Constructively received income, or what tax year applies to late-year payments?
Monday, December 27, 2010
Something unheard of happened to me over the weekend. In going through my 2010 receipts, I discovered that a client had paid me twice for some work.
That's a very nice surprise for a freelance writer. Like countless other small business people, we depend on prompt payment to cover our bills and buy the occasional Frappuccino.
Naturally, my unexpected and financially positive turn of events got me thinking about taxes and the perennial question I get from other independent writers each year:
If I get a check dated Dec. 31, but it doesn't arrive in my mailbox (yes, some clients still pay via paper) until Jan. 3, does it count as taxable income in the tax year indicated by the date on the check?
No. Yes. Maybe. It depends.
That there's no clear-cut answer is not news for even casual tax followers. Like every other tax situation, things regarding when a payment is taxable depend upon your personal facts and circumstances.
When is the money yours? Let's start with the IRS concept of constructively received income.
Essentially, this is when you have control over the money. What you decide to do with that money is immaterial. The IRS is just interested in whether you could do something with it.
In the case of the end-of-year mailing of payments that didn't arrive in your hand until the following year, despite the date on the check, you didn't constructively receive the money until the following year. So it's taxable income, in most cases, in the year you got the check.
Income receipt aside: Constructive receipt also comes into play for investors who have earnings automatically reinvested via direct reinvestment plans, or DRIPs. Even though you never get that cash in hand, it's plowed back into your fund or stock account, meaning you've constructively received it and owe taxes on the earning in the year in which they are reinvested.
Tax law established this receipt determination to prevent taxpayers from deliberately choosing to defer income just to avoid a legal tax obligation.
To tweak the example above, if you got the check dated Dec. 31 on the last day of the year but chose not to cash it until Jan. 3, that doesn't push your tax liability into the next year. You constructively received and could have cashed the check in the year you got it, so that makes it taxable in the year on the check.
Electronic payments also affect payment dates. If you had an e-payment or PayPal arrangement with the client and the money was deposited the money on Dec. 31, then there's no question. You had control over that money on that day.
But with snail mail's delay, we still get the tax timing question.
Conflicting tax reporting: Depending on how much you've received from the client, such late payments could pose a tax reporting problem.
Generally, the IRS requires payors to issue Form 1099-MISC to individual whom they've paid more than $600 during the year (this is the existing rule, not the added 1099 reporting that small businesses might face if that new law is not repealed next year).
Reporting aside: Even if you don't get a 1099 from a client, you are still responsible for reporting all the income you receive in a tax year. The failure to do so by many small businesses and independent contractors, i.e., folks who file Schedule C with their individual Form 1040s, is why the IRS is targeting more of us for audits.
If the late-year payment pushes your yearly pay amount to the reporting level, the IRS will hear of it from the client. And Uncle Sam will think you've earned that much taxable income even though you really didn't constructively receive some of it until the following year.
In this case, you have some decisions to make.
If the amount is not that much or won't substantially affect your eventual tax bill, you might just want to report it in the tax year noted on the check. That way your income amount and the 1099 info the IRS gets will be the same.
However, if it will cost you a lot more in taxes or you are just obsessive about reporting and paying for the proper tax year, then you can include a note with your return explaining the difference in your reported income and the 1099 data on file.
Will such a note satisfy an IRS examiner? Yes. No. Maybe.
Will it make the auditor question other things on your 1040? Yes. No. Maybe.
The problem with conflicting income payment/receipt dates is that it's hard to prove when you received a piece of mail via the U.S. Postal Service unless it is certified. Depending on your local mail service and where your client is located, you conceivably could receive a check dated Dec. 30 and mailed on that same day on Dec 31.
Even when you are completely honest about when you received the late-dated check, you have to ask yourself, is the explanation worth a possible audit that could arise from mismatched reporting info from you and your client? In most cases, the answer is "no," so most of us simply report the income as ours in the year noted on the check.
But again, the choice is yours. And many tax pros say that whatever you decide, it's important to that you be consistent in how you report.
If you can show that this is an annual issue and that the amount you didn't report the prior tax year was included in your next year's return, then you should be OK with the IRS.
Working around such situations also is advisable. When cash flow allows, I don't invoice clients after mid-December. That paperwork goes out on Jan. 1 of the next year to ensure there's no issue with late-dated checks.
Which accounting method do you use? There's one other personal circumstance to take into account here. Are you a cash or an accrual accounting taxpayer?
Most self-employed freelancers operate on the cash accounting method. This means you recognize the revenue when you actually get the payment. Expenses also are recorded in the tax year in which they are spent.
Accrual accounting taxpayers, on the other hand, book the income when they invoice for it, regardless of when they actually receive the payment. The same bookkeeping timing applies to expenses.
So as a cash accounting filer, the money isn't yours and isn't reportable, taxable income, until you've constructively received it in a tax year.
I hope this discussion has helped more than hurt. That's always a concern and possibility when it comes to taxes!
Most of all, I hope you've gotten paid properly this tax year and will receive all the earnings you're appropriately due in 2011 and beyond!
- Year-end business tax moves
- Tax breaks in the new small business bill
- Small business IRS survey and tax tips
- Senator slams SBA for not taking a stand
on new Form 1099 reporting rule
- Home office tax pros and cons
- Best, worst state tax climates for business
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