Barriers to the application of the constructive receipt doctrine.

• Author: Knight, Lee G.

Barriers to the Application of the Constructive Receipt Doctrine

1. Overview

   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

      up.

   3. The right to receive income is in dispute

      or litigation.

   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

      taxpayer-recipient.

   6. A corporate policy defers receipt of

      dividend checks until the year following

      authorization.

   7. A binding contract to receive payment in

      a year other than the year the transaction

      is completed.

   8. Geographic obstacles restrict the

      taxpayer's access to, and thus control of, the

      income.

   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)

2. 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.

   1. 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

      thereof.(22)

      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)

   2. 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...