KARNS PRIME & FANCY FOOD, LTD., Appellant v. COMMISSIONER OF INTERNAL REVENUE, 494 F.3d 404

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 Earns 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, Earns operated five grocery stores in Harrisburg, Pennsylvania. Earns’ principal supplier was Super Rite Foods, Inc., a wholly owned subsidiary of Rich Foods, Inc. Earns’ CEO, Scott Earns, prepared a capital budget in 1998 and determined that Earns required $1.5 million for capital improvements in the coming years. Earns 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 Earns’ loan obligations with its primary lender — PNC Bank— Earns 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 Earns, 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 Earns and Earns executed a promissory note to Super Rite on April 15, 1999. Earns signed the Supply Agreement on April 16,1999.

Pursuant to that agreement, Earns agreed to repay the note in six annual payments of $250,000. Significantly, the agreement provided that if Earns 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. Earns received the $1.5 million on May 4, 1999. Earns 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 Earns’ purchased products in the Harrisburg geographical area. Earns agreed to purchase $16 million worth of product annually from Super Rite. In addition, Earns agreed to Super Rite’s general policies and practices in effect, with respect to, for instance, product pricing (Earns 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, Earns 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 Earns 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. Earns had the right to cancel the Agreement in the event that Super Rite filed for bankruptcy protection.

Earns granted Super Rite a security interest in its assets, including inventory, accounts, equipment, and proceeds. Earns 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, Earns gave Super Rite a right of first refusal if Earns’ 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). Earns 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, Earns decided to relocate one of its stores. In order to satisfy the new lessor’s concerns, Earns requested that SuperValu guarantee its new lease. On or about January 25, 2000, SuperValu agreed to guarantee Earns’ lease; in return the parties amended the April 16, 1999 Supply Agreement to reflect the guarantee and Earns entered into several agreements with SuperValu, including, inter alia, an agreement that granted Super-Valu a security interest in some of Earns’ assets.

Earns 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 Earns 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 Earns reported the debt forgiveness of $250,000 as “Other Income — Reduction of Supplier Note Agreement.” App. at 39.

In 2001, Earns 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. Earns needed the funds to buy out the remainder of its existing lease and to purchase inventory and fixtures at the new location. Super-Valu agreed, and Earns executed a promissory note to SuperValu on March 9, 2001 in the amount of $300,000 with interest at 10.7% per year.

Earns 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. Earns 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, Earns 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 Earns 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 Earns’ failure to include the $1.5 million payment from Super Rite as income in its tax return. Earns 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 Earns was not a loan and thus was includable in Earns’ gross income. Karns, 80 T.C.M. at 365. Earns filed a timely notice of appeal to this court. We have jurisdiction pursuant to 26 U.S.C. § 7482(a)(1). 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, 75 S.Ct. 473, 99 L.Ed. 483 (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, 110 S.Ct. 589, 107 L.Ed.2d 591 (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-OS, 110 S.Ct. 589. The loan proceeds are not income to the taxpayer. Comm’r v. Tufts, 461 U.S. 300, 307, 103 S.Ct. 1826, 75 L.Ed.2d 863 (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, 81 S.Ct. 132, 5 L.Ed.2d 128 (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, 110 S.Ct. 589.

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, 110 S.Ct. 589. 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, 110 S.Ct. 589. The Tax Court disagreed with the IRS. Id. at 206,110 S.Ct. 589.

It held that the principal 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, 110 S.Ct. 589. It explained, “[t]he issue turns upon the nature of the rights and obligations that [are] assumed” when the transaction occurs. Id. at 209,110 S.Ct. 589. ■ 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, 110 S.Ct. 589.

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, 110 S.Ct. 589.

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, 110 S.Ct. 589. Then, in the sentence that may be most applicable to the 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, 110 S.Ct. 589.

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, 110 S.Ct. 589. 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 Earns 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 taxa-bility 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, 110 S.Ct. 589.

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 Earns 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 Earns 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 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: “[Earns] 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, 110 S.Ct. 589. Such is the case here. Earns, and Earns alone, was at all times in control of whether it would meet the Supply Agreement. Therefore, the funds provided to Earns were in substance a projected rebate for products to be supplied, analogous to an advance payment, and as such were taxable income.

Earns 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 Earns’ perspective it had an unconditional obligation to repay the note; such obligation could only be expunged upon Earns’ fulfillment of the Supply Agreement. However, this position exalts the form of the transaction over its substance. If Earns chose to meet the supply requirement, then Super Rite was obligated to forgive the indebtedness.

Conversely, if Earns chose not to live up to the Supply Agreement the funds under the note would become due. Therefore, Earns’ focus on the fact that it had an unconditional obligation to repay is misplaced. The point is that it was Earns, 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 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 “[clash 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, 77 S.Ct. 707, 1 L.Ed.2d 746 (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, 83 S.Ct. 601, 9 L.Ed.2d 633 (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, 451 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, 110 S.Ct. 589.

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 parties before us considered the Supply Agreement and the note to be “one unitary” device.

For instance, in its brief Earns states, “Super Rite agreed to loan [sic] the $1.5 million requested by [Earns] and [Earns] executed a Promissory Note in favor of Super Rite in the amount of $1.5 million. At the same time, [Earns] 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.”). Earns 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 Earns 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 Earns 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 Earns’ 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 Earns has no guarantee that it would be able to keep the $1.5 million, the dissent points to 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 Earns’ 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, Earns still was obligated to meet certain purchase mínimums and Super Rite still was obligated to allow Earns to keep the up-front payment if it did. In other words, “so long as [Earns] fulfilled the terms of the bargain, the money [was] its to keep.” Indianapolis Power, 493 U.S. at 213, 110 S.Ct. 589. The dissent conjectures that Earns might not continue to be viable. There is no suggestion in the facts that this is the case.

To the contrary, Earns operated with the understanding that it would not be required to repay any of the funds. See App. at 135 (deposition of Scott Earns, CEO of Earns — that he “anticipate^] 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, Earns did not repay the funds with the exception of the fourth year (after Earns and SuperValu agreed to increase the minimum purchase amount in 2001 by $5 million); in 2003, Earns was required to pay a pro rata portion of $4,929.19. App. at 40-41.

SuperValu treated this as a sales rebate that Earns 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 dissent as well as with the Ninth Circuit’s decision in Westpac. IV. For the reasons set forth above, we will affirm the judgment of the Tax Court. .

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. (CCH) 357, 360 n. 9 (2005). . 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 Ericlcson Post. . 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.