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Third Circuit Affirms: Receipt of Money from Supplier is Income, Not a Loan

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August 03, 2007

In Karns Prime & Fancy Food, Ltd. v. Commissioner (July 20, 2007), the Third Circuit affirmed the Tax Court decision (T.C. Memo 2005-233) holding that a company's receipt of $1.5 million from its principal supplier was taxable income and not a loan. In Karns, the company and the supplier entered into two related agreements: (1) an interest-bearing loan of $1.5 million from the supplier to the company and (2) a long-term supply agreement. Annual payments under the loan agreement would be forgiven if the company was in compliance with the terms of the supply agreement.

In deciding that Karns had complete control over the money (and, therefore, had income upon receipt), the Third Circuit emphasized that "Karns, and Karns alone, was at all times in control over whether it would meet the Supply Agreement" and whether it would have to repay the money. The Third Circuit assigned little weight to the fact that there were circumstances under which Karns would be required to repay the loan. Additionally, the Third Circuit stated that it disagreed with the Ninth Circuit's decision in Westpac Pacific Food v. Commissioner, 451 F.3d 970 (9th Cir. 2006) (holding that cash advances in exchange for volume purchase commitments, subject to pro rata repayment if the volume commitments are not met, are not income when received).

Even though the Third Circuit in Karns criticized the Westpac decision, a taxpayer that receives refundable advance trade discounts may still rely on Rev. Proc. 2007-53, which states that the IRS will follow the Westpac decision by allowing taxpayers with inventory to account for refundable advance trade discounts using the "Advance Trade Discount Method." It is unclear, at this point, whether the Third Circuit's decision in Karns will cause the IRS to reconsider its position in Rev. Proc. 2007-53.

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