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Greeting Card Company Argues It Is Exempt From UNICAP Rules

AUG. 23, 2000

Suzy's Zoo v. Commissioner

DATED AUG. 23, 2000
DOCUMENT ATTRIBUTES
  • Case Name
    SUZY'S ZOO, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
  • Court
    United States Court of Appeals for the Ninth Circuit
  • Docket
    No. 00-70461
  • Authors
    Shaw, Richard A.
    O'Brien, Bruce M.
  • Institutional Authors
    Higgs, Fletcher & Mack LLP
  • Cross-Reference
    Suzy's Zoo v. Commissioner, 114 T.C. No. 1; No. 9423-98 (January 6,

    2000) (For a summary, see Tax Notes, Jan. 17, 2000, p. 360; for the

    full text, see Doc 2000-1101 (24 original pages) or 2000 TNT 5-9 Database 'Tax Notes Today 2000', View '(Number'.)
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    capitalization rules, uniform, creative expenses
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-23086 (67 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 191-58

Suzy's Zoo v. Commissioner

 

=============== SUMMARY ===============

 

In a brief for the Ninth Circuit, a greeting card company has argued that it is exempt from the uniform capitalization rules because it is a "small reseller" of "property produced under contract."

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 that ended June 30, 1994, was the year in which 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 Database 'Tax Notes Today 2000', View '(Number'.)

Suzy's Zoo argues that the Tax Court erred in holding that it did not qualify for the "small reseller" exemption under section 263A(b)(2)(B). The company maintains that its creation of cartoon images is the creation of independent artwork, separate and distinct from the merchandise subsequently produced under contract from an unrelated third party. Suzy's Zoo insists that it, therefore, was not the actual producer of property that was property produced for Suzy's Zoo under contract for resale. It further argues that the Tax Court failed to properly apply section 803(D) of the Tax Reform Act of 1986, which required that any section 481 adjustment must be made in the taxpayer's first taxable year that ended after 1986. Suzy's Zoo also asserts that the statute of limitations bars the Service from making a section 481 change in 1994.

 

=============== FULL TEXT ===============

 

UNITED STATES COURT OF APPEALS

 

FOR THE NINTH CIRCUIT

 

 

ON APPEAL FROM THE UNITED STATES TAX COURT

 

HONORABLE DAVID LARO, PRESIDING

 

 

Agency No. 9423-98

 

Northern California

 

(San Francisco)

 

 

SUBSTITUTE APPELLANT'S OPENING BRIEF

 

 

Dated: August 23, 2000

 

Richard A. Shaw, Esq.

 

(SBN 044037-0)

 

Bruce M. O'Brien, Esq.

 

(SBN 108495)

 

 

HIGGS, FLETCHER & MACK LLP

 

401 West "A" Street, Suite 2600

 

San Diego, CA 92101

 

(619) 236-1551

 

 

Attorneys for Appellant,

 

SUZY'S ZOO

 

 

TABLE OF CONTENTS

 

 

I. STATEMENT OF ISSUES PRESENTED

 

 

II. STATEMENT OF JURISDICTION

 

 

III. INTRODUCTION

 

 

IV. STATEMENT OF THE CASE

 

 

V. STATEMENT OF FACTS

 

 

A. Background on Suzy Spafford and Suzy's Zoo(&

 

 

B. Licensing Side of the Business

 

 

C. Production Contract Side of the Business

 

D. Gross Receipts for Three Preceding Years

 

 

VI. STANDARD OF REVIEW

 

LEGAL ARGUMENT

 

 

VII. THE TAX COURT ERRED IN HOLDING THAT SUZY'S ZOO WAS SUBJECT TO

 

THE UNIFORM CAPITALIZATION RULES OF I.R.C. SECTION 263A AND WAS

 

NOT A "SMALL RESELLER" OF "PROPERTY PRODUCED UNDER CONTRACT"

 

EXEMPT FROM THE UNIFORM CAPITALIZATION RULES PURSUANT TO I.R.C.

 

SECTION 263A(b)(2)(B)

 

 

A. Introduction

 

 

B. General Application of the Uniform Capitalization Rules

 

 

TABLE OF CONTENTS

 

 

1. Uniform Capitalization Rules Require Taxpayers To

 

Capitalize Or Include In Inventory Costs Associated

 

With Production

 

 

2. Production Is Defined To Include Both Property

 

Manufactured By The Taxpayer And Property Produced For

 

The Taxpayer Under A Contract With Another

 

 

3. Property Produced Under A Production Contract With

 

Another Retains Its Separate Identity For The Purpose

 

Of Applying The $10 Million Small Reseller Exemption

 

 

4. A Production Contract Is Defined Very Broadly To

 

Include Contracts For Production Which Require The

 

Application Of A Special Design Provided By The

 

Taxpayer, Or A Specialized Application That Is Not

 

Intended For Self-Use By The Unrelated Manufacturer

 

(such as Suzy's Zoo Cartoon Image)

 

 

C. The Tax Court Erroneously Concluded That Suzy's Zoo Was

 

Not A "Reseller" On the Ground That It Actually Produces

 

The Merchandise Purchased, Rather Than Resells It

 

 

1. The Creation Of The Cartoon Images By Suzy's Zoo Is

 

The Creation Of Independent Artwork, Separate And

 

Distinct From The Merchandize Subsequently Produced

 

Under Contract From An Unrelated Third Party

 

 

2. Suzy's Zoos Was Not The Actual Producer Of Property

 

Which Was Property Produced For Suzy's Zoos Under

 

Contract For Resale

 

 

TABLE OF CONTENTS

 

 

D. The Lower Court Erred In Failing To Conclude That Suzy's

 

Zoo Was A Small Reseller Of "Property Produced Under

 

Contract," Exempt From The Uniform Capitalization Rules

 

Pursuant to I.R.C. Section 263(a)(b)(ii)(B)

 

 

VIII. THE TAX COURT ERRED IN CONCLUDING THAT THE "YEAR OF THE CHANGE"

 

FOR MAKING ADMINISTRATIVE ADJUSTMENTS UNDER I.R.C. SECTION 481

 

RESULTING FROM THE APPLICATION OF THE UNIFORM CAPITALIZATION

 

RULES WAS 1994, INSTEAD OF 1988, WHEN THE UNIFORM CAPITALI-

 

ZATION RULES FIRST APPLIED TO SUZY'S ZOO

 

 

A. Introduction

 

 

1. General Background

 

 

2. General Rules For Change In Method Of Accounting

 

Adjustments

 

 

B. The Tax Court Failed To Properly Apply Section 803(D) Of

 

The Tax Reform Act Of 1986 Which Required That Any Section

 

481 Adjustment Must Be Made In The Taxpayer's First Taxable

 

Year Ended After 1986

 

 

C. The Internal Revenue Service Is Barred From Making A

 

Section 481 Change In 1994 Under The Federal Statute Of

 

Limitations

 

 

IX. NO REQUEST FOR ATTORNEYS' FEES

 

 

X. CONCLUSION

 

 

CERTIFICATE OF SERVICE

 

 

CERTIFICATE OF COMPLIANCE

 

 

TABLE OF AUTHORITIES

 

 

FEDERAL CASES

 

 

Charles Peckat Mfg. Co. v. Jarecki 196 F.2d 849 (7th Cir. 1952)

 

 

Graff Chevrolet Co. v. Campbell 343 F.2d 568 (5th Cir. 1965)

 

 

Golden Gate Litho v. Commissioner 75 T.C.M. (CCH) 2312 (1998)

 

 

Keane v. Commissioner 865 F.2d 1088 (9th Cir. 1989)

 

 

Okin v. Commissioner 808 F.2d 1338 (9th Cir.) cert. denied, 484 U.S.

 

802 (1987)

 

 

Roszkos v. Commissioner 850 F.2d 514 (9th Cir. 1988) cert. denied,

 

489 U.S. 1012 (1989)

 

 

CODES

 

 

Internal Revenue Code, 26 U.S.C.

 

 

Section 263A

 

Section 263A(a)

 

Section 263A)(b)

 

Section 263A(b)(1)

 

Section 263A(b)(2)

 

Section 263A(b)(2)(B)

 

Section 263A(g)

 

Section 263A(g)(2)

 

Section 446(e)

 

Section 481

 

Section 481 (a)

 

Section 1221(a)(1)

 

Section 6213(a)

 

Section 6214

 

Section 6501

 

Section 7442

 

Section 7482

 

Section 7483

 

 

RULES AND REGULATIONS

 

 

Treasury Regulations, 26 C.F.R.

 

 

Section 1.263A-1(a)(3)(iii)

 

Section 1.263A-2

 

Section 1.263A-2(a)(1)(ii)(A)

 

Section 1.263A-2(a)(1)(ii)(B)(2)(i)

 

Section 1.263A-3

 

Section 1.263A-3(a)(1)

 

Section 1.263A-3(a)(2)

 

Section 1.263A-3(a)(3)

 

Section 1.446-1(e)(3)(i)

 

Section 1.471-1

 

Section 1.481-1(a)(1)

 

 

Federal Rules of Appellate Procedure,

 

 

United States Court of Appeals for the Ninth Circuit

 

 

Rule 13(a)

 

Rule 28-2.3

 

 

United States Tax Court Rules of Practice and Procedure

 

 

Rule 122

 

rule 190(a)

 

 

OTHER AUTHORITIES

 

 

Tax Reform Act of 1986 (P.L. 99-514, 100 Stat. 2085)

 

 

Section 803

 

Section 803(d)

 

Section 803(d)(2)

 

Section 803(d)(2)(A)

 

Section 803(d)(2)(B)

 

Section 803(d)(2)(B)(i)

 

Section 803(d)(2)(B)(ii)

 

Section 803(d)(2)(B)(iii)

 

 

Internal Revenue Service Notice 88-86, 1988 C.B. 401

 

 

I.

STATEMENT OF ISSUES PRESENTED

[1] 1. Whether the United States Tax Court erred in ruling that Suzy's Zoo -- a California corporation that creates and licenses original cartoon artwork, and that also purchases for resale various products impressed with its original artwork -- was subject to the federal income tax Uniform Capitalization Rules of Internal Revenue Code Section 263A as the "actual producer" of the products it has manufactured for it under contract by third parties, or whether it qualifies for an exemption from that rule as a "small reseller" of "property produced under contract"?

[2] As applied to this case, the essential question becomes this: Whether Suzy's Zoo should be deemed to be the "actual producer" of a greeting card, coffee mug, balloon, calendar, or other purchased product manufactured by a third party simply because Suzy's Zoo owns and controls the cartoon image imprinted on the product?

[3] 2. Assuming Suzy's Zoo IS deemed to be the actual producer of products manufactured under contract by third parties, and was, therefore, subject to the Uniform Capitalization Rules of Section 263A, whether the Tax Court erred in concluding that the "year of the change" for making adjustments resulting from application of those rules was 1994 (the year of the tax audit), instead of 1988 (when the Uniform Capitalization Rules first applied to Suzy's Zoo) under Internal Revenue Code section 481?

II.

STATEMENT OF JURISDICTION

[4] Jurisdiction of this Appeal is properly before this Court. The United States Tax Court had jurisdiction over the original deficiency suit against Suzy's Zoo under 26 USC Sections 6213(a), 6214, and 7442. This Court has jurisdiction over this appeal from the final Order and Decision of the Tax Court, dated March 10, 2000, pursuant to 26 USC Section 7482. The Appellant filed a Notice of Appeal on April 6, 2000. Such Notice of Appeal was filed timely pursuant to 26 USC Section 7483, Federal Rules of Appellate Procedure 13(a), and Tax Court Rule 190(a).

III.

INTRODUCTION 1

[5] This is an appeal from the decision of United States Tax Court determining a deficiency in federal income tax due from the Appellant taxpayer, Suzy's Zoo, in the amount of $131,077 for its taxable year ended June 30, 1994.

[6] The Appeal involves solely issues of federal income taxation and primarily, interpreting whether the Uniform Capitalization ("UNICAP") Rules of Section 263A of the Internal Revenue Code ("I.R.C.") should apply to Suzy's Zoo and if applicable, the tax year for which adjustments under the UNICAP rules is required. 2

[7] In summary, Suzy's Zoo is a California corporation, principally owned by Suzy Spafford, an artist who has created cartoon characters comprising Suzy's Zoo. Suzy's Zoo licenses its cartoon images to some manufacturers. However, a majority of its income is generated from the resale of various products which third parties produce and sell to her company, including such items as greeting cards, balloons, stationery, calendars, tote bags, mugs, and other items impressed with Suzy's Zoo's cartoon images. These products are resold directly to the public in its headquarters retail store or through independent distributors throughout the world.

[8] Since its incorporation in 1976, Suzy's Zoo has maintained an accounting practice of deducting expenses associated with the merchandise purchased from these unrelated producers who manufacture the products and sell them to Suzy's Zoo for resale.

[9] The Internal Revenue Service (the "IRS") and Tax Court determined that Suzy's Zoo should be subject to the UNICAP rules that would require the capitalization of these expenditures. I.R.C. section 263A(a). The UNICAP rules include: (1) property actually produced by the taxpayer, and (2) personal property acquired for resale by the taxpayer from a third party under a production contract. I.R.C. sections 263A(b)(1) and (g)(2). Although "property produced under contract" with a third party is treated as "produced" by the taxpayer, in order to generally require capitalization of expenses related to those production contracts under UNICAP, Congress also to excluded from the UNICAP rules "property produced under contract" for resale if the annual average gross receipts of the taxpayer for the three preceding taxable years do not exceed $10 Million (a "small reseller"). I.R.C. section 263A(b)(2).

[10] The Treasury Regulations also divide "produced" and "produced under a contract" into separate categories. Treas. Reg. sections 1.263A-2 and 1.263A-3. Any property produced for the taxpayer under contract with another is treated as property "produced" by the taxpayer for the purpose of bringing it within the umbrella of the UNICAP rules. However, the Regulations also recognized that the separate identity of "property produced under contract" must be preserved to determine whether the taxpayer is exempt from the UNICAP rules as a small reseller taxpayer within the $10 Million exclusion. The Treasury Regulations provide that a small reseller is not required to capitalize the costs of property produced under a contract with an unrelated person, if the property is resold to its customers. Treas. Reg. section 1.263A-3(a)(3).

[11] Suzy's Zoo satisfies the monetary conditions for qualifying as a small reseller, since its average annual gross receipts for the preceding three years prior to 1994 were not in excess of $10 Million.

[12] Suzy's Zoo maintains that it qualifies for the small reseller exclusion from the UNICAP rules.

[13] The lower court has concluded erroneously that, even though Suzy's Zoo purchased its balloons, tote bags, magnets, calendars and other paper products under production contracts, Suzy's Zoo was the "actual" manufacturer of the goods, because it owned and controlled the cartoon images that were affixed to the products and because the independent manufacturer could not sell products bearing Suzy's Zoo's images without its consent. As the actual producer of the goods, Suzy's Zoo would not be eligible for the small reseller exclusion.

[14] Appellant challenges the ruling of the Tax Court and asserts instead that Suzy's Zoo is a small reseller of property produced by others under contract and is therefore eligible for the exception. Suzy's Zoo maintains that the creation of the cartoon images by Suzy's Zoo must be recognized as artwork, separate and independent from the subsequent merchandise acquired under production contracts.

[15] Suzy's Zoo does not manufacture coffee cups, tote bags or paper products. Each requires its own specialized manufacturing facility and process. Each has its own independent utilitarian use; whether for drinking, carrying or for transmitting information. Merely affixing a Suzy's Zoo logo or image to a purchased product does not make Suzy's Zoo an "actual producer" instead of a "producer under contract."

[16] Just as a small coffee shop might buy for resale coffee mugs imprinted with the store's logo, without being in the actual business of manufacturing those mugs, Suzy's Zoo qualifies for an exemption from the UNICAP rules as a "small reseller" and should be permitted to continue its practice of deducting direct and indirect costs associated with the merchandise it purchases for resale from its third-party producers.

[17] Therefore, Appellant asks that the Court reverse the decision of the Tax Court based on its erroneous interpretation of the UNICAP statute and regulations.

[18] On a second technical issue, Appellant asserts that the Tax Court, having erroneously applied the UNICAP rules of Section 263A, then erred as a matter of law in concluding that the year of change for implementing the UNICAP rules should be 1994, even though Section 803 of the Tax Reform Act of 1986, requires that the year of the change in Appellant's method of accounting from a method of deducting costs to the method requiring capitalization was its taxable year ended June 30, 1987.

IV.

STATEMENT OF THE CASE

[19] In the course of an audit of Suzy's Zoo for its taxable year ended June 30, 1994, the Internal Revenue Service (the Appellee here) determined that Suzy's Zoo was subject to the UNICAP rules, and should, therefore be required to capitalize its indirect expenses related to the purchase of goods for resale under contracts between Suzy's Zoo and third-party manufacturers.

[20] The Internal Revenue Service issued a Notice of Deficiency to Suzy's Zoo on February 18, 1998. Suzy's Zoo timely filed a Petition in the United States Tax Court; the matter was submitted fully stipulated; and, on March 10, 2000, the Tax Court rendered its decision against Suzy's Zoo, determining a deficiency in federal income tax due from Suzy's Zoo in the amount of $131,077 for its taxable year ended June 30, 1994. The Tax Court held, in summary, that even though Suzy's Zoo purchased its products (whether greeting cards, balloons, tote bags, magnets, calendars or other paper products) under production contracts, Suzy's Zoo was the actual producer of the goods because it owned and controlled the cartoon images that were affixed to the products, and because the independent manufacturer could not sell products bearing Suzy's Zoo images without the consent of Suzy's Zoo.

[21] On April 6, 2000, Suzy's Zoo filed a timely Notice of Appeal from the Judgment of the Tax Court.

V.

STATEMENT OF FACTS

[22] This case was presented to the United States Tax Court based entirely on stipulated facts. Those facts are summarized here according to the following subject headings: (A) Background on Suzy Spafford and Suzy's Zoo; (B) Licensing Side of the Business; (C) Production Contract Side of the Business; and (D) Gross Receipts for Three Preceding Years.

A. BACKGROUND ON SUZY SPAFFORD AND SUZY'S ZOO

[23] Suzy Spafford is an artist. (SF 8.) 3 She graduated from San Diego State University with a Bachelor of Arts Degree in Fine Arts in 1967, and taught art at Point Loma High School from 1968 to 1969. (SF 4, 5.)

[24] In the 1960s, Suzy Spafford began developing cartoon characters, including her primary character, "Suzy Ducken," a yellow, smiling character who appears to be part duck and part chicken. (SF 6, 7.) In 1976, Suzy Spafford incorporated "Suzy's Zoo" as a California corporation. (SF 10.) She also obtained trademark registration for Suzy's Zoo with the United States Department of Commerce, Patent and Trademark Office. (SF 9.)

[25] Suzy Spafford owned 84% of the stock of Suzy's Zoo in 1994 and exercised complete dominion and control over the creation of her cartoon characters and their subsequent use in the business. The remaining 16% of the stock was owned 5.5% by her President and Chief Financial Officer, and 10.5% by an independent investor. (SF 11.)

[26] Suzy's Zoo is in the "social expression business." (SF 12.) Suzy Spafford, the principal artist for Suzy's Zoo (SF 47), creates original cartoon images of the Suzy's Zoo characters set in a variety of scenes. (SF 46.)

[27] Suzy's Zoo does not sell any of its original cartoon drawings. (SF 82.) Instead, Suzy's Zoo numbers its original drawings when completed, and then creates a "tracking card" for them. (SF 51.) The "tracking card" is a formal document recording each use of the original cartoon image, whether under licenses to licensees, or pursuant to production contracts with independent manufacturers for Suzy's Zoo. the particular image may be used on several different products during its useful life. (SF 30-33.) Tracking Card HB4382, "Corkey Standing in Crazy HB," indicates that six difference licensees and producers have used this "Turtle" image on products. (Ex. 7-J.) Suzy's Zoo produces between 300 and 400 cartoon images each year for licensing or for use on goods purchased for resale.

[28] Over the years, Suzy's Zoos and its menagerie of characters have become well-known around the world. Suzy's Zoos has its own Fan Club with over 15,000 members, most of whom are collectors of Suzy's Zoo products. (SF 83, 84.) Suzy's Zoo also maintains its own web site with information on its cartoon characters. (SF 86.) (See, www.suzyszoo.com.)

B. LICENSING SIDE OF THE BUSINESS

[29] A significant portion of Suzy's Zoo's income (over 10%) is derived from licensing agreements with a variety of independent product manufacturers. (SF 17, 18, 28.) 4

[30] Typical examples of a Suzy's Zoo licensing arrangements include its agreement with Janlynn Corporation, which manufactures and markets needlepoint kits bearing Suzy's Zoo images, its agreement with Current, Inc., which manufacturers and sells banking check forms and other products nationally bearing Suzy's Zoo images, and its agreement with Classic Balloons, which creates Mylar balloons bearing Suzy's Zoo images. (SF 20-24.) Suzy's Zoo generally charges the licensee a fee for the use of the original cartoon drawing, as well as a royalty based on a percent of the licensed products sold. (SF 18, 20, 22.)

[31] Suzy's Zoo does not sell products manufactured by its licensees through its catalogue or through its independent sales representatives. However, the retail showroom in its corporate headquarters contains a stock of every item of currently-available merchandise bearing Suzy's Zoo cartoon images, whether those products are produced by a licensee or directly for Suzy's Zoo. (SF 21, 23, 38.)

C. PRODUCTION CONTRACT SIDE OF THE BUSINESS

[32] The substantial majority of Suzy's Zoo's income (89% in 1994) is derived from sales -- through its catalogue, its retail salesroom, or its independent salespeople -- of various products manufactured for Suzy's Zoo by independent third parties under production contracts with Suzy's Zoo. (SF 26, 27.)

[33] The largest categories of goods purchased for resale include greeting cards (38.81%), boutique items such as mugs, balloons and party goods (16.21%), stationary and box notes (12.89%), and Christmas products (11.85%). (SF 30.)

[34] As an illustration of its business practice of purchasing goods for resale from third party manufacturers, the parties have stipulated to facts explaining the purchase of greeting cards under production contracts. (SF 53-76.)

[35] Suzy's Zoo uses several printing companies to purchase paper products. (SF 53.) For instance, following its ordinary procedures, Suzy's Zoo enters into independent production contracts with Golden Gate Litho in Oakland for the manufacture of greeting cards and Christmas cards. (SF 54, 55, 56.) Suzy's Zoo sends its original, numbered cartoon drawing as "flat art" to Golden Gate Litho. (SF 59; Ex. 8-J.) Golden Gate Litho then photographs the Suzy's Zoo image, does the necessary color separations and creates a "proof" of the particular card or cards. (SF 57, 58.)

[36] Under the purchase contract between Suzy's Zoo and Golden Gate Litho, the printer provides its own stock, ink and other supplies. Golden Gate Litho holds title to and bears all risks of loss to the supplies and printed goods until the finished goods are shipped. (SF 59, 60.)

[37] Golden Gate Litho then ships the "proof run" (in the case of greeting cards, about 350 cards) to Suzy's Zoo for approval. (SF 59, 60, 61.) Suzy's Zoo either approves the job or determines that alterations need to be made (for example, intensifying or changing colors). Suzy's Zoo communicates any changes back to the printer by telephone, fax or by marking the proof and mailing it back to the printer. (SF 62.) After the proof is finally approved, Suzy's Zoo sends a purchase order to the printer indicating the number of sheets it wants printed. (SF 65.)

[38] The printer then prints the approximate number of sheets of card stock ordered, and ships them (pursuant to Suzy's Zoo's instructions, and at Suzy's Zoo's expense) to San Diego Bindery to cut and fold the greeting cards. (SF 66, 71, 72.) San Diego Bindery -- which bears the risk of loss or damage during the cutting and folding process -- does its work and then ships the finished cards, along with an invoice, to Suzy's Zoo. (SF 73, 74.)

[39] Suzy's Zoo stores the finished greeting cards as inventory in its San Diego facility. (SF 75.) The company's independent, commissioned sales agents order products directly from Suzy's Zoo, and virtually all orders, whether obtained through salesmen or though the Suzy's Zoo merchandise catalogue, are then filled by hand, packed by hand, and shipped to customers directly from corporate headquarters. (SF 41, 42.) 5

[40] Suzy's Zoo does not manufacture any product that bears the imprint of its image (whether mugs, tote bags, balloon, paper products, or other merchandize. It does not sell any of its cartoon images. It generates profit by either licensing its cartoon images or by purchasing products which bear its cartoon images for resale.

D. GROSS RECEIPTS FOR THREE PRECEDING YEARS

[41] In order for Suzy's Zoo to qualify for the "small resellers" exclusion from the UNICAP Rules, Suzy's Zoo must have average annual gross receipts for the three preceding taxable years not in excess of $10,000,000. During the taxable years ended June 30, 1991 June 30, 1992, and June 30, 1993, Suzy's Zoo had gross receipts in the amounts of $6,711,723, $6,772,772, and $5,898,638, respectively, (SF 32.)

VI.

STANDARD OF REVIEW

[42] Decisions of the United States Tax Court are reviewed by the Appellate Court on the same basis as decisions of a United States District Court in civil bench trials. Okin v. Commissioner, 808 F.2d 1338 (9th Cir.), cert. denied, 484 U.S. 802 (1987). The Appellate Court is bound by findings of fact made by the Tax Court unless those findings are clearly erroneous. Keane v. Commissioner, 865 F.2d. 1088 (9th Cir. 1989). This case was submitted to the Tax Court fully stipulated under Tax Court Rule 122; there is no factual dispute to the facts set forth in the Stipulation. Interpretations and applications of law, however are not restricted by that standard, but are reviewed de novo. See Okin; see also, Roszkos v. Commissioner, 850 F.2d 514 (9th Cir. 1988), cert. denied, 489 U.S. 1012 (1989).

LEGAL ARGUMENT

VII.

THE TAX COURT ERRED IN HOLDING THAT SUZY'S ZOOS WAS SUBJECT TO THE

 

UNIFORM CAPITALIZATION RULES OF I.R.C. SECTION 263A AND WAS NOT A

 

"SMALL RESELLER" OF "PROPERTY PRODUCED UNDER CONTRACT" EXEMPT

 

FROM THE UNIFORM CAPITALIZATION RULES PURSUANT TO I.R.C.

 

SECTION 263A(b)(2)(B)

 

 

A. INTRODUCTION

[43] The Tax Court concluded that because Suzy's Zoo owns and controls its cartoon character images, it must, a fortiori, be treated as the owner and "actual" manufacturer of any product that bears the image of its cartoons from the beginning of the creation of the cartoon image to the end of production and delivery of any purchased products such as balloons, tote bags, and paper products, even though those products are produced under production contracts by other manufacturers.

[44] In reaching this erroneous conclusion, the Tax Court failed to comprehend the nature and purpose of the UNICAP rules and applicable regulations.

B. GENERAL APPLICATION OF THE UNIFORM CAPITALIZATION RULES.

 

 

1. UNIFORM CAPITALIZATION RULES REQUIRE TAXPAYERS TO

 

CAPITALIZE OR INCLUDE IN INVENTORY COSTS ASSOCIATED

 

WITH PRODUCTION.

 

 

[45] The UNICAP rules set forth in Section 263A of the Internal Revenue Code require that a taxpayer include in its inventory or capitalize all direct costs and certain indirect costs associated with the production and sale of property. Section 263A was added to the Internal Revenue Code as part of Section 803 of the Tax Reform Act of 1986. Pub.L. 99-514, 100 Stat. 2085, 2350. 6

[46] Section 263A(a), requiring that certain expenses be included in inventory or capitalized, states in relevant part as follows:

"(a) NONDEDUCTIBILITY OF CERTAIN DIRECT AND INDIRECT

 

COSTS. --

 

 

(1) IN GENERAL. -- In the case of any property to which

 

this section applies, any costs described in paragraph (2) --

 

 

(A) in the case of property which is inventory

 

in the hands of the taxpayer, shall be included in

 

inventory costs, and

 

 

(B) in the case of any other property, shall be

 

capitalized.

 

 

(2) ALLOCABLE COSTS. -- The costs described in this

 

paragraph with respect to any property are --

 

 

(A) the direct costs of such property; and

 

 

(B) such property's proper share of those indirect costs

 

(including taxes) part or all of which are allocable to such

 

property.

 

 

* * * *"

 

 

2. PRODUCTION IS DEFINED TO INCLUDE BOTH PROPERTY

 

MANUFACTURED BY THE TAXPAYER AND PROPERTY PRODUCED FOR

 

THE TAXPAYER UNDER A CONTRACT WITH ANOTHER.

 

 

[47] Section 263A then provides that the UNICAP rules will apply to all property actually produced by the taxpayer. Section 263A(b)(1) states:

"(b) PROPERTY TO WHICH SECTION APPLIES. -- Except as

 

otherwise provided in this section, this section shall

 

apply to --

 

 

(1) PROPERTY PRODUCED BY TAXPAYER. -- Real or tangible

 

personal property produced by the taxpayer."

 

 

[48] In order to assure that UNICAP rules would be applied on a broad base, "property produced" by the taxpayer is defined to also include goods which are purchased under production contracts by others for the taxpayer, as well as goods actually manufactured by the taxpayer. Therefore, Section 263A(g) provides as follows, in relevant part:

(g) PRODUCTION. -- For purposes of this section --

 

 

(1) IN GENERAL. -- The term "produce" includes construct,

 

build, install, manufacture, develop, or improve.

 

 

(2) TREATMENT OF PROPERTY PRODUCED UNDER CONTRACT FOR

 

THE TAXPAYER. -- The taxpayer shall be treated as producing

 

any property produced for the taxpayer under a contract

 

with the taxpayer . . . ." (Emphasis added.)

 

 

[49] The decision to include property produced for the taxpayer under production contracts with others is consistent with some earlier cases. For example, the Tax Court makes reference to Charles Peckat Mfg. Co. v. Jarecki, 196 F.2d 849 (7th Cir. 1952), as a situation where a taxpayer was treated as the manufacturer of a certain bracket purchased under a production contract with an independent machine shop. In that instance, the taxpayer owned a patent for a certain bracket for automobile visors and contracted with a machine shop to fabricate the bracket for it. The machine Shop fabricated the bracket to specifications for the taxpayer. The Court noted the quality control maintained by the taxpayer over the manufacturing process and subjected the taxpayer to an excise tax on the bracket, as the manufacturer. In part, the Court stated:

"It is not unusual in taxing statutes for the term

 

"manufacturer" to include one who has contracted with others to

 

actually fabricate the product." Id. at 851.

 

 

[50] This decision is consistent with the goal of the UNICAP statute to bring within the umbrella of the UNICAP rules property that is produced under separate production contracts. In fact, Section 263A(g) has gone so far as to cause the taxpayer to "be treated as producing any property produced for the taxpayer under a contract with the taxpayer (Emphasis added.)

3. PROPERTY PRODUCED UNDER A PRODUCTION CONTRACT WITH

 

ANOTHER RETAINS ITS SEPARATE IDENTITY FOR THE PURPOSE

 

OF APPLYING THE $10 MILLION SMALL RESELLER EXEMPTION.

 

 

[51] Although property produced for the taxpayer under a contract with a third party is treated as "produced" by the taxpayer in order to apply the UNICAP rules to expenses related to those production contracts, Congress also decided that it was important to exclude from the UNICAP rules certain smaller businesses where personal property is acquired by the taxpayer under production contracts, and resold. It therefore provided in Section 263A(b)(2) that any taxpayer with average annual gross receipts for the three (3) preceding tax years not over $10 Million, will be permitted to exclude from uniform capitalization personal property acquired for resale. Section 263A(b) reads as follows, in relevant part:

"(b) PROPERTY TO WHICH SECTION APPLIES. -- Except as

 

otherwise provided in this section, this section shall

 

apply to --

 

 

(1) PROPERTY PRODUCED BY TAXPAYER. -- Real or tangible

 

personal property produced by the taxpayer.

 

 

(2) PROPERTY ACQUIRED FOR RESALE,

 

 

(A) IN GENERAL. -- Real or personal property

 

described in section 1221(a)(1) which is acquired by the

 

taxpayer for resale.

 

 

(B) EXCEPTION FOR TAXPAYER WITH GROSS RECEIPTS OF

 

$10,000,000 OR LESS. -- Subparagraph (A) shall not apply to

 

any personal property acquired during any taxable year by the

 

taxpayer for resale 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."

 

 

[52] The Treasury Regulations set forth additional guidelines for determining when the taxpayer is a "reseller" and when the reseller is entitled to exemption under Section 263A(b)(2)(B). Treasury Regulation Section 1.263A-3(a)(1) defines a "RESELLER" as "a retailer, wholesaler, or other taxpayer" who acquires inventory or other property held primarily for sale to customers in the ordinary course of business. 7 A reseller is generally subject to the UNICAP rules. However, the UNICAP rules do not apply to property acquired for resale by a "SMALL RESELLER." A "small reseller" is defined as a reseller whose average annual gross receipts for the three previous taxable years do not exceed $10 Million. 8

[53] Treasury Regulations Section 1.263A-3(a)(2) explains that a reseller with production activities is generally required to capitalize all direct and all indirect costs under UNICAP. However, it expressly excludes from its coverage a small reseller described in Treasury Regulation Section 1.263A-3(a)(3).

[54] Treasury Regulations Section 1.263A-3(a)(3) then provides an express exception from the UNICAP rules which is directly applicable to Suzy's Zoo. It provides that a "small reseller," such as Suzy's Zoo, is not required to capitalize, under the UNICAP rules, personal property produced for it under a contract with an unrelated person if the contract is entered into incident to the resale activities of the small reseller and the property is sold to its customers. The second sentence in Treasury Regulation Section 1.263A- 3(a)(3) states:

"However, a small reseller is not required to capitalize

 

additional section 263A costs to personal property produced for

 

it under contract with an unrelated person if the contract is

 

entered into incident to the resale activities of the small

 

reseller and the property is sold to its customers. . . ."

 

 

4. A PRODUCTION CONTRACT IS DEFINED VERY BROADLY TO

 

INCLUDE CONTRACTS FOR PRODUCTION WHICH REQUIRE THE

 

APPLICATION OF A SPECIAL DESIGN PROVIDED BY THE

 

TAXPAYER, OR A SPECIALIZED APPLICATION THAT IS NOT

 

INTENDED FOR SELF-USE BY THE UNRELATED MANUFACTURER

 

(SUCH AS SUZY'S ZOO CARTOON IMAGE).

 

 

[55] In determining whether the taxpayer has entered into a production contract, it is necessary to determine the definition of a "production contract." Treasury Regulations Section 1.263A- 2(a)(1)(ii)(B)(2)(i) defines a contract as:

". . . any agreement providing for the production of property if

 

the agreement is entered into before the production of the

 

property to be delivered under the contract is completed.

 

Whether an agreement exists depends on all the facts and

 

circumstances. FACTS AND CIRCUMSTANCES INDICATING AN AGREEMENT

 

INCLUDE, for example, the making of a prepayment, or an

 

arrangement to make a prepayment, for property prior to the date

 

of the completion of production of the property, or THE

 

INCURRING OF SIGNIFICANT EXPENDITURES FOR PROPERTY OF

 

SPECIALIZED DESIGN OR SPECIALIZED APPLICATION THAT IS NOT

 

INTENDED FOR SELF-USE." (Emphasis added.)

 

 

[56] It is evident that this Regulation envisioned a contract providing for the "actual production of property" by another and that special production conditions might be established which are specific and personal to the taxpayer requesting production by another. Under these Regulations, these contract conditions reasonably include a "specialized design," such as the imprinting of cartoon characters on the product by Suzy's Zoo, or "specialized application that is not intended for self-use" by the actual manufacturer. In the instance of Suzy's Zoo, this would include the restrictions on the resale of products bearing Suzy's Zoo's cartoon images to others, without its consent.

C. THE TAX COURT ERRONEOUSLY CONCLUDED THAT SUZY'S ZOO WAS

 

NOT A RESELLER ON THE GROUND THAT IT ACTUALLY PRODUCES THE

 

MERCHANDISE PURCHASED, RATHER THAN RESELLS IT.

 

 

[57] The lower court concluded that Suzy's Zoo is and has been the only "owner" of the end products being resold from the time it creates its cartoon images, up until the time the end products are sold to its customers, and therefore Suzy's Zoo is "the only producer of those products" for purposes of Section 263A. In reaching its conclusion, the Tax Court erroneously relied heavily on the fact that Suzy's Zoo owned the cartoon images that were imprinted upon merchandise purchased under production contracts from others, as the basis for requiring that Suzy's Zoo was the "only producer of those products" for purposes of Section 263A. In effect, the lower court ruled that any time a wholesaler, retailer or other taxpayer (a "reseller" under Treasury Regulations Section 1.263A-3(a)(1)), affixes its label, trademark, image or other identifying feature of its own to a product produced for it under a contract, and exercises quality control over the product it expects to resell, the retailer must be treated as the actual producer of that merchandise purchased under a contract, and cannot qualify under the small reseller exclusion of the UNICAP rules.

[58] In reaching its conclusion, the Tax Court failed to recognize that the creation of the cartoon characters by Suzy Spafford through her corporation, is the creation of a significant, separately identifiable property, separate and distinct from the subsequent independent process of contracting for the production of merchandise for resale.

[59] Secondly, the lower court failed to understand the distinction preserved in the Regulations between an "owner" of a product who is a producer because he actually manufacturers [sic] his own product, and that of a "reseller" of goods produced under contract who is treated as a producer for one purpose, to bring him or her into the scope of the UNICAP rules, but is still separately identifiable as a reseller who is having a product produced for him by a third person, pursuant to his own specialized design and specialized application, for the purpose of resale.

[60] The effect of the lower court's failure to recognize the separate existence of property produced under contract, where required under I.R.C. Section 263A(b)(2)(B), and under Treasury Regulations Section 1.263A-3(a)(2), would leave the $10 Million small reseller exception available only to goods purchased for resale which are simple, generic products purchasable on the street, without any identification of the reseller. This was clearly not the intent of Congress.

1. THE CREATION OF THE CARTOON IMAGES BY SUZY'S ZOO IS

 

THE CREATION OF INDEPENDENT ARTWORK SEPARATE AND

 

DISTINCT FROM THE MERCHANDIZE SUBSEQUENTLY PRODUCED

 

UNDER CONTRACT FROM AN UNRELATED THIRD PARTY.

 

 

[61] The stipulated facts of this case support the conclusion that the creation of the cartoon characters by Suzy's Zoo is the creation of independent artwork which should be segregated from, and not integrated with, the subsequent activities of Suzy's Zoo in contracting for the purchase of merchandize under production agreements from unrelated third parties.

[62] Appellant Suzy's Zoo is a corporation engaged in the business of "social expression" through the creation of original drawings of cartoon characters, and the subsequent dissemination of the artwork by licensing or by affixing those images to various products purchased for resale.

[63] Suzy's Zoo and the menagerie of cartoon animals which reside in it, are solely the creation of Suzy Spafford. The presence of the image of Suzy Ducken or her other playmates establishes immediate recognition and identification with Suzy's Zoo in much the same sense that Mickey Mouse, Donald Duck or Goofy create identification with Disney products.

[64] The Suzy's Zoo images have become so popular that there is a fan club with over 15,000 members. SF 83-84, Ex. 14-J.) Suzy's Zoo has its own website and information on its cartoon characters (www.suzyszoo.com.) (SF 86.)

[65] When a cartoon image is recorded in the tracking card, Suzy's Zoo has a completed artwork which is owned solely by Suzy's Zoo. It has total flexibility on how to market and disseminate that artwork and the selection of various mediums for the distribution of that artwork in the public market.

[66] These proprietary cartoon images and the registered Suzy's Zoo trademark have independent significance and economic utility, separate and apart from the subsequent activity of purchasing merchandise under contract for resale.

[67] These cartoon images have separate identity in the same sense that any other trademark or logo stands as a representative image of any established business. The image represents the reputation and establishes the commercial buying power of that business. Whether the image is the Nike "Swoosh," the name "Gucci," or "Disney," or cartoon character images such as Mickey Mouse or Peanuts, the imprint establishes and carries identity which is independent from the underlying merchandise, such as shoes, shirts or coffee cups, that are purchased under production contacts for resale.

[68] The lower court failed to give credit to the fact that Suzy's Zoo utilizes different methods to market its cartoon artwork.

[69] Suzy's Zoo does not manufacture on its own any product that bears the imprint of its image.

Suzy's Zoo does not sell any of its cartoon images.

[70] It generates its profit either by licensing its images or by purchasing products which bear its cartoon images for resale.

[71] In some instances, manufacturers obtain a license from Suzy's Zoo, giving them the right to use a particular Suzy's Zoo cartoon image. These licensees then sell and distribute their own products with the Suzy's Zoo logo or cartoon image, and pay a royalty to Appellant. In these instances, Suzy's Zoo also purchases products from licensees bearing Suzy's Zoo identification for inclusion in its own inventory.

[72] Suzy's Zoo also purchases tangible items from unrelated third parties for the purpose of resale. The manufacturers of the items imprint Suzy's Zoo's images on their products. In these instances, the manufacturer then sells the end product to Suzy's Zoo as inventory which is then resold by Suzy's Zoo through its retail store or through independent sale representatives.

[73] It is evident that the cartoon images created by Suzy's Zoo had independent ownership identity, and could be marketed through various means. As such, the lower court erred in treating the creation of the artwork as simply an integrated part of the production of the end products purchased by Suzy's Zoo under contract.

2. SUZY'S ZOO WAS NOT THE ACTUAL PRODUCER OF PROPERTY

 

WHICH WAS PROPERTY PRODUCED FOR SUZY'S ZOO UNDER

 

CONTRACT FOR RESALE.

 

 

[74] The stipulated facts describe the process that Suzy's Zoo goes through when it purchases properties from third parties for the purposes of resale.

[75] In each instance, the contract producer establishes and regulates the entire production process. Suzy's Zoo's only involvement is to assure that the cartoon images are printed at a level of artistic quality acceptable to Suzy's Zoo as the purchaser. The independent manufacturer, which is the producer of the end product, owns its own equipment. It owns its own raw materials and work-in-process. It holds title to and bears the economic risk of loss of the supplies, materials, work-in-process, and completed inventory until they are shipped to Suzy's Zoo for acceptance or rejection. If an order is destroyed by fire, other act of nature, theft, or employee negligence or misconduct, the economic loss is a burden placed on the manufacturer, not Suzy's Zoo. The goods purchased by Suzy's Zoo are to be finished goods, manufactured based on quality controls to specifications established by Suzy's Zoo. If Suzy's Zoo rejects the goods, it informs the manufacturer, who must make the necessary changes to meet Suzy's Zoo's specifications at the manufacturer's own expense.

[76] An example of the purchase and manufacturing process of a production contact for paper goods is set forth in Stipulated Facts Numbers 53 through 75, demonstrating the production contract with Golden Gate Litho, an Oakland, California, independent printer.

[77] Until the finished paper products are delivered and accepted by Suzy's Zoo, the manufacturing printer, Golden Gate Litho, bears all of the burdens associated with manufacture and sale, and obtains none of the benefits until the finished product is accepted by Suzy's Zoo. The parties have stipulated that "Golden Gate Litho holds title to, and bears the risk of loss of, the supplies and printed goods until the goods are shipped. (SF 30.)

[78] The lower court erroneously concluded that:

"The facts of this case lead us to conclude that Petitioner is

 

and has been the only 'owner' of its paper products up until the

 

time they are sold to its customers, and, thus, that Petitioner

 

is the only producer of those products for purposes of section

 

263A."

 

 

[79] It was evident from the lower court's analysis, that the Tax Court had difficulty finding facts that would adequately support its intended goal of treating Suzy's Zoo as the sole owner and actual producer of the goods purchased for resale, to the exclusion of the real producer. In order to support its desired conclusion that Suzy's Zoo was the actual producer of the goods, it needed to demonstrate that the taxpayer was the actual "owner" of the property (e.g., the mug or balloon) from the beginning, and that the various benefits and burdens of ownership of the product being manufactured by the other person were vested in the taxpayer. Treasury Regulation Section 1.263A-2(a)(1)(ii)(A) explains that except for property produced under contract (and certain unrelated home construction contracts):

". . . A TAXPAYER IS NOT CONSIDERED TO BE PRODUCING PROPERTY

 

UNLESS THE TAXPAYER IS CONSIDERED AN OWNER OF THE PROPERTY

 

PRODUCED UNDER FEDERAL INCOME TAX PRINCIPLES. THE DETERMINATION

 

AS TO WHETHER A TAXPAYER IS AN OWNER IS BASED ON ALL OF THE

 

FACTS AND CIRCUMSTANCES, INCLUDING THE VARIOUS BENEFITS AND

 

BURDENS OF OWNERSHIP VESTED WITH THE TAXPAYER. . . ." (EMPHASIS

 

ADDED.)

 

 

[80] The lower court was compelled to attempt to characterize Suzy's Zoo as the owner and thereby sole producer of the goods from the beginning of the creation of the artwork until the product was sold by Suzy's Zoo to avoid the "production under a contract" small reseller exemption.

[81] The lower court reached its conclusion that Suzy's Zoo was the "actual owner" of the goods being produced under contract with an unrelated third party based on several unconvincing factors.

[82] First, the Court explains that Suzy's Zoo's "ownership interest in the paper products attaches at the first stage of their production; i.e., when the cartoon characters are developed and drawn." In doing so, the Court is saying that Suzy's Zoo must be treated as the actual manufacturer of any product, whether it be mugs, calendars, address books, or other products which it purchases from another party for resale, so long as those products bear any image from Suzy's Zoo.

[83] It is evident that the creation by a reseller of its trademark, logo or other proprietary artwork requires some creativity and skill and has economic value, but this is not a basis for treating any subsequent purchase of a product bearing that image as being actually manufactured by the purchaser for resale. If this were the case, every college or university selling blankets, pennants, shirts and other paraphernalia bearing a mascot image (e.g., an Oregon "Duck" or Wisconsin "Badger["]) would be in the active business of actually manufacturing goods. This is clearly not the intent of the Code or the Regulations.

[84] In defining a production contract under Treasury Regulation Section 1.263A-2(a)(1)(ii)(B)(2)(i), as quoted earlier, the Treasury Department envisioned that a production contract eligible for the small reseller exclusion would be permitted to include requirements for specialized design applications. The purpose of the Treasury Regulation is to separately identify production contracts as a specialized type of production that may entitle the purchaser for resale to be treated as a reseller entitled to avoid the UNICAP rules, if he is a small business person.

[85] Second, the Court relies on the fact that Suzy's Zoo does not let anyone sell, copy or use its cartoon characters without its permission and that anyone who does so is in breach of the license that Suzy's Zoo holds as to its own characters. In this instance, the lower court again places its emphasis solely on the cartoon artwork and not on the product which is being manufactured by the third party. Every reseller who purchases a product for resale bearing the identity of the reseller or its image or cartoon, owns that image and is entitled to prohibit its sale through any other source without consent. Ownership by Suzy's Zoo of its cartoon images and its trademark is not evidence that the company actually manufactured or produced the tote bags, coloring books, magnets, stitchery kits, or other miscellaneous products purchased by it.

[86] Third, the lower court emphasizes that Suzy's Zoo must be treated as the actual manufacturer/owner because the production process by the printer is merely mechanical in nature, in that it involves little independence on the printer's part and is subject to Suzy's Zoo's control, scrutiny and approval. This is misleading and inaccurate. The businesses of being a printer, ceramic manufacturer of coffee cups, or textile manufacturer of tote bags, are businesses that require specialized skill, expertise and substantial investment in capital equipment and labor. Each of these trade skills are reasons why Suzy's Zoo is not itself a manufacturer, and went to outside manufacturers to produce the various products to which it might affix its image and trademark.

[87] In the case of Golden Gate Litho, Suzy's Zoo simply sends the original cartoon drawing to Golden Gate Litho as flat art. Golden Gate Litho then photographs the cartoon drawing, does the necessary color separations and creates a printer's "proof" of the particular image. Golden Gate Litho provides its own paper stock and various inks. Golden Gate Litho holds title to and bears the risk of loss of the supplies and printed goods until the goods are shipped. Golden Gate Litho exercises its own internal management controls to minimize and avoid a risk of loss on its contract with Suzy's Zoo. If Suzy's Zoo determines that changes are needed with respect to any "proof," Golden Gate Litho must make the required corrections at its own expense.

[88] The lower court treats Suzy's Zoo as the actual producer of the end products because Suzy's Zoo personally selects the printer, the printer cannot print the particular products without the cartoon images, and the finished products must conform to Suzy's Zoo's specifications. None of these elements are unique to an actual manufacturer of goods. Any reseller exercises judgment in selecting a manufacturer to produce goods for it. Any reseller exercises quality control to assure that the finished product conforms to its specifications, as Suzy's Zoo has done with its producers. Every reseller of goods produced under contract undertakes those steps necessary to assure that the product manufactured (e.g., mug or balloon) is made up to the standard required under the contract for production.

[89] Disney is not going to accept Mickey Mouse figurines with three ears. In the same sense, Suzy's Zoo is entitled to assure that products manufactured by others for it to resell will bear cartoon images of high quality consistent with its national reputation and image, without being treated as the actual producer.

[90] Finally, the lower court asserts that Suzy's Zoo is the owner/manufacturer because the printer does not acquire a proprietary interest in the cartoon drawings, so that it can sell the drawing (or a copy of the drawing) separately. The lower court again places its focus on the wrong subject matter. The issue is not whether Suzy's Zoo owns or controls its own artwork. The issue is whether Suzy's Zoo has entered into an agreement to purchase a paper product or other merchandise produced to its specifications, with the view of reselling that property. The lower court fails to give any recognition or value to the utility of the actual products produced and owned by other manufacturers for Suzy's Zoo, whether it be a coffee mug, calendar, or other items.

[91] None of the factors raised by the lower court necessitate that Suzy's Zoo is the "owner" or has the benefits and burdens during manufacture of the product being purchased for resale, whether it is buying paper products or mugs or other resalable goods. In the case of paper products, it is the printer that owns the ink and paper and other raw materials. It is the printer that provides the equipment, labor and expertise necessary to print both the paper and the images required to satisfy Suzy's Zoo's quality standards. It is the printer that bears the economic risks and burdens related to the contract until the finished goods are shipped to Suzy's Zoo. The printer is the "owner" of Post-It notes, stickers, gift wraps or stationary until produced and delivered under the production contract.

[92] In the case of mugs, the foundry owns the clay, greenware, molds and glaze. The foundry bears the losses if the mugs are fired improperly in the kilns or the Suzy's Zoo image is improperly glazed onto the bisque mug. It is the owner of the mug products until delivered.

[93] All of the factors raised by the lower court are consistent with those demanded of any purchaser of goods monitoring the production process, assuring that quality control is maintained and protecting its own corporate identity when affixed to the product being purchased. None of these are indicia of "ownership" per se.

[94] In this instance,, the Tax Court concluded that Suzy's Zoo is the owner of the paper products produced by Golden Gate Litho during the stage when Golden Gate Litho is printing and coloring the paper products. This conclusion is directly opposite from the Tax Court's own recent finding in Golden Gate Litho v. Commissioner, T.C. Memo 1998-184 (May 18, 1998), where the Tax Court found that Golden Gate Litho, the printer frequently used by Suzy's Zoo, holds title to the paper products until they are shipped to its purchasers and bills the purchasers after the order is shipped. It concluded that since title was held by Golden Gate Litho, the merchandise should be included in its own inventory. It is clear that the Internal Revenue Service is attempting to "double-dip." It treated Golden Gate Litho as the owner of the property required to be included in inventory in Golden Gate Litho v. Commissioner, supra, and now asserts that Suzy's Zoo is really the owner of the paper products even during the period when it was being produced, by Golden Gate Litho. In Golden Gate Litho v. Commissioner, the Tax Court found that Golden Gate Litho sells items that it prints according to the specifications of its customers, that the printed items are held for sale, and the items are "merchandise" as defined in Treasury Regulation Section 1.471-1. The paper products are therefore required to be included in inventory. Treasury Regulation Section 1.471-1 states that "merchandise should be included in inventory only if title thereto is vested in the taxpayer." 9 It is evident from the opinion that both the IRS and the Tax Court concluded that Golden Gate Litho had sufficient indicia of ownership that it was required to maintain its paper products and work-in-process in inventory until completed and sold to Suzy's Zoo, its principal purchaser, as described in the facts of the case. Therefore, it is surprising that the Tax Court, as well as the IRS, have now taken the opposite position that Suzy's Zoo is really the owner of the property produced under contract with Golden Gate Litho.

[95] Appellant challenges the error of the lower court in treating Suzy's Zoo as the actual owner and actual manufacturer of products purchased by it under production contracts.

[96] Suzy's Zoo acknowledges that it is treated as the "producer" of property purchased by it under production contracts, pursuant to I.R.C. Sections 263A(g) and 263A(b)(1). However, the property is acquired by Suzy's Zoo for resale under production contracts. Those separate production contracts must be recognized as such in order to give Suzy's Zoo the benefit of the $10 Million small reseller exemption.

[97] In support of its conclusion, the lower court relied on Charles Peckat Mfg. Co. v. Jarecki, 196 F.2d 849 (7th Cir. 1952). This case actually is supportive of the taxpayer's position. Under the facts of Charles Peckat Mfg. Co., the taxpayer contracted with an independent machine shop to fabricate the bracket for it. In subjecting Charles Peckat Manufacturing Company to an excise tax on manufacturing, the Seventh Circuit explained that:

"It is not unusual in taxing statutes for the term

 

'manufacturer' to include one who has contracted with others to

 

actually fabricate the product." Id. at 851.

 

 

[98] It is important to recognize that the Seventh Circuit Court of Appeals acknowledged that it was only under the taxing statute that the term "manufacturer" was deemed to include a person who has entered into a production contract to have a third party produce a product, not actually manufactured by the patent holder. It is this distinction that is critical to the UNICAP rules.

[99] The UNICAP rules expressly recognized and preserved the distinction between property ACTUALLY produced by the taxpayer as an owner under Section 263A(b)(1), and property that is TREATED as produced by the taxpayer, when it is purchased for resale under a production contract with another. I.R.C. section 263A(b)(2).

[100] This distinction is also critical to Suzy's Zoo. Suzy's Zoo is treated as having "produced" merchandise actually produced under contracts with third parties, because I.R.C. Section 263A(g)(2) expressly provides that the taxpayer "shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer; . . . ." This was done intentionally, under the UNICAP rules in order to bring large resellers into the capitalization requirements of the UNICAP rules. However, the Code and the Regulations continue to honor the distinction between property actually manufactured by an owner who has all of the benefits and burdens of ownership during the manufacturing process, and the situation where the taxpayer goes out and hires someone else to produce it for him. The person who is a small reseller of goods produced under contract may rely on this distinction to continue to expense its indirect costs and not be subjected to the UNICAP rules.

D. THE LOWER COURT ERRED IN FAILING TO CONCLUDE THAT SUZY'S

 

ZOO WAS A SMALL RESELLER OF "PROPERTY PRODUCED UNDER

 

CONTRACT," EXEMPT FROM THE UNIFORM CAPITALIZATION RULES

 

PURSUANT TO I.R.C. SECTION 263(a)(b)(ii)(B).

 

 

[101] The Treasury Regulations expressly provide that Suzy's Zoo is eligible for the benefits of exclusion under the "small reseller" rules.

[102] Treasury Regulation Section 1.263A-3(a)(3) provides in relevant part:

"(3) Resellers with property produced under contract. Generally,

 

property produced for a taxpayer under a contract (within the

 

meaning of Section 1.263A-2(a)(1)(ii)(B)(2)) is treated as

 

property produced by the taxpayer. See section 1.263A-

 

2(a)(1)(ii)(B). HOWEVER, A SMALL RESELLER IS NOT REQUIRED TO

 

CAPITALIZE ADDITIONAL SECTION 263A COSTS TO PERSONAL PROPERTY

 

PRODUCED FOR IT UNDER CONTRACT WITH AN UNRELATED PERSON IF THE

 

CONTRACT IS ENTERED INTO INCIDENT TO THE RESALE ACTIVITIES OF

 

THE SMALL RESELLER AND THE PROPERTY IS SOLD TO ITS

 

CUSTOMERS.". . . .

 

(EMPHASIS ADDED.)

 

 

[103] The definition of "reseller" is provided in Treasury Regulation Section 1.263A-1(a)(3)(iii) and Treasury Regulation Section 1.263A-3(a)(1). Resellers are defined as "RETAILERS, WHOLESALERS AND OTHER TAXPAYERS THAT ACQUIRE PROPERTY DESCRIBED IN SECTION 1221(1) FOR RESALE (RESELLERS) . . . ." 10 This definition makes it clear that the term "reseller" is intended merely as a frame of reference for any person who acquires personal property inventory for resale, and it includes either retailers or wholesalers, or any other taxpayer. Suzy's Zoo is a "reseller" within the definition of the regulations, whether or not it is also a producer for other purposes.

[104] Suzy's Zoo is a "small reseller," as defined in Treasury Regulation Section 1.263A-3(a)(1) because Suzy's Zoo is a reseller who acquires property described in I.R.C. Section 1221(a)(1) for resale whose average annual gross receipts for the three previous taxable years do not exceed $10 Million.

[105] Treasury Regulation Section 1.263A-3(a)(3) confirms that a small reseller, such as Suzy's Zoo, is not required to capitalize the additional Section 263A costs to such personal property produced under a contract if the production is with an unrelated person and if the contract is entered into incident to the resale activities of the small reseller and the property is sold to its customers.

[106] The purpose of this Regulation is to clarify that A RESELLER WILL NOT BECOME INELIGIBLE for the small reseller exception of Section 263A(b)(2)(B) by reason of the fact that the property acquired for resale is being produced under contract for the taxpayer.

[107] This position is supported by Appellee's own administrative pronouncement, Notice 88-86, issued shortly after the enactment of Section 263A to "provide guidance to taxpayers regarding forthcoming regulations interpreting the Uniform Capitalization Rules under section 263A of the Internal Revenue Code." Notice 88-86, 1988 C.B. 401. In addressing the issue of property produced under contract for subsequent resale, Notice 88-86 provides:

"THE INTERNAL REVENUE SERVICE HAS RECEIVED COMMENTS NOTING

 

THAT ANY TAXPAYER THAT ACQUIRES PROPERTY FOR RESALE WHICH IS

 

PRODUCED FOR THE TAXPAYER UNDER CONTRACT may, under the present

 

regulations, be prohibited from using the simplified resale

 

method because the taxpayer WILL BE VIEWED AS PRODUCING THE

 

PROPERTY under section 1.263A-1T(a)(5)(ii) of the regulations.

 

Such a result would effectively prevent many prevent many

 

taxpayers acquiring property for resale from using the

 

simplified resale method because of arrangements such taxpayers

 

make with other taxpayer to resell. In addition, TREATING SUCH

 

PROPERTY AS PRODUCED BY THE TAXPAYER COULD EFFECT THE

 

DETERMINATION OF WHETHER THE TAXPAYER IS ELIGIBLE FOR THE $10

 

MILLION GROSS RECEIPTS EXCEPTION OF SECTION 263A(b)(2)(B) OF THE

 

CODE.

 

 

FORTHCOMING REGULATIONS WILL CLARIFY that a taxpayer

 

acquiring property for resale will not be ineligible to use the

 

simplified resale method solely by reason of the fact that

 

property is produced for the taxpayer under contract. Such a

 

taxpayer is however, required to capitalize, under the

 

simplified resale method, all costs it incurs with respect to

 

the property being produced under contract as if the property

 

were produced by the taxpayer. Moreover, A TAXPAYER WILL NOT BE

 

VIEWED, FOR PURPOSES OF THE $10 MILLION GROSS RECEIPTS EXCEPTION

 

IN SECTION 263A(b)(2)(B) OF THE CODE, AS PRODUCING PROPERTY

 

SOLELY BY REASON OF THE FACT THAT THE PROPERTY ACQUIRED FOR

 

RESALE IS BEING PRODUCED UNDER CONTRACT FOR THE TAXPAYER." Id.

 

at 405 (emphasis added).

 

 

[108] In this case, Suzy's Zoo engages in no manufacturing. All production is done by unrelated third parties, including Golden Gate Litho, and is acquired by Suzy's Zoo by means of a production contract. The products bear the "private label" (trademark and cartoon images) of Suzy's Zoo. The products are purchased for the express purpose of resale and are therefore incident to the resale activities of Suzy's Zoo. Finally, the products are resold to the taxpayer's customers consistent with the requirements of the regulations. Suzy's Zoo fits directly within the conditions set forth in Treasury Regulation Section 1.263A-3(a)(3), and as a result, Suzy's Zoo is not required to capitalize additional Section 263A costs to property produced under a contract.

[109] In summary, the language of I.R.C. Section 263A(b)(2)(B) is clear on its face. Any personal property acquired during the taxable year by the taxpayer for the purpose of resale is exempt from the Uniform Capitalization Rules of Section 263A if the average annual gross receipts of the taxpayer for the three preceding tax years do not exceed $10,000,000. Since Suzy's Zoo's average annual gross receipts do not exceed $10,000,000, all inventory acquired by Suzy's Zoo, including property produced under contract for Suzy's Zoo, is excluded from the Uniform Capitalization Rules. The $10,000,000 small reseller rule is clear and direct. It is intended to release smaller businesses such as Suzy's Zoo from the onerous and complex accounting standards imposed by the Uniform Capitalization Rules.

[110] The Tax Court erred in holding that Suzy's Zoo was subject to the Uniform Capitalization Rules of I.R.C. Section 263A, and in failing to hold that Suzy's Zoo was a "small reseller" of property produced under contract eligible for exemption from the UNICAP Rules under I.R.C. Section 263A(b)(2)(B).

VIII

 

 

THE TAX COURT ERRED IN CONCLUDING THAT THE "YEAR OF THE CHANGE" FOR

 

MAKING ADMINISTRATIVE ADJUSTMENTS UNDER I.R.C. SECTION 481 RESULTING

 

FROM THE APPLICATION OF THE UNIFORM CAPITALIZATION RULES WAS 1994,

 

INSTEAD OF 1988, WHEN THE UNIFORM CAPITALIZATION RULES FIRST APPLIED

 

TO SUZY'S ZOO.

 

 

A. INTRODUCTION

 

 

1. GENERAL BACKGROUND.

 

 

[111] In the case below, the Tax Court held that Suzy's Zoo was subject to the Uniform Capitalization Rules, and that none of the exceptions stated therein were applicable. As a result, the Tax Court determined that the year of the change in method of accounting was 1994, the year under audit, and that Suzy's Zoo's costs of goods sold for 1994 should be reduced by $737,277, representing the full difference between the costs of producing inventory as reported by the taxpayer prior to 1994, and those same costs as they would have been reported under the new Uniform Capitalization Rules, based on a 1994 change in method of accounting.

[112] This adjustment is actually comprised of two components: First, a Section 263A adjustment to ending inventory reflecting the capitalization of indirect costs incurred during the current year under the UNICAP rules, and second, an I.R.C. Section 481 adjustment reflecting the re-evaluation of the beginning inventory as a result of the change in the taxpayer's method of accounting. The Section 481 adjustment, computed as of the last day of the taxable year immediately preceding the year of change, reflects the cumulative difference between the former method of accounting and the proposed method of accounting. In this case, there would be a reduction in costs of goods sold in the amount of $737,277 as a Section 481 adjustment, to reflect the overall change to the UNICAP rules. In addition, there is an INCREASE in costs of goods sold for 1994 alone in the amount of $70,010, as a result of the Section 263A UNICAP rules adjustment. The net result of the two adjustments is a reduction in costs of goods sold in the amount of $667,267.

[113] It is the position of Suzy's Zoo that the proper year for making a required Section 481 method of account adjustment was 1987, as mandated by Congress, and that therefore, the Service is precluded by the statute of limitations applicable to 1987 from making a $737,277 cost of goods adjustment under Section 481 in 1994.

[114] The issue presented on this appeal with respect to Section 481, is one of statutory interpretation. Section 803(d) of the Tax Reform Act of 1986 (P.L. 99-514) 100 Stat. 2085, 2353) (the "Act"), which established the Uniform Capitalization Rules, required that the year of the change for making any Section 481 adjustment must be the first taxable year beginning after December 31, 1986. The Act then made an automatic change in method of accounting to the UNICAP rules for all taxpayers. Suzy's Zoo maintains the Tax Court erred in failing to recognize 1987 as the year of the change for Suzy's Zoo, as a matter of law.

2. GENERAL RULES FOR CHANGE IN METHOD OF ACCOUNTING

 

ADJUSTMENTS.

 

 

[115] In this instance, Suzy's Zoo is being required to change its method of accounting for production costs from a method of expensing production costs to a method of capitalizing those production costs under the Uniform Capitalization Rules.

[116] Absent a statutory mandate for changing one's method of accounting, I.R.C. Section 446 provides that a taxpayer who elects to change his method of accounting from the basis on which he regularly computes his income in keeping his books, is required before making the change, to obtain the consent of the Commissioner. See, I.R.C. section 446(e); and Treas. Reg. section 1.446-1(e)(3)(i).

[117] When the taxpayer changes a method of accounting, there is a risk that items of income and expense that are included or excluded in calculating the taxpayer's tax liability for prior periods, may be duplicated or omitted in later taxable periods. To prevent this risk of duplication or omission of items of income and expense, Congress enacted the Section 481 which permits the Commissioner in computing the taxpayer's taxable income for any taxable year, to make any adjustments which are determined to be necessary solely by reason of a change in method of accounting in order to prevent amounts from being duplicated or omitted. I.R.C. section 481(a). See, Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965).

[118] The adjustments required by Section 481 are to be made in the "year of the change." Generally, the "year of the change" is the first taxable year in which taxable income is computed under a method of accounting that is different from the method of accounting used in the immediately preceding year. See, Treas. Reg. section 1.481- 1(a)(1). In years subsequent to the "year of the change," the application of the UNICAP rules would result in an adjustment to costs of goods sold based only on the difference between inventories at the beginning and at the end of the taxable period.

B. THE TAX COURT FAILED TO PROPERLY APPLY SECTION 803(D) OF

 

THE TAX REFORM ACT OF 1986 WHICH REQUIRED THAT ANY SECTION

 

481 ADJUSTMENT MUST BE MADE IN THE TAXPAYER'S FIRST TAXABLE

 

YEAR ENDED AFTER 1986.

 

 

[119] The lower court looked solely to Section 481 and determined on the face of Section 481 that the year of the change for applying the UNICAP rules to Suzy's Zoo should be the year 1994, since that was the year in which the Court found that Suzy's Zoo was not properly reporting its income under the UNICAP rules. Under Treasury Regulation Section 1.481-1(a)(1), this is normally the first taxable year in which taxable income was actually computed under a method of accounting that was different from the method of accounting that was used in the prior year.

[120] Absent a special mandate made by Congress at the time of enacting the Uniform Capitalization Rules, the position taken by the lower court would be correct; however, Section 803(d) of the Tax Reform Act of 1986 requires a different result.

[121] Section 803(d) of the Tax Reform Act of 1986 sets forth the effective date of the Uniform Capitalization Rules and provides for mandatory adjustments as follows:

"(d) Effective Date. --

 

 

(1) IN GENERAL. -- Except as provided in this subsection,

 

the amendments made by this section shall apply to costs

 

incurred after December 31, 1986, in taxable years ending after

 

such date.

 

 

(2) SPECIAL RULE FOR INVENTORY PROPERTY. -- In the case of

 

any property which is inventory in the hands of the taxpayer --

 

 

(A) IN GENERAL -- The amendments made by this section SHALL

 

APPLY to taxable years beginning after December 31, 1986.

 

 

(B) CHANGE IN METHOD OF ACCOUNTING. -- If THE TAXPAYER IS

 

REQUIRED by the amendments made by this section to CHANGE ITS

 

METHOD OF ACCOUNTING with respect to such property for any

 

taxable year --

 

 

(i) such change SHALL BE TREATED AS INITIATED BY THE

 

taxpayer,

 

 

(ii) such change SHALL BE TREATED AS MADE with the consent

 

of the Secretary, and

 

 

(iii) the period for taking into account the adjustments

 

under section 481 by reason of such change SHALL NOT EXCEED 4

 

YEARS." (Emphasis added.)

 

 

[122] The taxpayer's fiscal year for tax purposes ends on June 30. Therefore, if the taxpayer is subject to the Uniform Capitalization Rules of Section 263A, those rules became mandatory for the fiscal year beginning July 1, 1987, and ending June 30, 1988 (the first taxable year beginning after December 31, 1986.) As such, any adjustment under Section 481 by reason of the change in accounting method must be reflected in that year and not in the taxable year ending June 30, 1994, as proposed by the Internal Revenue Service.

[123] Section 803(d)(2) affected only those taxpayers who had operated in business before the passage of the Act and were required on its adoption to change to the UNICAP method of accounting. The Act provided that the year of change would be deemed to be the first taxable period beginning after December 31, 1986. See, section 803(d)(2)(A). Thus, if Suzy's Zoo was required to determine its taxable income applying the Uniform Capitalization Rules, then it was required by the statute to do so for its taxable year beginning July 1, 1987, and ending June 30, 1988. Suzy's Zoo has continuously conducted its business in the same manner since prior to the enactment of the Uniform Capitalization Rules in 1986. If Suzy's Zoo was properly subject to the UNICAP Rules in 1994, Suzy's Zoo was also subject to the same UNICAP Rules in 1988. Therefore, by operation of law, as mandated by Act Sections 803(d)(2)(B)(i) and (ii), the method of accounting for the taxpayer was automatically changed to the UNICAP rules as mandated as a matter of law by Act Section 803(d)(2)(B)(i) and (ii).

[124] In order to avoid the problem of the taxpayer first obtaining the consent of the Commissioner under I.R.C. Section 446(e), Section 803(d)(2)(B)(i) arbitrarily treated the taxpayer as having initiated a request for change and Act Section 803(d)(2)(B)(ii) provided that the change "SHALL BE TREATED AS MADE . . . " in the first year commencing after enactment.

[125] The effect of the statute was to bypass the consent provisions of Section 446(e) and to cause the application of Section 481 adjustments to be made automatically in the year of the change imposed by the Act. Therefore, the Section 481 adjustment was required to be made for the first taxable year beginning after December 31, 1986, as mandated by Section 803(d)(2)(B) of the Tax Reform Act of 1986.

[126] In the case of Suzy's Zoo, it was converted to the UNICAP rules for its fiscal year beginning July 1, 1987, and ended June 30, 1988.

[127] Since Suzy's Zoo did not then maintain its books of record in accordance with its required method of accounting, it was subjected to the potential audit by the Internal Revenue Service that would result in a deficiency and Section 481 adjustment as of its fiscal year ended June 30, 1988.

C. THE INTERNAL REVENUE SERVICE IS BARRED FROM MAKING A

 

SECTION 481 CHANGE IN 1994 UNDER THE FEDERAL STATUTE OF

 

LIMITATIONS.

 

 

[128] The Section 481 adjustment made by the lower court in this case did not arise out of a change in method of accounting that occurred in 1994. The Section 481 adjustment arose as a result of the application of the UNICAP rules to Suzy's Zoo in 1988, when the arbitrary change in method of accounting was required by Congress by operating [sic] of law. Therefore, any deficiency that arose as a result of a Section 481 adjustment occurred in 1988, the mandatory year of change.

[129] The Internal Revenue Service is barred by two rules from seeking to make any Section 481 adjustment for the year 1994. First, under Section 803(d)(2)(B)(iii) of the Tax Reform Act of 1983, Congress limited the period during which the Internal Revenue Service could take into account the 1988 adjustments required under Section 481 to four (4) years. Therefore, this section prevents the Internal Revenue Service from asserting any assessment based upon a Section 481 adjustment for any year after 1992.

[130] Also, the federal statutes of limitations for making any assessment begins to run on the date the income tax return for the subject year is filed and expires three (3) years thereafter. I.R.C. section 6501. In this case, the federal income tax return for the taxable year of Suzy's Zoo ended June 30, 1988, was timely filed. Accordingly, the Internal Revenue Service is barred from assessing any deficiency arising from a Section 481 adjustment for the year ended June 30, 1988, three (3) years after the filing of Suzy's Zoo's federal income tax return.

[131] The Tax Court did not have statutory authority to impose a deficiency under Section 481 arising out of a change in method of accounting in 1988 and after the expiration of the statute of limitations for the taxable year ended June 30, 1988.

[132] The adjustment to costs of sales made by the Internal Revenue Service in the Notice of Deficiency for the year at issue was in reality an attempt by the Service to apply the cumulative effect of the Section 481 adjustment for the year ended June 30, 1988, plus the Section 263A adjustments for the years from June 30, 1988, through June 30, 1994. Each of these adjustments, except for the Section 263A adjustment for taxable year ending June 30, 1994, is barred by the statute of limitations. The Service may only make adjustments applicable to the current year.

[133] In this case, Congress has elected to make the Uniform Capitalization Rules and related change in method of accounting rules mandatory for the first taxable year beginning after December 31, 1986. The adjustments to Petitioner's costs of sales under the Uniform Capitalization Rules (if applicable) were required to be made for each taxable year from June 30, 1988, through June 30, 1994. The Government cannot chose [sic] to defer the accumulated adjustments into an open year that will bring it the most tax benefit, in violation of the Congressional mandate for change in 1986. For Petitioner's tax year ended June 30, 1994, the proper adjustment under Section 263A is only an increase in costs of sales in the amount of $70,010 and not the reduction proposed by the Service.

IX.

NO REQUEST FOR ATTORNEYS' FEES

[134] Pursuant to Ninth Circuit Rule 28-2.3, Appellant hereby notifies the Court that it is not its intention to request attorneys' fees on appeal.

X.

CONCLUSION

[135] For the foregoing reasons, Appellant Suzy's Zoo requests that this Court determine that Suzy's Zoo is a small reseller as defined in Treasury Regulation Section 1.263A-3(a)(2) and is not subject to the Uniform Capitalization Rules of Section 263A(a), pursuant to I.R.C. Section 263A(b)(2)(B); and therefore, that the decision of the lower court should be reversed, as there is no deficiency owed by Appellant.

[136] In the alternative, should this Court determine that the lower court ruled correctly that Suzy's Zoo is subject to the Uniform Capitalization Rules of I.R.C. Section 263A, then Appellant urges the Court to find that the proper year of change for making any such Section 481 adjustment was the taxable year of Suzy's Zoo ended June 30, 1988, and that therefore, the decision of the Tax Court should be reversed in part, to the extent that it improperly determined that the year of the change for purposes of making a Section 481 adjustment should be the fiscal year ended June 30, 1988.

[137] Accordingly, Appellant requests a determination that Appellant's costs of goods sold for 1994 should not be reduced by the sum of $737,277, as adjusted under the improper Section 481 adjustment, and that the only proper adjustment for 1994 is to increase the costs of goods sold of $70,010 as a result of the Section 263A application of the Uniform Capitalization Rules for 1994, should this Court determine that Appellant is subject to the Uniform Capitalization Rules.

Dated: August 23, 2000

 

Respectfully submitted,

 

 

HIGGS, FLETCHER & MACK, LLP

 

 

By: Richard A. Shaw

 

 

By: Bruce M. O'Brien

 

 

Attorneys for Appellant, SUZY'S

 

ZOO

 

 

CERTIFICATE OF COMPLIANCE

[138] This is to certify that the foregoing APPELLANT'S OPENING BRIEF, complies with the type-volume limitation of less than 14,000 words, pursuant to Rule 32(a)(7)(B) and (C) of the Federal Rules of Appellate Procedure for the United States Court of Appeals for the Ninth Circuit. According to the word processing system used to prepare the text of the aforementioned brief, MicroSoft Word, the document contains 12,035 words, including footnotes, and excluding the Table of Contents, Table of Authorities, or certificates of counsel attached thereto.

Dated: August 23, 2000

 

 

RICHARD A. SHAW

 

 

CERTIFICATE OF SERVICE

[139] This is to certify that two (2) copies of the foregoing APPELLANT'S OPENING BRIEF, was served on counsel for Appellee by mailing the same on August 23, 2000, in a postage paid wrapper addressed as follows:

Dated: August 23, 2000

 

 

A. Wray Muoio, Attorney

 

Appellate Section

 

U.S. Department of Justice

 

PO Box 502

 

Washington, D.C. 20004

 

 

RICHARD A. SHAW

 

FOOTNOTES

 

 

1 This Introduction contains no references to the record for ease of reading and only occasional references to the Internal Revenue Code. All assertions are repeated in the Statement of the Case, Facts, or Argument, with appropriate record citations.

2 26 U.S.C. section 263A. All references to the Internal Revenue Code sections will be referred to in text as "I.R.C." All references to Regulations issued by the United States Department Of Treasury will be referred to by the preface "Treas. Reg." or "Treasury regulation").

3 All factual references in this Brief are to the Stipulation of Facts submitted by the parties to the Tax Court. References to those stipulated facts are abbreviated as follows: (SF [number]).

4 Note that "royalties" derived from its licensing agreements income is not affected in any way by the UNICAP rules at issue in this appeal. Still, the existence of such royalty income corroborates the central point of this appeal: that the artwork created by Suzy's Zoo has independent value apart from the final product to which that artwork is later affixed.

5 The parties stipulated that the procedure Suzy's Zoo followed with Gold Gate Litho is similar to how it orders the printing of other products from other printers. (SF 56.)

6 The UNICAP rules are effective for taxable years beginning after December 31, 1986. TRA section 803(d)(2)(A).

7 The subject property is that defined in I.R.C. section 1221(a)(1) which includes:

"stock in trade of the taxpayer or other property of a kind

 

which would properly be included in the inventory of the

 

taxpayer if on hand at the close of the taxable, or property

 

held by the taxpayer primarily for sale to customers in the

 

ordinary course of his trade or business; . . . ."

 

 

8 Treas. Reg. section 1.263A-3(a)(1) states in part: In general. Section 263A applies to real property and personal property described in section 1221(1) [sic, should be 1221(a)(1)] acquired for resale by a retailer, wholesaler, or other taxpayer (reseller). However, section 263A does not apply to personal property described in section 1221(1) [sic] acquired for resale by a reseller whose average annual gross receipts for the three previous taxable years do not exceed $10,000,000 (small reseller). . . . . "

9 The taxpayer in Golden Gate Litho v. Commissioner, was not required to use the accrual method of accounting on its inventory because of described abuses by the IRS.

10 Old I.R.C. section 1221(1) is now section 1221(a)(1). I.R.C. section 1221(a)(1) includes property that would be included in the taxpayer's inventory if held at the end of the taxable year, and property held primarily for sale to customers in the ordinary course of a trade or business. See also, Treas. Reg. section 1.263A-3(a)(1).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Case Name
    SUZY'S ZOO, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
  • Court
    United States Court of Appeals for the Ninth Circuit
  • Docket
    No. 00-70461
  • Authors
    Shaw, Richard A.
    O'Brien, Bruce M.
  • Institutional Authors
    Higgs, Fletcher & Mack LLP
  • Cross-Reference
    Suzy's Zoo v. Commissioner, 114 T.C. No. 1; No. 9423-98 (January 6,

    2000) (For a summary, see Tax Notes, Jan. 17, 2000, p. 360; for the

    full text, see Doc 2000-1101 (24 original pages) or 2000 TNT 5-9 Database 'Tax Notes Today 2000', View '(Number'.)
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    capitalization rules, uniform, creative expenses
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-23086 (67 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 191-58
Copy RID