As kids playing ball, we learned about the “do-over” rule, pursuant to which the player in question was allowed to try again, without penalty, whatever it was that they were doing. As we got older and our games changed, some of us learned about “taking a mulligan,” again without penalty.[i] It may not come as a surprise, therefore, 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.
However, as we entered the final month of 2018, I found myself facing two situations in which the application of the rescission doctrine afforded the only solution for avoiding some adverse tax consequences.
In general, the tax law treats each taxable year of a taxpayer as a “separate unit” for tax accounting purposes, and requires that one look at a particular transaction on an “annual basis,” using the facts as they exist at the end of the taxable year; in other words, one determines the tax consequences of the transaction at the end of the taxable year in which it occurred, without regard to events in subsequent years.
It is this basic principle of the annual accounting concept that underlies the rescission doctrine, and from which is derived the requirement, set forth below, that the rescission occur before the end of the taxable year in which the transaction took place.[ii]
According to the IRS,[iii] the legal concept of “rescission” (i) refers to the canceling or voiding of a contract or transaction, that (ii) has the effect of releasing the parties from further obligations to each other, and (iii) restores them to the relative positions they would have occupied had no contract been made or transaction completed.
A rescission may be effected by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other (if sufficient grounds exist), or by applying to the court for a decree of rescission.
It is imperative, based on the annual accounting concept, that the rescission occur before the end of the taxable year in which the transaction took place.
If these requirements are satisfied, then the rescinded transaction is ignored for tax purposes – it is treated as though it never occurred.
Thus, a sale may be disregarded for federal income tax purposes where the sale is rescinded within the same taxable year that it occurred, and the parties are placed in the same positions as they were prior to the sale.[iv]
If the foregoing requirements are not satisfied, the rescission will not be respected, the tax consequences of the original transaction will have to be reported, and the “unwinding” of the original transaction will be analyzed as a separate event that generated its own tax consequences.
Whether the IRS will accept the parties’ claimed rescission of a particular transaction will, of course, depend upon the application of the above criteria to the facts and circumstances of the particular case.
Although the IRS has stated that it is studying the issue of rescission, and it has not issued letter rulings on the subject since 2012,[v] there are a number of earlier rulings to which taxpayers may turn for guidance regarding the IRS’s views.
These rulings illustrate some of the reasons for rescinding a transaction, as well as some of the means by which the rescission may be effectuated.
For example, the IRS has accepted the rescission of a transaction where the transaction was undertaken for a bona fide business reason, but without a proper understanding of the resulting tax consequences. When the parties realized what they had done, they sought to rescind the transaction and thereby avoid the unexpected adverse tax consequences;[vi] in one ruling, the parties not only rescinded the transaction, but then “did it over” so as to achieve the desired result.[vii]
The IRS has also looked favorably on the rescission of a transaction where, due to changed circumstances, the business purpose for the transaction no longer existed.[viii]
Thus, it appears that either a legitimate tax purpose or a bona fide business purpose may be the motivating factor for a rescission.
Restoring Pre-Transaction Status
Of the foregoing requirements for a successful rescission, the most difficult to satisfy may be the restoration of the parties 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.[ix]
For example, in one case, a taxpayer instructed their broker to sell $100,000 worth of a publicly-traded stock, but the broker instead sold 100,000 shares of such stock. In order to reverse this event, at the taxpayer’s direction, the broker reacquired over 96,000 shares in the same corporation. The court found that there was no rescission because the broker was not the buyer of the shares that were sold originally; that buyer was not returned to their original position.[x]
Regardless of the reasons for the rescission, the parties must be prepared to demonstrate that the requirements set forth above have been satisfied, including the requirement that the rescission restored, in all material respects, the legal and financial arrangements among the parties that would have existed had the transaction never occurred.
The taxpayers who were parties to the rescission transactions, for which the above-referenced rulings were requested, represented to the IRS – for the purpose of supporting their claim that they had been restored to their pre-transaction status – that, among other things: (i) no party took or would take any material position inconsistent with the position that would have existed had the rescinded transaction not occurred, (ii) no activities occurred prior to the rescission, or would occur after the rescission, that were materially inconsistent with the rescission, (iii) the purpose and effect of the rescission was to restore in all material respects the legal and financial arrangements among the parties that would have existed had the transaction never occurred, (iv) the legal and financial arrangements between the parties were identical in all material respects, from the date immediately before the rescinded transaction, to such arrangements that would have existed had the transaction not occurred, (v) the parties would take all reasonable actions necessary to effectuate those purposes, (vi) the parties would mutually agree to each of the steps to implement the rescission, (vii) all material items of income, deduction, gain, and loss of each party would be reflected on their respective income tax returns as if the transaction had not occurred, (viii) during the period between the transaction and the rescission, no material changes to the legal or financial relationships between parties occurred that would not have occurred if the transaction had not occurred, and (ix) the rescission would not involve any party that was not involved in the transaction.
As indicated above, I was presented with two separate transactions that had to be rescinded in December of 2018. Both had occurred several months earlier during 2018.
In one transaction, a C corporation had distributed a minority interest in a subsidiary corporation to one of its shareholders in complete redemption of the shareholder’s stock in the distributing corporation. For some inexplicable reason, both parties believed that the distribution was not a taxable event to either of them; the corporation did not consider Sec. 311(b) and the former shareholder did not consider Sec. 302(a).[xi]
The redemption distribution was rescinded by having the “former” shareholder return to the distributing corporation the stock in the subsidiary and re-issuing stock in the distributing corporation to the shareholder. Between the date of the transaction and its rescission, no dividend distributions were made by either the corporation or the subsidiary, and no other event occurred that was inconsistent with the rescission of the redemption distribution.
In the second transaction, a partnership had contributed a wholly-owned disregarded entity (an LLC) to a newly-formed, and wholly-owned, C corporation subsidiary of the partnership. The partnership erroneously believed that it could obtain loans more easily through a corporation. The LLC membership interests were returned to the partnership in rescission of the contribution. As in the first case, there were no distributions by either the corporation or the LLC, nor did any other events occur that were inconsistent with the rescission.
A Useful Tool
In general, the best way to avoid a situation that calls for the rescission of a transaction is to refrain from undertaking the transaction without first vetting it in consultation with one’s tax and corporate advisers.
That being said, there will be instances in which unforeseen post-transaction events may defeat the purpose for the transaction, or may cause the transaction to be unduly expensive from an economic perspective.
In those cases, the taxpayer should bear in mind the possibility of rescinding the transaction, and they should be aware that they have only a limited period in which to exercise the rescission option.
[i] I am not a golfer, and never will be, though I do enjoy the dinners that follow many golf outings.
[ii] The rescission allows the taxpayer to view the transaction “using the facts as they exist at the end of the taxable year” – i.e., as though the transaction never occurred.
[iii] Rev. Rul. 80-58.
[iv] Stated simply: the property is returned to the seller and the cash is returned to the buyer.
[v] Rev. Proc. 2012-3. This no-ruling policy was reaffirmed in Rev. Proc. 2019-3.
[vi] See, e.g., PLR 200309009 (rescinding a distribution of property that would have disqualified taxpayers from the low income housing credit). Moreover, it does not appear to matter whether the transaction to be rescinded was undertaken between unrelated persons or within a group of related taxpayers.
[vii] PLR 201211009 (rescinded a stock sale that did not qualify for a Sec. 338(h)(10) election; substituted a new buyer for which the election would be available).
[viii] See, e.g., PLR 200923010 (rescinding a spin-off where changes in the business environment and in management subsequent to the distribution negated the benefit of the spin-off).
[ix] For example, how might taxpayers rescind a merger? If you’re facing this issue, feel free to contact me.
[x] Hutcheson v. Commissioner, T.C. Memo 1996-127.
[xi] Under IRC Sec. 311(b), a distribution of appreciated property by a corporation to its shareholders is treated as a sale of such property by the corporation. Under IRC Sec. 302(a) and 302(b)(3), the redemption of a shareholder’s entire equity in a corporation is treated as a sale of such equity by the shareholder.