Tax issues

Constructive Receipt: Timing Is Everything

A fundamental principle in efficient tax planning is the contemplation of the timing of income and loss events. While this principle seems relatively elementary, determining when a tax item actually becomes taxable can be more complex.

Statutory Background
IRC Section 451 discusses rules for the timing of gross income inclusion, stating in part that any such item for a cash basis taxpayer will be included in gross income for the taxable year in which it is received.

This general rule applies unless the taxpayer is using a method of accounting such as accrual basis to compute taxable income that requires a gross income amount to be accounted for in a different tax period. For taxpayers using other accounting methods, such as cash and disbursements, income tax regulations stipulate that gross income includes amounts both actually and constructively received during the taxable year.

Constructive receipt is often difficult to determine. IRC Section 1.451-2(a) outlines the constructive receipt doctrine. It states that income, although not actually in a taxpayer’s possession, is constructively received in the taxable year during which it is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it during the taxable year if notice of intention to withdraw had been given. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

The Boccardo Case
This constructive receipt doctrine goes to the heart of a recent 9th Circuit Court opinion affirming the Tax Court’s decision to treat an extension of a seller-held note as a constructive receipt of income by the seller.

In the case, Sainte Claire, an S corporation, owned and operated real estate, including hotels, ranches, and manufactured-housing communities. During the period at issue, James Boccardo was the principal shareholder, owning 31.3 percent of its outstanding stock. He also was the company’s president, making everyday decisions for the company, which used the cash receipts and disbursements accounting method.

During 1968, Boccardo purchased two prune ranches from the company. He assumed the existing mortgages and gave the corporation a promissory note in the amount of $2.09 million that bore interest at the rate of 6.5 percent per year, payable semiannually, and provided for a balloon payment of the principal on or before Nov. 1, 1988.

Before the due date, he discussed with some board members the possibility of extending the note’s terms. However, he indicated that he would pay the balance on the original date of maturity if the corporation requested it.

In consideration for the extension, Boccardo offered to pay interest on the principal amount at the rate of 9 percent per year, saying he would rather pay interest to a company that he partially owned than a third-party bank. On Nov. 1, 1988, the date the note matured, the company’s board and shareholders unanimously voted to accept Boccardo’s proposal, extending the note’s due date until April 1, 1990.

In 1990 and again in 1991, the company’s board met and voted to extend the due date. At the 1991 meeting, the note’s due date was extended to April 1, 1994, using the original terms. In addition, during 1993, Boccardo paid the company $2.16 million — the original principal amount plus interest of $72,562. Also during that year, the company distributed the principal payment of $2.09 million to its shareholders. The company reported a gain on the sale of the two ranches in the amount of $2.09 million on its 1993 S corporation income tax return.

The Tax Court considered two principal issues. First, did the corporation constructively receive the principal amount of the note? Second, was the corporation able to collect the principal amount of the note at the time it was originally due?

The court determined that the evidence showed that when the corporation’s board first voted to renew the 1968 note, it had matured and the corporation had an unqualified right to receive the principal amount. Moreover, the court found that while Boccardo discussed extending his note with the board prior to the due date, the court was not completely persuaded that an agreement to extend the due date existed prior to the vote.

Accordingly, the court concluded that although "a taxpayer may effectively defer for tax purposes receipt of income payable pursuant to an agreement by entering into a superseding agreement prior to the time the income is due pursuant to the terms of the original agreement," this treatment does not apply in this case because an agreement to defer payment of the note was not made until the corporation had the right to receive the income.

In considering whether or not the corporation was able to collect the principal amount of the note when it was originally due, the court stated that despite the fact that no funds were transferred, set aside for, or otherwise made available to the corporation during 1988, such a direct crediting on the company’s books is not necessary to find constructive receipt. In addition, the court determined that the "obligor’s lack of ready cash does not prevent constructive receipt of an amount due [to] a taxpayer where the obligor has the ability to borrow the funds necessary for payment." The court held that the corporation’s voluntary choice not to receive payment is ineffective to prevent its constructive receipt of the principal amount of the note.

Thus, the corporation was treated as constructively receiving the principal amount of the 1968 note during 1988, which the corporation then re-advanced to Boccardo. The company was required to recognize in its 1988 taxable year the gain realized on the sale of the two ranches associated with the note.

In other words, the company triggered the tax that it otherwise had appropriately deferred on the installment basis. Although the corporation argued that both it and Boccardo had no tax avoidance or fraud in mind when they negotiated the extension of the note, this argument held no weight in the court’s analysis of the constructive receipt doctrine.

Lessons Learned
In the context of real estate, in order to avoid the potential constructive receipt of income, consider the timing when negotiating the extension of a purchase note.

Boccardo clearly indicates that an agreement to extend a purchase money note should be solidified prior to the date the note becomes due. As the old adage goes, timing is everything.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or and


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