Wellington Wimpy, the gluttonous gourmand from the Popeye comics famously said, “I’d gladly pay you Tuesday for a hamburger today.” Although the payment was to be made at a later date (if at all), the agreement between Wimpy and the Rough House diner was made at the time the “sale” was consummated. Assuming Wimpy made good on his promise and paid for the hamburger on Tuesday, when did the diner receive its income?
As even the most cursory glance at the burgeoning Internal Revenue Code will attest, this basic question of “When is income received?” is not as simple as it appears at first blush. In fact, few subjects have been so ferociously litigated in the income tax context as the actual and constructive receipt of income. In this article, we attempt to clarify one of the more practical problems faced by our clients—how can a taxpayer “receive” income or property when he or she is not in actual receipt or physical possession of it?
Imagine the following scenario, Uncle Bill and Aunt Ethel sell their car in late December. They are so tired from the fiasco that they do not get around to depositing the check until after they recover from New Year’s Eve. Understandably, when the time comes, Uncle Bill records the income on his income tax return for the new year—after all, that’s when the money hit his account. The IRS begs to differ, and sends Uncle Bill and Aunt Ethel a notice that, in the Government’s opinion, the income was received the year before, when the car was sold, not when the proceeds hit their account.
Unfortunately for dear Uncle Bill, the IRS is probably right. In general, a taxpayer is required to recognize income from the sale of property in the taxable year in which the taxpayer “actually or constructively” receives payment for the property. This means that even if income is not “actually reduced to a taxpayer’s possession,” it is constructively received by the taxpayer “in the year 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.” Income is not constructively received, however, if the taxpayer’s control of its receipt is “subject to substantial limitations or restrictions.”
Uncle Bill had the absolute right to enter into an agreement with the buyer that they will not be paid until some point in the future. As long as the deferred payment agreement is binding between the parties and is made before the taxpayer-seller has acquired an “absolute and unconditional” right to receive payment, then the taxpayer is not required to report the sales proceeds as income until he or she actually receives the proceeds. Thus, a previously agreed upon deferred payment arrangement that restricts the time and/or manner of payment serves as a “substantial limitation or restriction” on the taxpayer’s control of the proceeds in the taxable year of the sale.
Payment may be deferred if the purchaser was initially willing to contract for immediate payment, and even if the taxpayer’s primary objective in entering into the deferred payment agreement is to minimize taxes. A deferred payment agreement is considered bona fide if the parties intended to be bound by the agreement and were, in fact, legally bound. An existing agreement may be modified to provide for deferred payments, but only so long as no payments are already due.
In the cases that discuss constructive receipt, escrow agreements are among the most common perpetrators of unwanted income inclusion in the year of the sale. In general, escrow agreements provide that purchase money is paid to an escrow agent, and such funds are held until some future event occurs. If negotiated properly and in advance of the sale, an escrow agreement may avoid constructive receipt, economic benefit, and agency receipt (the latter two of which are discussed below). However, a seller cannot unilaterally decide to escrow funds that would have otherwise been available to avoid constructive receipt.
By way of example, a timber farmer entered into an agreement with a lumber company to sell timber for a set price. If the escrow agreement had been negotiated by the buyer and seller in advance of the first payment becoming due, then there would be no constructive receipt issue. In the Williams case, however, after the contract had been executed, the seller decided that he wanted to receive part of the purchase price in four installments in later years. In furtherance of this plan, the seller drew up an escrow agreement with his bank. The Fifth Circuit held that the escrow agreement was set up unilaterally and that the entire purchase price became available to the seller upon completion of the sale (which occurred just after the contract was executed). In fact, the buyer had no knowledge of the escrow agreement with the bank.
Another Fifth Circuit case demonstrates how escrow agreements may properly be used to avoid constructive receipt. In Busby, a cotton farmer used an escrow agreement to defer payments from the buyer until the year after the crop was harvested and delivered to the buyer. The farmer and the buyer agreed in advance of the sale that the buyer would deposit the funds with an escrow agent in the year of harvest and the agent would pay the farmer in the following year. Critically, the farmer could not demand payment from the escrow agent in the year of sale or assign the payments, and, as such, the taxpayer-farmer was not in constructive receipt of the sale proceeds. The same result occurred in the Tyler case, in which a seller of stock was required to deliver the shares in December, but the buyer and seller agreed in advance of the sale that the proceeds of the stock sale would not be made available to the seller until January of the following year. Once again, the Tyler court emphasized that the seller “could neither demand payment nor control its disposition” prior to the January date.
The Economic Benefit Doctrine
In addition to the constructive receipt doctrine, which provides that income or property can be included in a taxpayer’s income for a year before the taxpayer is in actual receipt, taxpayers must also be aware of the “Economic Benefit Doctrine.” In order for economic benefit to be found, money must be held in trust (or another account) for the taxpayer, and the taxpayer need not do anything (other than wait for the passage of time). Critically, for economic benefit to apply, the trust must not contain any restrictions on the taxpayer’s right to assign or otherwise dispose of the money placed in trust. Stated another way, a taxpayer-seller likely has a present economic benefit in the income if receipt is conditioned only upon the passage of time, or the taxpayer otherwise can control or dispose of the escrowed funds.
Once again, a taxpayer may avoid economic benefit by placing funds in escrow, but the escrow agreement must neither permit the taxpayer to receive any present economic benefit, nor may the escrow be a self-imposed limitation of the seller to funds in which the taxpayer-seller otherwise had a vested right to control. Thus, even if escrow is established prior to the consummation of the sale, if the taxpayer-seller has the right to investment income generated while the funds are held in an escrow account (or a trust), courts have found that such income “constitutes a property interest equivalent to cash,” thereby giving the taxpayer a present economic benefit in the property.
By contrast, a taxpayer-seller who receives only an unconditional promise that he or she will ultimately be paid in a future year (in accordance with a negotiated purchase and sale agreement) will not have an economic benefit in the sale proceeds. The proceeds will only be the “equivalent of cash” if the taxpayer received a present beneficial interest in the funds—or the income (e.g., investment or interest income) derived from such funds. Simply because the taxpayer-seller has an irrevocable and unconditional right to future payments does not mean that the taxpayer has the economic benefit of such payments; instead, the taxpayer-seller must be able to control such payments, whether through the ability to demand or assign the payments or through the ability to presently receive the income derived from the escrowed funds.
The final rung of the constructive receipt ladder is the doctrine of agency receipt. Agency receipt is a bit less common than constructive receipt or economic benefit, but it still can trip up an unwary taxpayer. Once again, agency receipt often arises in the context of escrow agreements, when the escrow agent is also the taxpayer’s agent. Nevertheless, as discussed below, not all escrow arrangements necessarily trigger agency receipt.
In terms of the taxability of the receipt of income, courts have long held that the receipt of proceeds by the agent of a taxpayer is tantamount to the receipt by the taxpayer-principal. Thus, if a taxpayer enters into an agreement to sell stock, with payment to be made to the taxpayer’s attorney, the taxpayer is considered to have personally, constructively received the payment. Agency receipt most often arises in escrow arrangements in which the escrow agent is also the agent for the seller. However, such an arrangement—if carefully structured—need not result in agency receipt.
Agency receipt will almost always be found if the escrow agreement is set up unilaterally with the taxpayer’s agent serving as escrowee. However, courts have found that an escrow agreement that was established as a part of a bona fide purchase and sale agreement between the taxpayer-seller and the buyer, under which agreement the escrow agent represented both the taxpayer and the seller (even though the escrowee was originally the taxpayer’s agent), will avoid receipt of income under the agency receipt doctrine. Thus, if a buyer is aware that the escrow agent is also the agent of the seller, and the buyer still agrees to the escrow arrangement as part of the purchase and sale agreement, there will not be agency receipt based upon this factor alone.
Although it is true that an escrow agreement will always tend to more greatly benefit the party being paid (i.e., the seller), this benefit is not enough to trigger agency receipt. If this were the case, no bona fide purchase and sale agreement providing for the escrow of funds would be legally effective to postpone income tax recognition. Thus, to establish an agency relationship between the escrow agent and taxpayer, the IRS must show that the escrow device was set up unilaterally by the taxpayer or that the escrow agent was functioning under the control or authority of the taxpayer.
Income deferral has numerous benefits, both from a tax planning perspective and for other practical non-tax purposes. If income deferral is negotiated by both purchaser and seller prior to the execution of the purchase and sale agreement, and is not later set up unilaterally by the seller, courts have shown a willingness to not recognize income immediately.
When funds are to be escrowed, it is important to understand in advance the consequences of receiving income from the funds while escrowed. Receiving even minimal interest or investment income from the escrowed funds might easily lead a court to decide that the seller had the economic benefit of the escrowed sale proceeds. Further, if a seller is able to demand payment or assignment of the deferred or escrowed funds, the courts have not hesitated to find that such seller had sufficient control over the funds for constructive receipt of the entire amount.
Many taxpayers, even sophisticated ones, do not understand the intricacies of the three doctrines discussed in this post. As such, the risks of unwanted income recognition can be substantial when deferring payments to later tax years. Nevertheless, with careful planning before the fact, such negative consequences can rather easily be avoided. As the old aphorism goes, an ounce of prevention is worth a pound of cure, and in the case of constructive receipt, seeking sound tax advice before a big sale is a worthy investment in order to avoid the potentially nasty surprise of constructive receipt. Perhaps, J. Wellington Wimpy was a savvy tax planner, after all.
 IRC § 451(a); Treas. Reg. § 1.451-1(a).
 Treas. Reg. § 1.451-2(a).
 Reed v. Commissioner, 723 F.2d 138, 142 (1st Cir. 1983); Ross v. Commissioner, 169 F.2d 483, 490 (1st Cir. 1948); Amend v. Commissioner, 13 T.C. 178, 185 (1949).
 Reed, 723 F.2d at 142; Schniers v. Commissioner, 69 T.C. 511, 516 n. 2, 517-18 (1977).
 Reed, 723 F.2d at 142; Oates v. Commissioner, 18 T.C. 570, 584-85 (1952); aff’d, 207 F.2d 711 (7th Cir. 1953); Glenn v. Penn, 250 F.2d 507, 508 (6th Cir. 1958); Commissioner v. Tyler, 72 F.2d 950, 952 (3rd Cir. 1934); Amend, 13 T.C. at 185. Assuming the taxpayer is a cash basis taxpayer.
 See Reed, 723 F.2d at 142; Schniers, 69 T.C. at 516; see also Tyler, 72 F.2d at 952.
 Goldsmith, 586 F.2d 819; Schniers, 69 T.C. 517-18; Cowden v. Commissioner, 289 F.2d 20, 23, 23 n.1 (5th Cir.1959).
 Oates, 18 T.C. at 585; Schniers, 69 T.C. at 516-18.
 Reed, 723 F.2d at 142; Oates, 18 T.C. at 585; 207 F.2d 712-14; Goldsmith v. United States, 586 F.2d 810, 817 (1978); Commissioner v. Olmstead, Inc., 304 F.2d 16, 21-2 (8th Cir. 1962).
 Williams v. United States, 219 F.2d 523, 527 (5th Cir. 1953).
 Busby v. United States, 679 F.2d 48 (5th Cir. 1982).
 72 F.2d 950 (3rd Cir. 1934).
 Id. at 952.
 Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d., 194 F. 2d 541 (6th Cir. 1952).
 See Kuehner v. Commissioner, 214 F.2d 437, 440-41 (1st Cir. 1954) (investment income); Williams v. United States, 219 F.2d 523, 527 (5th Cir.1955) (same); Pozzi v. Commissioner, 49 T.C. 119 (1967) (interest income).
 Reed, 723 F.2d at 146.
 Arnwine, 696 F.2d at 1108; Warren, 613 F.2d at 593; Williams, 219 F.2d at 526-27.
 Warren, 613 F.2d at 593.
 See Reed, 732 F.2d at 148; Warren, 613 F.2d at 593 (deferred payment agreement was between the seller-taxpayer and its selling-agent, the cotton gin, rather than between the seller and the buyer); Arnwine, 696 F.2d at 1108 (“the buyers were not privy to the deferral agreement and had not even been apprised of the fact that such an arrangement had been attempted.”); Williams, 219 F.2d at 526-27 (escrow device was unilaterally set up by the taxpayer, and had no connection to the purchase-sale agreement).
 See Johnston, 14 T.C. 564-65 (escrowed sales proceeds not constructively received by the taxpayer where escrow agent acted as agent for both purchaser and seller-taxpayer under the escrow agreement); Commissioner v. Tyler, 28 B.T.A. 367, 370-71 (1933), aff’d, 72 F.2d 950 (3rd Cir.1934); cf. Busby, 679 F.2d at 50, n. 6 (escrow agent not acting as taxpayer-seller’s agent for income recognition purposes where purchaser knew of escrow arrangement and approved the eventual payment of escrowed funds).
 Reed, 732 F.2d at 149.