Category: Individuals
Subject: Income
Title: Taxation of Escheated Funds
IRC Sections: 61
Filename: 1149.html
Date Produced: 4/96

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Background
In 1972, taxpayer was owed a refund from an insurance company in the amount of $450. At that time, the insurance company could not locate the taxpayer. The insurance company purchased stock on behalf of the taxpayer in the amount of the refund due her. Eventually this stock escheated to the State of California. Over the years, dividends were accumulated on the stock. In 1993 due to a change in state law, California sold the stock and retained the cash from the sale. In 1995, the accumulated funds were finally returned to the taxpayer minus a 10% finders fee. The net amount received in 1995 was roundly $43,000.

Issue
Is the receipt of these funds taxable?

Answer
The funds are clearly taxable.

Discussion
Under Internal Revenue Code Section 61, gross income includes income from whatever source derived unless specifically excluded by some other provision of law. There is no provision under which the amounts here in question are excludible. Economically, the funds received in 1995 represent the taxpayer's current realization of accumulations on an investment made in 1972. There is no question that this represents income in an economic sense. In the absence of a specific tax exclusion, this economic income is subject to taxation under the general principle of Section 61.

It has been suggested that the taxpayer was in constructive receipt of the income from this investment as it was earned over the years. The taxpayer had an obligation to report the income at the time. Accordingly, the taxpayer should amend all open tax returns to report the income earned. Obviously, most of the tax years going all the way back to 1972 are now statute-barred such that the returns for those years cannot be amended; hence, the income received in 1995 is not subject to further taxation to the extent it should have been reported in prior years.

The constructive receipt argument is creative, but it does not in my view withstand scrutiny. First, it seems illogical that a taxpayer would be required to report income about which she had no knowledge. Second, constructive receipt requires conditions not present in this case.

The taxpayer in this case reports income and expenses on the cash method of accounting. Such taxpayers must report income when actually or constructively received. Under Regulation Section 1.451-2(a), constructive receipt requires that the taxpayer be able to control disposition of the income in question. Also, the taxpayer's ability to enjoy the income cannot be subject to substantial limitations or restrictions. It seems clear to me that a taxpayer clearly cannot control income she does not know about. In essence, I view the fact that income was held without the taxpayer's knowledge by a third party as a very substantial restriction on that income. Accordingly, I believe the taxpayer in this case was not in constructive receipt of the income earned on this investment over the years.

It seems to me that the taxpayer's situation is analogous to the case of John Single, Jr. v. Commissioner, 56 TCM 762 (1988). In Single, the taxpayer's wife (without the taxpayer's knowledge) took a state income tax refund check payable jointly to them. The court held that since the taxpayer was not aware that the wife had taken the check, he could not control disposition of the income. Accordingly, the taxpayer was not in constructive receipt for the year the wife took the check.