The Doctrine of Cash Equivalence states that the U.S. Federal income tax law

Income tax in the United States

In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...

 treats certain non-cash payment transactions like cash payment transactions for federal income tax purposes. The doctrine is used most often for deciding when cash method (as opposed to accrual method) taxpayers are to include certain non-cash income items. Another doctrine often used when trying to determine the timing of the inclusion of income is the constructive receipt

Constructive receipt

For federal income tax purposes, the doctrine of constructive receipt is used to determine when a cash-basis taxpayer has received gross income. A taxpayer is subject to tax in the current year if he or she has unfettered control in determining when items of income will or should be paid...

 doctrine.

Most individuals begin as cash method taxpayers because their first form of bookkeeping is a checkbook. In contrast, some businesses start as accrual method taxpayers because businesses use different rules for recording income and expenditures. The Internal Revenue Code (IRC) §446(a) states, however, that "[t]axable income shall be computed under the method of accounting on the basis which the taxpayer regularly computes his income in keeping his books."

One of the major advantages to the cash method of accounting is the ability to defer taxation because the recognition of income applicable to amounts in accounts receivable can be deferred to a later year. The Doctrine of Cash Equivalence is important because many people are cash method taxpayers and would be subject to this rule.

Elements

Cash method taxpayers include income items (cash and cash equivalents) in the year the items are received. See also Treasury Regulations Certain payment transactions involve cash equivalents, such as receipts of checks and credit card payments. The cash equivalence doctrine arose out of a need to determine whether certain items that were either actually or constructively received must be accrued as income. A dispute over timing of income recognition for tax purposes may arise when the thing received is really not much more than a promise of payment, such as a promissory note or a bond. If mere promises to pay were considered cash equivalents, then there would be little difference between the cash and accrual methods for tax purposes.

The United States Court of Appeals for the Fifth Circuit

United States Court of Appeals for the Fifth Circuit

The United States Court of Appeals for the Fifth Circuit is a federal court with appellate jurisdiction over the district courts in the following districts:* Eastern District of Louisiana* Middle District of Louisiana...

 established the standard for applying the cash equivalence doctrine to promises of payment. The court first noted that the principle that "[a] promissory note

Promissory note

A promissory note is a negotiable instrument, wherein one party makes an unconditional promise in writing to pay a determinate sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms.Referred to as a note payable in accounting, or...

, negotiable in form, is not necessarily the equivalent of cash" remains true. But that principle also has a true inverse—that a non-negotiable instrument

Negotiable instrument

A negotiable instrument is a document guaranteeing the payment of a specific amount of money, either on demand, or at a set time. According to the Section 13 of the Negotiable Instruments Act, 1881 in India, a negotiable instrument means a promissory note, bill of exchange or cheque payable either...

 can be a cash equivalent if the following factors are met. A promise to pay will be considered a cash equivalent for cash method taxpayers if:

1. the promise to pay is unconditional;
2. the promise is made by a solvent person;
3. the promise is assignable;
4. the promise is not subject to set-offs; and
5. the promise is marketable.

Since taxpayers generally prefer to defer recognition of income to subsequent tax years (due to the time value of money

Time value of money

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

), a finding of cash equivalence will typically be to the disadvantage of the individual taxpayer.

Mechanics

In order to use the doctrine of cash equivalence, a taxpayer must have either actually received an item, or constructively received an item. If either of these situations exist, a taxpayer must determine whether the item received is cash equivalence, using the six factors described in Cowden v. Commissioner. If the item is deemed cash equivalent, then the taxpayer has income. If it is not cash equivalent, the taxpayer does not have income.