Income and Assets · Income

Constructive receipt of income

A cash-basis taxpayer reports income in the year it is received (IRC § 451(a)), and the whole difficulty of that sentence is what counts as receipt. The answer is not physical possession. Income is constructively received when the taxpayer could have had it and chose not to, and the only escape is a restriction on that control which is substantial. Getting this wrong moves income between years, which is rarely fatal on its own but compounds through estimated tax, phase-outs and statutes of limitation.

The rule

The test is availability, not possession. Income, although not actually reduced to a taxpayer’s possession, is constructively received 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 year had notice of intention to withdraw been given (Reg. § 1.451-2(a)). Each of the three limbs is independent, and the last matters most in practice because it defeats the argument that money left untouched was never received.

The escape is a substantial restriction. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions (Reg. § 1.451-2(a)). The regulation illustrates: where a corporation credits employees with bonus stock that is not available until some future date, the mere crediting on the books does not constitute receipt.

Four things the regulation says are not substantial. For interest, dividends or other earnings on a deposit or account at a bank or similar institution, none of the following is a substantial limitation: a requirement that the deposit and its earnings be withdrawn in even multiples; the fact that withdrawing during the year yields earnings not substantially less than would have been earned by leaving the money on deposit; a requirement that earnings be withdrawn only on withdrawing part of the deposit itself; or a requirement to give advance notice of intention to withdraw (Reg. § 1.451-2(a)(1)– (4)). Where the rate depends on the notice given, earnings at the maximum rate are constructively received.

The regulation’s own examples resolve the common cases. Matured and payable but uncashed interest coupons are constructively received in the year they mature, unless it is shown there were no funds available for payment that year. Dividends are constructively received when unqualifiedly made subject to the shareholder’s demand — but a dividend declared payable on 31 December and paid by the corporation’s usual practice of mailing cheques that arrive in January is not constructively received in December (Reg. § 1.451-2(b)).

Deferring compensation has its own regime. Where a nonqualified deferred compensation plan fails the requirements of § 409A(a)(2), (3) and (4), or is not operated in accordance with them, all compensation deferred under the plan for the year and all preceding years is includible to the extent not subject to a substantial risk of forfeiture and not previously included (IRC § 409A(a)(1)(A)(i)), and only for the affected participants (IRC § 409A(a)(1)(A)(ii)). The tax for that year is then increased by interest at the underpayment rate plus one percentage point, running from the year of first deferral, and by a further percentage of the included compensation (IRC § 409A(a)(1)(B)).

Current figures

How it works in practice

Ask when the taxpayer could first have taken the money, and what stood in the way. A restriction the taxpayer imposed on themselves is not a restriction at all — declining to cash a cheque, asking a payer to hold funds, or leaving a matured deposit in place are all decisions rather than limitations. A restriction imposed by the payer, by an agreement made before the income was earned, or by the terms of the instrument itself may be.

Year-end is where the doctrine bites. A cheque available for collection in December is generally income in December even if the client leaves it uncollected — but the regulation’s own dividend example shows the limit: where the payer’s ordinary practice puts the money beyond reach until January, the availability has not arisen. The distinction is between the taxpayer choosing not to collect and the payer not yet having made payment available.

For deferral arrangements, the timing of the election is the whole question. An agreement to defer compensation made before the compensation is earned can work; an election made once the right to payment has accrued generally cannot, because the taxpayer already controls it. Where any nonqualified deferral is in play, § 409A rather than the regulation governs the consequences of getting it wrong, and those consequences fall on the employee, not the employer.

Two practical checks. First, look at the deposit terms rather than the client’s description: the four items in Reg. § 1.451-2(a)(1)–(4) are exactly the features clients cite as reasons the money was not available, and the regulation says none of them counts. Second, where a rate varies with notice, the maximum rate is constructively received — so a client who took a lower rate by not giving notice still reports the higher figure.

How this has changed

The doctrine itself has not moved. Reg. § 1.451-2 is old, and the four non-limitations it lists for bank deposits read as a period piece — passbook accounts, withdrawal in even multiples, quarterly earnings periods. That antiquity is worth noticing rather than dismissing: the reasoning transfers to modern products, but the regulation’s examples do not describe anything a client will recognise, so the text has to be applied by analogy rather than quoted at them.

What has changed around it is the statutory overlay. Before IRC § 409A, a failed deferral arrangement produced ordinary constructive receipt and nothing more. Since § 409A, the same failure includes every prior year’s deferral, adds interest computed from the year of first deferral rather than from the failure, and adds a further amount — all imposed on the participant. So the practical stakes of the timing question are far higher than the doctrine alone suggests, and material written before § 409A understates them badly.

The other movement is in the neighbouring provision rather than this one. IRC § 451(b) now requires an accrual taxpayer to treat the all events test as met no later than when the item is taken into account in an applicable financial statement. That does not touch constructive receipt, which is a cash-method doctrine — but it means “when is this income” now has two quite different answers depending on the method, and a page or a question that treats timing as one subject will conflate them.

Exam focus

Know the three limbs of Reg. § 1.451-2(a) — credited, set apart, otherwise made available — and the “could have drawn upon it had notice been given” extension.

Know that the escape is a substantial limitation or restriction, and that a taxpayer’s own choice is never one. Expect a year-end cheque or a matured deposit as the fact pattern.

Know the December dividend example, because it is the one case where the doctrine does not apply on facts that look as though it should.

For deferred compensation, know that the election must precede the earning, and that a § 409A failure reaches all prior deferrals with interest and an additional amount, payable by the employee.

Check yourself

1. A cash-basis consultant receives a cheque on 30 December and deposits it on 6 January. In which year is the income reported?

Answer: the earlier year. Under Reg. § 1.451-2(a) income is constructively received when made available so that the taxpayer may draw upon it at any time. The cheque was in hand and nothing restricted her control of it — choosing when to deposit is not a substantial limitation or restriction.

2. A savings account credits interest on 31 December, but the bank requires 30 days’ notice before any withdrawal. Is the interest constructively received?

Answer: yes. Reg. § 1.451-2(a)(4) provides that a requirement to give notice of intention to withdraw in advance is not a substantial limitation or restriction. The same paragraph adds that where the rate payable depends on the amount of notice given, earnings at the maximum rate are constructively received.

3. A corporation declares a dividend payable on 31 December and, following its usual practice, mails cheques that shareholders receive in January. When is it income?

Answer: in January. Reg. § 1.451-2(b) states this case expressly — although dividends are constructively received when unqualifiedly made subject to the shareholder’s demand, a dividend declared payable on 31 December and paid by the corporation’s usual practice of mailing cheques that arrive the following January is not considered constructively received in December.

4. An executive whose bonus has already been approved and set for payment asks to defer it to the next year. What are the consequences?

Answer: the amount is likely income in the current year, and the arrangement is exposed under IRC § 409A. The right had accrued and payment was set apart, so it was made available within Reg. § 1.451-2(a), and the executive’s own request is not a substantial restriction. If the arrangement is a nonqualified deferred compensation plan failing § 409A(a)(2), (3) or (4), § 409A(a)(1)(A)(i) includes all compensation deferred under the plan for this and preceding years to the extent not subject to a substantial risk of forfeiture, and § 409A(a)(1)(B) adds interest at the underpayment rate plus one percentage point from the year of first deferral together with a further amount — all payable by the executive.