Retail cash advances: loans or income?
In light of two recent Tax Court decisions, and the IRS's response thereto, the answer is not clear. A review of these cases may lead one to conclude that whether the cash advance is a loan may be in the eye of the beholder. Unfortunately, if the Service is viewing the transaction, the result may not be good for the taxpayer.
In Erickson Post Acquisitions, TC Memo 2003-218, a retail gas station operator received $175,000 from Amoco (its supplier) in exchange for a promise to purchase and sell only Amoco products for a five-year period. The taxpayer executed an interest-bearing promissory note providing for the repayment of the cash advance in annual installments. The note provided that the amounts due would be deemed paid if the supply agreement remained in full force and effect. Neither party breached or terminated the supply agreement. Consequently, Amoco forgave the annual loan payments, as the taxpayer met its obligations under the agreement.
The taxpayer treated the $175,000 as unearned revenue and recorded it as a liability prorated over 10 years (the note's length). The taxpayer did not characterize the $175,000 payment as a loan, nor did it deduct accrued interest payments. On audit, the IRS determined that the $175,000 advanced by Amoco was income to the taxpayer in the year received.
The taxpayer contended that the $175,000 was a loan forgiven incrementally on the due date of each annual installment; the Tax Court agreed. In support of its conclusion, it pointed to the following: (1) the existence of a promissory note calling for fixed annual payments; (2) the debt was secured by the taxpayer's real property and a mortgage was recorded in the local county recorder's office; and (3) Amoco routinely enforced the collection of promissory notes in the event retailers defaulted. According to the court,"[t]he focus is on the obligation created at the time of the transaction"
The Service, on the other hand, argued that the taxpayer's obligation was subject to a condition precedent and, thus, was not a loan. The court rejected this argument, stating that "[r]espondent's argument blurs the fine but very real distinction between a contingency that prevents a liability from being fixed, i.e., a condition precedent, and a condition that may terminate an already fixed liability, i.e., a condition subsequent" (citing Burnham Corp., 90 TC 953 (1988)).The court noted that the focus should be on the obligation and the parties' intent when the agreement was entered into. The court distinguished its decisions in Westpac Pacific Foods, TC Memo 2001-175, and Colombo, TC Memo 1975-162, explaining that in those cases, there was no current obligation to repay the advances.
In Erickson Post, because there was an unconditional obligation to repay at the time of the agreement, the Tax Court held that the amounts Amoco advanced constituted a loan. In other words, the court found a current obligation to repay subject to a condition subsequent.
On June 12, 2006, the IRS published its nonacquiescence in Erickson Post; see AOD 2006-01. It stated that, despite the court's findings of fact, the evidence overwhelmingly showed that the payment's purpose was to induce the taxpayer to enter into a long-term, exclusive supply agreement. The Service argued that once Amoco advanced the funds to the taxpayer, it could keep them as long as it honored its contractual obligations. In other words, the IRS believed that Erickson did not have a current obligation to repay the advanced funds.
The Service stated that Karns Prime & Fancy Foods, Ltd., TC Memo 2005-233, contained a better analysis. It said that,"[o]n facts very similar to this case, the court [in Karns] focused on the substance of the transaction and found it an advance payment of income:' The IRS also cited the Tax Court decision in Westpac in support of its conclusion. (This decision has since been overturned by the Ninth Circuit; see Auclair, Tax Clinic, " Westpac Pacific Food: Advance Trade Discounts Are Not Income;' p. 80, this issue.)
Karns Prime & Fancy Foods, Ltd.
In Karns, the taxpayer operated several grocery stores. It entered into an agreement with its supplier, under which the supplier advanced $1.5 million to Karns and required it to enter into a supply agreement obligating it to purchase $16 million of products annually.
Karns signed an interest-bearing note requiring repayment of the advance over six years. The note provided a current obligation to pay, but stated that installments would be forgiven if Karns did not breach the agreement. This differs slightly from the facts in Erickson Post; in the latter, the payment obligation existed until a subsequent event occurred (i.e., performance by the taxpayer). As was the case in Erickson Post, this would appear to be a current obligation subject to a condition subsequent. The court did not agree.
The Tax Court stated that "[t]he determination of whether a transfer of funds constitutes a loan is a question of fact" It explained that, "[i]n order for a transfer of funds to constitute a loan, at the time the funds are transferred there must be an unconditional obligation (i.e., an obligation that is not subject to a condition precedent) on the part of the transferee to repay, and an unconditional intention on the part of the transferor to secure repayment of, such funds" (emphasis added). As in Erickson Post, the court noted that whether a transfer of funds constitutes a loan may be inferred from objective characteristics surrounding the transfer, including the presence or absence of a debt instrument, collateral securing the purported loan, interest accruing on the purported loan, repayments of the transferred funds and any attributes indicative of an enforceable obligation to repay the funds transferred. In determining whether a transfer of funds constitutes a loan, the substance, not the form, of the transaction is controlling for tax purposes.
However, based on similar facts and an analysis similar to Erickson Post, the Tax Court viewed Karns as not having a current obligation to repay the advanced amounts. In other words, it viewed the payment obligation as being subject to a condition precedent and, accordingly, held that there was no loan.
Erickson Post vs. Karns
While the legal analyses in Erickson Post and Karns are similar, they provide no clear answer as to when a payment from a supplier to a retailer will be treated as a loan.
In both cases, the taxpayers signed notes containing obligations to repay cash advances; those payment obligations were secured. Additionally, it can be safely assumed that the suppliers in both cases would have enforced their rights under the notes. Both cases acknowledged that the transactions were loans in form.
The Karns court stated that Erickson Post was materially distinguishable, because the transaction in that case was a loan in both form and substance. However, the Karns court does not explain how it reached a different result as to the transaction's substance.
The difference in result seems to arise from the fact that the Tax Court in Karns chose to recast the nature of the repayment obligation. Specifically, the note in Karns stated that the "annual payment shall be forgiven if" certain conditions were met. In other words, the note required payment unless some future event occurred. However, the court recast the obligation as being subject to a condition precedent, stating that the obligation under the note "would not arise unless and until [Karns] materially breached" the supply agreement.
It is the relative ease with which one can rephrase the nature of an obligation that gave the Karns court the ability to arrive at a different result from the Erickson Post court. For example, to change the results of a given case, all a court would need to do is restate an obligation from "I will pay you unless X happens" to "If Y happens, then I will pay you" In substance, there does not appear to be a significant difference between Erickson Post and Karns.
In light of the above problems and the Westpac decision (in which the transaction was not structured as a loan), one might wonder whether the IRS should move away from a standard based on whether an obligation is subject to a condition subsequent or precedent. For now, however, taxpayers seem to be left with conflicting answers to a common situation.
FROM RICHARD SHEVAK, J.D., WASHINGTON, DC
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|Title Annotation:||GROSS INCOME|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2007|
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