## Facts

- Karns Prime & Fancy Food, Ltd., a Pennsylvania grocery chain, sought approximately $1.5 million to fund capital improvements.
- Karns arranged to obtain the funds from Super Rite Foods, Inc., its principal supplier, after securing a waiver from its bank lender.
- Super Rite provided funds only to certain customers and only if the customer (1) entered a supply-and-requirements contract with minimum purchase obligations and (2) executed a promissory note.
- Karns executed a long-term supply agreement with minimum purchase requirements and signed a $1.5 million promissory note payable to Super Rite.
- The transaction was structured so that Karns’ repayment obligation would be forgiven over time if Karns met the supply agreement’s purchase-volume requirements.
- Karns reported the $1.5 million as a nontaxable loan.
- The IRS treated the $1.5 million as taxable income (an advance payment) upon receipt and determined a deficiency; the Tax Court sustained the deficiency.

## Issues

1. Whether the $1.5 million paid by Karns’ supplier and documented by a promissory note was a nontaxable loan or taxable income upon receipt as an advance payment tied to a supply agreement.
2. Whether, under a facts-and-circumstances analysis, Karns had an unconditional obligation to repay such that the payment lacked the characteristics of taxable income.

## Decision

- The Third Circuit affirmed the Tax Court.
- The court held the $1.5 million was taxable income upon receipt, not a nontaxable loan.
- The court reasoned that the promissory note’s form did not control where repayment was effectively contingent on meeting purchase obligations under an integrated supply arrangement.

## Legal Principles

- A loan generally is not income to the borrower because receipt of funds is offset by an unconditional, genuine obligation to repay.
- Funds are taxable upon receipt when they function as advance payments rather than borrowed capital.
- Characterization of a transaction as loan versus advance payment depends on all facts and circumstances, including whether repayment is unconditional and whether the recipient realizes an accession to wealth at receipt.
- Formal labels and documentation (e.g., calling an amount a “loan” and issuing a promissory note) are not determinative when the economic substance shows the payment is tied to performance under a commercial contract.
- When “repayment” is expected to be forgiven or offset through future purchases under a supply agreement, the arrangement may be treated as taxable consideration or inducement for the purchasing commitment.

## Conclusion

The Third Circuit concluded that a supplier’s up-front payment structured to be forgiven as the customer satisfied minimum purchase requirements was properly treated as taxable income when received, because the arrangement lacked a genuine unconditional repayment obligation and functioned as an advance payment integrated with the supply contract.


Karns Prime & Fancy Food, Ltd. v. Commissioner, 494 F.3d 404 (3d Cir. 2007)