February 1999
Volume 26
Number 1

Wake-up Call

by Dale Scott

The traditional smoke shop may no longer be economically viable in the Golden State. And if the folks that brought California its disastrous Proposition 10 tobacco taxation plan have their way, similar measures could soon be coming to your state. Will you be prepared to fight — and win — if Rob Reiner tries to put you out of business?

Proposition 10, cheerily tagged the "California Children and Families Act of 1998," carries another moniker: the "Meathead Act." It is the spawn of Hollywood director Rob Reiner, who years ago played the character of the same name in "All in the Family." California voters, driven not by reason but by passion, facilitated tyranny by bypassing the Legislature — the safeguard of a republic — approving what they thought was a simple tax hike on cigarettes; a statement aimed against Big Tobacco. They didn't know they'd practically be forcing small, family-owned tobacco shops out of business. Even worse, neither did the authors of Proposition 10 itself.

The situation concerning California's Proposition 10 is so complex and volatile that the smart money would sit out any bets on whether cigar smokers and retailers will find any recorse. But one thing is certain: it's one wretched piece of legislation. This trampling of the rights of a minority by the majority — the earmark of democracy — is exactly why our Founders abhorred it.

Bamboozled ballot-stuffers thought the initiative merely added a 50’-per-pack tax on cigarettes — acceptable to a populace who considers cigarette manufacturers and smokers social pariahs. But they didn't read the fine print. As a result, the measure passed by 80,000 votes last November, less than a 51% advantage. Only after the placards were ripped from telephone poles did the fact of how punitive — dare one say hateful — the tax was to purveyors of other tobacco products (OTP): cigars, pipe, and smokeless tobacco. The "For-the-Children" poseur was really a bureaucratic attack on retailers of tobacco products within the state of California. "This has nothing to do with health," Kerrie Aley, owner of Romeo et Juliette, Newport Beach. "It's all about revenues."

On January 1, 1999, the tax on OTP jumped from 26% to 61%. On July 1, 1999, it could climb to as much as 97%. The figure probably will fall more in the 70-75% range, because OTP will be taxed on a percentage basis of the cost of cigarettes last March. Since manufacturers have already increased prices — and will like do so again — the actual dollar value, calculated on the March percentage, will be a smaller percentage of the new price.

This tax is levied on the first entity to receive tobacco products in the state, be it distributor or retailer. The tax must be paid by the 24th of each month following the month a tobacconist receives a shipment of OTP.

Even more problematic than the OTP tax, retailers were crushed under a 35% floor tax on the wholesale value of all inventory in their control as of January 1, 1999. The due date was February 15, 1999, and tobacconists were forced to write large checks, possibly their profits for the entire year — up front, and probably before any stock is sold. Not surprisingly, store closures and relocations outside of California have already begun.

Some had to take drastic measures to survive even the first wave of financial blows. By December, Aley resorted to selling cigars at, or below, cost in order to reduce inventory levels and avoid facing an "unimaginable amount of tax liability" when the January 1st assessment deadline came around. "If I could not come up with this money in the month-and-a-half the state board gave me, they were going to hit me with a 10% penalty and charge me 11% interest," said Alley.

California's OTP Tax Formula
Set the Stage for Disaster

Last November 25, a blue-ribbon panel of four California state "Honorables" and an "Acting," met to try to decipher the language and consequences of Prop 10's taxation provisions. Their chief counsel issued a memorandum of the meeting, in which the panel agonized over it for 14 pages. In the end, they calculated the taxes at the highest possible rates, the most severe interpretation of the initiative possible.

Other not-so-trivial aspects of Prop 10, though they do not directly affect the state's struggling smoke shops, are equally troubling. The proposition creates the specter of 50 agencies statewide to divvy up the spoils, originally estimated at some $750 million a year. Imagine them, riding through every hamlet and inner-city alley of the Golden State, sweeping up and carrying off pre-schoolers for "development," and dysfunctional mommies and daddies for "assistance" — the techno-socialists' dream.

Unwilling to let Prop 10 merely steamroll over the state's specialty retailers were Charlie Hennegan, proprietor of Liberty Tobacco, a San Diego retailer, and Charles Jannigian of JMG International, a San Jose distributor. They formed the California Association of Retail Tobacconists, Inc. (CART) in mid-November. Other proprietors involved from the start include Linda Squires of The Squire in Santa Rosa; Manjit Bain of Tinder Box in Costa Mesa; Donna Brown of San Jose's Mission Pipe; Captain Hunt's Harry Hunt in San Diego; and Marty Pulvers of San Francisco's Sherlock's Haven. Several are or have been RTDA board members and officers.

CART members have already spotted the first cracks in the foundation of California's retailer ranks. "I see a paralysis among dealers who are afraid to buy product they can't pay for after writing checks to Sacramento for the 35% floor tax," said Pulvers. Others have simply folded under the economic burden. "I know of two stores in the San Diego area that have closed, and another shop owner says he's getting out of the business," reported Hunt. "It's not unreasonable to expect retailers will have no cash flow until autumn."

Squires explains her frustration on an even more personal level. "I can confirm a store closure within 20 miles of here," she said. "I hate to see established retailers face this. They have endured the lean years, the shortages and price increases, overstocking by back-ordered manufacturers, hurricanes, and now this tax."

CART's formation came too late to affect the election. Since then, however, they have honed themselves into a spear-point, which continues to gain mass daily. Some 30 original supporters have grown to 137 retailers and 30 manufacturers and distributors. RTDA donated $5,000 to support their efforts. Envelopes from around the country swelled their coffers to over $80,000 at last count, with early donations from cigar families such as the Newmans and the Padrons, as well as Lockwood Trade Journal Co., publisher of Smoke and Smokeshop magazine. Moral support was equally encouraging. "Eric Newman calls regularly to keep abreast of the developments," says Jannigan. "Carlos Toraρo Cigars and CAO International have told us to, 'Do what it takes, and we'll support you.'"

Jannigan is outspoken on the silence of the major manufacturers: "General, Consolidated, and Lane have offered no support at a time when 1,000 California retailers — no less than 10% of their national income — need it desperately. Remember this when they ask to support them with orders."

The Legal Attack
Couvert Brothers, an international law firm that specializes in civil litigation, filed for a Writ of Mandamus directly with the California Supreme Court. Plaintiffs are Hennegan/Liberty, Jannigan/JMG, and CART (representing 124 aggrieved shop owners). The writ would immediately stay (stop) implementation of the collection of taxes. "We need the stay until the merits of our arguments can be heard," advises Jannigan, "or too many shops will close in the meantime." Jannigan admits the Supreme Court can refuse to hear the case without reason, "in which case we have to start at the bottom."

Their case is based on violations of three sections of the California State Constitution:

  • It creates an autonomous commission without legislative- or executive-branch control over the revenues and spending. The commission's personnel are exempt from requirements of the state civil service.
  • Prop 10 violates the "single-purpose" clause by co-mingling two unrelated subjects: selective taxation of OTP and funding of child-development and family programs. Only a tiny portion of the revenues are earmarked for education of the dangers of tobacco, alcohol, and drugs.
  • The commission is quasi-private, which violates the provision that public funds cannot be used by such an entity.

Jannigan and attorney Ed Lozowicki of Couvert Brothers are touring the state to brief the trade and drum up support; Manny Kaufman of Nat Sherman, Inc., accompanies them to explain the breakdown of the proposition's tax schedules.

Days before a San Diego meeting, several organizations filed supporting briefs, including the Libertarian Party of California, the California Distributors Association, the Pipe Tobacco Council, and four smokeless tobacco organizations. This was met by a flurry of opposing briefs by the state officials named in the Writ: the Governor, Treasurer, Legislature, Board of Equalization, and Rob Reiner.

The Supremes have 60 to 90 days to rule, assuming they take the case. Retailers, meanwhile, should timely file their tax returns, pay the taxes under protest, and file for refunds; Proposition 10 is law until overturned. Retailers should preserve their rights with a formal protest and request for refund. "Simply writing 'paid under protest' on your check won't work," advises Jannigan. CART will advise retailers of the proper procedures.

"It is imperative the proposition be halted now," Lozowicki and Jannigan asserted. "How can you unravel a 250-agency commission and recoup $1.5 billion that have been disbursed two years later? The State would be reluctant to reimburse us out of the General Fund, to say nothing of the damages to all the businesses that have failed."

The Legislative Analyst, a Sacramento think tank employed by the Legislature, recently published a report that expresses some of the legal concerns expressed in the CART filings. Specifically, they are dubious about the issue of lack of governmental control.

The Analyst also acknowledged the loss of business and tax revenues as a result of the proposition. It has revised its pre-election $750 million estimated revenues downward by $50 million.

This doesn't surprise retailers who saw a sales dollars defecting to East Coast discount mail-order houses and the Internet, even before Prop 10. With the current tax burden, prices in Golden State shops are easily twice that of discounters. "The days of cigar smokers paying anything for cigars are over," notes Hunt. "They're bargain hunters now."

The price differentials could ultimately affect which brands stores will stock. "In the marketplace, regardless of the tax, shop owners must realize they are disadvantaged in selling major brands," explains Gilbert Frank, president of GilFranco Cigars, a San Diego distributor. "If a smoker comes in to try a Macanudo Robust, for example, why should he continue to buy it from a shop, when he can get it at a discount? You can't make it selling samples. You're better off convincing customers to try brands they must come to you for, like lesser-known cigars and cigars that aren't available through discounters." Frank also admitted nervousness in selling to retailers who may not be around to pay their invoices.

GilFranco, like Phillips & King International and other California distributors, compute the OTP tax on their cost, not the wholesale cost. Mike Gold, of Arango Cigar Company, Northfield, Illinois, says, "RTDA's Almanac confirms this, saying state taxes are computed on the Distributors Cost Price." Gold won a similar mid-'90s suit against the Illinois taxing authority. They were taxing in-state smokeless tobacco manufacturer U.S. Tobacco on its manufacturing cost, a fraction of what they were charging out-of-state Kodiak and Conwood, and OTP carried by Arango, among others. "This was unfairly discriminative taxation," says Gold, "against us, the retailers, and customers." Successful in his case, Gold is providing CART with valuable strategic advice.

Rich Perelman, of Perelman Pioneer & Co., Los Angeles publishers of Perelman's Pocket Cyclopedia of Cigars and other handbooks, sees the picture from a practical perspective. "Retailers must find better ways to sell their product, even at higher prices. I see the small shops disappearing and larger facilities emerging. I see success in diversification — where food and beverage proprietors join with tobacconists, perhaps including recreational facilities, forming 'destinations,' not just in-and-out retail shops. Before the cigar boom, tobacconists also sold gifts and other non-tobacco merchandise; I believe some will return to this." Perelman agrees it won't make sense for smoke shops to compete with out-of-state retailers. "They should sell non-discounted cigars like Diamond Crown, Davidoff, Avo, Padron, and the new Aristoff," he says.

While many mail order catalogs discount their merchandise, it is the exemption from sales tax that gives consumers the double edge. The surge of mail order business nationwide in recent years has Federal officials examining the taxation issue; however, dramatic changes could emerge in the next several years.

"The sales and the excise tax issue is something that a number of the larger states are already taking a look at," notes Aley. "None of the states are collecting sales tax on the sales. I wouldn't be surprised if we see a national sales tax, and the elimination of mail order tobacco within three years."

California Was First. Who's Next?
This isn't the first time in this century smoking has come under severe attack. When Queen Victoria forbade it for seven years, cigar divans flourished, and so did cigars. Some of England's oldest and most prestigious clubs were originally divans.

"I attended two dinner parties recently," Perelman notes. "Guests spoke of favoring the elimination of the nuisance of smoke, even if smokers lost their rights. This sentiment among the majority makes for scant public support of smokers. They will moderate their attitude only when tobacco Prohibition encourages crime, as the Volstead Act did. I envision a separate-but-equal society, where separate non-smoking and smoking bars, restaurants, shops, and other public places would exist, perhaps on a 3-1 ratio."

Linda Squires warns retailers nationwide: "California is the first, but not the last, state where this issue will erupt. Tobacconists must do two things. First, distance yourselves from the cigarette industry in the minds of the public and state government. Second, form your own CART now. Establish an ear and a voice in legislative matters concerning tobacco. Even after the storm of Prop 10 passes, remain active, because once the spotlight is on you, it doesn't go away."

Meathead is touring the country, hitting the national talk shows, eager to put you out of business. Perhaps you are the reader who will put this magazine down and start phoning your colleagues.

Contact CART at Tel: (408) 573-1105, or Fax: (408) 573-1106.

Dale Scott is the author of How to Select and Enjoy Premium Cigars...and Save Money! The new and expanded 1997 edition is now available to tobacconists. Contact Coast Creative Services, P.O. Box 113, Julian, CA 92036. Tel: (888) 811-6292.

SMOKESHOP - February 99