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© 2008 by Steven J. Willis. All Rights Reserved. 1

THE CONSTRUCTIVE RECEIPT DOCTRINE

I divide cases involving the constructive receipt doctrine into three general categories:

Traditional cases involving an offer and refusal.

Taxpayer control cases in which the taxpayer is related to or has control over

the payor.

Delay cases, in which the taxpayer and payor contract to defer payment.

The First Circuit explained the purpose of the doctrine and the necessity of the "refusal" requirement in an early case:

The doctrine of constructive receipt was, no doubt conceived by the Treasury in order to prevent a taxpayer from choosing the year in which to return income merely by choosing the year in which to reduce it to possession. Thereby the Treasury may subject income to taxation when the only thing preventing its reduction to possession is the volition of the taxpayer.1

Despite the evolution of the doctrine as a government weapon to prevent

timing manipulations, it is also available for use by taxpayers, as shown below. In addition, it is not a doctrine to be used frequently, but rather is to be used sparingly.2

Courts have also held the doctrine to raise primarily a question of fact. As a result, an appellate court will reverse a trial court on the issue only if the trier of facts findings were clearly erroneous.3

1. Traditional Cases

Although the three categories of cases - traditional, delay, and taxpayer control - arise in three distinct fact patterns, they nevertheless each involve the same underlying legal factors which give rise to the traditional constructive receipt doctrine. Two of the four main factors appear in treasury regulations, a third arose in the courts, while the fourth is implicit. The regulation provides:

Income although not actually reduced 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

1 Ross v. Commissioner, 169 F.2d 483, 491 (1st Cir. 1948). 2 Rev. Rul. 60-31, 1960-1 C.B. 174 (1960). 3 Baxter v. Commissioner, 816 F.2d 493 (9th Cir. 1987), rev'g the Tax Court after finding the application of the constructive receipt doctrine to be clearly erroneous. See also, Bennett v. United States, 293 F.2d 323, 326 (9th Cir. 1961).



he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.4

The two regulatory factors are thus: (a) availability and (b) the absence

of substantial limitations or restrictions. Courts have added a third factor: (c) knowledge. And, implicit in the regulation is a fourth factor: (d) a taxpayer refusal to accept the offered value.

a. Availability

In describing the "availability" requirement, the government has

described the payor as one who must be "ready," "willing," and "able" to pay.5 "Ready" and "willing" do not appear to be factors commonly disputed: either the payor was willing or not. "Ability to pay," however, is a different matter. A case in which the payor wanted to pay, but lacked the funds to do so, would not normally give rise to constructive receipt. Two notable cases put an interesting gloss on the "lack of funds" exception.

(1) Wright v. U.S.

In this 1991 Ninth Circuit case the taxpayer had invested money at a high interest rate in what was later determined to be a classic Ponzi scheme. She had the right to withdraw accrued "interest" from her investment account at the end of the year, but, instead, left her money on account. In reality, the borrower had been using new deposits to pay "interest" on old deposits. He did not have the money to pay interest to the taxpayer; however, he could easily have embezzled sufficient funds, had she demanded payment. The Ninth Circuit held that she had constructive receipt of the amount offered to her.6 The payor's ability to steal the funds and apparent willingness to do so - on demand - was sufficient to make him a "ready, willing, and able" payor. Thus, the funds were "available" to the taxpayer, without restriction, and she turned them down.

(2) Ohio Battery & Ignition Co. v. Commissioner7

A second interesting scenario involves the related taxpayer type of

constructive receipt, rather than the traditional type. The taxpayer was an accrual corporation controlled by two brothers and their wives. The corporation owed salaries to the owners but lacked the funds to pay; however, the corporation easily had the borrowing power to obtain the funds and the owners had the actual power and authority to cause the corporation to borrow the money. The court found that the corporation was not only ready and willing to pay, but also that it was "able" to pay because of its borrowing power, which it

4 Treas. Reg. §1.451-2(a) (1994) (emphasis added). 5 Id. 6 Wright v. Commissioner, 931 F.2d 61 (9th Cir. 1991). 7 5 T.C. 283 (1945).



could easily exercise. As a result, it was merely the lack of the owners' action that caused the delay in receipt. The court found that lack of action to be a sufficient refusal and thus held the owners to have had constructive receipt of the income.8

b. Without Substantial Limitations or Restrictions.

A second major factor of constructive receipt provides that if the amount available to the taxpayer is subject to substantial limitations or restrictions, no constructive receipt exists. Typically, "substantial limitations" involve the taxpayer forfeiting some value, having to take other significant action first, or having to travel a significant distance to receive the funds.

A common example of constructive receipt involves interest credited to a bank savings account, which the taxpayer may withdraw without restriction. If he withdraws the interest, he has actual receipt; if instead he leaves it on deposit, he nevertheless has constructive receipt of the income. The payor - the bank - is "ready, willing, and able" to pay without any "substantial limitation" other than requiring a withdrawal slip. The depositor's failure to withdraw the funds constitutes the requisite "refusal" and thus triggers the constructive receipt doctrine. In contrast, many savings plans subject a depositor to a substantial penalty for early withdrawal of funds, including interest. The treasury regulation posits a taxpayer who must forfeit three months interest on a twelve month certificate of deposit if he makes an early withdrawal. According to the regulation, that would constitute a substantial limitation or restriction.9 Note that the forfeited interest in the regulation example would constitute 25% of the total interest earnable on the deposit. If, instead, the certificate had a much longer term, or if the forfeited amount were significantly less, the answer would apparently be different.10

A second example of a "substantial limitation" involves the need for the

taxpayer to win a lawsuit in order to collect the money. Such a restriction appears obviously to moot the existence of constructive receipt for two reasons: it is surely "substantial" and it negate the "willingness" of the payor, another essential factor. Nevertheless, at least one court found such a limitation not to

8 Id. at 288. The issue before the court involved the deductibility of the salaries by the corporation. I.R.C. section 24(c)(2) then denied a deduction by an accrual taxpayer if it arose from a payment owed to a related cash method party unless the related party included the amount within 2-1/2 months of the deduction year. Absent application of the constructive receipt doctrine to the owners, the corporation would have lost its deduction because the salaries were not actually paid within the requisite time period. I.R.C. section 24 (1945) was the forerunner to I.R.C. section 267 (1995), which now provides for a mere delay of the deduction rather than an absolute bar. 9 Treas. Reg. § 1.451-2(a)(2). 10 The cited regulation does not provide similar examples of an insubstantial forfeit restriction. If the term of the certificate were greater than one year, I.R.C. sections 1272 through 1275 may require the accrual of the interest, which would moot the constructive receipt question because as to that item, the taxpayer could no longer use the cash method.



be substantial! In U. S. v. Hancock Bank,11 a 1968 decision, the Court of Appeals for the Fifth Circuit oddly found a taxpayer in constructive receipt of funds, payment of which was delayed for seven years pending the outcome of a state lawsuit. The court distinguished earlier cases finding lawsuit prerequisites to be substantial by questioning the merits of the suit involved. The court noted that the obstacle to payment was "wholly without legal basis" and thus was "insubstantial." In other cases, the court explained, the legal challenges to payment had some merit. Surely the decision is faulty. Not surprisingly it has been questioned. For example, the Tax Court, in a 1977 decision doubted the validity of Hancock Bank, finding that a payor's recalcitrance, however lacking it may be in merit, vitiates constructive receipt.12

A third example of a "substantial limitation" involves an offer of less than the amount claimed. If the offer amounts to an "accord and satisfaction" of the debt such that acceptance bars a claim for an additional amount, then constructive receipt does not result.13 However, if state law permits the payee to accept the tendered amount without prejudice to his rights, then the refusal of the offer does indeed amount to constructive receipt. For example, in a memorandum opinion,14 the Tax Court considered a taxpayer who refused a commission check in the amount of $1,500, claiming that substantially more was due. Under New York law, he could have endorsed the check "without prejudice" or "under protest" and thereby received the $1,500 and still retained his claim for more. The need for such an endorsement did not amount, in the eyes of the court, to a "substantial limitation"; therefore, the taxpayer had constructive receipt of the funds.

A fourth example of a substantial limitation involves the need for the taxpayer to travel some distance to obtain the funds. "How far is too far?" is the obvious question. Naturally some context is necessary: forty miles might be too distant for a small sum - perhaps a few thousand dollars - to be considered truly available,15 while it might be insignificant for large amounts. Several cases and a ruling have discussed the issue specifically.

(1) Baxter v. Commissioner16

In 1987, the Ninth Circuit reversed the Tax Court and essentially found

that an 80 mile round-trip was "too far" in a case involving a check for $13,095. The court thus rejected the application of constructive receipt. The taxpayer was due commissions for the year 1978. The payor prepared a check dated

11 400 F.2d 975 (5th Cir. 1968). 12 Byler v. Commissioner, 67 T.C. 878, 886-87(1977) 13 Bones v. Commissioner, 4 T.C. 415, 420 (1944); Griffith v. Commissioner, 35 T.C. 882, 891 (1961). 14 Stoller v. Commissioner, 46 T.C.M. 345 (CCH) (1983). 15 The "available" requirement and the "substantial limitations" requirement overlap, to some extent. 16 816 F.2d 493 (9th Cir. 1987).



December 30, 1978 (a Saturday), and informed Mr. Baxter, who admitted "the check was available to him in 1978 if he wanted to pick it up."17 Several points are worth noting.

First, the circuit court explained "The Tax Court properly put no weight on the fact that [the payor] reported the payment as a deduction in 1978 and the fact that Baxter originally reported the payment as 1978 income, only later correcting this report as mistaken."18 Note that treatment by the payor and payee - separate taxpayers - need not be consistent.19 Even if the deduction by the payor was erroneous (which it was), we do not correct such an error by creating another error in treating a different taxpayer - the payee. Instead, the error would be correctable in an action involving the error year and the deducting taxpayer. Note also that Baxter originally reported the income in 1978, later amending his return to exclude it. Because "constructive receipt" involves a question of fact, his procedural treatment was proper: to correct his alleged error, he properly filed an amended return.

Second, note four significant facts the court listed.20 The distance was 80 miles. The payment was by check, rather than currency. The amount was $13,095. The day was a Saturday and banks would not reopen until January 2, 1979, the following Tuesday. Unfortunately, the court did not weigh the factors. Had the offered payment been in currency, rather than by check, the result may have been different because another of the significant facts would have disappeared: the closure of the banks would have been irrelevant because Baxter would have had immediate use of the funds.21 Or, if December 30th

17 Id. at 494. 18 Id. 19 Apparently the payor took the generally correct position that a check is considered cash. Under that proposition, payment by check constitutes actual payment by a cash method taxpayer, assuming the check ultimately clears. Kahler v. Commissioner, 18 T.C. 31 (1952); cf., Treas. Reg. § 1.170A-1(b). In this case, however, the payor did not deliver the check until 1979, despite its availability to Baxter in 1978. Under the Vander Poel decision, this would not amount to a constructive payment and should not have given rise to a deduction. Vander Poel, Francis & Co. v. Commissioner, 8 T.C. 407 (1947). Nevertheless, the payor's treatment, however incorrect, has no legal significance in a case involving an unrelated recipient. Generally the inconsistent treatment would be the mirror image of Baxter: the government might more likely deny deduction by the payor, while requiring inclusion by the payee. This follows from Vander Poel, which rejected the existence of a "constructive payment" doctrine. Thus payees who refuse offers may trigger inclusion by themselves while precluding deduction by the payor.

I also note with some interest the Ninth Circuit's seeming ease with this issue - permitting inconsistent treatment by a payor and a payee - considering the circuit's later insistence on application of the supposed "matching principle" which allegedly requires payors and payees to act consistently. Albertsons v. Commissioner, 42 F.3d 537, (9th Cir. 1994), rev'g 12 F.3d 1529 (1993). 20 816 F.2d at 495. 21 This raises an interesting issue. Can a taxpayer have constructive receipt of a check or a cash equivalent, or even of the economic benefit of such an instrument? Generally one can; however, application of the doctrines in combination is problematic.



had been a banking day, the "limitations" faced by the taxpayer would have been less. Whether that would have caused them to be "insubstantial" is worth asking. Also, I wonder about the dollar amount: if it were substantially greater - suppose by a factor of ten - the distance involved would surely have been insignificant. But, would the combination of a check on a Saturday have been enough to bar constructive receipt? I suspect not; however, the court did not say.

(2) Paul v. Commissioner22

This Tax Court Memorandum opinion is most notable for its clarity. The taxpayer won a state lottery on December 29, 1987 in the amount of $1,087.50. Although he did not file his winning claim until 1988, he could have traveled 136 miles round-trip to do so on either December 30 or 31. Whether he could have then received the money or a check was not clear. Even assuming he could have been paid, the court found the distance to be too far, explaining "We will not confront taxpayers with the choice of traveling long distances to claim funds or face application of the doctrine of constructive receipt."23

(3) Hornung v. Commissioner24

This famous decision involved a substantially greater distance than did the two cases discussed above. In it, the court also decided against constructive receipt. The opinion is noteworthy mostly for its interesting facts.

Paul Hornung was selected as the most valuable player in the N.F.L.

championship game played on December 31, 1961, in Green Bay, Wisconsin. Following the game, at approximately 4:30 p.m., he learned that he had won a Corvette automobile, worth $3,331.04, which was available to him in New York City. He actually received the car three days later at a luncheon in New York. Hornung failed to report the award as gross income in any year and consequently received a notice of deficiency concerning it for 1962, the year of actual receipt. At trial, he maintained alternatively that the award was an excludable "gift" and that it was constructively received in 1961 (which by then was apparently a closed year).

The court rejected both taxpayer arguments. As to constructive receipt,

the opinion emphasized two points: (1) the distance involved - Green Bay, Wisconsin to New York City; and, (2) the date - a Sunday when the dealership in possession was closed. Had the dealership been open, the distance involved would likely still have been "too far," considering the lateness of the time on New Year's Eve when the award was announced.

22 64 T.C.M. 955 (CCH 1992). 23 Id. The taxpayer in this case failed to report the amount in any year. When faced with a deficiency notice for 1988, he argued that the correct year for inclusion was 1987. 24 47 T.C. 428 (1967).



(4) Revenue Ruling 76-325 In a ruling subject to criticism on other grounds, the government properly

stated that the need for a taxpayer to go to the Post Office to retrieve a check, or to his place of employment, is not a substantial limitation.

Rev. Rul. 76-3 976-1 C.B. 114

****

The individual, who uses the cash receipts and disbursements method of accounting and files Federal income tax returns on a calendar year basis, elected to receive severance pay following abolishment of the individual's position. The employer, following its usual practice, sent the payment to the separated employee by certified mail with return receipt requested. The individual was not at home on December 31, 1974, when the Postal Service attempted to deliver the certified letter containing the payment. An employee of the Postal Service left a Notice of Mail Arrival or Attempted Delivery indicating that the certified mail had arrived and could be picked up at a specific Post Office after 3 p.m. on that day. The specified Post Office was closed when the individual returned home later that day, and the individual was, therefore, unable to get actual delivery of the severance pay until January 2, 1975. The gross amount of the severance pay was included in the 1974 Wage and Tax Statement, Form W--2, that the employer furnished the individual in January 1975. ****

In Rev. Rul. 68-126, 1968-1 C.B. 194, a taxpayer received a retirement check drawn in late December and placed in the mail and delivered after the first of January of the following year, though the check had been available for personal delivery to the taxpayer on the last working day in December. That Revenue Ruling holds that the amount of the December check is includible in the taxpayer's gross income for the earlier year since the taxpayer could have received the check on the last working day of December by appearing in person and claiming it.

The facts of the instant case are similar to those in Rev. Rul. 68-126 because the check

was available to the taxpayer in the taxable year preceding the year in which the check was actually received. The individual's absence from home when delivery was attempted is not a limitation or restriction on receipt of the payment on that day and, thus, does not bar constructive receipt of the payment. Moreover, the fact that the Post Office was closed before the individual read the notice advising that the certified mail could be obtained there did not prevent constructive receipt. Accordingly, the severance pay is includible in the individual's gross income for the year ending on December 31, 1974.

The instant case is distinguishable from the case of S. L. Avery, 292 U.S. 210 (1934),

XIII-1 C.B. 131, wherein the Court concluded that a dividend check mailed on December 31 was not constructively received by the shareholder in December, and the amount of the check was not includible in the gross income of the recipient until the following year when the check was received in the mail. In the Avery case, the corporation intended to and customarily mailed the dividend checks on December 31, so that such checks could not and did not reach the shareholders until January of the following year. Furthermore, there was nothing to show that the shareholder could have obtained payment on December 31.

The above ruling's conclusion that travel to a local Post Office or place of

employment is not "too far" and thus is not a "substantial limitation" is

25 Rev. Rul. 76-3, 1976-1 C.B. 114.



uncontroversial. However, the inability of the taxpayer to obtain the check because the Post Office was closed at the time she learned of the certified letter would seem to raise a significant question as to whether the check was truly "available" to her during the taxable year. Had she known of the impending delivery and made herself unavailable to the postman, the result would be understandable.

In any event, Revenue Ruling 76-3 arose from actual litigation which the

government lost. The case - with facts slightly different from the ruling - raised the important issue of whether the taxpayer's knowledge of the available amount is relevant. That raises the third factor of the constructive receipt doctrine.

c. Knowledge. In a frequently cited memorandum opinion,26 the Tax Court understandably

rejected the government's assertion of taxpayer constructive receipt when the taxpayer "had no actual knowledge or expectation that the income would be available to her. . .." The 1978 decision - Beatrice Davis v. Commissioner - involved almost the same basic facts as Revenue Ruling 76-3.27

The taxpayer was entitled to $17,006.48 in severance pay. She received a

post office notice that a certified check was available for pick up at the post office, after three o'clock p.m., on December 31, 1974. She did not receive the notice until after five o'clock p.m., at which point the post office was already closed. She retrieved the letter on January 2, 1975, expecting it to be concerning a notice of a rent increase.

As in the above Revenue Ruling, the government argued in favor of

applying the constructive receipt doctrine, claiming that the funds were "unqualifiedly committed to petitioner on December 31, 1974 . . ." and were available to her at the Post Office.28 Although the court agreed that such a commitment coupled with availability is a prerequisite for constructive receipt, it added that "[i]mplict in availability is notice to the taxpayer that the funds are subject to his will and control." Such notice, the court found, was lacking because Davis had "no inkling that the certified mail was her severance pay."29

d. Refusal

26 Beatrice Davis v. Commissioner, 37 T.C.M. (CCH) 42 (1978). 27 Rev. Rul. 76-3, 1976-1 C.B. 114. The Tax Court opinion noted that Davis applied for a ruling on the constructive receipt issue but did not receive the adverse ruling until after she filed her 1974 return. "Apparently [her] circumstances became the subject of Revenue Ruling 76-3. . .." Davis v. Commissioner, 37 T.C.M. at n. 3. 28 Id. 29 Id. at 48.



The fourth factor in the doctrine involves the refusal of the taxpayer to accept the available payment. The refusal need not be overt in the sense that the payor presents the funds and the payee responds "I refuse." Instead, the refusal can be a mere failure to act after the payor makes the funds available without restriction. For example, recall the regulation illustration of the failure to withdraw interest credited on a bank deposit. The depositor's failure to withdraw the available interest constitutes the requisite "refusal."30 Two court decisions provide pertinent illustrations.

(1) Loose v. U.S.31

The taxpayer and his wife invested in coupon bonds, which naturally

required regular presentation of the coupons for collection of the interest earned. They kept the bonds, with the coupons attached, in a safe deposit box. Because of illness, they were unable to enter the box to clip the coupons and then present them. The court held that they nevertheless had constructive receipt of the interest income in the years the coupons matured. The funds were available without substantial restriction or limitation and the taxpayers failed to demand payment. As the court explained, someone other than the taxpayers could have been appointed to handle the matter.

(2) Rosenbaum v. Commissioner32

The taxpayer and her estranged husband invested in various mutual

funds. He managed the accounts; however, she was entitled to one-half the assets and income. Because of the marital separation, she failed to demand her one-half of the income for a particular year. The court held that passive failure to act to be a sufficient "refusal" such that it triggered application of the constructive receipt doctrine33

2. Taxpayer Control Cases

The four main factors of constructive receipt - a willing payor, available funds, the absence of substantial restrictions, and a refusal - apply to this type of case, as they do in more traditional instances. The cases differ from those described above because, in them, courts apply the doctrine despite the apparent lack of one or more of the necessary factors. They do so when sufficient payee control exists over the payor, and the two are sufficiently related, such that the missing factor is not truly "missing." As shown in the cases discussed below, payee control of the payor is not always sufficient: courts consider the various factors carefully and do not apply the doctrine liberally.

30 Treas. Reg. § 1.451-2(a). 31 74 F.2d 147 (8th Cir. 1934). 32 998 F.2d 1016 (7th Cir. 1994). 33 Id.



a. Modern Cases

Much of the litigation involving taxpayer control arose under a prior

statute, discussed below. Those cases retain some importance; however, I consider them separately because the statutory change greatly lessens their importance. Other cases, not involving the changed statute, are of greater interest.

(1) Hyland v. Commissioner34

In 1942, the accrual method corporation authorized compensation to a person who owned 85% of the corporate voting stock. Payment was scheduled for 1943, when it was actually made. The shareholder had no actual knowledge of the authorization and lacked the ability to write checks. In addition the corporation had insufficient cash to pay in 1942. The shareholder failed to report the amount until 1946, and then did so on a return amending 1942, claiming to have had constructive receipt of the amount in that year.35 The court disagreed and required inclusion in 1943.

The court emphasized that control by the shareholder was an insufficient

reason for application of the constructive receipt doctrine. If it were to apply, the court reasoned, controlling shareholders would have constructive receipt of all corporate earnings and profits, which would be contrary to the workings of subchapter C. Instead, the court emphasized two important facts: the amount was not yet due and the shareholder lacked authority to write checks. The court was thus willing to respect the corporate form. Even though the taxpayer could have authorized current payment and he could have assumed check writing authority, he had not done so. Thus the necessary factors for constructive receipt were lacking.

(2) Miele v. Commissioner36 This case reached a result quite different from that of Hyland. The facts

were sufficiently different, however, such that both cases are defensible.

The taxpayer and his partner were attorneys. They properly maintained a client trust account into which they deposited pre-paid and unearned legal fees and for which they properly acted as the trustees.37 As was also proper,

34 175 F.2d 422 (2d Cir. 1949). 35 Tax rates increased after 1942, which ostensibly was the motivation behind the taxpayer choice of year. 36 72 T.C. 284 (1979). 37 Penn. Code Prof. Resp. DR 9-102(a).



they did not draw on the account until the fees were earned.38 Once such fees were earned, their typical practice was to promptly withdraw them by way of writing a check, as trustees, to the partnership. They followed this practice for the months January through October of each year, typically making four annual transfers; however, they would delay paying over fees earned in November and December until the following January. As a result, they did not report the delayed fees in the year earned - and in which they could have been paid over; instead, they reported them in the following year - the year of actual receipt.

The Tax Court considered three government arguments:

(1) whether pre-paid fees for services are necessarily income;

(2) whether the taxpayers had constructive receipt of the trust funds; and

(3) whether the rules governing changes of accounting methods apply to these taxpayers.

The court first considered application of the trilogy of Supreme Court

decisions culminating in Schlude v. Commissioner39 and the proposition that "prepaid service income is taxable in the year received even though the services are to be performed in the future."40 The court properly rejected the government's position: the three cases applied to accrual method taxpayers which were forced to use the cash method of accounting for some purpose. The instant taxpayers were already using the cash method. The court, instead, considered the application of a different Supreme Court opinion applying to cash method taxpayers: North American Oil,41 which created the "claim of right" doctrine.42 The court nevertheless also properly rejected application of this case because the taxpayers lacked the requisite "unrestricted use" of the trust funds. State disciplinary rules, which they followed, required that the funds be kept in a trust account separate from taxpayer funds.

Next the court raised the constructive receipt doctrine and found it partially applicable. At the end of 1972 the firm trust account had a balance of $68,199, of which $35,623.75 had been earned. The court decided that the unearned portion - $32,575.25 - was subject to "substantial limitations," namely the disciplinary rules preventing disbursement. However, the court also found the earned portion to have been constructively received. The trust was a willing payor, the money was available without restriction, and the taxpayers "refused" the funds by choosing not to pay them over to themselves.

38 All jurisdictions require that unearned fees be deposited into a client trust account. Jurisdictions vary, however, as to whether pre-paid but earned retainer fees must be so deposited. 39 372 U.S. 128 (1963); American Automobile Assoc. v. U.S., 367 U.S. 687 (1961); Automobile club of Michigan v. Commissioner, 353 U.S. 180 (1957). 40 72 T.C. at 289. 41 North American Oil v. Burnet, 286 U.S. 417 (1932). 42 Id. at 424.



Finally, the court considered an important error correction device: that

involving a change of accounting method. Had the taxpayers merely failed to include the constructively received amounts in a single year, the matter would have involved two true errors - the erroneous exclusion and the erroneous inclusion the following year. Each would have been correctable by amended returns and/or notices of deficiency. Had the involved years been closed, correction would have been barred by the statute of limitations, absent the application of the mitigation provisions.43

But the matter did not involve a single erroneous exclusion followed by a

single erroneous inclusion. Instead, it involved a series of annual erroneous exclusions and inclusions. That, the court stated, amounted to a method of accounting, despite its erroneous nature. And, the court's decision requiring proper application of the constructive receipt doctrine amounted to a change of accounting method. As a result, the court approved application of section 481(a), applying to change of accounting methods. This section, covered in Chapter Six, effectively permits prospective correction of errors related to a changed accounting method, including those for which the statute of limitations bars correction. As explained in Chapter Six, the application of this correction device to a case such as Miele is controversial.

b. Section 267 Cases

Most taxpayer control cases considering the constructive receipt doctrine

arose under a predecessor to current section 267.44 Today, section 267(a)(2) defers deductions by payors who are "related" to their cash method payees. The deferral continues until the year in which the payee must include the corresponding income. The section is important, but its consequences are not overwhelming because it involves only timing.

In contrast, prior to 1984, section 267(a)(2) disallowed deductions by payors "related" to cash method payees unless the payee had to include the amount in income within 2-1/2 months of the end of the payor's year of attempted deduction. The disallowance was absolute: a tardy payment (or other inclusion event) did not revive the deduction, although it, of course, still resulted in inclusion by the payee.

The section thus became a significant trap for the unwary small accrual method business owned by a cash method individual. Amounts owed by the business entity to the owner had to be actually paid - or at least constructively received - no later than the end of the 2-1/2 month period. As might have been

43 The matter would have involved a likely application of a section 1312 (1) circumstance of adjustment: a double inclusion of an item of income. Still, for mitigation to have applied, the other six factors of mitigation would have been necessary. 44 I.R.C. § 267.



expected, many entities failed to make payments in time and thus faced loss of significant deductions even though the related owners were nevertheless required to include the applicable amounts.

As a result, the entities often claimed that in fact the owners had such control over the corporation that they had actually constructively received the amounts when they became owed, which was also the appropriate time for accrual of the deductions. Many such cases arose; however, courts were careful in applying the constructive receipt doctrine. As was true in the 1949 Hyland case, too broad an application - on the theory that controlling shareholders can always require the distribution of earnings - would result in the unfortunate situation of owners always having constructive receipt of earnings and profits. This would seriously undermine subchapter C and would not likely be defensible. Nevertheless courts have been willing to consider the taxpayer arguments.

(1) Lacy Contracting45

The corporation Board of Directors authorized bonuses totaling $15,000 to be divided among four officers, of whom Lacy was one. As of the end of the year, the apportionment had not occurred. Mr. Lacy had the power to effect it.

The Tax Court held that none of the officers had constructive receipt of the bonuses because the individual amounts remained indefinite. The court even applied this reasoning to Lacy, who had the power to fix the amount of his own bonus. The result and logic were similar to that used in Hyland, in which the court respected the corporate entity. Even though Lacy had the power to fix his bonus, he had not yet exercised that power. As a result, he did not have constructive receipt of the amount involved. Because he did not actually receive the amount within 2-1/2 months of the corporation's year end, the corporation permanently lost its deduction under section 267.

(2) Lombard46

In this memorandum decision, the Tax Court considered an accrual method corporation which had an informal oral agreement with the controlling shareholder to pay a bonus and monthly salary. The amounts of the bonus and salary were sufficiently determined such that the corporation accrued them as deductions. The government successfully argued, however, that section 267 disallowed the deductions because the shareholder neither actually nor constructively received the amounts within 2-1/2 months of the corporate year end.

45 56 T.C. 464 (1971). 46 38 T.C.M. 1158 (CCH) (1979).



The court explained that "the mere power to receive funds is insufficient to justify a finding of constructive receipt. . . The corporation must take the necessary action to set the funds apart and the taxpayer must have the unrestricted right to demand payment." In this case, the corporation had determined the amount owed, such that it could accrue the deduction, but it had not formally authorized payment. The court also explained that the shareholder's power to force the corporation to authorize payment was insufficient because the shareholder had not yet exercised that authority. Thus, the shareholder laced constructive receipt of the amount. As in Hyland, the corporation consequently lost its deduction.

In at least one other case, the Tax Court also found against the existence of constructive receipt because of the lack of a formal authorization of payment.47 In contrast, some courts have decided the opposite way. For example, in Fetzer Refrigerator Co. v. United States,48 the Court of Appeals for the Sixth Circuit found constructive receipt by a controlling shareholder who had the authority to write checks. The amount involved was due and the cash was available. Because the amounts involved rental payments, strict authorization was not necessary. The court thus distinguished cases requiring such a formality to precipitate constructive receipt. Similarly, in a 1979 memorandum decision,49 the Tax Court found constructive receipt of authorized salary by an officer/controlling-shareholder who had authority to write checks. The court was unconcerned with the taxpayer's claim that the corporation lacked the ready cash to pay the salary.

3. Delay Cases

This category of constructive receipt cases involve agreements between the payor and payee to defer payment. The central issue, as a result, concerns whether such a payee agreement amounts to a refusal of the amount involved. If so, then that important factor of constructive receipt would exist and the doctrine may apply.

Three important cases illustrate this category: Cowden, Veit I, and Veit II.

a. Cowden v. Commissioner50 Most often cited as a case illustrating the cash equivalency doctrine, this

decision is also an important part of constructive receipt analysis. For a cash

47 Kaw Dehydrating Co. v. Commissioner, 74 T.C. 370 (1980). 48 437 F.2d 577, 579 (6th Cir. 1971). 49 Congleton v. Commissioner, 38 T.C.M. (CCH) 584 (1979). Section 267 was not a factor in this decision because the corporation actually paid the salary within the requisite 2-1/2 months. The only issue was whether the recipient had income in the year of actual receipt of in the prior year of constructive receipt. 50 289 F. 2d 20 (5th Cir. 1961)



method taxpayer to avoid currently recognizing income, he must avoid all three of the cash method doctrines that trigger income. He must 1) avoid constructive receipt of the amount involved, 2) avoid receiving a cash equivalent, and 3)avoid receiving the economic benefit of the amount. The Cowdens were successful in avoiding constructive receipt; however, they unfortunately failed to avoid the second cash doctrine, cash equivalency For that failure the case is famous; however, the illustrative of their partial success is also helpful.

In 1951, the Cowdens executed a mineral lease to an oil company,

which agreed to pay $511,192.50 as an advance or bonus payment. Apparently, the company was ready, willing, and able to pay the entire bonus at the execution of the lease. The Cowdens, however, did not want all the money up front. Thus, the Cowdens refused to enter such an agreement, and instead entered an agreement with the oil company for bonus payments of $10,223.85 in 1951, $250,484.31 in 1952, and $250,484.34 in 1953. Later in 1951, the Cowdens sold the right to the 1952 payments for a small discount. Again, in 1952, they sold the right to the 1953 payments.

In reporting the payment assignments, the Cowdens characterized the

proceeds as long-term capital gain. Apparently, their plan all along was to defer payments for at least six months and then to take the position that the sale of the notes constituted the sale of a capital asset held long-term. That argument was seriously flawed in that the notes were almost certainly ordinary income substitutes and thus not capital assets. At the time of the litigation, however, jurisprudence concerning the "acceleration of income doctrine" and "carve-outs of ordinary income" was in its infancy.51 In any event both the Tax Court and the Fifth Circuit decided the case on other grounds.

According to the Tax Court, the Cowdens had ordinary income in 1951 to the full extent of the $511,192.50. In the eyes of the court, the contracts amounted to cash equivalents at the moment they were executed. It reasoned that "the bonus payors were perfectly willing and able at the time of execution of the leases and bonus agreements to pay such bonus in an immediate lump sum payment . . . and . . . that the sole reason why the bonuses were not immediately paid in cash upon execution of the leases involved was the refusal of the lessor to receive such payments."52

The Fifth Circuit disagreed with the Tax Court analysis. Essentially the Tax Court confused the doctrines of constructive receipt and cash equivalency: while the court described the notes as “cash equivalents,” it used language reminiscent of the constructive receipt doctrine. Although the Circuit Court did

51 P.G. Lake v. Commissioner, 356 U.S. 260 (1958). For a discussion of the doctrine, see Charles Lyon & James Eustice, Assignment of Income: Fruit and Tree as Irrigated by the P.G. Lake Case, 17 TAX L. REV. 293 (1962). 52 32 T.C. 853, 858 (1959).



not distinguish the doctrines as bluntly as I would, it nevertheless explained them clearly:

The taxpayers had the right to decline to enter into a mineral lease of their lands except upon the condition that the lessee obligate itself for a bonus payable in part in installments in future years, and the doing so would not, of itself, subject the deferred payments to taxation during the year that the lease was made. Nor would a tax liability necessarily arise although the lease contract was made with a solvent lessee who had been willing and able to pay the entire bonus upon the execution of the lease. While it is true that the parties may enter into any legal arrangement they see fit even though the particular form in which it was cast was selected with the hope of a reduction in taxes, it is also true that if a consideration for which one of the parties bargains is the equivalent of cash it will be subjected to taxation to the extent of its fair market value. Whether the undertaking of the lessee to make future bonus payments was, when made, the equivalent of cash and, as such, taxable as current income is the issue in this case.53

Those two paragraphs teach two important lessons: the first as to

constructive receipt and the second as to cash equivalency.

The constructive receipt lesson is this:

A cash method taxpayer may successfully agree to defer income, so long as he enters the agreement before (or along with) entering the contract which creates the income. That the payor may have been otherwise ready, willing, and able to pay the amounts involved is irrelevant, for in a successful delay case, such a contract for payment would never be entered.

The Cowdens were successful in avoiding constructive receipt because the

original contract for the bonus payments provided for deferral of those payments to future years. Thus, under the contract entered, the payor was never ready, willing, and able to pay earlier, for it, too, agreed not to do so. The result may very well have been different had the Cowdens originally bargained for current payments and had they later sought to modify that contract. Such a modified contract providing for deferral will not necessarily avoid the constructive receipt doctrine. That is the subject of the other cases discusses below.

The cash equivalency lesson of Cowden is also important. Just because a

taxpayer successfully avoids having constructive receipt of a payment does not necessarily mean the taxpayer has no income: he must also jump through other cash method hurdles for deferral. The cash equivalent doctrine is one of those hurdles. As explained below, the Tax Court, on remand, determined that the Cowdens indeed had income in the first year.54 The reason, however, was not that they had constructively received any payments, for they had not. Instead, the promises they received were cash equivalents. I cover this issue in more depth, below.

53 289 F.2d at 23.

54 20 T.C.M. 1134 (1961).



A more recent case relying on the Cowden constructive receipt holding was

Worden v. Commissioner,55 a 1993 decision of the Court of Appeals for the Tenth Circuit. The taxpayer was an insurance agent entitled to large commissions (up to 90% of the initial premium) on life insurance policies sold. He contracted with some clients to waive his commission. The client paid him the net premium, which he remitted to the company. The Tax Court56 held Warden had income equal to his entitled commission and that he further could not deduct what amounted to an illegal rebate of the commission to his client. The Tenth Circuit disagreed, holding that he never had income in the first place, mooting the deduction issue. The court, relying on Cowden, explained that Warden successfully avoided actual or constructive receipt of the commissions by entering the waiver contract from the beginning. The court further explained that had the taxpayer received the money and then refunded it, the result would be different.

b. Veit v. Commissioner57

Veit contracted in 1939 to perform substantial management services in 1939 and 1940. In exchange, he was to receive $25,000 per year plus ten percent of the company profits. He was also to share in some company losses. The original contract provided that he was to receive the 1939 and 1940 bonus payments in July and October, 1941. Both bonuses were conditioned on his continued employment for the entire two-year period. On November 1, 1940, the company and Veit further contracted for Veit’s employment in 1941, for an additional salary and bonus. In addition - and at the request of the company - the new contract modified the original plan for payment of the 1939-40 bonus. The parties agreed to an amount due for 1939 and a payment schedule during 1940-41. Also, they agreed that if any bonus were due under the original contract for 1940, it would be payable, with interest, in 1942 rather than 1941 as originally planned.

Again, on December 26, 1941, the company and Veit entered another contract for employment in 1941 and 1943. This contract also deferred the most of the 1940 bonus - payable under the second contract in 1942 - until the years 1943 through 1946. As before, this deferral bore interest.

The government determined that the bonus money from 1943 through 1946 was constructively received by Veit in 1941. The Tax Court, however, disagreed:

The whole agreement of November 1, 1940, was an arm's length business transaction entered into by petitioner and the corporation which was regarded as mutually

55 2 F.3d 359 (10th Cir. 1993). 56 1992 T.C.M. 447. 57 8 T.C. 809 (1947)



profitable to both. The only way we should be justified in holding that petitioner constructively received the $87,076.40 in 1941 would be to hold that the agreement to defer the payment of such $87,076.40 until 1942 was a mere subterfuge and a sham for the purpose of enabling petitioner to postpone his income tax on the amounts involved to another year. The evidence does not justify such a holding, but on the contrary, seems to establish that the agreement to defer the payments until 1942 was an arm's length contract, arrived at in the ordinary course of the business. **** The corporation, being on the accrual basis, deducted in its 1941 return the full amount of the $87,076.40 as an accrued liability due Veit, and it was allowed the deduction. Its right to such deduction is not in any way affected by the outcome of this proceeding. Therefore, taking into consideration all the evidence, we fail to see where there is any justification for applying the doctrine of constructive receipt to the $87,076.40 in question. Petitioner cites and relies on Kay Kimball, 41 B.T.A. 940, as a case which strongly supports his contention. We think it does. In the Kimball case the taxpayer had transferred certain oil leases to a corporation upon an oral agreement on its part to pay Kimball $15,512.70 upon transfer, and, commencing on January 1, 1934 to pay him a proportion of the oil production until oil to the value of $114,250 had been received. Shortly prior to January 1, 1934, another oral agreement postponed this oil payment, so that payment was to begin September 16, 1936, and continue until oil of the specified value was received, together with an additional $15,000. The Commissioner assessed a deficiency for the years 1934 and 1935 on the theory of constructive receipt of the oil involved during those years. In its opinion, holding that the Commissioner's action was erroneous, the Board of Tax Appeals said:

* * * It is only by giving recognition to the first oral agreement entered into at the time the leases were assigned to the corporation that respondent has any semblance of reason for his determination that the individuals constructively received the income in question. If the parties had a right to make the first oral agreement, they had a right to make the second, and our only concern is whether these agreements actually existed and were intended as real, genuine, bona fide agreements between the parties. * * * ****

. We think we should point out that the evidence shows that in a subsequent

contract entered into December 26, 1941, the petitioner and the corporation changed the dates of the payment of the $87,076.40 here in question from four equal payments of $21,769.10 each in 1942 to five equal installments of $17,415.38 each during 1942, 1943, 1944, 1945, and 1946. We do not have the year 1942 before us, and we express no opinion as to whether this contract of December 26, 1941 operates to make inapplicable the doctrine of constructive receipt for the year 1942. In other words, we express no opinion as to the effect of the contract of December 26, 1941. In a subsequent opinion, dealing with 1942, the Tax Court determined

that Veit also had no constructive receipt as a result of the second deferral. This opinion is subject to significant criticism.

Two lessons flow from the two Veit cases. First, Mr. Veit successfully deferred income from 1940 until 1941 by way of the original contract. No one suggested that this deferral, entered upon the inception of the contract, was invalid. While this was not an issue in the case, it is consistent with the later holding on similar facts in Cowden.



The second lesson concerns the second deferral - under the first modification. Prior to the original due date of the bonus, prior to the date on which the amount was determined, and pursuant to a bona fide contract (at the behest of the employer) Veit successfully modified the original contract. That the court approved this, finding no constructive receipt, is significant. However, readers should rely on the decision cautiously, considering the court=s great emphasis on peculiar facts of the case. Nevertheless, this case, coupled with the earlier Kimball decision should provide significant comfort to taxpayers wanting to modify existing contracts to defer income - so long as they do so in a bona fide contract, prior to the original due date and at a time when the amounts are not fully earned. Exactly how far prior to the original due date is a valid and unclear issue. The Veit modification occurred approximately eight months prior to the due date, while the Kimball modification was “shortly before” such time. While neither court described the amount of time remaining as critical, common sense would suggest that at some point, modification is too late.

A more recent case involving the same issue appeared before the Tax Court in 1991: Martin v. Commissioner.58 The Martin taxpayers participated in an unqualified deferred compensation plan providing for benefits payable in ten equal annual installments, without interest. In 1981, the employer offered participants a new plan, which required surrender of the old plan and provided two new options: a lump sum payment or ten equal annual installments with interest. The new installments were apparently deferred beyond the original dates. The taxpayers agreed to participate in the new plan.

The commissioner claimed that the taxpayers had constructive receipt of the lump sum payments because an option to receive the lump sum was available to participants in the new plan. The Tax Court disagreed, relying partially on Veit. The court explained that the mere available of the lump sum option was insufficient to cause constructive receipt because the taxpayers chose not to accept that option at the beginning of the new plan. This rationale is actually more reminiscent of the Cowden case, in that it permits a taxpayer to enter a deferral contract so long as he does so from the very beginning. The case is also important for issues it does not raise, but nevertheless seems to rely on.

The Martin exchange of old plan rights for new plan rights could be viewed by some as a taxable event, which would support the government=s result. Under such a theory, the taxpayers would have an amount realized equal to the value they received, ostensibly the offered lump sum payments. The deferral would be unsuccessful because, involving rights which do not constitute “property,” it is outside the province of the section 453 installment sales provisions.59 The commissioner, however, did not appear to offer this

58 96 T.C. 814 (1991). 59 I.R.C. section 453 applies to sales of “property.”



argument and the court did not raise it. Instead, the court held that one deferred compensation arrangement could be exchanged for another, without triggering income. In that view, the case is an important re-affirmation of Veit.

c. Revenue Procedures 92-65 and 71-19

Effectively the government has restricted the Viet cases through two revenue procedures describing circumstances in which it will grant determination letters approving such deferrals. The primary restriction found in Revenue Procedure 71-19 requires that the deferral occur prior to the "beginning of the period of service." This directly contravenes both Veit decisions, each of which approved deferrals occurring after most (and in Viet II, all) of the services had been performed. Thus, reliance on Veit should be considered risky.

Rev. Proc. 92-65 1992-2 C.B. 428

July 27, 1992 ****

In each request for a ruling involving the deferral of compensation, the Service will

determine whether the doctrine of constructive receipt is applicable on a case by case basis. The Service will ordinarily issue rulings regarding unfunded deferred compensation arrangements only if the requirements of Rev. Proc. 71-19 are met and, in addition, the arrangement meets the following guidelines.

(a) Section 3.01 of Rev. Proc. 71-19 states that, if the plan provides for an election to defer

payment of compensation, such election must be made before the beginning of the period of service for which the compensation is payable, regardless of the existence in the plan of forfeiture provisions. The period of service for purposes of this requirement generally has been regarded by the Service as the employee's taxable year for cash basis, calendar year taxpayers. Rev. Rul. 68-86, 1968-1 C.B. 184; Rev. Rul. 69-650, 1969-2 C.B. 106; Rev. Rul. 71-419, 1971-2 C.B. 220. The Service will issue advance rulings under two exceptions to this general requirement, as follows:

(1) In the year in which the plan is first implemented, the eligible participant may make an

election to defer compensation for services to be performed subsequent to the election within 30 days after the date the plan is effective for eligible employees.

(2) In the first year in which a participant becomes eligible to participate in the plan, the

newly eligible participant may make an election to defer compensation for services to be performed subsequent to the election within 30 days after the date the employee becomes eligible.

(b) The plan must define the time and method for payment of deferred compensation for

each event (such as termination of employment, regular retirement, disability retirement or death) that entitles a participant to receive benefits. The plan may specify the date of payment or provide that payments will begin within 30 days after the occurrence of a stated event.

(c) The plan may provide for payment of benefits in the case of an "unforeseeable

emergency.'' "Unforeseeable emergency'' must be defined in the plan as an unanticipated emergency that is caused by an event beyond the control of the participant or beneficiary and that would result in severe financial hardship to the individual if early withdrawal were not



permitted. The plan must further provide that any early withdrawal approved by the employer is limited to the amount necessary to meet the emergency. Language similar to that described in section 1.457-2(h)(4) and (5) of the Income Tax Regulations may be used.

(d) The plan must provide that participants have the status of general unsecured

creditors of the employer and that the plan constitutes a mere promise by the employer to make benefit payments in the future. If the plan refers to a trust, the plan must also provide that any trust created by the employer and any assets held by the trust to assist it in meeting its obligations under the plan will conform to the terms of the model trust, as described in Revenue Procedure 92-64 **** [dealing with Rabbi Trusts]. Finally, the plan must state that it is the intention of the parties that the arrangements be unfunded for tax purposes and for purposes of Title I of ERISA.

(e) The plan must provide that a participant's rights to benefit payments under the

plan are not subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant or the participant's beneficiary.

The last two provisions of Revenue Procedure 92-65 demonstrate a

common confusion of various cash method doctrines. While the procedure deals with issues of constructive receipt, paragraph (d) deals with issues involving the economic benefit doctrine. While that paragraph correctly requires that the taxpayer not have the economic benefit of the deferred compensation, it does not involve "constructive receipt" issues and would be clearer if it were so labeled.

Of greater concern is paragraph (e), which raises issues involving the "cash equivalency" doctrine, under the guise of dealing with the constructive receipt issue. With the possible exception of the "anticipation" factor, the proscribed factors listed in that paragraph have nothing to do with the constructive receipt doctrine. In addition, they are not determinative of a cash equivalent. As shown below, a transferable note is not necessarily a cash equivalent. Also, it certainly does not, without more, indicate constructive receipt of the amounts involved. As a result, the Revenue Procedure imposes “constructive receipt” factors which have no basis in judicial or regulatory doctrine. Also, by using some - but not all – “cash equivalency” factors it may prompt false comfort in taxpayers: they may satisfy all the Procedure’s factors and thus conclude they are safe, when in fact they have merely satisfied one of three doctrines. In fact, a confusion of these issues is what prompted the Fifth Circuit's reversal and remand of the Tax Court's Cowden decision.

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