The Cash Method
Learn about the cash method of taxpayer accounting, including the constructive-receipt doctrine.
The taxable year for which a taxpayer reports income or takes deductions often depends on the taxpayer's accounting method. In this lesson, we'll learn about the cash receipts and disbursements method, also called the cash method.
Generally, a cash-method taxpayer reports income for the year she receives it. See 26 C.F.R. § 1.446-1(c)(1). When a cash-method taxpayer receives income sometimes depends on the income's nature or the payment method. A cash-method taxpayer receives money when the money is actually paid or tendered to the taxpayer. See id. For payment by check, receipt generally occurs when the taxpayer receives the check. Lavery v. Comm'r of Internal Revenue, 158 F.2d 859 (7th Cir. 1946). This principle is true even if the banks are then closed, and regardless when the check is cashed. Kahler v. Comm'r of Internal Revenue, 18 T.C. 31 (1952).
The constructive-receipt doctrine prevents cash-method taxpayers from indefinitely postponing reporting income by refusing to accept it. Regardless when a cash-method taxpayer actually receives income, the regulations provide that he is deemed to receive it during the year when the income is tendered, credited, set apart, or made available to the taxpayer, so that he could reach out and take it at any time. If the income is in someone else's control, constructive receipt applies if just about all the taxpayer has to do, to take possession, is to give notice or make demand. 26 C.F.R. § 1.451–2(a). However, this rule doesn't apply if there are substantial restrictions or limits on the taxpayer's control of the income's receipt. Id.
Put differently, constructive receipt applies if the only reason a taxpayer hasn't received income is the taxpayer's knowing, willful refusal to take it. Hornung v. Comm'r of Internal Revenue, 47 T.C. 428 (1967), quoting Ross v. Comm'r of Internal Revenue, 169 F.2d 483 (1st Cir. 1948). Here, receipt is deemed to occur when the income is available to the taxpayer, even if the taxpayer actually takes it in a later year. Id.
Suppose a corporation declares a dividend in year one. That year, the dividends are unconditionally payable to any shareholder on demand. One shareholder, a cash-method taxpayer, knows about the dividend in year one but waits until year two to demand it. The dividend is income to the shareholder in year one, when she first had the unconditional right to demand the dividend. 26 C.F.R. § 1.451–2(b).
Substantial restrictions include contractual restrictions and other barriers to receipt. Suppose a cash-method taxpayer receives a car as a prize from a magazine. The magazine declares the prize and informs the taxpayer of it on December 31st of year one. However, the car is stored at a faraway dealership that is closed and won't reopen until January 3rd of year two. On that date, the magazine holds a luncheon for the taxpayer and hands her the car's keys and title. Practically speaking, the taxpayer couldn't access the car until year two, so that's when the car's fair-market value is income to the taxpayer. See Hornung, 47 T.C. 428.
Generally, if a taxpayer enters a contract, and the consideration includes deferred cash payments taking place in later years, then the government will respect the contractual timing of the payments. This condition is true even if the taxpayer could have negotiated for earlier payments and, indeed, even if the taxpayer negotiated for later payments to postpone taxable income. See Veit v. Comm'r of Internal Revenue, 8 T.C. 809 (1947); Veit v. Comm'r of Internal Revenue, 8 T.C.M. 919 (1949); Cowden v. Comm'r of Internal Revenue, 289 F.2d 20 (5th Cir. 1961).
Suppose in year one, a cash-method taxpayer contracts to receive $10,000 in each of years one, two, and three. Payment is made in cash according to the contract. Here, the taxpayer will report $10,000 in income in years one, two, and three, respectively.
This brings us to the cash-equivalents doctrine. Under this doctrine, if a cash-method taxpayer receives income that is property other than money, then the property's fair market value on the date of receipt must be reported as income for the year of receipt. See Cowden, 289 F.2d at 23.
Suppose a taxpayer receives a car as a taxable prize on January 3rd of year two, and on that date, the car is worth $20,000. The taxpayer must report $20,000 of income on her tax return for year two. See Hornung, 47 T.C. 428.
Finally, let's address the timing of deductions. For cash-method taxpayers, deductions are taken for the year the taxpayer actually makes the corresponding expenditures. There is no constructive-expenditure doctrine. See 26 C.F.R. § 1.461–1(a)(1).
Cash payment is made when the cash is transferred. Payment by check is made when the check is delivered, unless the check isn't ultimately presented or honored, or the payor restricts the manner or time of payment. See Estate of Spiegel v. Comm'r of Internal Revenue, 12 T.C. 524 (1949); Heritage Org., LLC v. Comm'r of Internal Revenue, T.C. Memo. 2011-246 (2011). If a check is mailed, then the check is generally deemed delivered when mailed. See, e.g., 26 C.F.R. § 1.170A–1(b) (timing of deduction for charitable contributions). Payment by credit card is deemed made when the charge occurs, not when the debt is repaid to the credit-card provider. Rev. Rul. 78-38 (1978).
Apart from credit-card payments, if a taxpayer borrows money for a deductible expenditure, then the expenditure is made when the taxpayer actually pays the expense. However, a promissory note executed by the taxpayer, by itself, isn't payment; the taxpayer gets the deduction when the note is actually paid. Chapman v. United States, 527 F.Supp. 1053 (D. Minn. 1981).
Suppose in year one, a cash-method taxpayer borrows $10,000 to pay deductible employee salaries. The taxpayer pays the salaries in year two and repays the loan in year three. The taxpayer gets the deduction in year two. However, if the taxpayer simply gives the employees a promissory note for the salaries in year two and then pays the note in year three, the taxpayer gets the deduction in year three.
Cash-method taxpayers often prepay multiple, consecutive years' worth of deductible expenses in one taxable year, seeking to get the full deductions in the year of payment. For instance, someone with a five-year lease could prepay the whole lease in year one. The federal tax laws limit this practice.
If a cash-method taxpayer prepays deductible interest, deductions will be postponed until the taxable years to which the interest corresponds. There's a limited exception for prepaid points on a loan secured by the taxpayer's principal residence. 26 U.S.C. § 461(g).
In other cases, prepayment may create an asset whose useful life transcends the taxable year. Here, the taxpayer may have to amortize the deduction, or take it in annual increments, over the life of the asset. 26 C.F.R. § 1.461–1(a)(1). Examples include multiyear insurance policies or leases. We'll talk more about amortization in our lesson on deductions, expenses, and capital expenditures.