Karns Prime & Fancy Food, Ltd. v. C.I.R.

• Decision Date: 20 July 2007
• Docket Number: No. 06-1031.,06-1031.
• Citation: 494 F.3d 404
• Parties: KARNS PRIME & FANCY FOOD, LTD., Appellant v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Third Circuit

494 F.3d 404

KARNS PRIME & FANCY FOOD, LTD., Appellant v. COMMISSIONER OF INTERNAL REVENUE.

No. 06-1031.

United States Court of Appeals, Third Circuit.

Argued March 5, 2007.

Filed: July 20, 2007.

Steven J. Schiffman, John D. Sheridan (Argued), Serratelli, Schiffman, Brown & Calhoun, Harrisburg, PA, for Appellant.

Richard Farber, Bethany B. Hauser (Argued), United States Department of Justice, Washington, DC, for Appellee.

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

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, 110 S.Ct. 589, 107 L.Ed.2d 591 (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 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 longterm 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

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 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. (CCH) 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 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...