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Constructive Receipt Doctrine

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John G. Hodnette

Taxpayers intuitively believe they will not be taxed until they have cash or other consideration in their hands. However, the constructive receipt doctrine can cause immediate taxation before the taxpayer’s actual receipt of the asset. 

The doctrine is articulated in Reg. § 1.451-2(a), which states income “although not actually deduced 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.” That prevents a taxpayer from choosing the timing of income by, for example, asking an employer to hold earned income and pay it instead in a future year. 

The regulations also provide “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.” One example is a benefit plan, where an employee may be entitled to payment, but only upon a triggering condition, such as the employee’s retirement. In contrast to an employee’s requesting an employer to delay payment, in that case, the condition for payment has not been met, and the income has not been constructively received by the taxpayer.

Another example is an escrow established in a merger or acquisition. Escrows that secure indemnification obligations do not result in constructive receipt by the seller because, until the lapse of the indemnification period, it is unclear whether the funds will be paid to the seller. Restrictions on access to funds in escrow “must serve a bona fide purpose of the purchase, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the purchaser.” SeeRev. Rul. 79-91. Any such restriction must be imposed before the right to receive the income occurs. See FSA 200151003. A limitation based solely on the passage of time is not sufficient. These rules prevent a taxpayer from having the right to the income but claiming an escrow defers taxation. An arrangement is not effective to defer taxation if the only restriction to the seller’s access to funds is the passage of time.

John G. Hodnette is a partner with Fox Rothschild, LLP in Charlotte