Court Opinion

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Opinions of the United
2007 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit

7-20-2007

Karns Prime Fancy v. Comm IRS
Precedential or Non-Precedential: Precedential

Docket No. 06-1031

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                                              PRECEDENTIAL

           UNITED STATES COURT OF APPEALS
                FOR THE THIRD CIRCUIT

                          No. 06-1031

           KARNS PRIME & FANCY FOOD, LTD.,
                                   Appellant
                          v.

          COMMISSIONER OF INTERNAL REVENUE

           On Appeal from the United States Tax Court
                      (No. 0090-1: 04-906)
            Tax Court Judge: Hon. Carolyn P. Chiechi

                     Argued March 5, 2007

          Before: SLOVITER, AMBRO, Circuit Judges,
                   and BRODY,* District Judge

                     (Filed: July 20, 2007)
                             _____

Steven J. Schiffman
John D. Sheridan (Argued)
Serratelli, Schiffman, Brown & Calhoun
Harrisburg, PA l7110-9670

      Attorneys for Appellant

      *
        Hon. Anita B. Brody, United States District Court for the
Eastern District of Pennsylvania, sitting by designation.
Richard Farber
Bethany B. Hauser (Argued)
United States Department of Justice
Washington, DC 20044

       Attorneys for Appellee

                             _____

                   OPINION OF THE COURT

SLOVITER, Circuit Judge.

        The distinction between a loan and an advance payment
for the purpose of whether the funds received are to be treated as
“income” subject to federal income tax is not always apparent on
the face of the documents. Instead, the issue is to be determined
after an examination of “all the facts and circumstances.”
Comm’r v. Indianapolis Power & Light Co., 493 U.S. 203, 207
(1990) (internal citation and quotation marks omitted). The
applicable law is not uncertain. It is “settled that receipt of a
loan is not income to the borrower.” Id. On the other hand,
funds received “are taxable as income upon receipt if they
constitute advance payments . . . .” Id. The courts’
determinations as to which side of the line a particular payment
falls have not always been consistent. In the appeal before us we
must decide whether the Tax Court erred in characterizing the
payment received by appellant as income, for which it had been
issued a notice of deficiency.

                                I.

       Appellant Karns Prime & Fancy Food, Ltd., is a
Pennsylvania corporation that operates grocery stores in the
Harrisburg, Pennsylvania area. During the taxable year ended
January 30, 2000, Karns operated five grocery stores in
Harrisburg, Pennsylvania. Karns’ principal supplier was Super
Rite Foods, Inc., a wholly owned subsidiary of Rich Foods, Inc.
Karns’ CEO, Scott Karns, prepared a capital budget in 1998 and
determined that Karns required $1.5 million for capital

                                2
improvements in the coming years. Karns approached Dale
Conklin, President of Super Rite, about borrowing funds from
Super Rite. Super Rite did not generally make loans to its
customers, but would, from time to time, make funds available to
“certain of its creditworthy and strategically important
customers.” Appellant’s Br. at 3. Due to Karns’ loan
obligations with its primary lender – PNC Bank – Karns
requested and obtained a waiver from PNC in order to secure the
funds that Super Rite was willing to provide.

       Super Rite requires customers to whom it provides
financial assistance to enter into a Supply and Requirements
Agreement (“Supply Agreement”) whereby the customer, in this
case Karns, agrees to purchase a minimum dollar amount of
products from Super Rite. Super Rite also requires the customer
to execute a promissory note payable to Super Rite in the
amount of the funds it provided. Thus, Super Rite agreed to
make $1.5 million immediately available to Karns and Karns
executed a promissory note to Super Rite on April 15, 1999.
Karns signed the Supply Agreement on April 16, 1999.1

       Pursuant to that agreement, Karns agreed to repay the
note in six annual payments of $250,000. Significantly, the
agreement provided that if Karns met the supply requirement for
the previous calendar year at issue by purchasing the stipulated
amount of Super Rite products, the $250,000 due and owing for
that year would be forgiven. Karns received the $1.5 million on
May 4, 1999. Karns recorded the note on its books as a long-
term note payable. Super Rite recorded the note as an asset and
amortized the note monthly over the six-year period.

       A. The Supply and Requirements Agreement

       1
         Although there is apparently an inconsistency in the record
as to the specific dates of the note and supply agreement, the Tax
Court stated that it is clear from the record that they “were entered
into around the same time and were interdependent.” Karns Prime
& Fancy Food, Ltd. v. Comm’r, 90 T.C.M. 357, 360 n.9
(2005).

                                 3
        The Supply Agreement provided that Super Rite would be
the principal wholesaler for all of Karns’ purchased products in
the Harrisburg geographical area. Karns agreed to purchase $16
million worth of product annually from Super Rite. In addition,
Karns agreed to Super Rite’s general policies and practices in
effect, with respect to, for instance, product pricing (Karns paid
a 2.5% markup for grocery products, 3% for dairy products, and
3.5% for frozen products), billing and payment terms, and
returns and credits for purchased products. Under the terms of
the Agreement, Karns was given seven days to make payment
for its product purchases. Failure to do so constituted default,
and Super Rite had the right to suspend shipments during the
term of default. Any default under the Supply Agreement also
constituted a default under the note, thus requiring the balance
under the note to become due immediately.

        Under the terms of the Supply Agreement, Super Rite
could cancel the Agreement if Karns filed for bankruptcy, failed
to pay in accordance with the agreement, or was in default of
any “material contract, instrument or agreement, including,
without limitation, any lease of real property, any material lease
of personal property or any promissory note, instrument or
agreement evidencing or in respect of any indebtedness for
borrowed money or any security therefor . . . .” App. at 52.
Karns had the right to cancel the Agreement in the event that
Super Rite filed for bankruptcy protection. Karns granted Super
Rite a security interest in its assets, including inventory,
accounts, equipment, and proceeds. Karns agreed to make its
internal financial statements available within ninety days of each
fiscal quarter and a financial statement prepared by its
independent accountant every six months. Finally, Karns gave
Super Rite a right of first refusal if Karns’ shareholders sold
either the corporation or its assets to a third party.

       B. The Note

       The promissory note had a face value of $1.5 million.
Interest on the unpaid balance was to be paid at prime plus 1%.
The note was to be repaid in six annual payments of $250,000
commencing April 16, 2000 and continuing on the third Friday
of each April thereafter up to and including April 16, 2005. The

                                4
note also provided the following:

      payment of the annual payment shall be forgiven by the
      Lender if the Lender determines that Borrower is in
      compliance with, and shall not have materially breached
      or then be in uncured default under, that certain Supply
      and Requirements Agreement of even date herewith
      among the Borrower and Lender. The entire unpaid and
      unforgiven principal balance hereof shall be due and
      payable, if prior to April 16, 2005, Borrower ceases, for
      any reason, to use Lender as its primary food supplier.

App. at 49 (emphasis added).

      Karns spent $750,000 of the $1.5 million received from
Super Rite on capital improvements and temporarily invested the
balance in certificates of deposit. The CDs were then pledged to
PNC as collateral for a new $960,000 loan from PNC. That
$960,000 was in turn invested in further capital improvements.

        In August 1999, SuperValu, Inc. acquired Rich Foods
(parent of Super Rite). Soon thereafter, Karns decided to
relocate one of its stores. In order to satisfy the new lessor’s
concerns, Karns requested that SuperValu guarantee its new
lease. On or about January 25, 2000, SuperValu agreed to
guarantee Karns’ lease; in return the parties amended the April
16, 1999 Supply Agreement to reflect the guarantee and Karns
entered into several agreements with SuperValu, including, inter
alia, an agreement that granted SuperValu a security interest in
some of Karns’ assets.

        Karns satisfied the Supply Agreement for the periods
ending April 16, 2000 and April 16, 2001, “and otherwise
complied with, did not materially breach, and was not in uncured
default under that . . . agreement.” Karns Prime & Fancy Food,
Ltd. v. Comm’r, 90 T.C.M. 357, 361 (2005). Because
Karns fulfilled the purchase requirements and the other
covenants, the required annual payments of $250,000 on the
promissory note were forgiven. In its January 30, 2001, and
January 30, 2002, tax returns Karns reported the debt
forgiveness of $250,000 as “Other Income – Reduction of

                               5
Supplier Note Agreement.” App. at 39.

       In 2001, Karns sought an additional $300,000 from
SuperValu in order to facilitate a move to a new location vacated
by Fleming Foods, a food wholesaler who declared bankruptcy.
Karns needed the funds to buy out the remainder of its existing
lease and to purchase inventory and fixtures at the new location.
SuperValu agreed, and Karns executed a promissory note to
SuperValu on March 9, 2001 in the amount of $300,000 with
interest at 10.7% per year. Karns executed new agreements,
including a second amendment to the Supply Agreement, which
increased the annual purchase requirements from Super Rite
from $16 to $21 million. The note called for debt service
payments to be made annually from March 9, 2002 through
March 9, 2005, but the new Supply Agreement did not extend
the term of the original Supply Agreement beyond April 16,
2005.

       Karns met the purchase requirement of $21 million for the
period ending March 9, 2002, and therefore did not pay the
$250,000 due annually under the note. For the period ended
March 9, 2003, Karns purchased only $19.8 million from
SuperValu, and it had to pay $4,929.19 toward the annual
payment due under the March 9, 2001 note.

                               II.

       The Commissioner of the Internal Revenue Service
mailed a notice of deficiency to Karns for its federal income tax
year ending January 30, 2000, in the amount of $486,355 on
October 24, 2003. The basis for the claimed deficiency was
Karns’ failure to include the $1.5 million payment from Super
Rite as income in its tax return. Karns timely petitioned the Tax
Court for a redetermination of the tax deficiency. The Tax Court
had jurisdiction pursuant to 26 U.S.C. §§ 6213(a), 6214, and
7442. After a trial, the Court entered its decision on October 5,
2005, holding that the $1.5 million payment to Karns was not a
loan and thus was includable in Karns’ gross income. Karns, 80
T.C.M. at 365. Karns filed a timely notice of appeal to this
court. We have jurisdiction pursuant to 26 U.S.C. § 7482(a)(1).

                                6
                                III.

       The statutory definition of gross income includes income
“from whatever source derived.” 26 U.S.C. § 61(a). The
Supreme Court has defined “income” as “undeniable accessions
to wealth, clearly realized, and over which the taxpayers have
complete dominion.” Comm’r v. Glenshaw Glass Co., 348 U.S.
426, 431 (1955). “In determining whether a taxpayer enjoys
‘complete dominion’ over a given sum . . . . [t]he key is whether
the taxpayer has some guarantee that he will be allowed to keep
the money.” Comm’r v. Indianapolis Power & Light Co., 493
U.S. 203, 210 (1990).

       Generally, the receipt of a loan is not includable as gross
income, because the recipient of the loan has an obligation to
repay the amount loaned. Id. at 207-08. The loan proceeds are
not income to the taxpayer. Comm’r v. Tufts, 461 U.S. 300, 307
(1983). A key question is whether, at the time of receipt of the
funds, the recipient of the loan was unconditionally obligated to
make repayment. To determine whether a given transaction
constitutes a loan, the substance, rather than the form, of the
transaction is controlling. Knetsch v. United States, 364 U.S.
361, 365-66 (1960).

       Most of the cases grappling with the issue have focused
on the treatment of advance payments for purposes of taxation,
probably because that was the factual pattern before the Supreme
Court in Indianapolis Power, the leading decision on this issue.

        In Indianapolis Power, the Indianapolis Power & Light
Company (“IPL”) required “certain customers to make deposits
with it to assure payment of future bills for electric service.”
493 U.S. at 204. Although IPL commingled the funds received
with other receipts and did not segregate them, it did not treat the
deposits as income on its books but instead carried them as
current liabilities. Id. at 205. The Internal Revenue Service
(“IRS”) had a different view of the transactions. It viewed the
deposits as advance payments for electricity and assessed
deficiencies on the ground that the deposits were gross income,
taxable to IPL upon receipt. Id. at 204. The Tax Court
disagreed with the IRS. Id. at 206. It held that the principal

                                 7
purpose of the deposits was to serve as security rather than as
prepayment of income. Id. The Court of Appeals for the
Seventh Circuit affirmed. Id.

       The Supreme Court granted certiorari to resolve the
conflict between the Seventh Circuit’s decision and the Eleventh
Circuit’s decision in City Gas Co. of Florida v. Comm’r, 689
F.2d 943 (11th Cir. 1982). In the course of its opinion, the Court
provided guidance as to the distinction for taxation purposes
between an advance payment and a loan. The Court stated, “[i]n
economic terms, . . . the distinction between a loan and an
advance payment is one of degree rather than of kind.”
Indianapolis Power, 493 U.S. at 208. It explained, “[t]he issue
turns upon the nature of the rights and obligations that [are]
assumed” when the transaction occurs. Id. at 209.

       The Court held that the advance deposits were not income
to IPL when received, stating that “such dominion as IPL has
over these customer deposits is insufficient for the deposits to
qualify as taxable income at the time they are made.” Id. at 214.
In holding that the deposits were not the economic equivalent of
advance payments, the court noted that the customers who made
the deposits “retain[ed] the right to insist upon repayment in
cash,” whereas the “individual who makes an advance payment
retains no right to insist upon return of the funds; so long as the
recipient fulfills the terms of the bargain, the money is its to
keep.” Id. at 213.

        In rejecting the IRS’s attempt to analogize the IPL
customers’ security deposits to advance payments, the Court
stated that although there was some similarity in that “[a]n
advance payment, like the deposits at issue here, concededly
protects the seller against the risk that it would be unable to
collect money owed it after it has furnished goods or services,”
an advance payment does much more: “it protects against the
risk that the purchaser will back out of the deal before the seller
performs. From the moment an advance payment is made, the
seller is assured that, so long as it fulfills its contractual
obligation, the money is its to keep.” Id. at 210.

       Then, in the sentence that may be most applicable to the

                                 8
situation before us, the Court stated, “Here, in contrast, a
customer submitting a deposit [to IPL] made no commitment to
purchase a specified quantity of electricity, or indeed to purchase
any electricity at all.” Id. at 210-211. Because IPL’s right to
keep the money depended upon the customer’s purchase of
electricity and that customer’s decision to have the deposit
applied to future bills, the Court noted that “IPL’s dominion over
the fund is far less complete than is ordinarily the case in an
advance-payment situation.” Id. at 211.

        It is not easy to analogize the facts in Indianapolis Power
to the facts in the case before us because the transactions and the
positions of the parties are different. Nor is the Karns-Super
Rite transaction the same as the advance payment transaction
discussed in that case. However, if the Super Rite loan and the
accompanying Supply Agreement are considered as an advance
rebate, the analogy becomes clearer. Super Rite provided Karns
with $1.5 million on condition that it purchase $16 million of
Super Rite products a year. When it did so, it was relieved of the
obligation to pay Super Rite $250,000. This agreement has all
the indicia of an agreement to rebate $250,000 a year in advance.
Some indication of the Court’s view of a loan transaction such as
the one before us can be gleaned from the Court’s distinction in
Indianapolis Power between a loan and an advance payment
(taxable upon receipt). After stating that the taxability of the
receipts must be determined by examining the relationship
between the parties at the time of the deposit, the Court stated in
the language quoted above, “so long as the recipient fulfills the
terms of the bargain, the money is its to keep.” Id. at 212. That
is the key element in a transaction, such as the one before us,
where the supplier gave cash in advance to a retailer in exchange
for a volume commitment. As long as Karns fulfilled its terms
of the bargain, i.e., to purchase $16 million of Super Rite’s
product, the money “[was] its to keep.”

        That was the basis for the decision of the Tax Court in
this case that the funds Karns received were income, not a loan.
In distinguishing Indianapolis Power from this case, the Tax
Court noted that in Indianapolis Power the Supreme Court held
that IPL did not have “‘complete dominion’ over the deposits in
question because it did not have ‘some guarantee’ that it would

                                9
be allowed to keep them.” Karns, 90 T.C.M. at 365. The Tax
Court pointed out that the customers in Indianapolis Power, and
not IPL itself, controlled whether IPL would keep the deposits.
The Court contrasted that with the situation before us, stating:
“[Karns] had ‘some guarantee’ that, for each annual period
covered by the April 16, 1999 supply agreement and the
corresponding April 15, 1999 note, it would be allowed to keep
the amount of the annual payment set forth in that note as long
as, for each such period, it lived up to its end of the bargain by
not materially breaching the April 16, 1999 supply agreement.”
Id.

        The logic of the Supreme Court’s holding in Indianapolis
Power applies here. According to that decision, if the taxpayer
has some guarantee that it will be allowed to retain the funds,
then it has complete dominion over the money. Indianapolis
Power, 493 U.S. at 210. Such is the case here. Karns, and Karns
alone, was at all times in control of whether it would meet the
Supply Agreement. Therefore, the funds provided to Karns were
in substance a projected rebate for products to be supplied,
analogous to an advance payment, and as such were taxable
income.

        Karns argues that the transaction was a loan and not an
advance payment because “any potential forgiveness under the
loan was a condition subsequent.” Appellant’s Br. at 15. From
Karns’ perspective it had an unconditional obligation to repay
the note; such obligation could only be expunged upon Karns’
fulfillment of the Supply Agreement. However, this position
exalts the form of the transaction over its substance. If Karns
chose to meet the supply requirement, then Super Rite was
obligated to forgive the indebtedness. Conversely, if Karns
chose not to live up to the Supply Agreement the funds under the
note would become due. Therefore, Karns’ focus on the fact that
it had an unconditional obligation to repay is misplaced. The
point is that it was Karns, and not Super Rite, that was in control
over whether the obligation would be triggered.

       Although the dissent recognizes that the facts in Westpac
Pacific Food v. Comm’r, 451 F.3d 970 (9th Cir. 2006), are
distinguishable from those before us, we must discuss that

                                10
court’s opinion because the result differs from the one that we
reach today. Westpac, a partnership of three grocery store
chains, entered into four contracts with four different suppliers
promising to buy a minimum quantity of merchandise and
received a volume discount in the form of cash up front. Id. at
972. If Westpac failed to purchase the required quantity, it was
obligated to refund the cash advance pro rata. On the other
hand, if it purchased the required quantity, its obligation to repay
would be nullified. Id. The Court of Appeals held that “[c]ash
advances in exchange for volume purchase commitments,
subject to pro rata repayment if the volume commitments are not
met, are not income when received.” Id. at 975. The court
reasoned that even though the recipient of a loan may have
complete dominion over the funds received, such funds do not
become “income” until there is an “accession to wealth.” Id.

        The Westpac court realized that it had to contend with
two decisions of the Supreme Court that suggested a contrary
result. In Automobile Club of Michigan v. Comm’r, 353 U.S.
180 (1957), the Court held that prepaid membership dues were
properly characterized as income when received. The reasoning
behind the Supreme Court’s holding was that pro rata
application of the dues to each month had no bearing on the
services that the club had to perform when called upon.
Similarly, in Schlude v. Comm’r, 372 U.S. 128 (1963), the Court
held that cash paid to a dance studio for ballroom dancing
lessons was income when received, not when the lessons were
provided. In a very brief statement constituting the totality of its
analysis of these cases, the court in Westpac stated that its case
“is like Indianapolis Power, not Automobile Club of Michigan or
Schlude.” Westpac, 431 F.3d at 976. The Westpac court ignored
the discussion in Indianapolis Power, quoted at length above,
that “so long as the recipient fulfills the terms of the bargain, the
money is its to keep.” 493 U.S. at 212.

       The dissenting opinion of our colleague argues that the
Supply Agreement and the note are not “one unitary advance
rebate,” because the Supply Agreement contained a liquidated
damages clause, thereby proving that the loan did not “simply
[function] as a mechanism for quick collection of any unearned
rebates. . . . [but rather was] a bona fide loan. ” However, the

                                 11
parties before us considered the Supply Agreement and the note
to be “one unitary” device. For instance, in its brief Karns
states, “Super Rite agreed to loan [sic] the $1.5 million requested
by [Karns] and [Karns] executed a Promissory Note in favor of
Super Rite in the amount of $1.5 million. At the same time,
[Karns] agreed to enter into a Supply and Requirements
Agreement.” Appellant’s Br. at 4 (emphasis added); see also
Appellant’s Br. at 8 (“Although the [n]ote is dated April 15,
1999 and the Supply Agreement April 16, 1999, the documents
were executed at the same time.”). Karns itself does not
characterize the note as an independent transaction. Instead, it
states that “[a] default under the Supply and Requirements
Agreement would constitute a default under the [n]ote and the
unpaid balance would become immediately due and payable.”
Id. at 5.

       The dissent attempts to avoid the effect of that analysis by
hypothesizing situations under which Super Rite “could cancel
the Supply Agreement.” The dissent speculates that Super Rite
could cancel the Supply Agreement, and then Karns would have
to pay. The dissent overlooks, or ignores, the provisions in the
note requiring Super Rite to forgive the annual payment as long
as Karns is in material compliance with its obligation under the
Supply Agreement. See App. at 49 (“the annual payment shall
be forgiven. . . .”). Thus, as we noted above, the control is in
Karns’ hands.

       We disagree with the dissent’s view that Super Rite had
“immense latitude to cancel the Supply Agreement.” The
dissent relies on Section 5(vi) of the Agreement in making this
point. However, the discretion referred to in that paragraph is
hardly “broad.” Indeed, it is quite narrow – cancellation can
occur only “upon the occurrence of a material adverse change in
the condition (financial or otherwise), business or prospects of
the Retailer or any guarantor of the Retailer’s liabilities and
obligations hereunder.” App. at 52 (emphasis added). Because
the Agreement requires the change to be not only material, but
also adverse, there is little room left for Super Rite’s discretion.

      In an attempt to show that Karns has no guarantee that it
would be able to keep the $1.5 million, the dissent points to

                                 12
Super Rite’s option to terminate and calls the loan-forgiveness
clause “illusory.” However, a termination option does not make
a promise illusory where, as here, one party “reserves the power
to terminate for good cause or on some condition that is not
wholly controlled by the promisor’s will.” 2 Corbin on
Contracts § 6.14, at 313–14 & n.1 (rev. ed, 2003) (citing, inter
alia, New England Oil Corp. v. Island Oil Mktg. Corp., 288 F.
961 (4th Cir. 1923) (seller of 2.7 million barrels of oil with
option not to deliver if the wells produced less). Only an actual
termination would affect Karns’s duty under the contract. See
U.C.C. § 2-106(3) (“‘Termination’ occurs when either party
pursuant to a power created by agreement or law puts an end to
the contract otherwise than for its breach. On ‘termination’ all
obligations which are still executory on both sides are
discharged . . . .”). Thus, regardless whether a termination
option existed for Super Rite, absent the exercise of that option
for cause, Karns still was obligated to meet certain purchase
minimums and Super Rite still was obligated to allow Karns to
keep the up-front payment if it did. In other words, “so long as
[Karns] fulfilled the terms of the bargain, the money [was] its to
keep.” Indianapolis Power, 493 U.S. at 213.

        The dissent conjectures that Karns might not continue to
be viable. There is no suggestion in the facts that this is the case.
To the contrary, Karns operated with the understanding that it
would not be required to repay any of the funds. See App. at
135 (deposition of Scott Karns, CEO of Karns—that he
“anticipate[d] that [he would] meet [his] purchase obligations”
such that the “outstanding balance due SuperValu as a result of
the [money transfer] in 1999” would “be zero.”). In fact, Karns
did not repay the funds with the exception of the fourth year
(after Karns and SuperValu agreed to increase the minimum
purchase amount in 2001 by $5 million); in 2003, Karns was
required to pay a pro rata portion of $4,929.19. App. at 40–41.
SuperValu treated this as a sales rebate that Karns failed to earn
through its failure to meet the minimum purchase requirements
that year. Id. at 40–41, 131–32. The Tax Court was dealing
with a real life contract in a real life situation, and it decided
accordingly.

       For the reasons set forth above, we disagree with the

                                 13
dissent as well as with the Ninth Circuit’s decision in Westpac.2

                                IV.

      For the reasons set forth above, we will affirm the
judgment of the Tax Court.3
              Karns Prime & Fancy Food, Ltd. v. Comm’r
                                No. 06-1031

           AMBRO, Circuit Judge, concurring.

                  I join Judge Sloviter’s opinion in full. I write
           separately to supplement, from the accounting side,
           why I believe the result she reaches is correct and that
           of the Ninth Circuit (and by implication, that of our
           dissenting colleague) is unpersuasive.

       2
          Karns also relies on the Tax Court’s memorandum
decision in Erickson Post Acquisition, Inc. v. Comm’r, 86 T.C.M.
(CCH) 111 (2003). The Government has notified us that Tax Court
memorandum decisions are not binding precedent in the Tax Court,
and that it has announced its nonacquiescence in the Tax Court’s
decision in Erickson Post.
       3
          The day before this opinion was due to be filed and after
it had cleared the full court, we received a letter from counsel in
this case for the Department of Justice’s Tax Division advising that
the Internal Revenue Service issued Revenue Procedure 2007-53,
to be effective July 23, 2007, stating that the IRS will generally
follow the Ninth Circuit’s decision in Westpac. The letter states
that “[t]he Department of Justice is presently considering whether
to change its position in this case in light of this new Revenue
Procedure.” Inasmuch as we have not been notified of any change
in position by a party before us, we proceed to file this opinion.
Any relevant matter can be raised in a petition for panel rehearing,
which will allow the DOJ and the IRS to confer further about what
position the Government wishes to take with respect to that
petition.

                                      14
                   As a preliminary comment, this case is about
           timing. The value of money depends on when it is
           received. Both loans and advance payments confer
           an economic benefit on recipients because they allow
           the recipient “both immediate use of the money (with
           the chance to realize earnings thereon) and the
           opportunity to make a profit by providing goods or
           services at a cost lower than the amount of the
           payment.” Comm’r v. Indianapolis Power & Light
           Co., 493 U.S. 203, 207 (1990) (emphasis in original).
           Yet, under our laws the tax consequences for these
           two types of money transfers differ. Whereas loans
           are not taxable upon receipt, advance payments are.
           Id. at 208 n.3 (citations omitted); Oak Indus., Inc. v.
           Comm’r, 96 T.C. 559, 563–64 (1991).

           I.     Contrary Decisions in the Ninth Circuit

                   In Westpac Pacific Food v. Comm’r, the Ninth
           Circuit concluded that an up-front payment with a
           conditional pro rata repayment liability was a
           nontaxable loan. 451 F.3d 970, 975 (9th Cir. 2006).4
           It based its decision on assertions that (1) there was
           no absolute repayment obligation, id., and (2) “[t]here
           was no accession to wealth when Westpac got the
           cash . . . ,” id. at 977. The opinion for the majority
           here has dealt with the first part of this reasoning (as
           Karns, not Super Rite, controlled whether the

       4
         The Ninth Circuit reached an outcome similar to the one
in Westpac in Milenbach v. Comm’r, 318 F.3d 924, 935–37 (9th
Cir. 2003) (concluding that $6.7 million paid by the Los Angeles
Memorial Coliseum Commission to the Los Angeles Raiders to
develop the Coliseum was a loan rather than taxable income upon
receipt even though the Raiders never built the Coliseum or repaid
the money, because the contract specified a repayment obligation
and did not contain a loan-forgiveness clause).

                                     15
obligation to repay would occur); I address the second
part.

      For the Westpac Court, the case was very
“simple,” as told through the following hypothetical:

             Harry Homeowner goes
             to the furniture store,
             spots just the right dining
             room chairs for $500
             each, and says “I’ll take
             four, if you give me a
             discount.” Negotiating a
             25% discount, he pays
             only $1,500 for the chairs.
             He has not made $500, he
             has spent $1,500. Now
             suppose Harry
             Homeowner is short on
             cash, and negotiates a
             deal where the furniture
             store gives him a 20%
             discount as a cash
             advance instead of the
             25% off. This means the
             store gives him $400
             “cash back” today, and he
             pays $2,000 for the four
             chairs when they are
             delivered shortly after the
             first of the year. Harry
             cannot go home and say
             “I made $400 today”
             unless he plans to skip out
             on his obligation to pay
             for the four chairs. Even
             though he receives the

                          16
              cash, he has not made
              money by buying the
              chairs. He has to sell the
              chairs for more than
              $1,600 if he wants to
              make money on them.
              The reason why the $400
              “cash back” is not income
              is that, like a loan, the
              money is encumbered
              with a repayment
              obligation to the furniture
              store and the “cash back”
              must be repaid if Harry
              does not perform his
              obligation.

Id. at 971–72 (emphasis added). “This case is that
simple,” the Court reiterated, “except that it involves
a little more math and a lot more money . . . .”
Convinced that the agreement in that case was a
nontaxable loan, the Westpac Court commented that
“[i]t is hard to think of a way to make money by
buying things.” Id. at 971. Let’s check that out.

II.    The Ninth Circuit Tax Shelter, or How to
       Make Money By Buying Things

        Consider a hypothetical involving Hal
Homeowner, who would like to open a grocery
distribution center out of his garage. Hal goes to the
supermarket and, like Harry, is short on cash. Also
consider what happens when Hal Homeowner files
his taxes, which makes any simple hypothetical more
complex. We will suppose that Hal makes a 100%
profit on the value of each carton, meaning that for
every $2,000 worth of food he buys he resells for

                           17
$4,000. We will also assume a typical corporate tax
rate of 34% (which the Government applied to Karns)
applies here.

             Scenario 1

             Hal Homeowner walks
             into a supermarket and
             eyes cartons of food for
             $400 each that would be
             ideal for his garage mini-
             mart. The store owner
             sees what Hal
             Homeowner has in mind,
             and when it becomes clear
             that Hal has no money but
             a lot of potential, the
             owner puts this offer on
             the table: “I will give you
             20% off now if you agree
             to buy five cartons
             ($2,000 worth of food)
             each year for the next six
             years.” Under this
             scheme, Hal pays each
             year just $1,600 for five
             cartons. This is an
             example of a “volume
             supply discount” similar
             to the one that Harry
             Homeowner negotiated;
             Hal has gotten a 20%-off
             deal, except there is no
             cash advance involved
             here, which makes the tax
             calculation
             straightforward. Each

                          18
year, Hal simply pays
$1,600 for $2,000 worth
of goods. He deducts that
$1,600 in business
expenses and reports
$4,000 in resale to yield a
taxable income of $2,400,
which carries a tax
liability of $816 per year.

Scenario 2

Now suppose the store
owner proposes this: “I
will give you $400 now if
you buy $2,000 worth of
food each year for the
next six years. This will
get you started with your
business, and you can just
pay me back the $400 at
the end of the year from
your resale proceeds.”
Hal cannot go home and
say “I made $400 today,”
because he has an
unconditional obligation
to repay the $400 loan at
the end of the year. At
the end of the first year,
Hal duly pays back the
loan, and on his tax forms
he simply deducts $2,000
as business expenses from
his total resale proceeds
of $4,000 to yield a
taxable income of $2,000,

             19
             which carries a tax
             liability of $680 each
             year. This is $136 per
             year less than the tax
             liability in Scenario 1,
             which makes sense
             because Hal makes $400
             less each year.

        The reason that the $400 was not income is
that it was subject to an unconditional repayment
obligation, notwithstanding whether Hal performed
on his contract by meeting minimum purchase
requirements. In other words, it was a bona fide loan.

             Scenario 3

             Suppose the store owner
             proposes this: “I’ll give
             you $400 now if you
             agree to buy five cartons
             ($2,000 worth of food)
             each year for the next six
             years. If you can manage
             that, you don’t have to
             worry about paying me
             back at the end of the
             year.” This seems like
             quite a deal to Hal, who
             readily agrees. At the end
             of the first year, Hal
             deducts on his tax returns
             $1,600 in business
             expenses ($2,000 for the
             food minus $400 “cash
             back” off the full
             purchase price given in

                          20
              exchange for the purchase
              commitment), and reports
              $4,000 in resale proceeds
              to yield a gross income of
              $2,400, which carries a
              tax liability of $816. This
              is the same as the tax
              liability in Scenario 1, for
              Hal has made the same
              amount. In subsequent
              years, Hal deducts $2,000
              in business expenses and
              reports $4,000 in resale
              proceeds to yield a gross
              income of $2,000 each
              year, which carries an
              annual tax liability of
              $680.

       When he first made the deal, Hal could go
home and say, “I made $400 today,” because he did
not plan to skip out on his obligation to buy five
cartons each year, was confident that he would resell
the goods for profit, and thus had some assurance that
he could keep his money and make back the rest from
the proceeds of his resale. With this understanding,
the $400 given to him at the outset was an advance
payment that was taxable income when received.

       So far, there is little cause for controversy over
how Hal has done his taxes. He reported his profits
as gross income in Scenario 1 (the volume supply
discount without a cash advance); he repaid his loan
and then reported his profits as gross income in
Scenario 2 (the loan); and he reported his profits,
along with the amount of cash he received up front, as
gross income in Scenario 3 (the advance payment).

                           21
What happens if Hal wants to do his taxes a little
differently in Scenario 3 in order to save some
money?

              Scenario 4

              The facts are the same as
              Scenario 3, but Hal does
              his tax reporting
              differently. Instead of
              deducting $1,600 in the
              first year, Hal deducts
              $2,000 in business
              expenses and reports
              resale proceeds of $4,000
              to yield a gross income of
              $2,000 in the first year,
              which carries a $680 tax
              liability. Hal plans on
              waiting until the end of
              his six-year term to pay
              tax on the $400 as “other
              income” (i.e., “loan”
              forgiveness). He has
              realized a $136 tax
              savings (the difference
              between $816 due on
              $2,400 in Scenario 3 and
              $680 due on $2,000 in
              this scenario).

       By deferring the taxes due on the $400, Hal is
able to take advantage now of $2,400 (the up-front
cash plus the $2,000 he makes in profits) without
paying taxes on that full amount. Put differently, this
means that he is able to take advantage of a $136 tax
savings in the first year. If he pays taxes on the $400

                           22
           as income in the year of receipt (as in Scenario 3), the
           present value of his tax liability over the course of the
           six-year deal is $3,368.35.5 But if Hal defers payment
           of taxes on the $400 until the end of Year 6 (as in
           Scenario 4), the present value of his tax liability will
           be only $3,331.87 over this same period. The present
           value of his total tax savings is a difference of $36.48
           ($3,368.35 in Scenario 3 minus $3,331.87 in Scenario
           4), which is negligible when dealing in amounts so
           small. But the amount grows when dealing in
           millions.

                  In Karns’s case, the deferral of the tax
           payment resulted in a savings of about $500,000 by
           Year 6—the same amount that the Government
           argues is owed in back taxes. This sort of difference
           demonstrates how advance payments confer an
           economic benefit. As noted, they allow the recipient

       5
         The present value of money (at some future time) is
calculated by dividing the monetary amount (here: $816 in taxes on
a $2,400 income) by the following: the product of the number of
years (here: 1) and the discount rate (assumed: 7%) raised to the
power of the number of years (here: 1).
       Thus, the present value of an $816 tax liability for Year 1 at
the end of the first year at a 7% rate is $762.62; the present values
of a $680 tax liability for Years 2–6 are $593.94 at the end of the
second year, $555.08 at the end of the third year, $518.77 at the
end of the fourth year, $484.83 at the end of the fifth year, and
$453.11 at the end of the sixth year. Added together, this yields a
sum of $3,368.35.
       By contrast, the present value of an $816 tax liability for
Year 1 at the end of the sixth year at a 7% rate is $543.74; the
present values of a $680 tax liability for Years 1–5 are $635.51 at
the end of the first year, plus—as before—$593.94 at the end of the
second year, $555.08 at the end of the third year, $518.77 at the
end of the fourth year, and $484.83 at the end of the fifth year.
Added together, this yields a sum of $3,331.87.

                                       23
“immediate use of the money [or savings] . . . and the
opportunity to make a profit by providing goods or
services at a cost lower than the amount of the
payment.” Indianapolis Power, 493 U.S. at 208
(emphasis in original). For in Scenario 4 Hal’s
business expenses actually are only $1,600 ($2,000
minus the $400 advance), and by reporting his
expenses as $2,000, he inflates his business
deductions. He has gained immediate use of the up-
front money and is able to profit by providing goods
at a cost lower than the amount of the payment,
resulting in a $136 tax savings in the first year. The
arrangement in this case is similar. The lesson: when
taxes on funds advanced in Year 1 are deferred and
goods purchased in Year 1 are resold for profit,
money indeed can be made by buying things.

III.   Conclusion

        At first blush, both tax payment schemes—pay
now or pay later—may appear to be merely alternate
ways of doing the math, because Hal Homeowner and
Karns will eventually pay taxes on the up-front
money. But we cannot view the “pay later” method
as just another way of calculating taxes, because our
laws require otherwise. First, Karns avails itself of an
economic benefit through this method, which
functions like a tax-deferral shelter that the Code has
not authorized. Second, Karns’s attempt to consider
as a loan money that it will never have to repay
contravenes the requirement that “an accrual-basis
taxpayer [which Karns is] . . . [must] treat advance
payments as income in the year of receipt.”
Indianapolis Power, 493 U.S. at 207 n.3 (citations
omitted).

       In sum, I am not persuaded by the analysis in

                          24
the Ninth Circuit. It is the first and only Court of
Appeals to conclude that trade discounts paid by the
supplier to a taxpayer to offset the taxpayer’s required
minimum purchases are loans rather than advance
payments. Its conclusion contradicts our own
emphasis (both before and after Indianapolis Power)
that income may be considered to be a “loan” only
when there is an unconditional repayment obligation.
See, e.g., Geftman v. Comm’r, 154 F.3d 61, 68 (3d
Cir. 1998); Diamond Bros. v. Comm’r, 322 F.2d 725,
731 (3d Cir. 1963).

        To reiterate, when understood this way, our
case is about timing. Funds received with no
unconditional repayment obligation result in one set
of profit margins and tax liabilities, and deferred tax
payment on those same funds results in another set.
For practical and policy reasons, our Tax Code and
most decisions interpreting it require taxpayers to pay
taxes for the year of receipt on funds advanced to
them by suppliers when any purported repayment
obligation is conditional on acts controlled by
taxpayers—i.e., when there is no unconditional
repayment obligation. Because there was no
unconditional obligation to repay the money here, I
believe that the $1.5 million received up front by
Karns was an advance payment, taxable upon receipt.
I therefore concur in affirming the Tax Court’s
assessment of taxes owed.

                          25
                   Karns v. C.I.R.

                       Dissent

BRODY, District Judge

       Because the agreements between Super Rite
and Karns provided no guarantee that Super Rite
would allow Karns to keep the money it received as a
loan from Super Rite, I respectfully dissent from the
majority’s conclusion that the loan was taxable
income in the year it was received.

       According to the majority, the agreement
between retailer Karns and supplier Super Rite is
functionally a single advance rebate formally divided
into two parts: a loan with a multi-year repayment
period; and a multi-year Supply Agreement. Super
Rite would pay the advance rebate in the form of a
loan, and would forgive the loan in annual
installments as long as Karns annually bought the
requisite amount of product under the Supply
Agreement. The majority concludes that the money
was taxable when received because Karns was never
obligated to repay the loan and always had control
over whether it would keep the money. That Karns
might not be able to meet its obligations in the Supply
Agreement is of no moment to the majority, which
views Karns’ ability to perform its contractual
obligations as under Karns’ “control” for tax law
purposes.

                          26
                  As the majority recognizes, this decision holds
          that all advance trade rebates are taxable in the year
          received, in direct opposition to the Ninth Circuit’s
          opinion in Westpac Pacific Food v. C.I.R., 451 F.3d
970 (2006) (Kleinfeld, J.) I would not reach that
          broader question because the facts of Westpac are
          distinguishable: in this case, the transactions gave the
          taxpayer less control over the money than in the pure
          advance rebate in Westpac. In Westpac, the retailer
          was guaranteed to be able to keep the funds upon
          completion of its purchase obligations. But here, the
          loan provided no advance guarantee of forgiveness
          even if Karns made every effort to complete the
          purchases required by the Supply Agreement.6

                 It is true that Karns’ annual loan payment
          would be forgiven as long as Karns was “in
          compliance” with the Supply Agreement for the year,
          and that the two transactions are linked. App. at 49
          (“Promissory Note”). But Super Rite (in its role as
          supplier) had immense latitude to cancel the Supply
          Agreement. Under Section 5(vi) of the Supply
          Agreement, Super Rite could cancel the agreement

                 Immediately upon the occurrence of a material
                 adverse change in the condition (financial or
                 otherwise), business or prospects of the
                 Retailer or any guarantor of the Retailer’s
                 liabilities and obligations hereunder.

      6
        I also disagree with the majority – Westpac was correctly
decided. Advance rebates should be considered income only when
they are actually earned through completed purchases.
27
Ohio App. at 52 (emphasis added).

                   This broad discretion to cancel the Supply
           Agreement for almost any kind of change in Karns or
           its guarantors’ “condition” renders nigh illusory any
           control Karns might have had over the continued
           existence of the Supply Agreement.7 If Super Rite
           cancelled the Supply Agreement, Karns would be
           required to repay the loan. Karns, then, had little
           meaningful control or “guarantee” that its loan would
           be forgiven at the time it received the loan. Karns’
           actions (meeting the Supply Agreement’s purchase
           amount requirements) would have some role in
           determining whether the loan would be forgiven. But
           rather than being under Karns’ exclusive control,
           forgiveness was ultimately subject to lender Super
           Rite’s discretion over the Supply Agreement. As
           such, it cannot be said that Karns had a “guarantee”
           that it would be able to keep the money. See Comm’r
           v. Indianapolis Power & Light Co., 4893 U.S. 203,
           210 (1990) (“In determining whether [money is
           taxable income when received], the crucial point is . .
           . whether the taxpayer has some guarantee that he will
           be allowed to keep the money.”)

                  The Supply Agreement also contained a

       7
          This is not to say that the Supply Agreement is
unenforceable as a matter of contract law – this is a federal law tax
case, not a state law contract case. The degree of control Karns
had over the continued existence of the Supply Agreement is
relevant here only to show that Karns had no meaningful
“guarantee” that the Supply Agreement would continue.

                                       28
liquidated damages clause:

       [T]he parties agree that upon Super Rite’s
       cancellation of this agreement pursuant to
       Sections 2 or 5 of this Agreement, the Retailer
       will pay Super Rite as liquidated damages an
       amount equal to 1.0% of the product of (i) the
       Retailer’s aggregate purchases from Super Rite
       during the preceding calendar year multiplied
       by (ii) the number of years remaining in the
       term of this Agreement.

App. at 53 (Section 7 of Supply Agreement). That a
remedy for breach of the Supply Agreement is
contained within the Supply Agreement itself belies
the view that the loan and the Supply Agreement
were one unitary advance rebate, with the loan simply
functioning as a mechanism for quick collection of
any unearned rebates. Instead, the loan was an
independent transaction with all the characteristics of
a bona fide loan.

       The retail grocery business is a low-margin,
cash-intensive endeavor. See Supermarket News 9,
Credit Crunch (July 30, 2001), 2001 WLNR
9062811; National Governors Association Center for
Best Practices, Case Study: Pennsylvania’s Fresh
Food Financing Initiative (noting that “[a]s
communities become less dense, it is harder for

                          29
         grocery stores to remain viable.”).8 As such, access to
         credit is extremely important to retailers like Karns,
         and it makes sense that suppliers might step in to
         provide that credit. That Super Rite served dual
         functions of supplier and creditor does not mean that
         in this case, the loan was not a loan.

     8
         A v a i l a b l e          o n l i n e      a t
http://www.nga.org/Files/pdf/0510ACTIVELIVINGPA.PDF.

                                   30