'm on vacation this week but I wrote up this Classic Lesson before I left so you could have something to chew on as you drink your morning beverage of choice.
Timing is at least as important in tax as it is in comedy. Although less common than it used to be before the age of direct deposit and mobile banking apps, the question sometimes arises about when must a taxpayer report as gross income a check received on December 31st but not cashed until January. The flip side is when may a taxpayer take a deduction for a check sent out on December 31st but not cashed until January.
Taxpayers tend to want to push off reporting income into a later year and tend to want to pull back deductions into the current year. Specifically taxpayers who receive a check on the last day of the year would like to say they don’t have income until they cash the check in January. But at the same time, taxpayers who write a check for a deductible expense on the last day of the year want to deduct that expense in that year and not the next.
Taxpayers cannot have it both ways. The good news is that the IRS has long allowed checks mailed on December 31st to be deductible in the year mailed, even when not cashed until January, so long as the taxpayer has truly parted control over the delivery of the check. See Treas.Reg. 1.170A-1(b).
The bad news is that taxpayers are also generally required to report checks received on December 31st as income. The rationale for that, however, is not entirely clear, as one sees in the classic case of Kahler v. Commissioner, 18 T.C. 31 (1952).
The facts in Kahler are simple. Mr. Kahler (1912-1990
) earned both salary and commissions each year from the Sumner Seed Co. Normally, his employer paid him in January for the commissions earned the previous year. In 1946, however, Mr. Kahler received a check for about $4,300, reflecting about $5,400 of commissions earned (the net amount reflected withholding and another small adjustment).
Mr. Kahler did not report the $5,400 as income on his 1946 return. However, he also disclosed the facts and requested an audit to determine whether he should have reported that income. The IRS said “yep, you should have” and Mr. Kahler was off to Tax Court.
Mr. Kahler’s main argument in Tax Court centered on the inability to deposit the check in 1946. He argued that the inability to cash the check in the tax year it was received meant that the check could not count as income.
The Tax Court majority rejected that argument, reasoning that checks were really the equivalent of cash “as a practical matter, in everyday personal and commercial usage” because “the parties almost without exception think and deal in terms of payment except in...the unusual circumstance not involved here...” The majority thus took that position that the amount of gross commissions reflected in the check was the proper amount to include in income.
Judge Murdock had a slightly different rationale for concluding that the check was income in 1946. Judge Murdock pointed out that even if Mr. Kahler could not cash the check in 1946 at a bank, he “might have cashed it at some place other than at a bank or hem might have used it to discharge some obligation, within the year 1946.”
If one follows the majority’s rationale, then checks are includable in income at their face value (or for the face value of the gross income they represent). But if one follows Murdock’s concurrence, then while all checks are still includable in the year received, the amount that must be reported as gross income might be less than the face value if the checks actually have a fair market value of less than their face amount. They would instead be includable at their fair market value. To use Murdock’s example, if I receive a check for $1,000 and owe a debt of $900, my creditor might accept the check in satisfaction of the debt. In that case, I would have $900 of income, not $1,000 (and my creditor would get a basis of $900 in the check). Or I might sell the check for $900 and assuming that sale is to an unrelated buyer, that would set the market value.
Murdock’s rationale makes sense, of course, because a check, after all, is not cash. It is the right to receive the amount stated on the face of the check. A right to receive something is a piece of property. No, not property like my lawn mower. That’s tangible. It’s property like a lawn-mowing contract. An intangible right to something that, if necessary, can be enforced in the courts by an action at law. The old English word for “property” is “Chose” and so this kind of intangible property right is called a “Chose in Action.”
Courts have settled on the majority rationale, however, at least for checks and other potential cash equivalents: they are includable at their face value, not their fair market value. If their fair market value is so uncertain or so low relative to their face value, then they are simply not income. For checks, this rarely happens. However, for other types of “property-that-we-will-treat-as-cash” taxpayers may be able to prove that the fair market value is so small or uncertain that the item should not count as income that year. That is most obvious when one looks at the cases on promissory notes.
Promissory notes are just a promise to pay. Like a check they are a chose in action. Unlike a check, they are not used with such regularity as to be viewed by parties as in and of themselves a payment. Nonetheless, they might be cash equivalents. The Fifth Circuit explained why in Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961): “We are convinced that if a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation.”
You can quickly run the reverse statements and find support for them in the law. Thus, if the taxpayer shows that the promise to pay is from an insolvent obligor then it is not income. Williams v. Commissioner, 28 T.C. 1000 (1957). If the promise to pay is subject to some significant restriction, it is not income in the year received. Bright v. United States, 926 F.2d 383, 386-87 (5th Cir.1991).
The difference between the majority rationale and Murdock’s rationale is the difference between cash and property. Sometimes a promissory note looks like cash. But sometimes it just looks like property. You can see that tension in Jones v. Commissioner, 68 T.C. 837 (1977), where the taxpayer sold property and took a promissory note in exchange. The face value of the note was about $133,000.00 but the taxpayer showed that the fair market value of the note was only about $76,000. On those facts the Tax Court said “no income.” But the 9th Circuit reversed. It instead held that §1001 controlled the outcome because when you sell property, that section tells you that your amount realized is the total cash PLUS the fair market value of property received. Since the promissory note was indeed “property” (a chose in action), taxpayers had to count its fair market value as part of determining the tax consequences of the sale of their property.
Despite the uncertain extension of the cash equivalency doctrine to promissory notes, the importance of Kahler remains this: checks are viewed as cash. Especially in this age of mobile banking applications, the receipt of a check on the last day of your tax period means it is income in the year received at its face amount.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.