This morning I came across an obscure Appeals Court Case. The details of Santangelo, (CA 5 12/27/2014) are strange and I thought I would share them, because it teaches us an important lesson. What seems logical isn’t always logical when it comes to the Tax Code. Some background IRS Reg. § 1.451-2(a) deals with something called constructive receipt.
Income not actually received is constructively received and reportable if it’s within the taxpayer’s control. Cash basis taxpayers must report money unconditionally subject to their demand as income, even if they haven’t received it. However, there’s no constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.
What does this ACTUALLY mean? Very simply this, if you have rights to income, even if you don’t take control of the money it is income. For example, let’s say that you are a business owner and on December 31st a customer writes you a check. You don’t actually receive that check until January. When would you report the income? With the constructive receipt rule, you are actually supposed to count the income in the prior year. You had a right to that income on December 31st, and just because you didn’t receive the income, doesn’t mean that it wasn’t income in the prior year. When a business is audited by the Internal Revenue Service, they are issued an Information Document Request (IDR) that states what the IRS needs to conduct the audit. If they are auditing 2013, they will ALWAYS ask for the bank statement from January of the following year. Why? Because they are looking for constructive receipt. The IRS calls it kiting your income.
So in this case, this poor old lady owned 21,534 shares of common stock in HCA, Inc. The stock was divided into two certificates, one for 7,178 shares and another for 14,356 shares. Rather than turn the certificates over to a broker or bank, Santangelo maintained possession of the physical stock certificates. In November 2006, HCA merged with another corporation. As part of the merger agreement, all common stock holders would receive $51 per share, and their stock would be cancelled. Pursuant to the merger agreement, HCA deposited the funds with a paying agent on Nov. 20, 2006. Natalie was therefore eligible to receive $1,098,234 (21,534 x $51) as of that date. To collect, she was required to surrender the physical stock certificates or follow the steps outlined in the merger agreement for stockholders who had misplaced their certificates.
Despite the funds being available in November 2006, neither Natalie, nor her daughter Rita, who had power of attorney, took any action to obtain the proceeds before her death on Mar. 29, 2007. In November 2007, the stock certificate for 7,178 shares was located and redeemed, with the proceeds being deposited in the Estate account on Jan. 8, 2008. The second stock certificate for 14,356 shares was never found. The Estate therefore followed the steps outlined for a lost certificate, culminating in a final payment on Oct. 19, 2009.
HCA issued a Form 1099 indicating that Natalie received taxable proceeds in the full amount in 2006. IRS argued that Natalie had income from the sale in 2006. Natalie’s estate took the position that the income should not have been claimed in 2006 because it was not actually received in 2006.
The taxpayer did not report the income on their 2006 tax return, instead the Estate reported it on their 2008 and 2009 tax return. The IRS audited 2006, and deemed the amount income in 2006. Now, let’s pause for a second. It seems logical that you would claim the income when you had the income, right? Not according to the appellate court. The 5th Circuit sided with the IRS, and declared that the taxpayer had to pay taxes on the money in 2006.
Just a little quirk in the tax system for you to think about today. What seems logical, sometimes isn’t. Tax law works like this; we have them because someone tried to get away with something. We started with a one page tax return, and a 15 page tax code. Then people hired people like me, to get them out of paying taxes, and more laws were created to fix the law that we, as professionals got around, and then we found another way around that new law, and another law was made….and on and on. That is why you can’t simplify the Tax Code. Someone will always think they are paying too much and look for a way around it.