In Depth April 8, 2010, 5:00PM EST

How Altria Is Winnowing Out Fake Marlboros

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Buffalo brand cigarettes manufactured on Seneca Nation land Jennifer S. Altman

A tax stamp on a pack of Marlboros

Subrina Mini Mart Jennifer S. Altman

Workers manufacture cigarettes at a factory on Seneca Nation land in upstate New York Jennifer S. Altman

Seneca Nations Snyder has made a profitable business selling tobacco Jennifer S. Altman

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Proximity to lower-tax states isn't the only reason New York has become the largest market for illegal cigarettes in the U.S. The tobacco businesses on sovereign Native American lands in the Northeast also present a challenge to tax collectors.

The Seneca Nation of Indians—some 7,900 people who live in generally modest conditions on two remote territories south of Buffalo in Western New York—has sold tobacco products without any taxes for more than 20 years. Altria and the state of New York argue that the Seneca should collect levies on sales to non-Indians. The Seneca have refused, citing 18th century treaties with the U.S. government.

The sale of tax-free cigarettes from the Seneca Nation, over the Web and in person, has become a substantial business. Law enforcement officials suspect that a lot of the product ends up resold illicitly on the street. Indian retailers sell a carton of 10 packs of Marlboro tax-free for about $50. Transported to New York City, the carton might sell for $100 in a convenience store, yielding $50 in black market profit.

Seneca leaders say they don't condone the shipment of large quantities of cigarettes for resale. They allege that Altria's current crackdown is aimed at least in part at squelching sales on Seneca lands, especially those of rival discount brands manufactured locally. "We do a lot of business through our own marketing and brands, and that's competition" for Altria, says Seneca Nation President Barry E. Snyder.

Along with a thriving casino business, cigarettes are an integral part of the impressive $1 billion Seneca economy. Snyder, who began opening tobacco shops in the early 1980s, has prospered. He drives a silver Hummer and spends parts of the winter in Arizona rather than frigid upstate New York.

For a time, Marlboro courted the Seneca trade, sending company representatives to negotiate deals with Native American vendors similar to those offered mainstream retailers. Altria has tried in recent years to cut off wholesalers that supply retailers not charging taxes, including the Seneca. That strategy was successfully challenged in the courts, and Altria has resumed its dealings with the wholesalers. Still, the company alleges that the tribe's sale of large amounts of cigarettes via Internet sites gives teenagers too young to buy tobacco products a chance to obtain Marlboros and other brands. The Seneca vehemently deny this.

The company encouraged the decision in 2005 by all major credit-card companies to stop processing online tobacco sales. It also lobbied for legislation passed by Congress in March that forbids the U.S. Postal Service from shipping cigarettes. Both moves have the effect of limiting the Seneca's online sales.

Seneca retailers operate most of the largest tobacco sales sites online. Tribe member Suzanne Smith built a thriving business at senecasmokeshop.com. These days her top sellers are Seneca, Pride, and other Native American brands. As a result of the new postal restriction, she expects to lay off at least one-third of her 45 full-time workers. Those who stay will work for other businesses she runs, including a temporary-nurse registry.

Her daughter, Alyse Pierce, a mother of five, is one of her mother's employees. She, too, resents Altria's recent actions. "We sell tons of their stuff, yet they work against us," Pierce says. Once, she adds, Marlboro and other major brands comprised 50% of her sales. Now that figure is closer to 10%.

Altria's Thorne-Begland concedes that Native American sales have put a modest dent in Marlboro revenues. The "Seneca do shift buyers from Marlboro" to their own cheaper brands, he says. "They offer a trade-off: If you like Marlboro, you'll love this."

The tobacco company executive portrays Altria as the victim. What's unfair, he argues, is that the Seneca and other retailers sell untaxed cigarettes at half the price of competitors': "We want a level playing field," he says, "where everyone plays by the same rules."

Byrnes is a senior writer for BusinessWeek.