Federal and State Tobacco Taxes - On Fire or Just Smoking?

Federal and State Tobacco Taxes - On Fire or Just Smoking?

by Daniel G. Mudd *

Editor's Note: The following is abridged from a feature article appearing in the March 2014 edition of the Lexis® Federal Tax Journal Quarterly. **

§ 3.01  Introduction 

For those in the business, manufacturers, wholesalers, distributors, importers, dealers and retailers of tobacco products, there are a staggering amount of Federal and state excise tax compliance obligations and responsibilities that must be fully considered prior to the commencing of such operations, as well as on an on-going basis.  As Part I of a two-part overview and analysis of these considerations, this article will focus on all Federal excise tax (“FET”) obligations, as well as basic procedure for challenging assessments of such FET liabilities.

 Tobacco worker tending to plant

§ 3.02  Basics of Tobacco Products and Types of Businesses for Purposes of the FET

As an initial matter, when evaluating a business’ FET liability, if any, one must first determine the specific type of tobacco product being manufactured, imported, sold or otherwise distributed by same, as the tax rate and reporting responsibilities vary greatly for cigarettes, cigars and other tobacco products.  The term tobacco products, for purposes of the FET, includes cigars, cigarettes, and several other tobacco products.[1]  While most think of cigarettes and cigars only in terms of the FET, many other tobacco products are also subject to the FET and related reporting requirements for same, including actual tobacco products such as chewing tobacco, snuff, pipe tobacco, roll-your-own tobacco, as well as tobacco components such as cigarette papers and tubes, all of which are statutorily defined.[2]  There are, however, limited exemptions from the FET for certain types of tobacco products and cigarettes papers and tubes.[3

In addition to these general categories of tobacco products, both cigarettes and cigars are further broken down into small and large classes based on weight per 1,000 units (cigars or cigarettes).[4]  The importance of the distinction between small and large cigars has become an extremely hot topic over the past few years as cigars have traditionally been taxed at a much lower rate than small (regular) cigarettes.  Similar issues have also arisen due to the FET rate disparity between roll-your-own tobacco and pipe tobacco. As such, there has been a recent trend of persons intentionally misclassifying or mislabeling certain tobacco products to obtain a lower FET (and state excise tax) rate on same.  As a result, several measures have been taken at the Federal and state level to prevent and punish such intentional misclassifications and schemes.[5]

Once the type of tobacco product has been properly identified under the applicable statutory and regulatory definition, the next step is to determine the specific operation involved, as the FET applies primarily to domestic manufacturers and importers.[6]  In general, any manufacturer or importer of such products (as well as an “export warehouse prospector”[7]) must qualify for and obtain a permit from the Alcohol and Tobacco Tax and Trade Bureau (“TTB”) to engage in such activities, all of which are subject to suspension or revocation if certain violations are committed by the permit holder.[8]  The typical permit process through the TTB takes a minimum of sixty (60) days to process, and typically much longer, on average, based upon the documentation requested by the TTB.[9] 

§ 3.03 Overview of Applicable FET Rates, 2009 Floor Stock Tax and Related FET Requirements and Recent Legislative Changes to Same

Once the specific type of tobacco product and the exact operations involved with same have been identified, and the proper permits have been obtained, one can then look to the specific FET rate and Federal reporting, compliance, and other requirements for such products and activities. 

As a general matter, the FET applies to and is imposed on tobacco products and cigarette papers and tubes that are manufactured in, or imported into, the United States pursuant to Chapter 52 of the Internal Revenue Code of 1986, as amended (“Code”).[10]  The FET is imposed on the manufacturer or importer of the tobacco product, and collected on the basis of a return filed based upon the time of removal from the manufacturer’s facilities, or in the case of importers, upon release from the customs custody or bond.[11]  In general, payment of the FET on tobacco products and cigarettes papers and tubes falls on the fourteenth day after the last day of each semimonthly period where such products are removed; certain timing requirements for imported products and other exceptions may, however, apply.[12]  Upon removal, tobacco products (and cigarette papers and tubes) must be properly packaged and bear all marks, labels, and notices as required by relevant regulations.[13]  Additionally, strict record retention and inventory and sales reports must also be complied with on an ongoing basis.[14]

The FET rate and related reporting requirements were drastically changed with the enactment of the Children’s Health Insurance Program Reauthorization Act (“CHIPRA”) in 2009, as it, among other things, increased the FET rate, effective April 1, 2009, on all tobacco products and related items (e.g., cigarette papers and tubes), as well as imposed what is known as a “floor stocks” tax on such products.   CHIPRA also added new requirements for manufacturers and importers of certain processed tobacco products, and changed the authority and basis for an applicable tobacco product permit to be denied, suspended or revoked.[15]  As a result of CHIPRA, the FET rate jumped over 158% from $19.50 and $40.95 per 1,000 for small and large cigarettes, respectively, to $50.33 and $105.69 per 1,000 units.[16]  The FET rate for small and cigars likewise substantially increased as of April 1, 2009, with small cigars being taxed at $50.33 per 1000 (previously $1.828 per 1000), while large cigars are taxed at 52.75% of sales price, not to exceed $402.60 per 1,000 cigars (previously only 20.719% of sales price, not to exceed $48.75 per 1,000).[17]  FET rates for other tobacco products like pipe tobacco, chewing tobacco, snuff, roll-your-own tobacco and cigarette paper and tubes were likewise adjusted and in Section 5701 of the Code, as well as on the TTB’s website.[18]

Note that unlike, cigarettes and small cigars, the FET on large cigars is based on the “sale price,” which for FET purposes, is generally based on the actual sales price charged by the manufacturer to the purchaser,[19] unless the large cigars are sold: (i) at retail; (ii) on consignment; or (iii) other than through an arms-length transaction and at less than the fair market price (e.g., sales between affiliated parties at less than fair market price[20]).  In such situations, the FET on large cigars is computed using a “constructive sale price,” generally defined to be “the price for which articles are sold, in ordinary course of trade, by manufacturers or producers thereof, as determined by the [TTB]” and based on a number of applicable methodologies set forth in Section 4216 of the Code and relevant regulations and other administrative guidance.[21] 

In addition to the increase in the FET rates for all tobacco products and cigarette papers and tubes, CHIPRA also imposed a “floor stocks tax” on all of these items held for sale on April 1, 2009, except for large cigars.[22]  In general, a floor stocks tax was “a one-time excise tax placed on a commodity undergoing a tax increase,” and thus attempts to amount to the difference between the new FET rate and the prior rate.[23]  The one-time tax applied to any person in possession of these products for sale on April 1, 2009, including wholesalers, retail dealers, manufactures and importers.[24]  A full breakdown of the increased FET on all tobacco products, papers and tubes, as well as the applicable floor stocks tax rate, can be found on the Alcohol and Tobacco Tax and Trade Bureau’s website.[25]



[1] 26 USC § 5702(c) (defining tobacco products). 

[2] 26 USC § 5702 (a), (b), (e), (f), (m)-(o).

[3] See 26 USC § 5704.

[4] 26 USC § 5701(a)(1) & (2).

[5] See e.g., Children’s Health Insurance Program Reauthorization Act, Pub. L. No. 111-3, H.R.2, 111th Cong. (Jan. 6, 2009) (significantly increasing FET rate on other tobacco products, including small cigars to have same FET rate as small cigarettes); Tobacco Tax Equity Act, S. 194, 113th Cong., 1st Session (proposed Jan. 31, 2013 to require the same FET rate on all tobacco products and cigarettes); “FDA Acts to Stop Tax-Evading Misbranding of Roll-Your-Own-Cigarette Tobacco as Pipe Tobacco,” Press Release from FDA Campaign for Tobacco-Free Kids (Aug. 12, 2013), available at http://www.bizjournals.com/prnewswire/press_releases/2013 /08/12/DC62706 (last visited Jan. 5, 2014).

[6] 26 USC § 5702(d) (g) (defining manufacturer of tobacco products and cigarettes, and importer).

[7] 26 USC § 5702(h) & (i).

[8] See 26 USC §§ 5712 & 5713; 27 CFR §§ 40.61(a), 41.190 & 191.

[9] “Days to Process Permits Online Original Applications,”  Alcohol and Tobacco Tax and Trade Bureau website, available at http://www.ttb.gov/nrc/average-days.shtml (last visited Jan 4, 2014).

[10] See 26 USC § 5701.

[11] 26 USC § 5703(a) & (b).  Moreover, although outside the scope of this article, note that Sections 5731-34 of the Code imposes an annual special occupational tax on manufacturers and export warehouse proprietors (not importers).

[12] 26 USC § 5703(b)(2)(A) & (B). 

[13] 26 USC § 5723(a) & (b); 27 CFR §§ 40.211-40.217, 41.71-41.75.

[14] 26 USC 5721-22 & 5741; 27 CFR §§ 40.181-40.187, 40.201 & 40.202; 41.181-41.182.

[15] PL 111-3, HR2, 111th Cong (Jan. 6, 2009).  See also, “Federal Excise Tax Increase and Related Provisions,” Alcohol and Tobacco Tax and Trade Bureau website, available at http://www.ttb.gov/main_pages/schip-summary.shtml (last visited Dec. 28, 2013).

[16] 26 USC § 5701(b)(1)&(2); “Federal Excise Tax Increase and Related Provisions,” supra note 16.

[17] 26 USC § 5701(a)(1)&(2); “Federal Excise Tax Increase and Related Provisions,” supra note 16.

[18] 26 USC § 5701(c)-(h); Tax and Fee Rates,” Alcohol and Tobacco Tax and Trade Bureau website, available at http://www.ttb.gov/tax_audit/atftaxes.shtml (last visited Jan. 4, 2014).

[19] 27 CFR § 40.22(a).

[20] 27 CFR § 40.22(b)(1); Rev. Rul. 71-240, 1971-1 C.B. 372 (“any intercompany sale price which is less than 95 percent of the selling company’s lowest established resale price to unrelated wholesale distributors is considered less than fair market price….”); Rev Rul 76-182, 1976-1 CB 343 (“[T]he 95 percent rule stated in Rev Rul 71-240 is presumptive of fair market price”).

[21] 26 USC § 4216(b); 26 USC § 5702(l)(3); 27 CFR §§ 40.22(b) & 41.39; TTB Industry Circular No. 2011-03 (Apr. 26, 2011).  See also, 26 CFR §§ 48.4216(b)-1 to (b)-4; Rev. Rul. 76-182, 1976-1 C.B. 343; Rev. Rul. 71-240, 1971-1 CB 372; Rev Rul 62-68, 1962-1 CB 216.

[22] PL 111-3. HR2, 111th Cong (Jan. 6, 2009); TTB Form 5000.28T09 (03/2009).

[23] “Floor Stocks Tax FAQ,” Alcohol and Tobacco Tax and Trade Bureau website, available at http://www.ttb.gov/tax_audit/floor-stocks-tax-faqs-answer.shtml#g1 (last visited Jan. 4, 2014).

[24] PL 111-3. HR2, 111th Cong. (Jan. 6, 2009); TTB Form 5000.28T09 (03/2009).

[25] “Federal Excise Tax Increase and Related Provisions,” supra note 16.

 

* Daniel G. Mudd, Esq., is an Associate and tax attorney resident in the Louisville, Kentucky office of regional law firm Frost Brown Todd, LLC.  Daniel’s practice focuses on controversy, litigation and planning relating to tax matters, primarily in state and local tax matters and incentives.  Through his representation of a number of prominent local and national clients, Daniel has gained experience and expertise in the areas of Federal and state tobacco tax, sales and healthcare-related tax, and energy exemptions.  Daniel has also represented a variety of corporate and individual clients in Federal tax controversy and collection matters.

** LEXIS users can view more information about tobacco taxes related to Enforcement of the FET and Challenging FET Assessments

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