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Constructive Receipt Processing

Typical distributions of investment income (for both fixed income and equity securities) are taxable to the investor in the year the payments are made to the investor by the corporation - that is, the year the payment is received by the investor. For example, if the investor receives a cash dividend on his or her equity investment in XYZ Corp. - the investor must report that dividend as investment income on his or her tax return for the year in which the cash was transferred from the corporation to the investor.

The same would apply for an interest payment paid to the investor for his or her investment in the debt securities of XYZ Corp.

The investment - and by extension the investor - earned the income in the year it was paid and accordingly, must investor must report the distribution as investment income earned in the current tax period.

This distinction becomes less clear when the record date of the investment distribution falls in one tax year but the actual payment to the investor does not occur until the next tax year.

For example, assume that the following investment distribution is declared:

Record Date:

12/12/01

Payable Date:

01/05/02

Under certain circumstances the above distribution is taxable to the investor in the year paid - the 02 tax year. However, in other instances it might be reportable as income in the year declared - the 01 tax year.

A distribution of investment income that is taxable to the investor in the year declared - not the year paid - is referred to as a Cons. A Constructive Receipt payment is investment income declared in one tax year but paid to the investor in the next. The investor must report the investment income to the IRS in the year declared - not the year in which it is paid.

The distinction between a normal distribution of investment income and a Constructive Receipt is significant and bears repeating - the important feature of the Constructive Receipt is that it is taxable to the investor in the year declared by the corporation - not in the year in which it is paid.

The determination of whether or not the investment income qualifies as a Constructive Receipt is determined by an assessment of when the income was earned. This determination is typically based on the type of investment security and the nature of the distribution.

Mutual Fund Distributions:

The typical Constructive Receipt involves Mutual Fund Distributions that are declared during one tax period but paid in the next. As such, the investor must report cross tax period Mutual Fund distributions as investment income in the period the distribution was declared. This applies to both Mutual Fund Dividend Distributions and Mutual Fund Capital Gains Distributions.

Mutual Fund Dividend Distributions:

As mentioned previously Cash Dividends are reportable as investment income when paid. This is true for both individual investors and Mutual Funds. If Cash Dividends are reportable in the tax period paid why does a Mutual Fund Dividend Distribution declared in one period and paid in the next qualify as a cons?

The distinction is the inclusion of the term 'Distribution'. Many Mutual Funds hold investments of equity securities in their portfolios. From time to time the equity investments pay Cash Dividends that are received by the Mutual Fund and, by extension, the fund's investors.

Periodically the Mutual Fund might transfer - or 'distribute' - the cash received from dividends to its investors. This transfer is done through a Mutual Fund Dividend Distribution, and is a taxable event for the Mutual Fund shareholder.

Cash Dividends are reportable as investment income in the tax year in which paid. When the Mutual Fund Dividend Distribution is paid to the fund's shareholders in the same tax period in which the Cash Dividend payments were received by the fund, the distribution is taxable in the current year.

However, often (typically for year-end distributions) the distribution of Cash Dividends is not made during the same tax period. For example, a Mutual Fund announces the following Dividend Distribution:

Record Date:

12/31/01

Payable Date:

01/15/02

The above distribution represents a cash payment from the Mutual Fund to its shareholders of Cash Dividends paid to the fund through December 31st of the '01 tax year.

The distribution to the shareholders, however, will not occur until January 15th of the following tax period - '02.

The distribution qualifies as a Constructive Receipt because Cash Dividends received by the fund - from its investments in Equity Securities - are taxable investment income in the period paid to the fund. The investment income is not taxable to the funds individual shareholders unless it is distributed to the shareholders in the form of a Mutual Fund Dividend Distribution.

Upon distribution the fund's shareholders must report the distributed dividends as investment income for the tax period in which the dividends were earned by the fund - '01 - not the period when actually distributed - '02 - to the shareholders.

The fact that the cash will not be physically distributed to the fund's shareholders until the following tax year does not change the fact that the income was earned during the current period - and therefore should be reported as such.

Mutual Fund Capital Gain Distributions:

Through a Mutual Fund Capital Gain Distribution the Mutual Fund distributes to it's shareholders realized Capital Gains - in the form of cash - resulting from the sale or other disposition of fund assets. These gains are taxable in the year realized by the fund - not in the year distributed to the fund's shareholders.

Therefore, the taxability of Mutual Fund Capital Gains Distributions is similar to the distribution of dividends by the Mutual Fund. A Mutual Fund Gain Distribution declared during one tax period but paid in the next also qualifies as a Constructive Receipt and is taxable in the year the distribution is declared by the fund - not in the year paid to the fund's shareholders.

If the fund announces a Capital Gain Distribution record in one tax period but payable in the next the distribution is a Constructive Receipt and is taxable in the year of record - not when paid.

Money Markets, CD's and REIT Securities:

Interest Income earned on certain investments in debt securities - specifically money markets, CD's and REITS (Real Estate Investment Trusts) - also qualifies as a Constructive Receipt. Money Markets, CD's and REITS are similar to Mutual Funds in that they are comprised of investments in other securities or Real Estate. For example, money market securities and CD's are typically comprised of investments in varying short-term debt instruments such as Commercial Paper.

The underlying investments that comprise these debt securities typically generate a stream of interest and/or rental income that is periodically distributed to the holders of the debt securities. The income streams generated by the underlying securities are taxable when paid.

Investors in Money Markets, CD's and REIT Securities are not required to report income generated by the underlying securities until such time that the income is distributed to the investors in the form of a cash distribution. At such time, the investor must report the distribution as investment income for the period in which it is declared - not the period in which it is paid.

Therefore, when a Money Market, CD or REIT Security declares a distribution of investment income in one tax period but payable in the next the payment qualifies as a Constructive Receipt. As such, the shareholder must report that distribution as investment income in the period declared - not in the period in which it is paid.

The Role of the Brokerage Firm

As it pertains to the processing of Investment Income Distributions that qualify as Constructive Receipts, the brokerage firm must ensure that its clients are provided sufficient details to properly report the Investment Income in the proper tax period.

Additionally, the brokerage firm must ensure that the income - when reported by the firm to the IRS - is reported as income for the appropriate tax year.

The firm's Dividend Department is typically responsible for the processing and reporting of Constructive Receipt payments.





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