Third Circuit holds that advance payments of trade discounts are income on receipt.

• Author: Beavers, James
• Position: Karns Prime & Fancy Food Ltd. v. Internal Revenue Service

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 products annually 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 the Tax 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...