 481. (Id. at 24.)

[21] Taxpayer now appeals.

SUMMARY OF ARGUMENT

[22] 1. Section 263A of the Internal Revenue Code provides uniform capitalization rules which generally require a taxpayer to capitalize certain costs associated with property "produced" by the taxpayer or property "acquired for resale" by the taxpayer. Section 263A(g)(2) provides that property produced for the taxpayer under a contract is treated as property produced by the taxpayer, and the courts have long recognized that the term "manufacturer" or "producer" may include taxpayers who use other agents to fabricate their products. Although the uniform capitalization rules generally apply to "producers" and "resellers" in the same manner, I.R.C. section 263A(b)(2)(B) provides an exception for resellers of personal property with average annual gross receipts for the three preceding tax years of less than $10 million (the "small-reseller" exception). At issue here is whether taxpayer, which draws cartoon images and contracts with outside printers to print its images on greeting cards and other items that it sells, is a producer or a reseller of those products.

[23] The Tax Court correctly found that taxpayer is a producer of the products bearing its cartoon images. Taxpayer creates the original cartoon drawings, determines what type of product is to be made using that image, and selects the printers and binders to fabricate the product. Moreover, taxpayer maintains strict control over the design of the products throughout the printing (and binding) process. After the printer makes a "proof" of the product in accordance with taxpayer's specifications, taxpayer determines what changes need to be made, such as brightening a color. Taxpayer also controls the products once the printing process is completed; it instructs the printer to ship the cards to a specific binder, and it employs the trucking companies that transport the cards. Taxpayer contracts with the binder to cut and fold the cards, and the binder then ships the cards to taxpayer, where taxpayer's employees package them for sale to retailers. The printer and binder do not acquire any proprietary interest in taxpayer's cartoon images, and only taxpayer can sell the products.

[24] Contrary to its argument, taxpayer cannot simultaneously be a "producer" and a "reseller" of the products at issue. The language and the statutory structure of I.R.C. section 263A make clear that property "produced" by the taxpayer and property "acquired for resale" are two separate categories under section 263A. Moreover, taxpayer's argument that it "resells" the products at issue lacks merit.

[25] Even if taxpayer's cartoon images are "independent artwork," as taxpayer claims, they are also the first step in taxpayer's production of the items at issue. And the fact that the printers hold title to, and bear the risk of loss of, the supplies and products during the production process is immaterial. Where, as here, property is produced under contract, there is no requirement that the taxpayer must be considered the "owner" of the property before it may be considered the "producer" of that property. In any event, a taxpayer may be considered an "owner" of property even though it does not have legal title to the property.

[26] Finally, taxpayer errs in relying on the regulatory exception for small resellers who also produce property under contract. For that exception to apply, the taxpayer must first be a "reseller," and it must have entered its production contracts incident to its resale activities. But taxpayer is a "producer" -- not a "reseller" -- of the products at issue. Furthermore, contracting for the production of items that bear its cartoon images is taxpayer's primary activity, not something it does "incident to its resale activities." Accordingly, the regulatory exception for small resellers who also produce property under contract is inapplicable to taxpayer.

[27] 2. When a taxpayer's taxable income is computed under a different method of accounting from that used in the previous year, I.R.C. section 481 provides that there shall be taken into account those adjustments which are necessary to prevent amounts from being duplicated or omitted. The purpose of section 481 is to prevent income from escaping tax solely by reason of a change in accounting method, and, therefore, section 481 was specifically designed to require reporting in the year of the change in accounting method those amounts that might otherwise be barred by the statute of limitations. The "year of the change" in which section 481 adjustments should generally be taken into account is the first taxable year in which the taxpayer's income is computed using a different accounting method.

[28] Here, the Tax Court correctly held that the year of change was taxpayer's 1994 tax year, which was the first year in which taxpayer's taxable income was computed in accordance with the uniform capitalization rules of section 263A. Although taxpayer concedes that its 1994 tax year was the first year in which its income was actually computed using a different method, it argues that the year of change is its 1988 tax year because that is the year in which it should have changed its accounting method to reflect section 263A. This argument is absurd.

[29] Treasury Regulation section 1.481-1(a)(1) plainly provides that the year of change is the first year for which a taxpayer's taxable income "is computed" under a different method, not the year in which it "should have been" changed. Here, the simple fact is that taxpayer did not change its accounting method in its 1988 tax year to comply with section 263A, as it was required to do. Indeed, taxpayer never changed its accounting method to reflect section 263A, and its noncompliance was discovered only through the Commissioner's examination of its 1994 return. Taxpayer's contention that the section 481 adjustments are barred by the statute of limitations is thus incorrect.

[30] The decision of the Tax Court is correct and should be affirmed.

ARGUMENT

[32] Presumably to avoid the implications of the "clearly erroneous" standard of review in challenging the Tax Court's determination, taxpayer implies (Br. 15) that the issue in this case is not an issue of fact because "[t]his case was submitted to the Tax Court fully stipulated" and "there is no factual dispute as to the facts set forth in the Stipulation." While it is true that the parties stipulated to the underlying facts in this case, it is obvious that they did not agree on the central question of fact -- whether taxpayer produces or resells the products at issue. The Tax Court, considering all of the underlying facts of this case, concluded that taxpayer produces the products it sells, and that determination is a factual finding which is reviewed only for clear error. See, e.g., 19 James Wm. Moore, Moore's Federal Practice section 206.03[5] at 206-19 (3d ed. 1997) ("[t]he clearly erroneous standard also applies to findings made by the trial court that are based upon . . . undisputed or stipulated facts . . .").

A. INTRODUCTION

[33] Section 263A of the Internal Revenue Code was enacted as part of the Tax Reform Act of 1986, Pub. L. No. 99-514, section 803, 100 Stat. 2085, 2350, to provide a single, comprehensive set of rules to govern the capitalization of the costs of producing, acquiring, and holding property. The uniform capitalization rules of I.R.C. section 263A are designed to reflect income more accurately, to prevent unwarranted deferral of taxes by properly matching expenses and related income, and to make the tax system more neutral by eliminating the differences in former capitalization rules that created distortions in the allocation of economic resources and the organization of economic activity. See S. Rep. No. 99-313, at 140 (1986), reprinted in 1986-3 (Vol. 3) C.B. 1, 140; H. Rep. No. 99-426, at 625 (1985), reprinted in 1986-3 (Vol. 2) C.B. 1, 625; see also Preamble to T. D. 8482, 58 Fed. Reg. 42198, 42199 (1993), reprinted in 1993-2 C.B. 77, 78. Section 263A provides in pertinent part as follows:

(a) NONDEDUCTIBILITY OF CERTAIN DIRECT AND INDIRECT

[35] At issue in this case is whether taxpayer, which draws cartoon images and contracts with outside printers to print its images on greeting cards and other items that it sells, is a producer or reseller of those products. Taxpayer claims (Br. 15-45) that it is a reseller of the products, and that because its average annual gross receipts for the three tax years preceding 1994 did not exceed $10 million (ER C at section 32), it falls within the small-reseller exception. The Tax Court, however, found that, for purposes of I.R.C. section 263A, taxpayer is a producer of the cards and other items it sells, and is therefore subject to the uniform capitalization rules of section 263A. Far from being clearly erroneous, the Tax Court's finding is amply supported by the record. ³

B. THE TAX COURT CORRECTLY FOUND THAT TAXPAYER IS A PRODUCER,

[37] The Tax Court has repeatedly noted that the language of I.R.C. section 263A and the purpose behind its enactment show that Congress intended the term "produce" to be construed broadly. Reichel v. Commissioner 112 T.C. 14, 17-18 (1999) (real estate taxes paid for property taxpayer intended to develop are preproduction costs that must be capitalized under section 263A); Von-Lusk v. Commissioner, 104 T.C. 207, 215-216 (1995) (pre-development activities relating to development of real property, such as obtaining permits, engineering studies, etc., fall within section 263A's definition of "produce" and must be capitalized). Moreover, courts have long recognized that, for purposes of statutes imposing a tax on "manufacturers" or "producers," the term "manufacturer" or "producer" may include taxpayers who use "other aid and instrumentalities, machinery, servants, and general agents" to fabricate their products. Carbon Steel Co. v. Lewellyn, 251 U.S. 501, 506 (1920) (taxpayer was manufacturer of explosive shells even though it used outside contractors to complete their production); see also Boise National Leasing, Inc. v. United States, 389 F.2d 633, 636-638 (9th Cir. 1968) (taxpayer was manufacturer of trucks constructed by another where it furnished some of the truck materials and the constructor had no proprietary interest in trucks); Klepper v. Carter, 286 F. 370, 371- 372 (9th Cir. 1923) (taxpayer was producer of trucks even though chassis and body were made by others); Vinal v. Peterson Mortuary, Inc., 353 F.2d 814, 817-818 (8th Cir. 1965) (taxpayer who contracted with third party to convert automobiles into hearse and ambulance was manufacturer of those vehicles even though third party supplied all labor and materials necessary for conversion); Polaroid Corp. v. United States, 235 F.2d 276, 277-278 (1st Cir. 1956) (taxpayer was manufacturer of cameras for which it owned patent even though another company performed all manufacturing operations and supplied all materials and labor used therein); Charles Peckat Mfg. Co. v. Jarecki, 196 F.2d 849, 851-852 (7th Cir. 1952) (patent owner who contracted with another party to produce patented item was manufacturer of item); Chandler Laboratories, Inc. v. Smith, 88 F. Supp. 583, 585 (E.D. Pa. 1950) (manufacturer included one who caused product to be transformed by labor and equipment of others); Warner- Patterson Co. v. United States, 68 Ct. Cl. 237, 242-246 (1929) (taxpayer that used others to produce patented lenses was producer of such lenses).

[38] Here, the Tax Court correctly concluded that taxpayer is a "producer" of its products for purposes of I.R.C. section 263A. Taxpayer creates the original cartoon drawings (ER C at paragraphs 45-49), and, as the Tax Court noted (Supp. ER at 13-14), this step "requires the most skill, expertise, and creativity of any step in the production process" and "is critical and indispensable to the paper products' production." Taxpayer then determines what products are to be made using those images (e.g., greeting cards, stationery, stickers), and it selects the printers (and binders) to fabricate the products. (ER C at paragraphs 51-55; see also ER D-5.) Indeed, taxpayer itself proclaims (Br. 27) that it "has total flexibility on how to market and disseminate [its] artwork and the selection of various mediums for the distribution of that artwork in the public market."

[39] In addition to creating the cartoon image, determining the type of product to be made, and choosing a printer to fabricate it, taxpayer maintains strict control over the design of the products throughout the printing process. After taxpayer sends its cartoon image to the printer, the printer creates a "proof" of the product in accordance with taxpayer's specifications. (ER C at paragraphs 56-58; see also ER D-7.) Taxpayer reviews the proof and determines what changes need to be made, such as intensifying or changing a color. (ER C at paragraphs 61-62.) Indeed, as the printer's invoice attached to the stipulation of facts shows, taxpayer's instructions regarding the adjustments to be made are quite specific (see ER D-9 (noting taxpayer's instructions to "clean up overwork," "straighten outside text," "brighten color in face," etc.)), and demonstrate taxpayer's close oversight of the printing process. Thus, as the Tax Court stated (Supp. ER at 14), the reproduction process "involves little independence on the printers' part" and is "mechanical in nature." See Carbon Steel, 251 U.S. at 504-505 (taxpayer that "kept control throughout" production process was manufacturer of shells even though outside contractors completed production).

[40] The printer does not acquire any proprietary interest in taxpayer's cartoon images, and it cannot sell taxpayer's products. (ER C at paragraph 69.) See Vinal, 353 F.2d at 817-818 (taxpayer was manufacturer of vehicles fabricated by third party where that party did not acquire proprietary interest in vehicle during production). Indeed, the printer does not even print taxpayer's products until taxpayer has sent it a purchase order. (Id. at paragraph 68.)

[41] Taxpayer also strictly controls the products once the printing process is completed. In the case of Christmas cards and greeting cards, which account for the largest portion of taxpayer's sales, taxpayer instructs the printer to ship the printed sheets of cards to a bindery. (ER C at paragraphs 30, 67.) Taxpayer even employs the trucking companies that transport the cards from the printer to the bindery. (Id. at section 71.) Taxpayer contracts with the bindery to cut and fold the sheets into individual cards, and the bindery then ships the cards to taxpayer's headquarters, where taxpayer's employees package them in boxes for sale to retailers. (Id. at paragraphs 72-76.)

[42] In short, taxpayer controls the entire development and design of the products -- from creation of the cartoon images through completion of the production process. Furthermore, only taxpayer can sell the products. The fact that taxpayer uses outside contractors to fabricate its products does not mean that it is not the producer of those products for purposes of I.R.C. section 263A. As noted above, section 263A(g)(2) specifically states that property produced for a taxpayer under a contract with the taxpayer shall be treated as property produced by the taxpayer. See also Carbon Steel, 251 U.S. at 506; Klepper, 286 F. at 371-372; Vinal, 353 F.2d at 817-818; Polaroid Corp., 235 F.2d at 277-278; Charles Peckat, 196 F.2d at 851-852; Chandler Laboratories, 88 F. Supp. at 585; Warner-Patterson, 68 Ct. Cl. at 242-246. The Tax Court thus correctly found that, for purposes of section 263A, taxpayer is a producer of the products at issue.

2. TAXPAYER CANNOT SIMULTANEOUSLY BE A "PRODUCER" AND A

[44] Taxpayer's argument, however, is directly contradicted by the language and the statutory structure of I.R.C. section 263A. First, taxpayer's argument (Br. 40) that section 263A "expressly recognized and preserved" a distinction between property produced for a taxpayer under contract and property "actually" produced by the taxpayer is simply incorrect. Section 263A(g)(2) expressly states that "[t]he taxpayer shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer . . ." See also Treas. Reg. section 1.263A-2(a)(1)(ii)(B)(1), Addendum, infra. Thus, the text of the statute clearly provides that, for purposes of section 263A, there is no distinction between a taxpayer that "actually" manufactures the products it sells and a taxpayer that has products produced for it under contract; rather, both are "producers" for purposes of section 263A. ⁶ Second, as the structure of the statute makes clear, property "produced" by a taxpayer and property "acquire for resale" by a taxpayer are two separate categories under I.R.C. section 263A. Section 263A(b)(1) involves producers, and section 263A(b)(2) applies to resellers. The use of separate provisions to address producers and resellers denotes that they are distinct categories under section 263A.

[45] The statutory distinction between producers and resellers is also reflected in the structure of the final regulations. Treas. Reg. section 1.263A-2 provides the "[r]ules relating to property produced by taxpayer," while a separate regulation, Treas. Reg. section 1.263A-3, sets forth the "[r]ules relating to property acquired for resale." This organizational structure was adopted "so that rules relating primarily to producers are separate from rules relating primarily to resellers." 58 Fed. Reg. at 42200.

[46] That "producers" and "resellers" are separate categories under I.R.C. section 263A is further evidenced by the fact that the statute provides an exception for certain small resellers, but it does not provide any such exception for small producers. See Golden Gate Litho v. Commissioner, 75 T.C.M. (CCH) 2312, 2317 n.5 (1998) (no exception for small producers under section 263A). ⁷ There are no subparagraphs relating to producers under section 263A(b)(1), but there are three subparagraphs pertaining to resellers under section 263A(b)(2). The first subparagraph, section 263A(b)(2)(A), states the general rule that section 263A applies to resellers; the second subparagraph, section 263A(b)(2)(B), then sets forth an exception for small resellers. Specifically, section 263A(b)(2)(B) states that "[s]ubparagraph (A) shall not apply to any personal property acquired . . . for resale" by a reseller with average annual gross receipts over the preceding three years of less than $10 million. ⁸ The statute thus plainly provides that "small resellers" are a subcategory of "resellers," and that a taxpayer may not qualify for the small-reseller exception unless it is first categorized as a reseller.

[47] Thus, taxpayer's claim (Br. 39) that, even though it is a "producer" of the products at issue under I.R.C. section 263A(g)(2) it can also qualify as a "reseller" of those same products, is flatly contradicted by the language and structure of the statute. Furthermore, as the Tax Court correctly found (Supp. ER at 13-17), taxpayer's argument that it is a reseller of the products at issue is simply not persuasive. ⁹

3. WHETHER TAXPAYER'S CARTOON IMAGES ARE INDEPENDENT

4. TAXPAYER IS A PRODUCER OF THE PRODUCTS AT ISSUE EVEN

[50] Furthermore, although the printers (and binders) use their equipment and expertise in printing (and binding) taxpayer's products, it is taxpayer that determines what type of product is to be made, specifies precisely how that product must appear, and decides when the product is to be printed (and bound). ¹¹ (ER C at paragraphs 51-55, 61-62, 68-69.) The printers (and binders) do not acquire any proprietary interest in taxpayer's cartoon images, and cannot sell the images or the products bearing those images. (Id. at 69.) The printers and binders are simply the means that taxpayer uses to complete the fabrication of its products.

[51] Thus, contrary to its argument, taxpayer does not simply purchase products produced by the printers (and binders) for resale; rather, it pays the printers (and binders) to fabricate products for it to sell in the first instance. As the Tax Court observed (Supp. ER at 16), the approximately 60% gross profit percentage ¹² that taxpayer reported on its sales of the products produced for it under contract in its 1994 tax year "leads directly to the conclusion that the printers charge [taxpayer] solely for the paper, ink, and labor devoted to the paper products, rather than for the value of the paper products as items that are sold to [taxpayer] for purposes of resale."

5. TAXPAYER IS A PRODUCER OF THE PRODUCTS AT ISSUE EVEN

[53] Treasury Regulation section 1.263A-2(a)(1)(ii)(A), Addendum, infra, provides:

(ii) Ownership --

[54] Moreover, the regulation expressly states that a taxpayer may be considered an owner of property even though it "does not have legal title to the property," and that the determination as to who owns a product is based on all the facts and circumstances. Treas. Reg. section 1.263A-2(a)(1)(ii)(A). As the Tax Court correctly found (Supp. ER at 13), the facts of this case lead to (indeed, virtually compel) the conclusion that taxpayer here can be considered an "owner" of its products for purposes of I.R.C. section 263A. Again, as discussed above, taxpayer maintains tight control over all aspects of the production process. The printers (and binders) do not acquire any proprietary interest in the products, and they cannot sell the products. That the printer (and binder) must bear the loss of any supplies and labor used to fabricate the products if they are damaged during printing (or binding) is merely one of many factors to be considered in determining who "owns" the products, and it is hardly surprising that the printer (and binder) bear the risk of loss while the products are in their possession. In the words of the Tax Court (Supp. ER at 17), "a reasonable printer would most likely have factored into its price of the print job the projected expense for damaged or nonconforming goods."

[55] Taxpayer's reliance (Br. 38) on Golden Gate Litho v. Commissioner, 75 T.C.M. 2312 (1998), is misplaced in this regard. At issue in that case was whether one of the printers which taxpayer uses to print its products was required to change from the cash method of accounting to the accrual method. Id. at 2313. In addressing that issue, the Tax Court found that the printer was required to maintain inventories because the printed items it produced for and sold to its customers were "merchandise" within the meaning of Treas. Reg. section 1.471-1, but that only those items as to which the printer held title were included in its inventory. Id. at 2316-2317. The Tax Court then noted that the printer held title to the items it printed until they were shipped. Id. at 2317. Taxpayer argues that these findings somehow preclude a determination that in this case, for purposes of I.R.C. section 263A, taxpayer is the owner of the printed items it orders and designs.

[56] The Tax Court's findings in Golden Gate Litho are not pertinent here, for the simple reason that the question whether a taxpayer is a "producer" under I.R.C. section 263A does not depend on whether the printer's printed items are deemed to be merchandise under Treas. Reg. section 1.471-1. And, while the fact that the printer holds title to the items until they are shipped (and, thus, might be deemed to hold "items for sale") was determinative as to whether those items were properly included in its inventory, see Golden Gate Litho, 75 T.C.M. at 2317, it is not controlling in this case. As noted above, under section 263A a taxpayer may be considered an owner of property produced even though it does not have legal title to the property. Treas. Reg. section 1.263A-2(a)(1)(ii)(A). Moreover, where, as here, property is produced under contract, a taxpayer may be considered the "producer" of the property regardless of whether it is considered an owner of the property. Id. Accordingly, Golden Gate Litho is irrelevant here.

6. THE REGULATORY EXCEPTION FOR SMALL RESELLERS WHO ALSO

[58] Taxpayer does not satisfy either of these requirements. As discussed above, taxpayer is a "producer," not a "reseller." ¹³ Furthermore, taxpayer does not enter into its production contracts "incident to its resale activities." With the minor exception of Mylar balloons made by Classic Balloons, which accounted for only 1.71% of taxpayer's sales in its 1994 tax year, every item that taxpayer offers for sale in its catalogue or through its independent sales representatives was produced for taxpayer under contract. ¹⁴ Clearly, contracting for the production of items that feature its cartoon images is taxpayer's primary activity, rather than something taxpayer does "incident to its resale activities." Accordingly, as the Tax Court correctly found (Supp. ER at 17 n.6), Treas. Reg. section 1.263A-3(a)(3) is inapplicable to taxpayer.

[59] Likewise, taxpayer's citation (Br. 43-44) to IRS Notice 88-86, 1988-2 C.B. 401, is without merit. That notice was issued to provide guidance to taxpayers regarding forthcoming regulations, and it addresses the same circumstance discussed in Treas. Reg. section 1.263A-3(a)(3) of a reseller who contracts with producers to produce certain "private label" goods for it to resell. 1988-2 C.B. at 401, 405. Because taxpayer is not a reseller, IRS Notice 88-86 is irrelevant.

[60] In sum, the Tax Court correctly found that taxpayer produces, rather than resells, the paper products at issue. Taxpayer creates the cartoon images, decides what type of product is to be made using that image, chooses a printer (and binder) to fabricate the product according to its specifications, and maintains strict control over the design of the product throughout the printing (and binding) process. The printers (and binders) do not acquire any proprietary interest in the products, and they cannot sell the products. Accordingly, the Tax Court's conclusion that, for purposes of I.R.C. section 263A, taxpayer is a producer of the products at issue, is not clearly erroneous and should be affirmed.

II

A. INTRODUCTION

[62] Taxpayers are required to use a method of accounting which clearly reflects income. I.R.C. section 446; Treas. Reg. section 1.446-1(a)(2). As a general rule, a taxpayer who wants to change its method of accounting must secure the Commissioner's consent before using the new method, even if the change is made to correct an impermissible or erroneous method of accounting. I.R.C. section 446(e); Treas. Reg. section 1.446-1(e)(2)(i); see Witte v. Commissioner, 513 F.2d 391, 394-395 (D.C. Cir. 1975). If a taxpayer using an improper method fails to change its accounting method, the Commissioner is authorized to change the taxpayer's method of accounting. See I.R.C. section 446(b); Thor Power Tool v. Commissioner, 439 U.S. 522, 540 (1979).

[63] Because a change in accounting methods "can create a situation in which a taxpayer is able to deduct the same expense -- or is required to recognize the same income -- in two separate tax years," I.R.C. section 481(a), Addendum, infra, permits the Commissioner to make adjustments in a taxpayer's taxable income to prevent duplication or omission of items occasioned by a change in accounting method. See Rankin v. Commissioner, 138 F.3d 1286, 1288 (9th Cir. 1998) (quoting National Life Ins. Co. v. Commissioner, 103 F.3d 5, 7 (2d Cir. 1996)). Section 481(a) provides in pertinent part that, when a taxpayer's taxable income is computed under a different method of accounting from that used in the previous year, "there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted . . . ." Section 481 enables the Commissioner to make such adjustments regardless of whether he or a taxpayer initiates a change of accounting method. See Knight-Ridder Newspapers v. United States, 743 F.2d 781, 797 n.34 (11th Cir. 1984); Grogan v. United States, 475 F.2d 15, 16-18 (5th Cir. 1973).

[64] The purpose of I.R.C. section 481 is "to prevent a distortion of taxable income and a windfall to the taxpayer stemming from a change of accounting at a time when the statute of limitations bars reopening the taxpayer's returns for earlier years." Graff Chevrolet Company v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965). Section 481 was therefore specifically designed to require reporting in the year of the change those amounts that might otherwise be barred by the statute of limitations. Rankin, 138 F.3d at 1288; Kohler Co. and Subsidiaries v. United States, 124 F.3d 1451, 1455- 1456 (Fed. Cir. 1997); Knight-Ridder, 743 F.2d at 797; Western Casualty and Surety Co. v. Commissioner, 571 F.2d 514, 519-520 (10th Cir. 1978); Graff Chevrolet, 343 F.2d at 572; Hamilton Industries v. Commissioner, 97 T.C. 120, 125 (1991); Superior Coach of Florida v. Commissioner, 80 T.C. 895, 912 (1983); Primo Pants Co. v. Commissioner, 78 T.C. 705, 726-727 (1982).

[65] Section 481 adjustments should generally be taken into account in "the year of the change." I.R.C. section 481(a). ¹⁵ The year of the change is the taxable year for which the taxpayer's taxable income is computed using a different method of accounting from that used in the previous tax year. Treas. Reg. section 1.481- 1(a)(1), Addendum, infra.

[66] In this case, the Commissioner, upon examination of taxpayer's 1994 return, determined that taxpayer was required to change its accounting method to reflect I.R.C. section 263A. As a result of the change in taxpayer's accounting method, the Commissioner made section 481 adjustments that increased taxpayer's tax liability in 1994. Taxpayer does not dispute that if it is subject to section 263A, the changes required by that section are a change in its accounting method to which section 481 applies. (See Br. 48.) Nor does taxpayer contest the Commissioner's determination as to the amount of the section 481 adjustments. (See Br. 46-47.) Instead, taxpayer claims (Br. 47-55) that "the year of the change" for purposes of the section 481 adjustments was its 1988 tax year, rather than its 1994 tax year, and that those adjustments are therefore barred by the statute of limitations. As shown below, this argument is meritless.

B. THE TAX COURT CORRECTLY CONCLUDED THAT TAXPAYER'S 1994 TAX YEAR

[68] Taxpayer concedes (Br. 50), as it must, that its 1994 tax year was the first year in which its taxable income was actually computed under a different accounting method. Yet taxpayer contends (Br. 47-55) that its 1994 tax year is not the year of change. Taxpayer argues that since I.R.C. section 263A was effective for taxable years beginning after December 31, 1986, the year of change must be its 1988 tax year (its first taxable year beginning after December 1, 1986), because that is the year in which it should have changed its accounting method to conform to section 263A. In other words, taxpayer argues that the year of change is not the year in which it actually changed (voluntarily or involuntarily) its accounting method, but rather the year in which it should have changed its accounting method. Taxpayer's argument is absurd.

[69] First, taxpayer's argument simply ignores the language of Treas. Reg. section 1.481-1(a)(1). As noted above, that regulation states that the year of the change is the taxable year for which the taxpayer's income "is computed" under a method of accounting different from that used in the preceding year. Treas. Reg. section 1.481-1(a)(1) (emphasis added). Accordingly, the regulation clearly instructs that the year of change is the year in which a taxpayer's accounting method "is" actually changed, not the year in which it "should have been" changed.

[70] Second, taxpayer's argument falsely assumes that if the law requires a taxpayer to take a certain action, that action must have occurred. As taxpayer notes (Br. 50-51), when Congress enacted the uniform capitalization rules, it expressly provided that those rules "shall apply" for taxable years beginning after December 31, 1986. See Tax Reform Act of 1986 ("TRA"), section 803(d), Pub. L. No. 99-514, 100 Stat. 2085, 2356, Addendum, infra. Taxpayer contends (Br. 52) that because the uniform capitalization rules were mandatory, its method of accounting was converted "by operation of law" in its 1988 tax year.

[71] The fact of the matter, however, is that taxpayer did not change its accounting method in its 1988 tax year to comply with I.R.C. section 263A, as it was required to do. ¹⁶ Nor did taxpayer change its accounting method when the IRS issued Notice 88-78, which provided guidance for taxpayers that had failed to change their accounting method to comply with section 263A in accordance with its effective date, and which permitted such taxpayers to file amended returns changing their accounting method to conform to section 263A. See I.R.S. Notice 88-78, 1988-2 C.B. 394, 396. That notice specifically provided that if a taxpayer failed to change its accounting method to comply with section 263A and the Commissioner, upon examination, discovered such noncompliance, the entire section 481 adjustment "shall be taken into account in computing taxable income of the year of change," and the taxpayer would not be able to spread the adjustment over several years. Id. at Section IV, 1988-2 C.B. at 396. ¹⁷

[72] I.R.S. Notice 88-78, therefore, shows that the year of change for a taxpayer required to change its accounting method to conform with I.R.C. section 263A is the year in which the taxpayer's accounting method is actually changed. Moreover, that notice alerted taxpayer that waiting until the Commissioner discovered its failure to change its accounting method to comply with section 263A would result in the entire section 481 adjustment being taken into account in the year of the change. Yet even when the IRS extended the time to file amended returns complying with section 263A, see I.R.S. Announcement 89-72 (May 15, 1989), 1989-24 I.R.B. 79, taxpayer still did not change its accounting method to conform with section 263A. In fact, taxpayer never changed its accounting method to reflect section 263A, and its noncompliance was discovered only through the Commissioner's examination of its 1994 return. Thus, taxpayer's complaint (Br. 54-55) regarding the cumulative effect of the section 481 adjustment is groundless. The crucial fact here is that taxpayer failed to comply with the mandatory accounting changes required by section 263A. Having failed to do so, it cannot now object to the fact that the required adjustments under section 481 are relatively large.

[73] Taxpayer mistakenly emphasizes (Br. 51-52) that Sections 803(d)(2)(B)(i) and (ii) of the TRA stated that where the uniform capitalization rules required a taxpayer to change its accounting method, such a change would generally be treated as an automatic change in accounting method that was initiated by the taxpayer and approved by the Commissioner. These sections, however, did not automatically convert a taxpayer's accounting method to comply with I.R.C. section 263A; rather, they merely provided that where taxpayers were required by the new rules to change their accounting method, they did not have to obtain the Commissioner's consent before using the new method, as is generally required under I.R.C. section 446(e). Here, because taxpayer never voluntarily changed its accounting method to comply with the uniform capitalization rules, the provisions of Section 803(d)(2)(B) of the TRA are irrelevant.

[74] In addition, taxpayer erroneously claims (Br. 53-54) that Section 803(d)(2)(B)(iii) of the TRA imposed a statute of limitations on I.R.C. section 481 adjustments. In that section, Congress provided that where a taxpayer was required by the uniform capitalization rules to change it method of accounting, "the period for taking into account the adjustments under section 481 by reason of such change shall not exceed 4 years." TRA section 803(d)(2)(B)(iii), 100 Stat. at 2357. Thus, that section set forth the maximum number of years over which a taxpayer may be permitted to spread any section 481 adjustments required by a change of accounting under the uniform capitalization rules. Section 803(d)(2)(B)(iii), therefore, addresses the extent to which a taxpayer may be allowed to ease the impact of any section 481 adjustments; it does not prevent the Commissioner from making section 481 adjustments.

[75] Moreover, taxpayer's argument (Br. 53-55) that the adjustments under I.R.C. section 481 are barred by the statute of limitations contravenes the fundamental purpose of section 481. As discussed above, Section 481 was specifically designed to allow the Commissioner to make adjustments stemming from a change in accounting method, notwithstanding the fact that direct adjustments to the taxpayer's earlier returns might otherwise be barred by the statute of limitations. Rankin, 138 F.3d at 1288; Kohler, 124 F.3d at 1455- 1456; Knight-Ridder, 743 F.2d at 797; Western Casualty, 571 F.2d at 519-520; Graff Chevrolet, 343 F.2d at 572; Hamilton Industries, 97 T.C. at 125; Superior Coach, 80 T.C. at 912; Primo Pants, 78 T.C. at 726-727. Contrary to taxpayer's argument, there is no conflict between section 481 and the statute of limitations because "[u]ntil the year of the accounting change, the Commissioner has no claim against the taxpayer for amounts which the taxpayer should have reported in prior years." Graff Chevrolet, 343 F.2d at 572; see also Knight-Ridder, 743 F.2d at 797. When a taxpayer uses an improper accounting method that accelerates deductions or defers income, the taxpayer has not succeeded in permanently avoiding the reporting of any income. Rather, the taxpayer has impliedly promised to report that income at a later date when the improper method would require it. Graff Chevrolet, 343 F.2d at 572. Accordingly, the Tenth Circuit has emphasized that, although section 481 adjustments may present the taxpayer with a substantial tax bill in the year of change, "the large sum represents improper deductions which would otherwise result in omission from income." Western Casualty, 571 F.2d at 520.

[76] Thus, the purpose of I.R.C. section 481 is to prevent income from escaping tax solely by reason of a change in accounting method, and, therefore, as this Court has stated, "the statute of limitations does not apply to section 481." Rankin, 138 F.3d at 1288; see also Knight-Ridder, 743 F.2d at 797; Western Casualty, 571 F.2d at 519-520; Graff Chevrolet, 343 F.2d at 572. Indeed, "[S]ection 481 would be virtually useless if it did not affect closed years." Graff Chevrolet, 343 F.2d at 572. Thus, taxpayer's contention that the section 481 adjustments are barred by the statute of limitations is simply wrong. ¹⁸

[77] In short, taxpayer's argument is wholly without merit. Taxpayer's 1994 tax year was the first year in which its income was computed in accordance with I.R.C. section 263A. Thus, the Tax Court correctly held that taxpayer's 1994 tax year was "the year of the change" for which taxpayer was required to take into account section 481 adjustments.

CONCLUSION

[78] For the foregoing reasons, the decision of the Tax Court is correct and should be affirmed.

Respectfully submitted,

[79] It is hereby certified that service of the foregoing brief has been made on counsel for the appellant, on this 14th day of September, 2000, by mailing two copies thereof in an envelope properly addressed to them as follows:

Richard A. Shaw, Esq.

² Under I.R.C. section 6213(a), a taxpayer has 90 days after the mailing of a notice of deficiency in which to file a petition with the Tax Court. Here, taxpayer's petition was deemed timely filed under I.R.C. section 7502, which treats a document that is timely mailed as timely filed, because it was postmarked May 18, 1998, 89 days after the mailing of the notice.

³ As discussed supra, pp. 8-9, the Tax Court also determined that taxpayer did not qualify as an artistic business that was exempt from the uniform capitalization requirements under I.R.C. section 263A(h). (Supp. ER at 17-20.) Taxpayers have not challenged this determination in their opening brief, and they have therefore waived appellate review of the issue. See, e.g., Smith v. Marsh, 194 F.3d 1045, 1052 (9th Cir. 1999) (arguments not raised by a party in its opening brief are deemed waived); Eberle v. City of Anaheim, 901 F.2d 814, 818 (9th Cir. 1990) (same).

⁴ Temporary regulations under I.R.C. section 263A were published in the Federal Register on March 30, 1987, 52 Fed. Reg. 10052, and amendments were published on August 7, 1987, 52 Fed. Reg. 29375. On August 9, 1993, the IRS published final regulations under sections 1.263A-1 through 1.263A-6, which adopted the temporary regulations as revised by Treasury Decision 8482. 58 Fed. Reg. at 42199. The final regulations relating to property produced by the taxpayer, Treas. Reg. section 1.263A-2, and property acquired for resale, Treas. Reg. section 1.263A-3, are effective for taxable years beginning after December 31, 1993. Treas. Reg. section 1.263A- 1(a)(2)(i), Addendum, infra. For taxable years beginning before January 1, 1994, taxpayers were required to take reasonable positions on their income tax returns consistent with the temporary regulations, revenue rulings and procedures, notices, and announcements concerning section 263A. Treas. Reg. section 1.263A- 1(a)(2)(ii), Addendum, infra.

Because the taxable year at issue in this case began July 1, 1993 (ER D-1), Treas. Reg. sections 1.263A-2 and 1.263A-3 were not in effect. Nevertheless, for purposes of this appeal, and in light of the fact that the final regulations are an outgrowth of, and expansion upon, the temporary regulations, they are helpful in explaining the distinction between producers and resellers under I.R.C. section 263A. See, e.g., 1 J. Mertens Law of Federal Income Taxation section 3.101 (1991) (Treasury regulations "clarify what the language of the statute was always intended to say"). Furthermore, taxpayer cites the final regulations throughout its brief. Accordingly, where pertinent, we have included references to the final regulations. In any event, this case does not turn on the final regulations; as discussed in detail, infra pp. 24-27, section 263A itself clearly provides that property produced by a taxpayer and property acquired for resale by a taxpayer are two separate categories, see section 263A(b), and that a taxpayer is treated as the producer of property produced for it under contract, see section 263A(g)(2).

⁵ As taxpayer discusses (Br. 23-24), Treas. Reg. section 1.263A-2(a)(1)(B)(2)(i), Addendum, infra, broadly defines a contract as "any agreement providing for the production of property if the agreement is entered into prior to the production of the property," and it includes contracts involving specialized designs.

⁶ Likewise, there is no merit to taxpayer's claim (Br. 40) that Charles Peckat, 196 F.2d 849, supports its position that I.R.C. section 263A distinguishes between producers who "actually" manufacture their products and those who have products produced for them under contract. To the contrary, Charles Peckat supports the conclusion that, for purposes of taxing statutes, there is no such distinction. In that case, the Seventh Circuit held that a taxpayer which contracted with another company to fabricate its products was itself a "manufacturer" of those products for purposes of a statute imposing an excise tax. Id. at 851-852.

⁷ The legislative history does not specifically explain why there is a statutory exception for small resellers but not for small producers. It seems logical to conclude, however, that Congress did not provide for a small producer exception in I.R.C. section 263A because producers were required to capitalize most costs incurred in producing property even prior to enactment of section 263A, but resellers were subject to more liberal capitalization rules under prior law. See, e.g., Staff of the Joint Comm. on Taxation, 100th Cong., General Explanation of the Tax Reform Act of 1986 501 (Comm. Print 1987). Although small producers are not excepted from section 263A, the final regulations allow certain small producers to elect to use a special method of accounting (the "AFR plus 3 method"). Treas. Reg. section 1.263A-9(e), Addendum, infra.

⁸ The third subparagraph, I.R.C. section 263A(b)(2)(C), provides that certain aggregation rules apply for purposes of determining whether a reseller qualifies as a small reseller under subparagraph (B).

⁹ That is not to say that a taxpayer could not be both a reseller and a producer as to different products. See Treas. Reg. section 1.263A-2(a)(5), Addendum, infra (noting that a taxpayer could be "engaged in both production and resale activities" and providing special accounting rules in such circumstances). But, as we explained in the text above, a single product line fits in only one category or the other (but not both).

¹⁰ Contrary to taxpayer's argument (Br. 33), the determination that it is a "producer" of the products bearing its cartoon images does not compel the conclusion that a university bookstore selling products bearing the university logo or mascot (e.g. sweatshirts) is a "producer" under I.R.C. section 263A. Treasury Regulation section 1.263A-2(a)(1)(ii)(B)(2)(ii), Addendum, infra, specifically provides that, for purposes of determining whether property is produced for the taxpayer under a contract, "a routine purchase order for fungible property is not treated as a contract." Thus, a university does not become a "producer" under section 263A simply by placing an order with a sweatshirt company to stamp the university logo on the company's sweatshirts.

The routine-purchase-order exception does not apply, however, if the contractor is required "to make more than de minimis modifications" or "cannot satisfy the agreement within 30 days out of existing stocks and normal production of finished goods." Treas. Reg. section 1.263A-2(a)(1)(ii)(B)(2)(ii). Accordingly, if a university was as extensively involved in the design and production of sweatshirts as taxpayer is involved in the production of its products (e.g., designing the sweatshirt, having the sweatshirts manufactured according to its exact specifications regarding color, cut, and so forth, maintaining strict control throughout the manufacturing process, etc.), the routine-purchase-order exception would not apply, and the university would, in such circumstances, be regarded as a producer of those sweatshirts.

¹¹ The determining factor, therefore, is not simply whether taxpayer's "cartoon images" are set forth on the paper products, as taxpayer charges (see Br. 24-25). Rather, the critical inquiry is whether taxpayer is so involved in the entire process, from inception to completion, that it is considered to be a "producer" of the product.

¹² For its 1994 tax year, taxpayer reported sales of $5,241,830, cost of sales of $2,108,921, and gross profit of $3,132,909. (ER D-13.)

¹³ The fact that taxpayer describes its activities (see Br. 8, 28) as involving the "purchase" of paper products from its printer is hardly determinative in this regard.

¹⁴ In its opening brief filed in the Tax Court, the Commissioner conceded (Doc. 13 at 22) that taxpayer resells the Mylar balloons. Such de minimis resale activities, however, do not convert taxpayer from a producer to a reseller. Similarly, taxpayer's incidental sales of licensee products (such as tote bags, magnets, etc.) in its on-premises gift shop, where sales of both taxpayer's products and licensee products totaled only $84,248 in 1994 (ER C at section 39), do not convert taxpayer from a producer to a reseller (although it may qualify taxpayer for the "simplified production method" of accounting as specified in the regulations (see Treas. Reg. section 1.263A-2(a)(5), Addendum, infra). Indeed, taxpayer does not argue that its incidental sales of Mylar balloons or licensee products are determinative here.

¹⁵ Section 481(c), Addendum, infra, authorizes the Commissioner to issue regulations that, in certain circumstances, allow a taxpayer to spread the section 481 adjustments over several years, which eases the impact of those adjustments. Here, as explained infra pp. 43-44, because taxpayer failed to change its accounting method to conform with section 263A and because the Commissioner discovered taxpayer's noncompliance upon examination of its 1994 tax return, the entire section 481 adjustment must be taken into account in the year of change. See I.R.S. Notice 88-78, 1988-2 C.B. 394, 396.

¹⁶ Where I.R.C. section 263A required a taxpayer to change its accounting method, the taxpayer was required to make that accounting change in accordance with Temporary Treasury Regulation section 1.263A-1T(e), and to file an "Application for Change in Accounting Method" (Form 3115) with its federal income tax return. See I.R.S. Notice 88-78, 1988-2 C.B. 394.

¹⁷ Although I.R.S. Notice 94-24 withdrew one section of I.R.S. Notice 88-78 for taxable years beginning after December 31, 1992, and before January 1, 1994, it expressly stated that "[a]ll other sections of Notice 88-78, including section IV which is applicable to taxpayers under examination, will continue to remain in effect for taxable years beginning before January 1, 1994." I.R.S. Notice 94-24, 1994-1 C.B. 341, 342. Because taxpayer's 1994 tax year began on July 1, 1993 (ER D-1), Section IV of Notice 88-78 applies here.

¹⁸ Indeed, taxpayer's argument would have obliged the Commissioner to have examined every one of the hundred of millions of taxpayer returns filed for the 1987 or 1988 tax years to determine whether the uniform capitalization rules were complied with, or else face the expiration of the statute of limitations. Neither logic nor the statute mandates such an absurd conclusion.