Getting a Second Chance from the IRS
Have you ever closed a transaction only to realize that it has disastrous tax consequences?
If you answered yes, you are not alone. Such situations often occur as a result of conducting business in a fast-paced, dynamic economy, but a solution may exist to eliminate the negative tax consequences—rescission. Rescission provides an opportunity to void a transaction and thereby treat it as if it never happened—a true “do over.”
The rescission doctrine originated with Rev. Rul. 80-58 which outlined the following key requirements to rescind a transaction for federal income tax purposes:
- The parties involved must return to the positions they were in prior to the transaction.
- The rescission generally must occur within the same taxable year as the original transaction.
In Rev. Rul. 80-58, a taxpayer sold a tract of land to a third party in exchange for cash. The third party was unable to secure the required zoning, so it was necessary for the buyer to reconvey the property back to the taxpayer. Since the original sale and the reconveyance occurred in the same taxable year, IRS concluded that the sale was void and was ignored (no gain was recognized). Because the rescission of the sale placed the taxpayer and the buyer at the end of the taxable year in the same positions as they were prior to the sale, the original sale was disregarded for federal income tax purposes. The rescission extinguished any taxable income for that year with regard to the transaction. However, if the rescission had not occurred within the same tax year as the original transaction, IRS concluded that the consequences of the sale transaction in the first year would have been respected and the taxpayer would have been treated as reacquiring the land in the second year.
Rev. Rul. 80-58 summarizes the legal principle of rescission as follows:
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The legal concept of rescission refers to the abrogation, canceling, or voiding of a contract that has the effect of releasing the contracting parties from further obligations to each other and restoring the parties to the relative positions that they would have occupied had no contract been made. A rescission may be affected 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.
Although the rescission doctrine has typically been used to rescind contracts, recent private letter rulings (PLRs) suggest that the principles of Rev. Rul. 80-58 may also be used to unwind the formation or dissolution of entities, to reduce taxes, and to provide financial statement benefits for public companies. In one ruling (PLR 200843001), IRS allowed a foreign corporation to maintain its status as a disregarded entity where the sale of its stock was rescinded. IRS ruled that the parent company could apply the rescission doctrine to disregard the sale of its foreign entity’s stock to a third party and to continue to treat the foreign entity as a disregarded entity from the date of the initial transaction. IRS also affirmatively ruled that the rescission of the foreign entity stock sale would not be treated as a liquidation of a partnership.
In another ruling (PLR 200701019), IRS permitted a taxpayer to rescind the Sec. 332 liquidation of a subsidiary in its consolidated group to preserve the higher outside basis in the stock of the subsidiary. The higher outside basis allowed the taxpayer to minimize the gain from an impending sale of the subsidiary. This ruling permitted the taxpayer to use hindsight to unwind a transaction in order to achieve a more favorable tax result.
In PLR 200613027, IRS allowed a taxpayer to rescind the incorporation of a limited liability company (LLC). As a result of the successful rescission, the parties avoided tax on any corporate-level and shareholder-level gain that would have resulted had the conversion back to an LLC been treated as a fully taxable liquidation.
Finally, in PLR 200533002, IRS permitted a taxpayer to rescind the issuance of preferred stock to avoid terminating its S election. IRS concluded that the shareholders of the company (seller) and the venture fund (buyer) were restored to the relative positions they would have occupied if the stock had never been sold to the fund. Since the restoration was achieved within the same taxable year, IRS ruled that the rescission doctrine applied so the parties could disregard the issuance of the convertible preferred stock and the company continued to be an S corporation.
IRS continues to issue favorable rulings on rescission transactions – eight rulings in the last three years, including three in the last three months. If you have been adversely affected by the tax consequences of a transaction, consult your WTAS tax advisor to discuss rescinding the transaction and to work through the potential issues:
- Is it possible to restore the parties to their relative tax and legal positions prior to the rescinded transaction?
- Do the parties have different taxable years that may impact the ability to rescind the transaction?
- Does state law impact the ability to rescind the transaction?
- Is an IRS ruling desired because of the materiality of the transaction or the risk tolerance of the parties?
- Have you considered and discussed with your auditor the financial statement ramifications of the planned rescission?
