As kids playing ball, we learned about the “do-over” rule; following an unintended result at the plate, the player in question was allowed to try again, without penalty. As we got older and our games changed, we learned about “taking a mulligan”, again without penalty. It may not come as a surprise that a variation of this principle has found its way into the tax law. It is called the “rescission doctrine”, and although it has been recognized for many years, it has been applied only in limited circumstances. A recent ruling by the IRS illustrated its application.
The shareholders of an S corporation sold their shares to individual buyers in exchange for promissory notes. Under the terms of the purchase agreement, the parties agreed to treat the transaction as a sale of the corporation’s assets for tax purposes.
After the closing, the parties realized that the transaction did not qualify for the election. Within the same tax year as the stock sale, they agreed to rescind the sale; the sellers would return the consideration they received and the buyers would return the shares they acquired (the “Rescission”). Also within that tax year, the buyers would create a new corporation which would then purchase the S corporation stock from the sellers in a transaction that qualified for the election.
The parties represented to the IRS that there had been no distributions from, or contributions to, the corporation during the period between the date of the original transaction and the execution of the Rescission. They further represented that no activity or tax filings had occurred with respect to the parties that was inconsistent with the Rescission and the new transaction.
On the basis of the foregoing, the IRS ruled that the original transaction would be disregarded for tax purposes and the stock would be treated as having been owned by the sellers until the effective date of the second sale transaction.
The IRS explained that the concept of rescission refers to a voiding of a contract that releases the parties from further obligations to each other and restores them to the relative positions they would have occupied had no contract been made. The tax law, it said, treats each tax year as a separate unit for tax accounting purposes, and requires that one look at a transaction on an annual basis using the facts as they exist at the end of the year.
In general, the following requirements must be satisfied in order for the IRS to respect the rescission of a transaction: (a) a contract for the transaction; and (b) the transaction must be rescinded (i) by the parties, (ii) pursuant to a provision in the contract, or (iii) by court order; (c) the parties must be returned to the position they were in before the transaction; and (d) the rescission must occur before the end of the tax year in which the transaction took place.
The most difficult element to satisfy in effecting the rescission of a transaction is likely the requirement that the parties be restored to their pre-transaction status. The difficulty is compounded where events have occurred during the period preceding the rescission which may prevent or which appear inconsistent with an unwinding of the transaction. Closely related to this requirement is the manner in which the rescission is effectuated; i.e., the steps that are taken to return the parties to their earlier positions.
In the event taxpayers find themselves in a situation where it may behoove them to unwind a transaction for valid business or tax reasons, they should not overlook the application of the rescission doctrine. Even where it may appear that a transaction cannot be undone and the parties restored to their pre-transaction status, a close examination of IRS rulings may disclose the manner in which to effect the rescission without adverse tax consequences.