Economic Benefit: Formulating a Workable Theory of Income Recognition

I.R.C. § 4462 permits taxpayers to compute taxable income by using the accounting method regularly used to keep their business books.' The cash method of accounting is the simplest method because it permits taxpayers to use the deposit slips and check records from their checking account to keep track of taxable income and deductions. For cash basis taxpayers, income is reported when payments are actually or constructively received and deductions are taken only when payment is actually made. Because taxpayers have the power to postpone the receipt of cash, three doctrines 6 have developed that require immediate income recognition even though actual receipt has not occurred. First, the constructive receipt doctrine requires a cash-method taxpayer to report income if the taxpayer has the power to obtain payment.7 Second, the cash equivalence doctrine requires that a cash basis taxpayer report income if he receives an asset that he can readily convert into cash, such as a negotiable promissory note of the obligor.' Third, the economic benefit doctrine applies when the transaction is structured so that the taxpayer recognizes income when he is economically benefited even though he does not have power to obtain immediate payment.9 In its simplest form, the economic benefit doctrine is applicable when the right to the future cash payment is nonforfeitable and the payment is funded or set aside for future payment.1 ° The economic benefit doctrine is often misunderstood, misapplied, and even ignored as a separate doctrine. If the economic benefit doctrine is applied broadly, any right to future payment could be taxed presently because the taxpayer is "better off," thereby eliminating the distinction between the cash and accrual methods of accounting. If applied narrowly, the economic benefit doctrine merges with the other two doctrines and allows the taxpayer overly broad discretion in selecting the year of taxation. For example, in Reed v. Commissioner a taxpayer deferred receipt of cash for seven days by placing the purchase price for the sale of stock into an escrow account to be paid out during the next tax year. Childs v. Commissioner is another instance where the doctrine was narrowly applied. In Childs, attorneys (taxpayers) representing tort claimants agreed to accept their fees over an extended period of time as part of a structured settlement. The Tax Commissioner (the Commissioner) ruled that the taxpayers had to report the present value of future payments in income in the year of settlement.' The taxpayers argued that because they had no right to immediate payment, the fees should be reported when received. The Tax Court agreed and allowed the attorneys wide latitude in structuring a deferred compensation arrangement without adhering to any of the complex rules normally governing such plans. The latitude afforded to the taxpayers in Reed and Childs constitutes an abuse of the cash method of accounting. Under I.R.C. § 446(b),the Commissioner may challenge accounting methods that do not clearly reflect income. If properly applied, however, the "economic benefit" doctrine could prevent such abuses and allow taxpayers flexibility to minimize their taxes and preserve the simplicity of the cash method of accounting. Because taxpayers construct complex transactions to take advantage of the cash method's simplicity, the economic benefit doctrine performs a valuable service in limiting such transactions. This article will examine the "economic benefit" doctrine and discuss how its overly narrow application allows taxpayers to abuse the cash method of accounting. The author recognizes that rules applying to the cash method of accounting also impact scenarios covered by specific code sections. This article, in turn, will only address those situations where such sections do not apply. Part II A will layout for the general reader the concepts underlying the three major income recognition doctrines. Part II B will explain how decisions such as Reed and Childs have misapplied the economic benefit doctrine. Part II C will demonstrate how a consistent definition and application of the economic benefit doctrine is consistent with a number of long-standing tax rules. Part II C will also suggest how other tax rules may be used to limit the deferral abuses of the cash method of accounting.