The Accidental Income Traps and How to Avoid Them

I defend a lot of IRS audits. Almost all of my clients are honest and hardworking people. Yet occasionally, they trip up and the IRS says “gotcha.” One common problem my clients run into is failing to report income because they believed in good faith they didn’t have to report it. Here’s how it happens:

The Constructive Receipt Trap

Constructive receipt requires you to pay a tax if you had a right to payment of income even though you did not actually receive actual payment of income. For example, your employer pays you a bonus but you insist you’d rather receive the check in January. That’s a problem because you had the right to receive the check in December and therefore it is taxable income even though you didn’t actually pick up the check until January.

However, if your employer will agree to delay the payment of the check by paying it to you in January, and they report on their books paid in January, you will probably be able to put off recognition of the income until the next year. I use the word “probably” because the IRS has been known to still contend you had a right to the payment in the previous year.

Using Conditions to Avoid Constructive Receipt

There are clever, effective strategies to avoid constructive receipt by using specific conditions. One condition is to agree to deferred payment before services are provided. For example, suppose you are a consultant and contract to provide professional services in 2016 with the express understanding that you will complete the services in 2016, but you will not be paid until January 1, 2017. Is this constructive receipt? No. This kind of tax deferral planning is allowed as long as you negotiate it up front and have not yet performed the work.

Another condition is to agree that a contract is not formed until you reach a specific date. For example, you are selling your prized car collection consisting of a 1967 Shelby GT500 and a 1971 Ferrari Daytona. A buyer offers you $950,000 cash, and lets you count it!

Is this constructive receipt? No, unless there is a transfer of legal rights where title is transferred and payment is made. I had a client with a similar situation and while he agreed to sell his car collection, it was on the condition that the vehicles were to be inspected at a later date. This did not constitute constructive receipt. Even if you simply refuse the offer because you don’t want to sell the cars until January, that will be avoid constructive receipt and the tax consequences that go with it.

Another effective condition involves lawsuits. For example, you settle a lawsuit but refuse to sign the settlement agreement unless it states that the defendant will pay you in installments. This would not be constructive receipt because you conditioned settlement on receiving payment in a very specific structure. By the way, when it comes to tax issues in litigation, it’s wise to get professional advice in how you structure payments and define exactly what is being paid. Huge tax implications can turn on just a few words.

Cancellation of Debt Income

This happens all the time. You settle with a credit card company or other debt collector. While you did not actually receive payment, according to the IRS you received income because part of the debt was forgiven. When debt is forgiven, lenders are required to issue a Form 1099-C reporting this a cancellation of debt income.

However, there are ways around it. For example, if the debt was forgiven while you were in bankruptcy there is no cancellation of debt income. If the debt was forgiven while you were insolvent, this is also not cancellation of debt income (See IRS Form 952). Also, if the debt was a business purpose debt, then you have a good argument that you are not personally liable. And finally, courts have ruled that if you negotiate the settlement of a debt and define the settlement not as a cancellation of debt, but a “discount” of what you are obligated to pay due to an “infirmity” in the contract, then this may not trigger taxable income.

Phantom Income from Partnerships, LLCs and S Corporations

Phantom income from partnership and corporate entities can cause major tax headaches. Partnerships, limited liability corporations (LLCs) and S corporations are pass-through entities and so they are generally not taxed themselves, but their owners are taxed. Owners receive a Form K-1 that reports the owner’s share of the income or loss even if that income is retained by the business and not distributed to the owners. If you’re an owner, you are obligated to report this income even if you never actually received it. Keep in mind that the IRS matches Forms K-1 against individual tax returns, and numerous clients, who have unintentionally failed to report income, get tagged by the IRS when the numbers don’t match up.

Call me if you have questions about this or any other tax issue. 800 659 0525.