Barriers to the application of the constructive receipt doctrine.
The doctrine of constructive receipt --largely formulated by the courts, but also defined in the regulations(1) --complements the doctrine of actual receipt as a test of realization in that it prevents a cash-basis taxpayer from deliberately turning his back on income and thereby selecting the year in which he reports it.(2) Not recognizing the constructive receipt of income as realized income clearly would open the door to tax avoidance and, possibly, tax evasion.
The doctrine of constructive receipt generally applies whenever a cash-basis taxpayer is entitled to money, the money is immediately available to him, and his failure to receive it is due entirely to his own volition.(3) The doctrine, however, cannot stretch the theory of cash receipts to the point where it destroys the distinction between the cash-receipts and the accrual methods of accounting.(4)
Since the doctrine of constructive receipt is, in a sense, a fiction that brings income not in fact received within the scope of taxable income, the courts for a long time held that the doctrine was "an artificial concept which must be sparingly applied--a conceptual device whose `primary function is to bring about a fair and reasonable application of the income tax.'"(5) This early reluctance to use the constructive receipt doctrine also contributed to the courts holding that a taxpayer who had not reported an amount as income in prior years could not invoke the doctrine to escape taxation on this income when it was actually received in a later year.(6)
In more recent decisions, the courts have broadened the doctrine of constructive receipt to allow the taxpayer, as well as the Internal Revenue Service, to invoke the doctrine.(7) The doctrine, therefore, no longer is merely a tool for preventing taxpayers from selecting the years in which they report income; it is "a test of realization of income . . . providing that income should be taxed in the year it is received."(8) For income in fact constructively received in a prior year, the taxpayer may invoke the doctrine to defeat any attempt by the IRS to assess tax on it in a later year.(9) The taxpayer may do this even though the amount was not reported as income in the earlier year and even though the statute of limitations bars assessment of a deficiency in tax for the earlier year.(10)
Whether income is subject to a taxpayer's demand without qualification or reservation normally is a question of fact.(11) Because of the many factors involved, however, exact precedents are rare and one must look for distinguishing factors. Even with this narrow focus, the analysis is difficult because of the number of cases involved: more than 100 court decisions involving some aspect of the constructive receipt doctrine.
The critical issue in most constructive receipt cases is determining the proper cutoff between taxable years for inclusion of items of income. This article examines the following barriers to constructive receipt in cutoff determinations:
1. The time or manner of payment is subject
to substantial limitations or restrictions.
2. Exercising the right to income requires
that a valuable right or privilege be given
3. The right to receive income is in dispute
4. The property received in an exchange or
sale transaction is not a cash equivalent.
5. The right to receive salary or bonus is
evidenced only by corporate
authorization and not shifting of control to the
6. A corporate policy defers receipt of
dividend checks until the year following
7. A binding contract to receive payment in
a year other than the year the transaction
8. Geographic obstacles restrict the
taxpayer's access to, and thus control of, the
9. A valid escrow arrangement is
established. These latter two barriers are given particular attention since they emanate from the recent cases of Baxter v. Commissioner(12) and Granneman v. United States.(13)
II. Substantial Limitations or Restrictions on Time or Manner of Payment
Where the time or manner of payment is subject to substantial limitations or restrictions, income is not constructively received until the limitations or restrictions are removed.(14) The courts have considered this point in several different contexts: the receipt of checks, deferred compensation arrangements, ability to take control of assets received as income, prepaid legal fees held in trust, wages earned but not received, and premature withdrawal penalties on short-term investments.
A. Receipt of Checks
A check normally is constructively received when it is delivered to the taxpayer or his agent.(15) In Kahler v. Commissioner,(16) the Tax Court held that a check was delivered to the taxpayer even though it was received after banking hours on the last day of the year. In Davis v. Commissioner,(17) however, constructive receipt was barred because the taxpayer recipient was not home on the last day of the year to accept delivery of certified mail containing a check. The court found that the taxpayer's absence was not for the purpose of avoiding taxes, but that it clearly restricted the taxpayer's control of the income.
The Tax Court also has treated an agreement not to cash a check until the following year as a substantial restriction on the taxpayer-recipient's control of the income.(18) In Madigan v. Commissioner,(19) the court stated that the taxpayer's control was substantially restricted when he received a check with an express understanding that he "was to hold the amount in trust until after the accounting for the tax year could be completed."(20) Similarly, in Fischer v. Commissioner,(21) the court found a substantial restriction because the taxpayers, at the payor's request, had agreed to not cash their check until the following year. Explaining its decision, the court stated:
The obvious fact is that the check was not
income to Fischer in 1942. He could not use
the money in that year. The check he
received in 1942 was subject to a very
substantial restriction arising from his
agreement that he would not deposit the check
until after the first of the year 1943. Income
is not realized until the taxpayer has the
funds under his dominion and control, free
from any substantial restriction as to the use
The Tax Court has further stated that any bona fide understanding (oral or written) that makes the receipt of an amount contingent upon some future event or condition prevents a constructive receipt.(23) The amount involved may be from dividends or some other source, such as the proceeds of a sale of property.(24)
B. Deferred Compensation Arrangements
The doctrine of constructive receipt has been invoked in a number of deferred compensation cases.(25) Since the issuance of Revenue Ruling 60-31,(26) however, taxpayers have been successful in deferring income and taxation with nonqualified deferred compensation arrangements. The exemptions provided in Revenue Ruling 60-31 showed that a variety of deferred arrangements could avoid constructive receipt. Moreover, in its discussion of these examples, the IRS stated:
. . . it seems clear that in each case
involving a deferral of compensation a
determination of whether the doctrine of constructive
receipt is applicable must be made on the
basis of the specific factual situation
involved.(27) This sanction of a facts-and-circumstances approach paved the way for establishing a deferred arrangement that would include restrictions or limitations sufficient to bar the application of the constructive receipt doctrine. The typical arrangement provides for a stated amount to be paid upon retirement as an annuity or for a fixed number of years. This stated amount usually represents the value at the time of payment of a present periodic amount of salary, withheld and deferred, plus interest. The employer remains the owner of the withheld and deferred sums until they are paid. The employer may credit the employee on his books or he may use the money to currently fund his future obligations--e.g., by investing in an annuity contract. The employee usually has only the employer's unsecured promise of payment in the future.
The case of Goldsmith v. United States(28) shows how the courts have found the constructive receipt doctrine inapplicable to such nonqualified arrangements. The taxpayer, Goldsmith, was an anesthesiologist who worked exclusively, but as an independent contractor, at one hospital. The issue was whether amounts withheld from his compensation under a deferred compensation arrangement were taxable to him in the year withheld on the ground that they were constructivly received at that time.
The deferred arrangement was established, at Goldsmith's initiative, after discussion with the executive director of the hospital and an agent of an insurance company. Under the agreement, Goldsmith was to continue as an independent contractor with the hospital until his retirement at age 65. In return, he was to receive, at retirement, numerous payment options for the amounts currently withheld. Severance payments also were to be made to Goldsmith at retirement if he left the hospital for reasons other than retirement, death, or total disability. The hospital was not obligated to either fund a reserve or set aside money to meet the provisions of the agreement. Both parties, however, understood that the benefits under the agreement were in lieu of $450 of Goldsmith's monthly compensation and were to be funded by the hospital's purchase of a life insurance endowment offered to Goldsmith at a premium of $450 per month. In addition, the parties understood that the deferred compensation arrangement could be terminated by either of them with 30 days notice.
The IRS argued that Goldsmith constructively received the entire $450 withheld from his compensation each month because (1) he controlled the establishment of the arrangement, including the selection of the insurance company and (2) he continued to control it through his power to end the arrangement on 30 days' notice The Court of Claims, however, found no evidence that the deferral agreement could or would be disregarded at will. In the court's view, "[t]he parties meant to be bound, and once the agreement was made and deductions began, there were patently the `substantial limitations or restrictions' on plaintiff's access to the deducted sums which, under the regulation, negated constructive receipt."(29) The court also found that in Revenue Ruling 68-99(30) the IRS had approved a similar type arrangement: the deferral of compensation and taxation to an employee whose employer had promised to pay him a pension at a stated future time and had funded the pension by purchasing a life insurance policy of which the employee was the sole owner and beneficiary.
The court found that the funding of the insurance in Goldsmith was merely a method of investment by the hospital to finance its undertakings. Goldsmith had no rights in the withheld sums either against the hospital or the insurance company since the hospital was the sole owner and beneficiary of the policy. In the event of the hospital's bankruptcy, Goldsmith would only be an unsecured, general creditor.
The court ultimately concluded that the deferred compensation arrangement was valid, and not a sham, because it effectively limited and restricted Goldsmith's right to the $450 deducted from what otherwise would have been his compensation. Goldsmith, therefore, was not in constructive receipt of the withheld amounts.
C. Ability to Take Control of Asset Received
Constructive receipt requires that the taxpayer have the ability to take control of the asset received. In Hornung v. Commissioner,(31) the taxpayer was awarded an automobile one year, but did not receive it until the following year. The taxpayer tried to invoke the constructive receipt doctrine and have the value of the car reported as income in the year the award was announced. The Tax Court, however, held that the taxpayer could not claim constructive receipt because the car was not set aside for the taxpayer's use in the year of award. The award was made at approximately 4:30 on the afternoon of Sunday, December 31, 1961, in Green Bay, Wisconsin, while the car was located at a New York City dealership that was closed on Sundays. In the court's view, the fact that the automobile was not available for the taxpayer's use until the following year was a substantial limitation sufficient to nullify constructive receipt. The value of the automobile, therefore, could not be included in the taxpayer's income until the year of receipt.
D. Prepaid Legal Fees Held in Trust
Attorneys required by professional ethics or by the courts to hold fees in trust pending the final disposition of legal proceedings or the approval of the courts normally can avoid the imposition of the constructive receipt doctrine with the substantial limitation argument. In Miele v. Commissioner,(32) the Tax Court clarified the meaning of substantial limitation or restriction in this context. The court held that whether a law firm receives income when prepaid legal fees are received depends upon whether the fees are received under a claim of right and without restriction on their disposition. A prohibition against commingling client advances with a law firm's other funds and a restriction upon their use until the amount is no longer in dispute were factors the court deemed supportive of a firm's not receiving the funds under a claim of right and without substantial restriction as to disposition. The court further stated that the key issue relative to constructive receipt in this context is when the funds are earned--i.e., whether the funds held in the trustee account are subject to substantial limitations or restrictions which bar the application of the constructive receipt doctrine. Since the law firm in Miele was not free to transfer the funds to the firm's general accounts and to enjoy the use of the funds until all events had occurred to show that the amounts had been earned, the income was not taxable until then. The court also noted that the firm could not postpone the reporting of the income (by simply exercising its right to transfer the funds to its general accounts) once all the events defining the firm's right to the funds transpired.
E. Wages Earned But Not Received
A taxpayer who has earned his salary or wages, but has not received them because of factors beyond his control may claim a limitation sufficient to bar constructive receipt. In Carter v. Commissioner,(33) the Tax Court held that because bureaucratic inefficiency did not allow the taxpayer, Carter, free and unrestricted control of his wages prior to actual receipt, he did not constructively receive them when earned. Carter, who worked for New York City, had been transferred between departments and, owing to tardiness in forwarding his records and a backlog in payroll processing, was not paid for six weeks. Carter made numerous protests and demands for his wages before he received four weeks backpay and two weeks timely pay on January 3, 1975. The Tax Court held that Carter's control over his wages was subject to substantial limitations or restrictions, and that the presence of wages in the New York City budget was an insufficient basis for finding that he constructively received his wages before they were actually received in 1975.
F. Premature Withdrawal Penalties on Short-term Investments
Treas. Reg. [section] 1.451-2(a)(2) states that a substantial forefeiture of earnings upon the premature withdrawal or redemption of a one year or less certificate of deposit, time deposit, bonus plan, certain short-term corporate obligations, or other deposit arrangement constitutes a substantial limitation or restriction on the taxpayer's control over the receipt of such earnings. For example, assume three month's interest must be forfeited upon the withdrawal or redemption before maturity of a one year or less certificate of deposit. Since the earnings payable on withdrawal or redemption of this certificate would be substantially less than the earnings that would be available at maturity, the forfeiture is considered a substantial limitation or restriction. Constructive receipt, therefore, would be barred.(34)
III. Valuable Right or Privilege
Must Be Lost
Income unqualifiedly subject to the demand of the taxpayer is not constructively received if the exercise of the right to the income requires the taxpayer to lose a valuable right or privilege.(35) Constructive receipt will not be barred, however, if the rights that the taxpayer must surrender to receive the income are not "sufficiently substantial."(36)
In Letter Ruling No. 8151114, the IRS ruled that a requirement of surrender or forfeiture of a valuable right qualifies as the loss of a sufficiently substantial right. The ruling involved a fee dispute between two firms representing the same client; one of the firms had offered a sum of money to the other firm in settlement of the dispute. The IRS ruled that this offer did not constitute receipt of the offered amount because a final settlement would result in the offeree-firm forfeiting its right to claim additional amounts due. Moreover, the deposit of the disputed amount with an investment broker did not result in constructive receipt because neither firm independently controlled the investment or withdrawal of the funds.
In Dennis v. Commissioner,(37) the Tax Court reached a similar conclusion involving an alimony claim. The court held that the taxpayer did not receive money, actually or constructively, from her former husband until formal releases were executed. Until that time, the taxpayer's receipt was contingent upon giving up something of value--i.e., releasing the claims she had against her former husband. If she had repudiated the proposed settlement, the money deposited by her former husband would have gone back to him and she would have been free to prosecute her claims in the courts. The execution of the formal releases, therefore, was the transaction of real substance--i.e., the one that fixed the rights between the parties to the money deposited.(38)
If the loss of the valuable privilege or right is within the taxpayer's control, the courts are not likely to uphold it as a bar to constructive receipt. In Estate of Shelton v. Commissioner,(39) the Tax Court found that an estate tax refund, consisting in part of taxable interest, was payable upon receipt of an executor's bond. Since the time at which the bond requirement would be satisfied was within the executor's complete control, the court held that it was not sufficiently substantial to bar constructive receipt of the refund.
IV. Right to Receive Income
in Dispute or in Litigation
A dispute over the right to receive income may prevent application of the constructive receipt doctrine until the parties settle the dispute or it is settled through a court judgment or court approved settlement.(40) This barrier has been at issue in connection with the receipt of checks and judgments that are being appealed or changed by mutual consent of the litigants.
A. Receipt of Checks
A taxpayer who refuses to accept a check for a disputed claim may avoid constructive receipt of the amount. In Bones v. Commissioner,(41) the Tax Court held that income was not recognized because (1) the taxpayer's acceptance of the check would have effected an accord and satisfaction of the disputed claim and (2) the check tendered was in effect only an offer. The IRS, however, has ruled that a check received for interest in an amount less than the proper amount is income received even though it is returned, since it could be cashed without prejudice to a further claim.(42) In the same ruling, the IRS ruled that income would not be recognized when a check in excess of the proper amount is returned, because a valid basis for not accepting it would exist.(43)
B. Judgments on Appeal and Changes in Amounts Awarded
While a judgment is being appealed, no income is recognized.(44) The rationale here, of course, is that the judgment may be reversed on appeal.
Parties to litigation sometimes decide that the loser will pay the winner an amount that will be income to the winner and a deduction for the loser. If the parties to this agreement hold up the signing of the final release papers until the following year, both the income and the deduction must be deferred until then. This unintended result occurred in Estate of Richards v. Commissioner(45) where the taxpayer reached an informal understanding with the defendant, against whom she held a judgment, to settle in the following year for a lesser amount. The Second Circuit held that there was no constructive receipt in the year the agreement was reached even though the motive for the agreement was to save taxes. The court concluded that the taxpayer was not obligated to take less than the full amount of the judgment and that she could make any settlement she wished. The receipt of the money was conditioned upon the delivery of a release, which was not done until the following year, and thus, the funds were not unconditionally available to the taxpayer until the following year.
V. Property Received Not a
A cash-basis taxpayer who sells or exchanges property realizes income to the extent the fair market value of the "property (other than money) received" exceeds his adjusted basis in the property sold or exchanged. Where the full purchase price, in the form of money or tangible property, is received in the year of sale or exchange, the cash-basis taxpayer may realize gain on the basis of such receipt. Where the purchaser merely promises to pay the face amount of the purchase price in the future, however, there is some question whether (1) the promise constitutes "property" within the meaning of section 1001(b), the value of which must be reported in the year received or (2) the seller may be considered to have received "property" only when the purchaser's promise to pay is fulfilled. This issue often is phrased in terms of whether the right to payment is a "cash equivalent." If so, the fair market value of this right must be treated as realized income when received.
The courts initially held that a contract right not evidenced by a note or other instrument was not a cash equivalent.(46) A negotiable note, on the other hand, generally was treated as a cash equivalent and its fair market value was included as realized income in the year of receipt.(47) In more recent cases, the courts have modified both of these positions. Various tests are now used to determine the cash equivalence of contract rights not evidenced by promissory notes, and the receipt of a note is not automatically treated as receipt of income.
A. The "Cowden" Test of Cash Equivalence
In Cowden v. Commissioner,(48) the Fifth Circuit developed a test of cash equivalence that included several factors: (1) a solvent obligor, (2) an unconditional and unassignable promise to pay, (3) a promise to pay not subject to setoff, and (4) a promise to pay readily transferable to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money. In presenting the test, the court emphasized that "economic realities, not legal abstractions," govern the reach of the tax laws.
The income at issue in Cowden arose from the sale of an interest in an oil lease for $10,000 cash and a written promise to receive the remainder of the agreed bonus or advanced royalty payments, $501,000, during the succeeding two years. Shortly after the sale, the sellers assigned their rights to receive the future payments to a bank (in which one of the sellers was an officer and director) for their face amount, less a $750 discount. The Tax Court held that, because the purchasers were willing and able to pay cash in the year of sale and because the assignee bank was willing to accept the payment right at a nominal discount, the sellers had to realize the full face amount of the promise to pay less a four-percent discount in the year of sale under constructive receipt principles.
The Fifth Circuit rejected the Tax Court's premise that the willingness and ability of the purchaser to pay cash was sufficient to cause constructive receipt, but remanded the case to the Tax Court to determine the issue of whether the purchaser's promise to pay was the equivalent of cash. In doing so, the Fifth Circuit held that the negotiability of such a right was not a prerequisite to cash equivalence and that the following test was appropriate for determining cash equivalence:
If a promise to pay of a solvent obligor is
unconditional and assignable, not subject to
setoffs, and is of a kind that is frequently
transferred to lenders or investors at a
discount not substantially greater than the
generally prevailing premium for the use of
money, such promise is the equivalent of
cash and taxable in like manner as cash
would have been taxable had it been
received by the taxpayer rather than the
B. The "Warren Jones" Test of
In Warren Jones Co. v. Commissioner,(50) the Tax Court relied on the language in Cowden to reject the IRS's contention that an apartment building purchaser's contractual promise to make deferred payments was the equivalent of cash. The court had found that the contract was assignable only at a discount of almost 50 percent of the face amount of the purchase price. On appeal, the Ninth Circuit reversed the Tax Court's decision on the ground that, because the right to payment had a fair market value--even though not "readily realizable"--such right had to be considered "property" within the meaning of section 1001(b). Based on its reading of the legislative history of section 1001(b) and its predecessors, the court concluded:
We cannot avoid the conclusion that in 1924
Congress intended to establish the ... rule
... that, ... if the fair market value of
property received in an exchange can be
ascertained, that fair market value must be
reported as an amount realized.(51)
Thus, the Warren Jones test looks to the definition of "property" as used in section 1001(b) to determine cash equivalency, while the Cowden test determines it by considering whether the right received is comparable to cash. Both tests were reflected in the subsequent case of Watson v. Commissioner.(52)
In Watson, the Fifth Circuit affirmed the Tax Court's holding that the face amount of an irrevocable letter of credit received by the taxpayer, a cotton producer, was included in income in the year received. The court found that the letter of credit fulfilled all of the Cowden standards required for realization when received: it was issued by a solvent maker, unconditional, assignable, and not subject to set-off. Moreover, the letter met the Warren Jones requirement of being "property" with an ascertainable fair market value (its full face amount). The court sympathized with the taxpayer's plight of not knowing what a letter of credit was or that it was assignable, but stated that "the invitation to apply a subjective standard when assessing a tax liability must be rejected."(53)
D. Transferability and Cash Equivalence
In a subsequent case involving a standby letter of credit, Griffith v. Commissioner,(54) the Tax Court followed Watson in holding that the taxpayer-seller's right to deferred payments under a sales contract that he had fully performed, together with a standby, nontransferable letter of credit securing the payments, constituted a cash equivalent. The court based this holding on its determination that the rights to the proceeds of the letter of credit were assignable under state law, even though the letter was nontransferable. No contingency that could have relieved the buyer or the bank issuing the letter of the obligation to pay existed and thus, the taxpayer-seller could have realized cash simply by transferring the rights to the deferred payments and the proceeds of the letter.
Since Griffith involved an installment sale, the key issue was whether year-of-sale payments received by the taxpayer-seller exceeded 30 percent of the sale price (thus disallowing the installment sales reporting method). In a subsequent case involving this same issue, Sprague v. United States,(55) the Tenth Circuit reversed a district court's holding that paralleled the Griffith decision. The Tenth Circuit believed that the Griffith decision was incorrect, primarily because section 453(b)(2)(B)--now section 453(f) (3)--specifically provided that the purchaser's evidences of indebtedness did not constitute year-of-sale payments. The Tenth Circuit did not seem to question the validity of the court dictum in Watson (i.e., that a taxpayer might be held to have constructively received the face amount of a well-secured short-term note), but it indicated that this reasoning was not applicable to cases involving installment sales.
The Installment Sales Revision Act of 1980(56) eliminated the 30-percent rules for installment sales occurring in taxable years ending after October 19, 1980. The Act also enacted section 453(f)(3), which provides that the term "payment" does not include receipt of evidences of indebtedness of the purchaser whether or not secured by a third party. Section 453(f)(4) provides, however, that a debt instrument payable on demand or issued by a corporation or governmental unit and readily tradeable on an established market is considered a payment when received.
E. Receipt of Promissory Notes
As previously discussed, the receipt of a promissory note no longer means automatic realization of income.(57) The regulations on compensation for services with respect to the receipt of a note, however, provide:
Notes or other evidences of indebtedness
received in payment for services constitute
income in the amount of their fair market
value at the time of the transfer. A taxpayer
receiving as compensation a note regarded
as good for its face value at maturity, but not
bearing interest, shall treat as income as of
the time of receipt its fair discounted value
computed at the prevaling rate. As payments
are received on such a note, there shall be
included in income that portion of each
payment which represents the proportionate
part of the discount originally taken on the
entire note.(58) This provision probably represents the general rule in case law.(59) In the following factual situations, however, the courts have departed from the general rule and held that the receipt of a note does not cause the realization of income:
1. The maker of the note was without funds,
and a fair market value for the note was
2. The court determined that the note in
reality was merely a promise to pay.(61)
3. The notes were in escrow and the payee
lacked the power to bring them within his
The assignment of a note due a taxpayer constitutes a realization event, and the taxpayer ordinarily must recognize a gain or loss equal to the difference between his basis in the note and the amount realized.(63) If neither the holder nor the assignee can obtain payment, however, the assignment does not result in income recognition.(64)
VI. Right to Salary or Bonus
Not Accompanied by Sufficient
An employee must have a minimum degree of control over compensation to which he is entitled before it is considered constructively received. Defining this minimum degree of control has been particularly difficult in cases involving employee-shareholders of closely held corporations.
In Hyland v. Commissioner,(65) the the Tax Court found the minimum degree of control for constructive receipt lacking because the taxpayer, the president-shareholder of a closely-held corporation, did not have the ability to fix the time of payment. The corporation's board of directors had voted in December to approve the employee's salary payment, but nothing had been said as to the time of payment, and the company had made no entries on its books to indicate that the taxpayer was entitled to receive part of his salary in that year. Although the taxpayer was president and controlling shareholder, he was not empowered to draw checks on the corporation. The court concluded that there was nothing, apart from the taxpayer's stock ownership, to indicate that he could have received payment of any part of his salary before it was actually received in the following year.
In Haack v. Commissioner,(66) the Tax Court reached a different conclusion when it found that the taxpayer possessed the minimum degree of control. The court held that bonuses authorized to be paid to the taxpayer, the majority shareholder and president of the closely-held corporation, were constructively received in the year of authorization because (1) the money was currently available to him, (2) the right to receive the money was not restricted, and (3) the failure to receive cash currently resulted from the exercise of the taxpayer's own choice (i.e., as controlling shareholder, president, treasurer, and director, the taxpayer clearly could have obtained payment before year-end). Because of the degree of control possessed by the taxpayer, the court rejected the taxpayer's argument that the corporation had a tradition of deferring the payment of year-end bonuses to the following year.
In Kahn v. United States,(67) which involved only a slightly different set of circumstances than Haack, a district court found the minimum degree of control lacking. This conclusion was based upon two important factors: (1) for 25 years, the corporation had consistently followed the policy of authorizing bonuses at the end of the year and paying them in the following year, and (2) two signatures were required on all checks drawn on the corporation. The combination of these factors meant that the taxpayer alone could not have ordered the bonus checks to be drawn; hence, he lacked the minimum degree of control necessary for constructive receipt.
Hyland, Haack, and Kahn together suggest that the ability of the employee-shareholder to determine the time of payment of compensation reflects the degree of control the taxpayer has over the compensation. If the employee-shareholder can determine the time of payment, he possesses the minimum degree of control considered necessary for constructive receipt.
VII. Corporate Policy Defers
Receipt of Dividends
Treas. Reg. [subscript] 1.451(b) provides that dividends on corporate stock generally are constructively received when they are unqualifiedly made subject to the demands of the shareholder. Constructive receipt is barred, however, when a corporation declares its dividends payable the last day of the year, but follows its usual practice of mailing the dividend checks so that the shareholders will not receive them until the following year.(68)
A request by a taxpayer to receive his dividend check by mail in order to delay its receipt will not have this same effect.(69) When the check is made available to the taxpayer, it will be deemed constructively received.(70) An officer-shareholder will not be deemed, however, to have unqualified control over his dividend check, even if it is dated and payable to him on December 31, if the corporate practice is to mail employee and officer-shareholder checks through office mail and other shareholders' checks through the regular mail so that they will not be received until the following year.(71) Such a holding will not change even if the taxpayer can receive his dividend check on December 31 by picking it up in person.(72)
VIII. Binding Contract to
Receive Payment Completed
Entering into a binding contract to receive payment in a year other than the year a noninstallment sales transaction is completed may avoid application of the constructive receipt doctrine in the transaction year.(73) The major prerequisites to securing this deferral are that the agreement result from an arm's-length transaction and that the seller have no rights to the income before a stipulated date.(74) That the transaction is entered into for tax purposes, or that the payor is willing and able to pay immediately, is immaterial.(75) Similarly, a valid amendment to the agreement will not jeopardize the deferral.(76) The taxpayer, by private agreement, however, may not shift income that is immediately available to him by reason of a fully completed transaction from one year to another.(77) If the taxpayer is legally entitled to receive payment in the earlier year, he will be deemed to have constructively received it in that earlier year.(78)
A. Application of Binding Agreement Rules to Farmers
Cash-basis farmers often sell their crops under arrangements that provide for payment to be deferred until the following year. The IRS has sometimes resisted such arrangements. Two Fifth Circuit cases, Busby v. United States(79) and Arnwine v. Commissioner,(80) illustrate the factors the courts consider material in determining whether a farmer-taxpayer has constructively received income before a stipulated contract date. In both cases, the taxpayers used local cotton ginners as agents to defer income from their crops to the year after they were harvested and sold to buyers. The compensation paid to the ginners was only for ginning cotton.
The taxpayer in Busby successfully deferred taxes on the sales proceeds by persuading the Fifth Circuit that (1) the ginner was acting as an agent of the buyer and (2) the deferred payment contract imposed a limitation on the taxpayer's right to payment that was sufficient to bar constructive receipt. Conversely, in Arnwine, the Fifth Circuit regarded the ginner as the taxpayer's agent and held that the deferred payment contract was merely a self-imposed limitation.
In Arnwine, the Fifth Circuit did not question the legitimacy of deferring the proceeds from crop sales. The court's concern, and primary basis for objection, was that the contract ran between the taxpayer-seller (Arnwine) and his agent-ginner (Owens). The ginner acted solely on the taxpayer's behalf and at his direction with respect to the distribution of the crop sale proceeds. The real buyer was a textile company that was not a party to (or even aware of) the arrangement between Arnwine and Owens. The court also noted that Arnwine had the ability to obtain the proceeds from Owens at any time, a factor normally sufficient to involve the constructive receipt doctrine in the year of sale.
The Fifth Circuit found several critical differences between the facts in Arnwine and those in Busby. First, the taxpayers in Busby had emphasized the importance of deferring payment from the outset of the transaction and had conditioned the sale upon such a deferral. Second, the ginner in Busby had agreed to take care of the deferment and had established an irrevocable escrow account in a bank so that the buyer would deposit the sales proceeds at the time of delivery. Third, the taxpayers did not have a right to receive the money in the escrow account until the following year. Finally, the taxpayers were not entitled to any incidental benefits of the escrow account, such as interest or the issuance of a letter of credit.
B. Binding Agreement Rules: The Absence of an Agent
The binding agreement rules also have been interpreted in a farm-related case that did not involve an agent of either party. In Cummings v. United States,(81) the taxpayer sold (i.e., title passed to the purchaser) cattle in October, November, and December of one tax year, but was not entitled to receive payment until the following January. A district court, affirmed by the Eighth Circuit, held that the proceeds were not constructively received in the year of sale. The IRS had argued that the taxpayer-sellers could have received payment in the year of sale if they had only asked for it. The court, however, found that a more useful test was to ask what the rights of the buyer to the money were after he bought the cattle and before the stipulated payment date. On this issue, the court found that the buyer had sold the cattle one day after they were received, bought certificates of deposit to cover the debt, and kept the interest on the certificates. The terms of the purchase of the certificates of deposit had not created a security interest in the sellers such that they would be preferred creditors if the buyer had gone bankrupt. Additionally, as noted by the Eighth Circuit in affirming the district court, the parties had entered into bona fide agreement rather than a consignment arrangement.
IX. Geographic Obstacles Restrict Taxpayers Access To and Control of Income
Income normally is deemed to be constructively received by the taxpayer in the year it is credited to his account, set apart for him, or otherwise made available for his use. If some barrier to actual possession exists, however, the income is not constructively received until the barrier is removed. In the recent case of Baxter v. Commissioner,(82) the Ninth Circuit reversed the Tax Court to hold that geography may be one of these barriers to actual possession.
At issue in Baxter was a check dated December 30 (a nonbusiness day, Saturday) for commissions earned by the taxpayer. The taxpayer could have picked the check up on December 30, but chose not to because he would have had to have driven 80 miles round trip to get it and would not have been able to cash it at a bank until January 2. The Tax Court found that the taxpayer had constructively received the check in the year it was dated because it was available to him at that time.
The Ninth Circuit rejected the Tax Court's finding of constructive receipt in the year the check was dated on the ground that the taxpayer could not have exercised control over the check even if the 80 mile trip had been made. The court noted that although the Fifth Circuit in McEuen v. Commissioner(83) had suggested that geography does not create a barrier, McEuen was not applicable to Baxter because it depended on the taxpayer controlling the time of payment by agreement, and no such agreement existed in Baxter.
The Ninth Circuit also found the geographic barrier in Baxter analogous to the corporate practice barrier upheld by the Supreme Court in Avery v. Commissioner.(84) At issue in Avery were dividend checks prepared by a corporation on December 31, but not regularly available until the first business day of January of the following year. The court held that the checks did not constitute income before they were actually received by the shareholders. In the court's view, the mere promise or obligation of the corporation to pay on a given date was insufficient to subject the dividend funds to the shareholders' unqualified demand. The corporate practice of holding the dividend checks until the following year acted as a barrier to the shareholders' receipt of income.
The Ninth Circuit believed that the day, the distance, and the futility of making the trip in Baxter were as effective a barrier to the taxpayer's control over the check as was the corporate practice barrier in Avery. The taxpayer would have had to have made an 80 mile round trip on a Saturday in order to pick up a check that could not even be cashed until the next year. Such barriers clearly restricted the taxpayer's exercise of control over the checks.
X. Establishment of Valid Escrow Arrangement
In Granneman v. United States,(85) a district court held that a valid escrow arrangement, used for security purposes, may prevent application of the constructive receipt doctrine. At issue was the sale of farm property by a married couple who wanted to receive the sales price in installments in order to minimize their taxes. The buyer offered to pay the entire price in the year of sale, but the taxpayers refused to accept such an offer because of the tax consequences. The taxpayers, however, did demand some security for the installment payments. Since the buyer was unwilling to give a mortgage deed of trust (because of a desire to transfer the property to a third party free of any encumbrance), the parties developed an escrow arrangement to provide security for the installment payments.
At the closing date of the sale, the buyer paid less than 30 percent of the purchase price to the taxpayer (the threshold for installment sales treatment at that time) and delivered four promisory notes payable over the next four years for the remainder. The buyer then deposited cash equal to the entire amount of the notes in a bank escrow account for collateral.
Under the escrow arrangement, the money and the interest accruing on it belonged to and were payable to the buyer. The taxpayers could obtain this money only if the buyer defaulted on the payment of one of the notes. Throughout the four-year period, the buyer paid off the notes from its own general accounts rather from the escrow account.
The IRS argued that by having the buyer place the money in escrow, the taxpayers constructively received the entire price of the farm in the year of sale. The court, however, disagreed on the ground that payments in escrow intended and regarded solely a security for promissory notes are not "payments" for purpose of the installment sales rules.(86) The court also found that the following factors identified by the First Circuit in Reed v. Commissioner(87) as indicative of a valid escrow arrangement were present in the taxpayers' agreement with the buyer:
1. the arrangement was part of a bona fide
arms-length agreement between the
purchaser and seller calling for deferred
2. the seller received no present beneficial
interest from the escrow funds--e.g.,
investment income, and
3. the escrow agent (i.e., the bank) was not
acting under the exclusive authority of
the buyer. Consequently, the court concluded that the money placed in the escrow account was not constructively received by the taxpayers in the year of sale.
The doctrine of constructive receipt primarily is intended to determine whether a cash-basis taxpayer should be taxed on an item of income that has not been physically received, but may have been within his unconditional capacity to reduce to possession. A taxpayer who desires to postpone the taxation of an item of income until receipt, therefore, must be ready to prove that the income was not within his unfettered control or command before actual receipt. A knowledge of some of the limitations or barriers to constructive receipt, as discussed in this article, is critical to proving this point. Only then may the taxpayer expect to defeat the IRS's constructive receipt arguments.
(1)Treas. Reg. [subsection] 1.451-2(a) provides the following definition of constructive receipt:
Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. (2)Hamilton National Bank of Chattanooga v. Commissioner, 29 B.T.A. 63 (1933); Washington v. Commissioner, 80 F.2d 829 (2d Cir. 1936); Baker v. Commissioner, 30 B.T.A. 188 (1934), aff'd, 81 F.2d 741 (3d Cir. 1936). (3)Newmark v. Commissioner, 311 F.2d 913 (2d Cir. 1962); Denver & R.G.W.R. Co. v. United States, 318 F.2d 922 (Ct.Cl. 1963). (4)Massachusetts Mutual Life Insurance Co. v. United States, 59 F.2d 116 (Ct. Cl. 1932), aff'd, 288 US 269 (1933). (5)Moran v. Commissioner, 26 B.T.A. 1154, 1157 (1932), aff'd, 67 F.2d 601 (1st Cir. 1933). (6)Id. (7)Sowell v. Commissioner, 302 F.2d 177 (5th Cir. 1962); Cohen v. Commissioner, 39 T.C. 1055 (1963). (8)Ross v. Commissioner, 169 F.2d 483 (1st Cir. 1948); Weil v. Commissioner, 173 F.2d 805 (2d Cir. 1949). (9)Id. (10)Id. (11)Avery v. Commissioner, 292 U.S. 210 (1934). (12)87-1 USTC [paragraph] 9315 (9th Cir. 1987), aff'g in part and rev'g in part, 50 TCM 545 (1985). (13)87-1 USTC [paragraph] 9287 (D.C. Mo. 1987). (14)Treas. Reg. [subsection] 1.451-2(a); Olson v. Commissioner, 24 B.T.A. 702 (1930), aff'd, 67 F.2d 726 (7th Cir. 1933); Hamilton National Bank of Chattanooga v. Commissioner, 29 B.T.A. 63 (1933). (15)Lavery v. Commissioner, 158 F.2d 859 (7th Cir. 1946); Bolin v. Commissioner, 26 T.C.M. 62 (1967); Granger v. Commissioner, 29 T.C.M. 667 (1970); McEuen v Commissioner, 196 F.2d 127 (5th Cir. 1952). But see United States v. Unger, 159 F. Supp. 850 (D.N.J. 1958). (16)18 T.C. 31 (1952). (17)37 T.C.M. 42 (1978); however, this is contrary to Rev. Rul. 76-3, 1976-1 C.B. 114. (18)Madigan v. Commissioner, 43 B.T.A. 549 (1941), acq, 1941-1 C.B. 7; Fischer v. Commissioner, 14 T.C. 792 (1950), acq, 1950-2 C.B. 2. (19)43 B.T.A. 549 (1941). (20)Id. at 551. (21)14 T.C. 792 (1950). (22)Id. at 802. (23)Johnston v. Commissioner, 23 T.C.M. 2003 (1964). (24)Id. (25)See Note, "Contract Right Income to Cash Method Taxpayer Who Refused Cash Offer," 58 Mich L. Rev. 480, 481-82 (1960). (26)1960-1 C.B. 174. (27)Id. at 178. (28)586 F.2d 810 (Ct. Cl. 1978). (29)Id. at 817. (30)1968-1 C.B. 193. (31)47 T.C. 428 (1967), acq., 1967-2 C.B. 2. (32)72 T.C. 284 (1979). (33)40 T.C.M. 654 (1980). (34)Treas. Reg. [subsection] 1.451-2(a)(2). (35)Blum v. Higgins, 150 F.2d 471 (2d Cir. 1945); Treas. Reg. [subsection] 1.451-2(a). (36)Blum v. Higgins, 150 F.2d 471 (2d Cir. 1945). (37)51 T.C. 46 (1968). (38)See also Estate of Richards v. Commissioner, 150 F.2d 837 (2d Cir. 1945). (39)68 T.C. 15 (1977), aff'd, 612 F.2d 1276 (10th Cir. 1980). (40)Fitzgerald v. Commissioner, B.T.A. Memo (May 11, 1938); Parr v. Scofield, 89 F. Supp 98 (D.C. Tx. 1950), aff'd, 185 F.2d 535 (5th Cir. 1950), cert. denied, 340 U.S. 951 (1951); Farrell v. Commissioner, 134 F.2d 193 (5th Cir. 1943), cert. denied, 320 U.S. 745 (1943); Cory v. Commissioner, 23 T.C. 775 (1955), aff'd on other issue, 230 F.2d 941 (2d Cir. 1956), cert. denied, 352 U.S. 828 (1956). (41)4 T.C. 415 (1944), acq., 1945 C.B. 2. (42)Rev. Rul. 73-486, 1973-2 C.B. 153. (43)Id. (44)Rev. Rul. 70-109, 1970-1 C.B. 115. (45)150 F.2d 837 (2d Cir. 1945). (46)Kleberg v. Commissioner, 43 B.T.A. 277 (1941). (47)Board v. Commissioner, 18 B.T.A. 650 (1930). (48)289 F.2d 20 (5th Cir. 1961), rev'g and rem'g 32 T.C. 853 (1959), on remand, 20 T.C.M. 1134 (1961). (49)Id. at 24. (50)60 T.C. 663 (1972), rev'd, 524 F.2d 788 (9th Cir. 1975). (51)524 F.2d 788, 792 (9th Cir. 1975). (52)613 F.2d 594 (5th Cir. 1980), aff'g 69 T.C. 544 (1978). (53)613 F.2d 594, 599 (5th Cir. 1980). (54)73 T.C. 933 (1980). (55)627 F.2d 1044 (10th Cir. 1980). (56)Pub. L. No. 96-471, 96th Cong., 2d Sess. (1980). (57)See supra note 47 and accompanying text. (58)Treas. Reg. [subsection] 1.61-2(d)(4). (59)Laramy v. Commissioner, 25 T.C.M. 809 (1966); Schlude v. Commissioner, 22 T.C.M. 1617 (1973), on remand from 372 U.S. 128 (1963); Estate of Scharf v. Commissioner, 38 T.C. 15 (1962), aff'd, 316 F.2d 625 (7th Cir. 1963). (60)Woodman v. Commissioner, 36 T.C.M. 121 (1977); Williams v. Commissioner, 28 T.C. 1000 (1957), acq., 1958-1 C.B. 6; Omholt v. Commissioner, 60 T.C. 541 (1973), acq., 1974-2 C.B. 4 (61)Courtis v. Commissioner, 16 T.C.M. 433 (1957); Dial v. Commissioner, 24 T.C. 117 (1955), acq., 1955-2 C.B. 2. (62)McLaughlin v. Commissioner, 113 F.2d 611 (7th Cir. 1940). (63)Hurwitz v. Commissioner, 23 T.C.M. 2011 (1964). (64)Timken v. Commissioner, 47 B.T.A. 494 (1942), aff'd, 141 F.2d 625 (6th Cir. 1944). (65)175 F.2d 422 (2d Cir. 1949), aff'g 7 T.C.M. 236 (1948). (66)41 T.C.M. 708 (1981). (67)81-1 USTC [paragraph] 9187 (W.D.N.C. 1981). (68)Treas. Reg. [subsection] 1.451-2(b). (69)Kunze v. Commissioner, 203 F.2d 957 (2d Cir. 1953), aff'g 19 T.C. 29 (1952). (70)Id. (71)Avery v. Commissioner, 67 F.2d 310 (7th Cir. 1933), rev'd 292 U.S. 210 (1934). (72)Commissioner v. Fox, 20 T.C. 1094 (1953), acq., 1955-2 C.B. 6, aff'd, 218 F.2d 347 (3d Cir. 1955). (73)Rev. Rul 58-62, 1958-1 C.B. 234; Lewis v. Commissioner 30 B.T.A. 318 (1934); Penn v. Glenn, 265 F.2d 911 (6th Cir. 1959); Glenn v. Penn, 250 F.2d 507 (6th Cir. 1958); Schniers v. Commissioner, 69 T.C. 511 (1977); Watson, Jr. v. Commissioner, 69 T.C. 544 (1978), aff'd, 613 F.2d 594 (5th Cir. 1980); Griffith v. Commissioner, 73 T.C. 933 (1980). (74)Schniers v. Commissioner, 69 T.C. 511 (1977). (75)Id. (76)Pittsburgh-Des Moines Steel Co. v. United States, 360 F. Supp 597 (W.D. Pa. 1973). (77)Lewis v. Commissioner, 30 B.T.A. 318 (1934). (78)Penn v. Glenn, 265 F.2d 911 (6th Cir. 1959); Glenn v. Penn, 250 F.2d 507 (6th Cir. 1958); Pittsburgh-Des Moines Steel Co. v. United States, 360 F. Supp 597 (W.D. Pa. 1973). (79)679 F.2d. 48 (5th Cir. 1982) (reversing unpublished district court decision). (80)696 F.2d 1102 (5th Cir. 1982), rev'g 76 T.C. 532 (1981). (81)80-2 USTC [P] 9542 (D. N.D. 1980), aff'd, 655 F.2d 135 (8th Cir. 1981). (82)87-1 USTC [P] 9315 (9th Cir. 1987), rev'g in part, 50 T.C.M. 545 (1985). (83)179 F.2d 422 (1952). (84)292 U.S. 210 (1934), rev'g 67 F.2d 310 (7th Cir. 1933). (85)87-1 USTC [P] 9287 (D. Mo. 1987). (86)Porterfield v. Commissioner, 73 T.C. 91 (1979). (87)723 F.2d 138 (1st Cir. 1983).
Ray A. Knight is an associate professor of accounting at Mississippi State University. He received a B.S. degree in accounting from the University of Houston, an M.A. degree in accounting from the University of Alabama, and a J.D. degree from Wake Forest University. He is a member of the American Institute of Certified Public Accountants, the American Bar Association, the American Taxation Association, and several other professional organizations. Mr. Knight has published articles in several professional journals, including The Tax Executive. Lee G. Knight is an associate professor of accounting at Mississippi State University. She received a B.S. degree in accounting from Western Kentucky University, and M.A. and Ph.D. degrees from the University of Alabama. She is a member of the American Accounting Association and the American Taxation Association. Ms. Knight has published articles in several professional journals, including The Tax Executive.
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|Author:||Knight, Ray A.|
|Date:||Jan 1, 1989|
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