Why is this Topic Important to Wealth Managers? Many wealth managers are probably aware that when a client receives income, there is generally a tax effect which has implications on the determination of the income tax liability.  This blogticle presents situations that may or may not trigger specific tax consequences related to common transactions.

As a starting point, The Internal Revenue Code states that gross income, the top line calculation used in determining taxable income, includes income from whatever source derived unless otherwise excluded by law.  [1] One such exclusion occurs when death benefits are received by a beneficiary of a life insurance contract. [2]

To show the extent of the taxing power to include all income except excluded income, the Supreme Court examined a situation where taxpayers received money as settlement in punitive damages arising from anti-trust and fraud litigation.  The Court, in Commissioner v. Glenshaw Glass Co., adopted a broad definition of income as “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” [3] The Supreme Court’s ruling overturned both the District Court and Appeals Court decisions; it was therefore held the taxpayer’s receipt of money from settlement of a lawsuit was an increase in the taxpayer’s wealth, and furthermore, since not excluded under any section of the code, was consequently includable as gross income. [4]

However, where income is not “realized”, the taxpayer does not incur a tax liability.  In Eisner v. Macomber the taxpayer, a shareholder of a corporation, received additional shares representing undistributed earnings. [5] The Supreme Court “determined that a shareholder’s receipt of a stock distribution was not income to the shareholder and, therefore, Congress’s attempt to tax the stock dividend was not authorized by the Sixteenth Amendment.” [6]

The Court in Eisner also illustrated the now well known “fundamental relation of ‘capital’ to ‘income’ ”, as “the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time.” [7]

In another respect, when property or services are received by a taxpayer, a realization of income has occurred.  It is a long recognized principal that “if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income.” [8]

Barter transactions are afforded the general tax treatment as if the bartered property, goods, or services were sold, and the property, goods, or services received was purchased with the funds obtained from the that “sale.”  [9] Taxpayers are required to file Form 1099-B for barter transactions.

However, there are instances where even though the taxpayer may not receive anything today,    he has a right to receive something today, and is therefore taxed on it today.  This is the doctrine of constructive receipt.  “Income although not actually reduced to a taxpayer’s possession is constructively received by him” when he can draw upon it, or is otherwise made available to him. [10]

An example of constructive receipt occurs when interest from a savings account is taxed because the right to withdrawal interest from a savings account is present, and therefore the taxpayer has realized the income. [11] Another example is when a corporation “advises its employees that they will be receiving cash Christmas bonuses on December 20.”  One of the employees requests that “the payroll department not issue his bonus check until January 2.”   Since the employee “had an unrestricted right to receive the money on December 20, he is considered to have constructive receipt of the income as of that date.”

This last example as well of the contents of this article are discussed more thoroughly in

Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit. 09-36. (09/01/2009).  Please access AdvisorFX for the above article, or for more information on a free trial membership.

Tomorrow’s blogticle will discuss the similar but slightly different tax theory of economic benefit.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 26 U.S.C. § 61(a); 26 U.S.C. § 63.

[2] 26 U.S.C. § 101.

[3] Commissioner of Internal Revenue v. Glenshaw Glass Co. 348 U.S. 426, 431. 1955.

[4] Glenshaw Glass Co. 348 U.S. at 432-433. Citing, Helvering v. Midland Mutual Life Ins. Co., 300 U.S. 216.

[5] Eisner v. Macomber. 252 U.S. 189, 201. 1920.

[6] Nathel v. C.I.R. 615 F.3d 83, 88. 2010.

[7] Eisner. 252 U.S. at 206.

[8] Rev. Rul. 79-24, 1979-1 CB 60. Citing 26 C.F.R. § 1.61-2(d)(1)

[9] U.S. v. General Shoe Corp. 282 F.2d 9, 12.  1960.  (Taxpayer realized exactly the same gain by transferring real estate as it would have had it sold the real estate for the fair market or appraised value and paid funds to a third party).

[10] 26 C.F.R. §1.451-2(a).

[11] 26 C.F.R. §1.451-2(a)(1).