Lost check is income in the year originally received.

The constructive receipt doctrine was recently addressed in Walter, 8th Cir. (1998). This case involved the issue of when a lost check is income--in the year of receipt or the year of replacement.

Under the cash method of accounting, actual receipt of income is usually required before a taxpayer incurs a tax liability; an exception to this rule occurs when there is constructive receipt of income. Under Regs. Sec. 1.451-2(a), the doctrine of constructive receipt treats income unqualifiedly subject to the demand of a cash-basis taxpayer as immediately taxable, whether or not such income was actually received in cash. If income is credited to a taxpayer's account, set apart for the taxpayer or otherwise made available so that the taxpayer may draw on it at any time (or could have drawn on it during the tax year if notice of intention to withdraw had been given), income is deemed constructively received. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limits or restrictions.

In this case, an IRS auditor discovered a document indicating a sale of steers to a company in March 1986; the document appeared to be the top portion of a business check. No deposit of this check was found in the taxpayer's records. The Walters contacted the company and determined that the original check was lost. A new check was issued in January 1988 and reported on the Walters' return in that year. The Walters (cash-basis taxpayers) unsuccessfully argued that this check was income in the replacement check year (1988), not the original receipt year (1986).

The taxpayers argued that the date of payment should relate to the check's delivery date only if it was presented and honored. Therefore, a lost check that was never honored should not be taxable income in the year it was received. The Walters relied on the negotiable instruments law as stated in Kahler, 18 TC 31 (1952). The law of negotiable instruments states that payment by check is considered to be a conditional payment, subject to the condition that the check will be honored on presentation. Once presented and honored, the date of payment relates back to the delivery date.

The Eighth Circuit disagreed and held that the doctrine of constructive receipt as developed in the Code takes precedence over the law of negotiable instruments. The company that issued the check was not insolvent and did not place any substantial restrictions on the check. Losing the check was a restriction on collection imposed by the taxpayers (the payees) and not the payors; therefore, the check was income in the year of receipt and not the year of replacement.