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Understanding the Doctrine of Constructive Receipt

Uncle Bill Sells the Buick

Your dear Uncle Bill calls you all in a tizzy asking for some (free) legal advice from his “favorite” nephew. You want to remind him that you are (a) the only lawyer in the family, and (b) the only one of his nephews who not currently in the hoosegow, but you think better of it and indulge him.

Bill and Aunt Ethel, who apparently are back together after the Thanksgiving turkey-leg-fisticuffs, sold their old trusty Buick on December 30th two years ago for $1,500 to Ethel’s step-nephew Jim-Bob for bail money. (You don’t ask questions at this point.) Ol’ Jim-Bob gave Bill a check, but Bill had been day-drinking on New Years Eve, and he was in no shape to visit the bank until a few days after the ball dropped and Bill’s blood alcohol content followed suit in the days afterwards.

Bill included the proceeds on last year’s tax return, but the IRS took issue with Bill’s reporting, and issued a deficiency for the year prior claiming that Bill had unreported income. After Bill’s customary tirade against the ungrateful Government, Agent Orange, and the shrapnel in his knee, he wants to know your opinion about whether he received the income when he sold the car or when he deposited the check. Cursing your mother for giving out your direct line to her lineal descendants, and for that truly awful bowl haircut in the fourth-grade class picture, you tell Bill that unfortunately, the IRS is likely in the right.

Constructive Receipt, Generally

When a taxpayer sells something, the money he receives in return is income under the Code. It’s basic income tax law that a taxpayer recognizes income when he actually receives payment for the property. However, under IRC § 451, a taxpayer may also recognize when he constructively receives the property.

Even if a taxpayer doesn’t have cash in hand (i.e., the income is not “reduced to the taxpayer’s possession”), if it is credited to his account, set apart for him, or otherwise made available so that he can draw upon it at any time, he is in constructive receipt of the income.[1] If, however, there are “substantial limitations and restrictions” on the taxpayer’s control or receipt of the income, there will be no constructive receipt.[2]

So, for instance, if Jim-Bob said that he was going to shoot off Bill’s big toe if he cashed the check before January 1st, this would likely be a substantial limitation on Bill’s receipt of the payment for the Buick, and there would be no constructive receipt.

Deferred Payment Agreements

Uncle Bill is well within his right (and well within the appropriate boundaries of the tax laws) to enter into an agreement with the buyer wherein Bill will not be paid until some point in the future.[3] As long as the deferred payment agreement is binding between the parties and is made before the taxpayer-seller has acquired an “absolute and unconditional” right to receive payment, all is copacetic, and the taxpayer is not required to report the sales proceeds as income until he or she actually receives the proceeds.[4] Heck, even if Bill’s entire purpose for delaying the payment is to minimize his taxes, courts have upheld these agreements.[5]

A deferred payment agreement is considered bona fide if the parties intended to be bound by the agreement and were, in fact, legally bound.[6] An existing agreement may be modified to provide for deferred payments, but only so long as no payments are already due.[7]

Escrow Agreements

Be wary of haphazard escrow agreements. They are among the most common perpetrators of unwanted income inclusion in the year of the sale.

In general, escrow agreements provide that purchase money is paid to an escrow agent, and such funds are held until some future event occurs. If negotiated properly and in advance of the sale, an escrow agreement may avoid constructive receipt, economic benefit, and agency receipt (the latter two of which are discussed below). However, a seller cannot unilaterally decide to escrow funds that would have otherwise been available to avoid constructive receipt.

Say Bill has a bunch of “mementos” that he brought back from ‘Nam, and he finds a buyer on Craigslist, who’s willing to take the “mementos” off of Bill’s hands for a set price. (You know Bill well enough to not ask what his “mementos” are. Plausible deniability and such…) Bill agrees to take $1,000 for the “mementos” (and to not report the sale to the ATF). When Bill agrees to the lump sum payment, he cannot thereafter decide that he wants the funds escrowed.[8] Alea iacta est. The die is cast. The Rubicon is crossed. Go has been passed, and $200 has been collected.

However, if Bill entered into the escrow agreement with the buyer and/or Bill’s bank to defer payments from the buyer until the year after the sale (and after Bill was no longer on his ankle monitor after his heated “discussion” with “that damn smelly hippie” at the grocery store just before the Buick sale), this would be perfectly acceptable under the constructive receipt doctrine.[9] Whether the transaction itself might not be, strictly speaking, not exactly 100% legal is outside the scope of Bill’s question and your advice.

The same result occurred in the Tyler case, where a seller of stock was required to deliver the shares in December, but the buyer and seller agreed in advance of the sale that the proceeds of the stock sale would not be made available to the seller until January of the following year.[10] The court emphasized that the seller “could neither demand payment nor control its disposition” prior to the January date; therefore, there was no constructive receipt in December.[11]

There are two other doctrines related to constructive receipt – the economic benefit doctrine and the agency receipt doctrine – which I will discuss in another post. All three impute income when the taxpayer could benefit from or control the income presently.


Footnotes:

[1] See Treas. Reg. § 1.451-2(a).

[2] See, e.g., Reed v. Commissioner, 723 F.2d 138, 142 (1st Cir. 1983).

[3] Id.; Schniers v. Commissioner, 69 T.C. 511, 516 n. 2, 517-18 (1977).

[4] Reed, 723 F.2d at 142; Oates v. Commissioner, 18 T.C. 570, 584-85 (1952).

[5] See Goldsmith v. United States, 586 F.2d 810, 817 (Fed. Cir. 1978).

[6] Oates v. Commissioner, 18 T.C. 570, 584-85 (1952).

[7] Commissioner v. Olmstead, Inc., 304 F.2d 16, 21-2 (8th Cir. 1962).

[8] See Williams v. United States, 219 F.2d 523, 527 (5th Cir. 1953).

[9] See Busby v. United States, 679 F.2d 48 (5th Cir. 1982).

[10] Tyler v. United States, 72 F.2d 950, 952 (3rd Cir. 1934).

[11] Id.

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