Like many things in life, taxes are largely about timing. The method of accounting you use largely determines when you get to take deductions and have to recognize (and pay tax on) income. Virtually all individuals and many smaller businesses use the cash basis method of accounting. The cash method is based on the commonsense idea that you haven’t earned income for tax purposes until you actually receive the money, and you haven’t incurred an expense until you actually pay the money. In other words, you record income only when the money is received and expenses only when they are actually paid.
If you use the cash method, you might be thinking that you can avoid having to recognize income in the current year (and thereby lower your taxes for that year) simply by postponing receipt of the income until a later year. For example, if your employer pays you a Christmas bonus on December 24, can you avoid having to pay tax on the amount until the following year by not cashing the check until January? The answer is no. The reason is an IRS rule called constructive receipt.
If you’re a cash method taxpayer, you have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have physical possession of it. For tax purposes, constructive receipt is the same as actual receipt of income. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent receives it. The rationale for the constructive receipt rule is that if income is available to a taxpayer during the tax year, the taxpayer should pay tax on that income for that tax year.
Because of the constructive receipt rule, you cannot hold checks or postpone taking possession of property from one tax year to another to avoid paying tax on the income. For example, if you receive a paycheck at the end of the year, you must include it in your income for that year, even if you don’t actually deposit the check until the following year. According to the IRS, this is true even if you receive a valid check after banking hours on December 31 and can’t deposit the check until January.
However, there is no constructive receipt if there are substantial limitations or restrictions on your control of the money or property. For example, if your employer gives you a year-end bonus in December but tells you not to cash the check until January because there are not sufficient funds in the bank to cover the check, you don’t have taxable income until January when you cash the check.
The constructive receipt rule applies to all types of income including interest, compensation, dividends, and rent.
Generally, there is constructive receipt of income when interest is posted to your savings or checking account. It makes no difference if you don't actually withdraw or spend the interest, or don't have the bank record the interest in your passbook.
If you have a certificate of deposit (CD) or some other deferred interest account, interest can be paid one or more times per year, or in one lump sum at maturity. Generally, you have to report the interest as income when you actually receive it or when you can withdraw money from the CD without paying a substantial penalty.
If you withdraw funds from a deferred interest account before it matures and you have to pay a penalty, you must report the total amount of interest paid during the year without subtracting the penalty.
Cash basis taxpayers must include in their annual income all the compensation they were entitled to receive during that year. You can’t delay paying tax on income by asking that payment be postponed to a later year.
Example: Jones, a self-employed service contractor, was entitled to receive a $10,000 payment on a contract with Acme, Inc. in December 2016. She was told by Acme’s accounting department in December that her payment was available, but requested that she not be paid until January 2017. She must include the $10,000 in her 2016 income because she constructively received it in 2016.
If you’re an employee, the value of the employee sick leave you receive is not taxable income. However, if your employer pays you cash for unused sick leave, you must include the amount in your taxable income in the year it is paid. Thus, for example, if you elect to exchange unused sick leave for a cash payment upon retirement, you must include the payment in income. Generally, the payment is reported in the year you made the election. What if, instead of taking a lump-sum cash payment for your unused sick leave when you retire, you trade it for additional pension service time, thereby increasing the payments you’ll receive over the life of your pension? You have to report the amount of the cash payment you gave up as income for the year you made the trade.
Dividends on corporate stock are constructively received when a shareholder can demand them. However, if a dividend is declared payable on December 31, but is postal mailed and the shareholders don't receive the dividend checks until January, the dividends aren't constructively received until January.
A taxpayer can rent commercial real estate to a corporation wholly-owned by the taxpayer. If the corporation stops paying rent but continues using the property, the taxpayer is in constructive receipt of the missed payments. This is because the taxpayer has both the right and the power to obtain the income.
