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THE GENERAL RULE FOR INCOME INCLUSION is found in IRC Sec. 451(a). For a cash-basis taxpayer, items of income should be included in the gross income total for the year that the taxpayer receives that income. Treas. Regs. Sec. 1.451-2 explains that a taxpayer need not have physical possession for an amount to be included in gross income. Income that is set aside for the taxpayer, credited to an account, or otherwise made available is constructively received by the taxpayer. If the taxpayer's control is subject to "substantial limitations or restrictions," however, the income isn't considered to be received. The difficulty is that neither the IRC nor the Regulations precisely define "substantial limitations or restrictions" so understanding of this phrase and its operation comes from reviewing judicial interpretations and their application.
Overview of Constructive Receipt
Determination of whether or not income has been constructively received is made on a factual basis. Slight differences in facts require the tax professional to examine a case carefully before using it as a precedent. Constructive receipt requires an unqualified vested right to receive income-there can be no condition, limitation, or restriction that prevents the taxpayer from having unrestricted access to his or her money without penalty. The taxpayer, however, can't waive a present right to receive income-in other words, the taxpayer may not "turn his back" on income that is already earned. But if the taxpayer requests deferral of payment prior to receiving an unqualified vested right to income, constructive receipt doesn't occur.
Avoiding control is essential if a taxpayer seeks to avoid income recognition. The limitations or restrictions preventing constructive receipt, however, can't be imposed by the taxpayer. In Williams [CA-5, 55-1 USTC *9220], a taxpayer attempted to defer income recognition by using an escrow account. At the taxpayer's request, the entire sales price of the transaction was paid to an escrow account. The Fifth Circuit declared "a 'self-imposed limitation' created by the seller-taxpayer is legally ineffective to shift taxability on escrowed funds one year to the next."
The Tax Court has followed Williams but without broadening its scope. Williams...