What is Constructive Receipt of Income?
When does an employee receive a paycheck? When does a check get counted as being received? These sound like obvious questions, but they aren't really. The answers depend on the concept of constructive receipt.
Constructive receipt is an accounting concept that determines when income must be taken, for both tax and accounting purposes. It's especially important at the end of a year, because when you receive income affects your taxes for the year.
The principle of constructive receipt is determined by when the person who receives the income had control over it. An individual or company is considered to have control over income when it is credited to that person or company. Basically, it's when you could spend that income if you wanted, even if you don't spend it.
If you receive a check and you don't deposit it, it's still under your control (you can deposit it any time), so it counts as income.
If you deposit a check, and the bank puts a hold on it, it's not under your control (you can't use it), so you don't have control over it and it doesn't count as income.
If you make a credit card payment, the charge is deductible in the year the charge is made, even if you pay the credit card company in the following year.
Constructive receipt applies only in cash accounting situations. Most of us use cash accounting, so that's not an issue. But some businesses use accrual accounting, and constructive receipt doesn't apply in these cases.
Constructive Receipt of Dividends: An Example
When do you actually receive a dividend on a stock you own? Several dates are important in the process of giving dividends to shareholders:
- The first is the date the dividend is declared or announced by the company's board of directors.
- The second is the dividend record date. The shareholders on record at this date are the only ones who receive the dividend (excluding shareholders who buy after this date).
- Finally, there's the dividend payment date, the date the dividend is in your brokerage account.
Although you may have received notice that you will receive a dividend, the dividend payment date is the one that counts. It's the day you actually have the dividend. You can't spend it until then.
If the dividend process begins in December and the dividend payment date is in January (extremely unlikely), the January date is the one that counts for the purpose of paying income tax on that dividend.
Constructive Receipt in Business Taxes
According to IRS (Publication 538), income is constructively received when an amount is credited to your account or made available to you without restriction, even if you don't have possession of it.
The IRS goes on to note that,
"Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations" (like the bank hold described above).
Here's another example: if an agent is holding the money for you, it has been considered to be received by you, even if the money is not in your bank account.
Constructive Receipt at the End of a Year
Constructive receipt is an important concept when timing business income and expenses at the end of the calendar year. Here are some more examples of how constructive receipt works in end-of-year tax timing:
- Employee paychecks. If a check is in an employee's bank account before the end of the year, it's considered pay for that year, even if the employee hasn't spent it.
- Other income. If you receive an interest payment or other income before the end of a year, it's available to you, and you must count it as income in that year. That's the case even if you don't put the amount in your own bookkeeping system.
- Pre-payments. Most insurance payments are pre-paid. Your auto insurance, for example, is usually paid for six months ahead. These payments are considered payments in the year the check is dated.
- interest payments. If you receive interest on investment or your bank account, the date the interest is added to your account is the date that counts. The funds were under your control, so constructive receipt applies.
More Examples of How Constructive Receipt Works
Here are two more examples that might help explain this concept.
In one instance, a business receives a check in payment from a customer on December 30, but doesn't deposit that payment check until January 1. Since the business had control over the check in December, it is considered to have received the funds in December.
Constructive Receipt in Accrual Accounting
Constructive receipt doesn't apply in accrual accounting. In accrual accounting, income is counted when the work is done and the bill is sent to the customer, and expenses are counted when they are incurred (when the bill is received). There is no cash changing hands in this case.