Constructive Receipt

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What Is Constructive Receipt?

A Constructive Receipt is an income that is not physically received by the taxpayer but is credited to his account, thus giving him immediate control over it. It is a tax and accounting concept for income recognition; thus, the taxpayer is accountable for paying taxes on all such income.

Constructive Receipt

Such a phenomenon is valid in cash-based accounting methods but doesn’t apply in accrual-based accounting. As per the Internal Revenue Service (IRS), a taxpayer must comply with the constructive receipt doctrine to ensure proper reporting of taxable income. It applies to all kinds of income, such as dividends, salary, wages, interest, rent received, etc.

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  • Constructive receipts are when income is credited to the taxpayer's account rather than being physically received, but the taxpayer still retains full control over the income.
  • It is applicable in the cash-basis of accounting for determining the taxation of various types of income, including salaries, wages, interests, dividends, rental income, etc.
  • Reviewing the paid time off (PTO) plans and using qualified intermediaries are the two ways in which these receipts are avoided.
  • Both constructive and actual receipts are income recognition phenomena. It’s just that the latter reflects the actual cash flow of income, both on paper and physically, for the taxpayer.

Constructive Receipt Of Income Explained

Constructive receipt is an income recognition principle that accounts for earnings being taxable when they are available for taxpayers’ use without any condition. It doesn’t consider whether the taxpayer has received possession of the respective amount. Section 451 of the Internal Revenue Code recognizes any such income that is in the control of the taxpayer. Individuals are required to report their income in their tax filing, even if they cannot use it as cash.

The constructive receipt doctrine came into existence with the Davis V. Commissioner’s case, where Beatrice Davis, the plaintiff, received a check sent by her former employer through a post on December 31, 1974. It was a massive amount. Due to her absence during the post office delivery attempt, she failed to account for the same in the year's tax filing. The Tax Court considered the check as a constructive receipt that should have been included at the time of 1974 tax filing.

The constructive receipt rule is restricted to the cash basis of accounting, while it does not apply to the accrual basis. The following are various scenarios that add to the presence of constructive receipt income:

  • Interest Income: Any interest credited by the bank on the last day of the accounting period.
  • Rental Income: Rent received by the landlord in the form of a check at the end of the current accounting year.
  • Deferred Compensation: Employees are offered bonuses, commissions, or paid time off, but their accounts have not yet been credited.
  • Unclaimed Wages Or Salaries: Paychecks issued at the end of the accounting period, collected by the employees in the following year.
  • Constructive Dividends: Shareholders are yet to receive dividends announced and issued at the end of the year in cash.

Examples

The constructive receipt doctrine applies to various forms of income through the use of specific examples:

Example #1

Suppose Stella rents out a portion of the house she owns in New York to Brian at $1,200 monthly rent. She received this payment on the 10th day of every month through a check. On December 6, 2023, Stella went on vacation to Indonesia. However, Brian dropped the account payee check in the name of Stella for November's rent at her office on December 10, 2023. However, the office boy put that check on the table in her cabin.

When she came back, she couldn’t deposit the check in her bank account due to the Christmas and New Year holidays. Therefore, this rental income is considered as constructive receipt. Thus, the income received on December 10, 2023, needs to be recorded in the books.

Example #2

The IRS can tax individuals even if they have a legal right to payment, but they didn't receive it. The concept of constructive receipt is part of the tax law. Paying in December 2022 means taxes are due in April 2023, while paying in January 2023 means April 15, 2024.

If the employer tries to give a bonus check at year-end, it is taxable even if it is received in December. But if the company agrees to delay the payment and reports it on its taxes as paid in January, one could be successful in putting off the income until the following year. Negotiating for deferred payments before providing services can help with tax deferral planning.

However, a Forbes report published in Dec 2022, emphasized how IRS does its best to tackle constructive receipt issues, and disputes. It specified there is no constructive receipt if there is a transaction involving the transfer of legal rights. It is different from having already performed services, being offered a paycheck, and delaying taking it.

How To Avoid?

Constructive receipts complicate income reporting for individuals and companies, as they need to pay taxes on earnings they are yet to receive in cash. Therefore, it is advisable to consider the following measures to avoid such practices:

#1 - Considering Qualified Intermediaries

Taxpayers or investors can avoid capital gain tax liability under the 1031 exchange. They can switch real estate with a qualified intermediary instead of reinvesting property proceeds. Thus, it allows investors to refrain from paying any taxes on such receipts.

#2 - Reviewing PTO Plans

Companies record cash compensation at year-end to redeem employees' paid time off (PTO), which may not be used during the year. In this case, the income yet to be received is subject to tax payment by the employee. Thus, the employer should check and improve their PTO plans to eliminate any such burden on employees.

Constructive Receipt vs Actual Receipt

Both constructive and actual receipts are income recognition phenomena in tax and accounting procedures, although they hold significant differences, as discussed below:

BasisConstructive ReceiptActual Receipt
DefinitionIt is the income that is taxable as and when it is available for use by the taxpayer, even though they are not in physical possession of that money.It is the payment received both on paper and physically by the taxpayers.
PurposeConsider any income made available to the taxpayer as taxable to avoid manipulation or delay income receipts to limit taxable income.It reflects the actual cash inflow.
Timing of ReceiptRecognition of available income for tax purposes before its physical possession is claimed by the taxpayer.Recognition of income is based on the direct receipt of funds.
ControlPossess control over income without having funds in hand.Direct control and possession of money received.
Risk InvolvedIt involves the risk of losing funds.No such risk is involved.
ExamplesPaychecks issued to employees in the last week of December are not yet collected or encashed by them until next year’s January month.Paychecks are issued to employees in December, then received and deposited by them into their bank accounts.

Frequently Asked Questions (FAQs)

1. What is the purpose of the constructive receipt doctrine?

The primary objective of the constructive receipt doctrine is to ensure that taxpayers don’t engage in any intentional delay in encashing their income to reduce their taxable income in the current accounting period. Therefore, it emphasizes the recognition of income when it becomes available to use rather than when it is physically used.

2. What is not considered constructive receipt income?

As per Federal Regulation’s Code 26 CFR § 1.451-2, only those receipts are considered constructive receipts of income when certain limitations or conditions restrain their control or possession.

3. What is a constructive receipt date?

The constructive receipt date is the day the taxpayer receives control of such income. Whether or not they physically possess the respective amount.