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.

Last year saw many taxpayers selling appreciated assets.  The primary reason for this activity was the imminent increase, in 2013, of the long term capital gain rate, and the imposition (in some cases) of a 3.8% tax on net investment income, both of which would impact sales of assets owned directly by individuals or by pass-through entities owned by such individuals, including S corporations.

Notwithstanding the foregoing tax rate increases, 2013 may be a good time for certain S corporations to consider a sale of assets. Built-in Gain Tax

Unlike C corporations, S corporations generally pay no corporate-level tax.  Instead, items of income and loss of an S corporation pass through to its shareholders.  Each shareholder takes into account its share of these items on its individual income tax return.  Thus, any gain recognized by an S corporation on the sale of assets is passed through and taxed to its shareholders.

There is an exception to this rule for asset sales by S corporations that were previously taxed as C corporations.  Specifically, under Section 1374 of the Internal Revenue Code (the “Code”), a corporation level tax, at the highest marginal rate applicable to corporations (currently 35%), is imposed on that portion of an S corporation’s gain that arose prior to the conversion of the C corporation to an S corporation (the “built-in gain” inherent in its assets at that time; “BIG”) and that is recognized by the S corporation during a specified period of time following the conversion (the “recognition period”).

The amount of corporate BIG tax imposed upon the S corporation is treated as a loss taken into account by the corporation’s shareholders in computing their individual income tax.  The character of the loss is based upon the character of the BIG giving rise to the tax; thus, the sale of an asset that produces a capital gain would generate a capital loss.

Assume, for example, that ACME Inc. was a C corporation with no liabilities and with the following assets on January 1, 2010:

ACME made an S election effective January 1, 2010.  The BIG inherent in its assets is $3MM.  In 2013, ACME sells its assets to an unrelated third party for $3.5 MM.  The sale occurs within ACME’s recognition period.  Of the $3.5 MM gain recognized, $3 MM represents BIG and is subject to corporate level tax at a 35% rate.  Thus, ACME is liable for $1.05 MM of corporate income tax.  Because ACME is an S corporation, the gain recognized passes through to its shareholders, who are also allocated a loss in the amount of the tax liability arising from the BIG.  Thus, the shareholders are allocated $3.5 MM of gain and $1.05 MM of loss, they pay a 20% capital gain tax, and they net proceeds of $1.96 MM: sale proceeds ($3.5 MM) minus corporate tax ($1.05 MM) minus individual capital  gains tax ($490K).

By comparison, if the asset sale had not been subject to the BIG tax, there would have been no corporate tax, the $3.5 MM of gain recognized by the corporation would have been taxed only to the shareholders (at 20%), and they would have retained $2.8 MM of the sale proceeds.

Recognition Period & ATRA

Given the economic impact of the BIG tax, shareholders have historically been reluctant to cause their S corporation to sell its assets during its recognition period.

Before 2009, this period was defined as the first ten taxable years that the S election was in effect.  However, Congress temporarily reduced the recognition period to five tax years, and the American Taxpayer Relief Act of 2012 (P.L. 112-240; “ATRA”) extended the five-year period to include tax years beginning in 2013.  Thus, with respect to any pre-conversion BIG, (for sales occurring in 2013)  no tax will be imposed under Section 1374 if such sales occur after the fifth taxable year the S corporation election is in effect.

2013

In light of the foregoing, 2013 may be a good time for an S corporation that converted from C corporation status in 2007 or earlier to consider selling all or some of its assets.

As an illustration, assume ACME Inc. was a C corporation that elected to be taxed as an S corporation beginning on January 1, 2008.  At that time, it had net unrealized BIG of $3 million.  Prior to ATRA, if ACME had sold its assets in 2013 and recognized gain of at least $3 million, then the entire BIG would have been subject to corporate level federal income tax because the sale would have occurred within the ten-year recognition period.

Under ATRA, however, the recognition period is reduced to five years.  Since ACME will have been an S corporation for five years at the end of 2012, its recognition period will end at that time, and any gain on the sale of its assets in 2013 will escape corporate level taxation, even if that gain is recognized and taxed after 2013 (during what would have been the 10-year recognition period before ATRA) under the installment method.

Notably, the ATRA provision that reduced the recognition period to 5 years expires at the end of 2013, and the ten-year recognition period is then reinstated.  Thus, if ACME delays the sale of its assets to any time from 2014 through 2017, it will be subject to corporate tax on its BIG.

Conclusion

The foregoing is not to suggest that a pre-2008 S corporation with assets subject to the BIG tax should hurry to sell those assets only to capture the tax benefit afforded by ATRA before it expires.  However, an S corporation that was otherwise contemplating a sale should consider the fact that the shortened recognition period expires at the end of 2013, thereby increasing the tax cost of a later sale.

This article originally appeared in the May 2013 of The Suffolk Lawyer.

The Internal Revenue Service is serious about cracking down on U.S. taxpayers who have failed to disclose the existence of foreign accounts in which they have a financial interest, or over which they have signature authority.  Typically, these same taxpayers have failed to report certain transactions on their tax returns, the proceeds of which reside in these accounts, as well as any income or gains realized in such accounts.

Offshore Voluntary Disclosure

In 2009, the IRS instituted an Offshore Voluntary Disclosure Program (OVDP) allowing taxpayers with undisclosed foreign accounts to make a voluntary disclosure to the IRS.  By coming forward, the taxpayer would avoid both substantial civil penalties and, generally, criminal prosecution.

The 2009 OVDP was so successful that the IRS started a second initiative in 2011 to enable more taxpayers to come forward voluntarily and report their previously undisclosed foreign accounts and assets.  This program closed on September 9, 2011, but the IRS announced in January 2012 that it was reopening the voluntary disclosure program for a third time.

The “New” Environment

The extension of the program is good news for delinquent taxpayers, especially given the increasingly aggressive enforcement environment surrounding foreign accounts.  In January 2013, the IRS issued final regulations under the Foreign Account Tax Compliance Act (FATCA) requiring foreign financial institutions to identify their account holders who are U.S. persons and to report account information to the IRS with respect to these persons.  Moreover, the U.S. Treasury has been active in implementing FATCA through agreements with other countries.

Finally, the IRS has begun mining the information it gathered from taxpayers who participated in the earlier disclosure programs to identify foreign financial institutions in which U.S. taxpayers hold undisclosed accounts.

The combined result of these developments is that the IRS has more tools than ever to uncover hidden accounts.

 What’s a Taxpayer to do?

In light of the foregoing, any U.S. taxpayer who has a foreign account that has not been disclosed to the IRS is advised to apply immediately for participation in the voluntary disclosure program.  The extended disclosure program has no expiration date and may be terminated by the IRS at any time, leaving taxpayers once again subject to both severe penalties and criminal prosecution.

To participate in the current disclosure program, the U.S. taxpayer must provide a significant amount of documentation with respect to the years covered, pay back taxes, interest and several penalties, and agree to cooperate throughout the disclosure process.  However, if the taxpayer is accepted into the program, the IRS generally does not conduct an examination with respect to the disclosure made.  Additionally, when the taxpayer truthfully, timely and completely complies with all provisions of the program, the IRS usually will not recommend criminal prosecution.

Conclusion

The IRS is actively engaged in ferreting out the identities of those taxpayers with undisclosed foreign accounts.  This information is becoming increasingly available through FATCA, treaties, data-mining technology, and even whistleblowers.  The bottom line:  a non-compliant U.S. taxpayer cannot assume that his account will not be discovered; on the contrary, according to the IRS, it is only a matter of time.

This article originally appeared in the July issue of Queensborough: the Magazine of the Queens Chamber of Commerce.

As we reached the end of 2012 and the expiration (or so we thought) of the $5 million gift/estate tax exemption, many taxpayers scrambled to make gifts to, or for the benefit of, their family members.  With these gifts, they sought to remove assets, and their appreciation, from the reach of the estate tax.

Other taxpayers took a “wait and see” approach.  As it turned out, the $5 million exemption became “permanent”, allowing these taxpayers to plan their gifting at a more leisurely pace – or so we thought.

The Obama Administration released its 2014 budget on April 10, 2013.  Although the budget included a number of proposals aimed at increasing the income tax burden on wealthy taxpayers – for example, by implementing the so-called “Buffett Rule” and limiting the value of certain deductions and other tax benefits – the budget also proposes significant changes to the estate and gift tax regimes.  These are described below.  Some of the provisions appeared in earlier budgets (as far back as the Clinton administration); others are new.  Taxpayers and their advisers should familiarize themselves with these proposals and consider whether to take action.

Transfer Tax Rates, Exemptions

  • The American Taxpayer Relief Act of 2012 permanently raised the top tax rate for estate, generation skipping transfer (GST), and gift taxes from 35 percent to 40 percent.  It also made permanent the substantive estate, GST and gift tax provisions in effect during 2012, fixing the exclusion amount at $5 million, indexed for inflation.
  • The budget proposal would undo the foregoing so-called “permanent” changes.  It would make permanent the estate, GST, and gift tax parameters as they applied during 2009.  The top tax rate would be 45 percent.  The exclusion amount would be $3.5 million for estate and GST taxes and $1 million for gift taxes.  There would be no indexing for inflation.

Fortunately, the proposal confirms that, in computing gift and estate tax liabilities, estate or gift tax will not be incurred for a prior gift that was excluded from tax at the time of transfer.  Portability of unused estate and gift tax exclusions between spouses is allowed.

The proposal would be effective for the estates of decedents dying, and for transfers made, after December 31, 2017.

Basis Consistency

  • The budget proposal imposes both a consistency and a reporting requirement.  The basis of property received by reason of death must equal the fair market value of that property for estate tax purposes.  The basis of property received by gift during the donor’s life must equal the donor’s basis. No rule explicitly requires the recipient of the property to use the estate/gift tax value for purposes of the property’s income basis. The proposal requires that the basis of the recipient’s property be no greater than the property value determined for estate or gift tax purposes.

A reporting requirement would be imposed on the decedent’s estate and on the donor (as to lifetime gift) to provide valuation and basis information to the recipient and to the IRS.  The proposal would be effective for transfers on or after the enactment date

GRATs

  • The proposal requires that a Grantor Retained Annuity Trust (“GRAT”) have a minimum term of ten years and a maximum term of the actuarial life expectancy of the annuitant plus ten years.  The minimum term proposal increases the risk that the grantor will not outlive the GRAT term, thereby losing any anticipated transfer tax benefit.  The proposal also includes a requirement that the remainder interest have a value greater than zero at the time the interest is created.  It prohibits any decrease in the annuity amount during the GRAT term.  The proposal would apply to trusts created after the enactment date.

Duration of GST Exemption

  • The proposal provides that, on the 90th anniversary of a trust’s creation, the GST exemption allocated to the trust terminates.  This would be achieved by increasing the trust’s inclusion ratio to one, thereby rendering the entire trust subject to GST tax. The proposal would apply to trusts created, and to additions made to a pre-existing trust, after the enactment date.

Grantor Trusts

  • When a person, who is the deemed owner of a trust for income tax purposes, engages in a sale or exchange with the trust, the transaction is disregarded for income tax purposes.  Upon the deemed owner’s death, the portion of that trust attributable to the property received in that transaction (including all of its retained income and appreciation) would be subject to estate tax as part of the gross estate of the deemed owner.

In addition, such portion would be subject to gift tax during the deemed owner’s life when his treatment as the deemed owner of the trust is terminated.  Any distribution from the trust to another person will also be treated as a gift by the deemed owner.  The transfer tax would be payable from the trust.  The proposal affects trusts that engage in a described transaction on or after the enactment date.

What’s Next?

It remains to be seen whether any of these proposals will be enacted into law.  Some certainly stand a better chance than others.  Given the fact that the proposals have been made, coupled with the likelihood that we are entering a period during which “tax reform” will be a legislative priority, especially as regards wealthy taxpayers, it behooves taxpayers to consider their estate planning options.  With respect to the 2014 budget proposals, a taxpayer may wish to consider:  (1) utilizing the taxpayer’s remaining gift tax exemption; (2) creating shorter-term or zeroed-out GRATs (for which the low interest rate environment is favorable); (3) creating GST-exempt dynasty trusts; and/or (4) completing sales to intentionally defective grantor trusts.