Third Circuit Holds That Advance Payments of Trade Discounts Are Income on Receipt

Karns Prime & Fancy Food, Ltd. (Karns), is a Pennsylvania corporation that operates grocery stores in the Harrisburg, Pennsylvania,area. In 1998,Karns’s management determined that the company required $1.5 million for capital improvements to its stores. Karns approached its primary supplier, Super Rite, Inc., about borrowing funds from it to make the improvements. In 1999, Super Rite agreed to make $1.5 million immediately available to Karns; in return, Karns executed a promissory note to Super Rite and signed a supply agreement as required by Super Rite.

The supply agreement provided that Super Rite would be the principal wholesaler for all of Karns’s purchased products and that Karns would purchase $16 million worth of productsannually from Super Rite.The promissory note was interest bearing and was to be repaid in six annual payments of $250,000.However, the supply agreement provided that if Karns met the supply requirement for the previous calendar year by purchasing the stipulated amount of Super Rite products, Super Rite would forgive the $250,000 note payment due and owing for that year. If Karns fell short of its total purchase requirements for a year, Super Rite would forgive a portion of the payment based on the amount of purchases Karns made.

Karns recorded the $1.5 million advance as notes payable and treated it as a loan. In the years 2000–2003, Karns either fully or partially met its purchase requirements, and Super Rite forgave all or a large portion of the payment due under the note for those years. Karns reported the amount of the payment that was forgiven each year as other income on its income tax return for that year.

The IRS disagreed with Karns’s treatment of the Super Rite advance, contending that it was not a loan and that the full $1.5 million was includible in income in 1999 when it was received. Therefore, the Service sent Karns a notice of deficiency for 1999 for tax on the full amount of the advance. Karns challenged the IRS’s determination in the Tax Court, which held that the full amount of the advance was includible in income in 1999.Karns appealed theTax Court’s decision to the Third Circuit Court of Appeals.

Third Circuit’s Analysis

The Third Circuit affirmed the Tax Court and held that the full amount of Super Rite’s advance to Karns was includible in Karns’s income in 1999. The Third Circuit’s holding was based on Indianapolis Power & Light Co., 493 US 203 (1990). In that case, the taxpayer, an electric utility company, required some of its customers to pay security deposits, which the company was not entitled to keep unless the customer actually purchased electricity and subsequently did not pay for it. The Supreme Court held that the deposits were not includible in income when they were received. According to the Court, the determination of whether a payment is a deposit,which does not have to be included in income when received, or an advance payment, which does have to be included in income when received, depends on which party controls the ultimate disposition of the payment. If the payor’s actions control whether or not the payee can retain the payment, it is a deposit. If the payee’s actions control (i.e., if the payee lives up to the terms of the agreement, it can keep the payment), it is an advance payment. According to the court, the customers controlled whether or not the company kept the security deposits, so they were deposits, not advance payments.

In its analysis, the Third Circuit treated the note payable and the supply agreement as one unified agreement because the facts indicated that the parties had treated them as one agreement. The court found that although Karns had an absolute obligation to pay back the Super Rite advance under the note payable, under the supply agreement Karns was in control of whether or not it would actually have to pay the advance back, because Karns controlled whether or not it made the purchases necessary to meet the requirements under the supply agreement for forgiveness of the payments due under the note. Therefore, applying the precedent in Indianapolis Power, the court found that the Super Rite advance was an advance payment that was includible in income on receipt because Karns controlled whether or not it had to repay the advance.

Reflections

The IRS’s win in Karns is tempered by the fact that it announced its acquiescence to the Ninth Circuit’s holding in Westpac Pacific Food, 451 F3d 970 (6th Cir. 2006), before the Third Circuit filed its decision in the case. In Westpac, the Ninth Circuit held that advance payments of trade discounts by a supplier are equivalent to loans and are not includible in income when received. As the Third Circuit did in Karns, the Ninth Circuit purported to base its holding on the Supreme Court’s Indianapolis Power opinion; however, for the reasons discussed by the Third Circuit, the Ninth Circuit fundamentally misinterpreted the Indianapolis Power holding in Westpac. Given the similarity of the facts in Karns to those in Erickson Post Acquisitions, TC Memo 2003-218, a case to which the Service issued a nonacquiescence in 2006, further challenges on this issue may well be forthcoming from the IRS despite its acquiescence in Westpac. See Shevak, “Retail Cash Advances: Loans or Income?”; and Auclair, “Westpac Pacific Food: Advance Trade Discounts Are Not Income,” Tax Clinic, The Tax Adviser (February 2007), pp. 78 and 80, for a further discussion of Erickson Post Acquisitions and Westpac.

KARNS PRIME & FANCY FOOD, 3D CIR., 7/20/2007