Constructive Receipt Tax Rules Every Lawyer Should Know
| Publication year | 2017 |
| Author | By Robert W. Wood |
By Robert W. Wood1
Constructive receipt is a fundamental tax concept that can have a broad and frightening impact. According to the Internal Revenue Service ("IRS"), you have income for tax purposes when you have an unqualified, vested right to receive it. Asking for payment later does not change that.2 The idea is to prevent taxpayers from deliberately manipulating their income.
The classic example is a bonus check available in December, but which the employee asks to hold until January 1. Normal cash accounting suggests that the bonus is not income until paid. The employer tried to pay in December, and made the check available. That makes it income in December, even though it is not collected until January.
Constructive receipt is an issue only for cash method taxpayers like individuals. Accrual basis taxpayers (like most large corporations) have constructive receipt built into the accrual method. The accrual method says you have income when all events occur that fix your right, if the amount can be determined with reasonable accuracy.3
Thus, in accrual accounting, you book income when you send out an invoice, not when you collect it.4 For cash method taxpayers, the IRS worries about "pay me later" shenanigans. The tax regulations say that a taxpayer has constructive receipt when income is credited to the taxpayer's account, set apart, or otherwise made available to be drawn upon.5
On the other hand, there is no constructive receipt if your control is subject to substantial limitations or restrictions. There is considerable discussion of what substantial limitations or restrictions prevent constructive receipt. For example, what if the employer cuts the check on December 31 but tells the employee he can either drive 60 miles to pick it up, or he will mail it?
The employer may book this as a December payment (and issue a Form W-2 or 1099 that way). The recipient may have a legitimate position that it is not income until received. Such mismatches occur frequently, and there is little to suggest there is manipulation going on.
Whether they know it or not, lawyers deal with constructive receipt issues all the time. Suppose a client agrees orally to settle a case in December, but specifies that the money is to be paid in January. In which year is the amount taxable? The mere fact that the client could have agreed to take the settlement in Year One does not mean the client has constructive receipt.
The client is free to condition his agreement (and the execution of a settlement agreement) on the payment in Year Two. The key will be what the settlement says before it is signed. If you sign the settlement agreement and condition the settlement on payment next year, there is no constructive receipt.
In much the same way, you are free to sell your house, but to insist on receiving installment payments, even though the buyer is willing to pay cash. However, if your purchase agreement specifies you are to receive cash, it is then too late to change the deal and say you want payments over time. The legal rights in the documents are important.
If a case settles and funds are paid to the plaintiff's lawyer trust account, it is usually too late to structure the plaintiff's payments. Even though the plaintiff may not have actually received the money, his lawyer has. For tax purposes, a lawyer is the agent of his client, so there is constructive (if not actual) receipt.
Suppose that Larry Lawyer and Claudia Client have a contingent fee agreement calling for Larry to represent Claudia in a contract dispute. If Larry succeeds and collects, the fee agreement provides that Claudia receives two-thirds and Larry retains one-third as his fee. Before effecting the one-third/two-thirds split, however, costs are to be deducted from the gross recovery.
Suppose that Larry and Claudia succeed in recovering $1 million in September of 2016. Before receiving that money, however, Larry and Claudia become embroiled in a dispute over the costs ($50,000) and the appropriate fee. Larry and Claudia agree that $25,000 of costs should first be deducted. However, Claudia claims that the other $25,000 in costs is unreasonable and should be borne solely by Larry.
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Furthermore, Claudia asserts that a one-third fee is unreasonable, and that the most she is willing to pay is 20 percent as a legal fee. Larry and Claudia try to resolve their differences but cannot do so by the end of 2016. In January 2017, the $1 million remains in Larry's law firm trust account. What income must Larry and Claudia report in 2016?
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