Sometimes you work really hard and things go well; other times you work just as hard and things go, well, not so well.

The Tax GuyIn the tax planning business, the job is usually interesting but always complex, and so it is easy (and in all events wise) to be humble. Tax mistakes occur all the time, and the reason we know this is because the mistakes are often widely publicized-through tax court cases in which the IRS prevails, through various IRS enforcement actions, and through the often-scary word-of-mouth lore that is shared among tax professionals about transactions gone horribly awry.

When “Undoing the Deal” Is the Best Solution

What all these circumstances have in common is that, after a transaction has closed, someone discovers that the tax consequences are dramatically worse than originally anticipated. This discovery can lead to acrimony, recrimination and lawsuits. At least some of the time, however, a far better resolution is to consider whether it is possible to rescind or unwind the transaction.

Let’s start with the good news: Both case law and IRS rulings recognize that a complete rescission of a transaction may, under appropriate circumstances, be given full effect for federal income tax purposes to nullify and abrogate a transaction. The seminal authority governing the federal income tax consequences of the rescission transaction are a case, Penn v. Robertson, and an IRS ruling, Rev. Rul. 80-58.

In Penn v. Robertson, the taxpayer, during 1930 and 1931, was allowed to participate in an employees’ stock plan established by the employer corporation without obtaining necessary shareholder approval. The taxpayer was credited with earnings from the plan for 1930 and 1931. After a subsequent shareholder law suit, the plan was rescinded in 1931, and employees who agreed to give up their rights under the plan received back all prior contributions. The IRS attempted to assess income taxes for both 1930 and 1931. The U.S. Court of Appeals held that the rescission would be respected for tax year 1931 (the year of rescission), but not for tax year 1930, since under the “annual accounting period principle” it was not appropriate to recompute income after the close of a taxable year.

In Rev. Rul. 80-58, the IRS adopted the analysis in Penn and ruled that where a contract for the sale of land obligates the seller to accept reconveyance of the land if the buyer is unable to have the land rezoned for his business purposes and to return to the buyer all amounts spent in connection with the sale, the tax consequences of a reconveyance are as follows:

• if the reconveyance takes place in the same year as the original transfer, the original sale is disregarded and thus the rescission extinguishes any income from the sale;

• if the reconveyance occurs in a latter year, the original sale is recognized; any gain or loss to the seller must be reported in the year of sale, and, on the reconveyance, the original seller acquires a tax basis in the property equal to the amount paid by original seller to original buyer for the reconveyance.

Same Tax Year as Transaction

In a subsequent Private Letter Ruling, PLR 9408004, the IRS cited Rev. Rul. 80-58 as standing for the proposition that there are at least two conditions that must be satisfied for the rescission doctrine to apply: (1) the parties to the transaction must be restored to the relative positions they would have occupied had no contract been made; and (2) this restoration must be achieved within the same tax year as the original transaction.

Even the two “core” requirements set forth above can sometimes be subject to exception. For example, there is authority suggesting that, in rare cases, a modification can be given retroactive effect after the close of a tax year. In Rev. Rul. 71-416, retroactive effect was given to a modification nunc pro tunc of a divorce decree two years after the original decree was entered by the court, where the purpose of the modification was to correct a prior computational error. Far more typically, however, the IRS has typically prohibited rescission treatment for steps taken after the close of the taxable year.

Returning Parties to Status Quo Ante

Just as taxpayers must complete the unwinding in the sale tax year, so too must they return all parties to the same position they would have been in but for the transaction. This latter principle was illustrated by the case of Richard L. Hutcheson, where a taxpayer instructed a broker to sell $100,000 worth of Wal-Mart stock in January 1989, but the broker instead erroneously sold 100,000 shares at a price of approximately $30 per share, generating approximately $3 million of sales proceeds.

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Joe Darby, a tax law expert, is also the author of Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition, published by The National Underwriter Company, a division of ALM Media.  ThinkAdvisor readers can get this resource at a 10% discount. Go there now.

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In December 1989, in an effort to rectify the situation, the taxpayer, through the same broker, repurchased 96,400 shares of the Wal-Mart stock at a price of approximately $45 per share. The court held that there was no rescission under Rev. Rul. 80-58, and emphasized that, in order for a rescission to be effective, both the buyer and seller must be put back in their original positions.

This requirement was not met in Hutcheson because neither the taxpayer nor the original purchasers of the Wal-Mart stock were put back in the relative positions that they would have occupied had no sale been made. The original buyers did not return the stock they bought to the taxpayer, and the taxpayer did not repurchase the same shares he sold.

Business Purpose

Perhaps the most interesting and tantalizing question is whether a taxpayer can rescind a transaction motivated solely by a desire to avoid the resulting tax consequences. As a general proposition, tax-motivated transactions are subject to challenge by the IRS, particularly if there is no bona fide business purpose apart from tax considerations. However, cases and rulings on the rescission doctrine rarely examine the motivation for the transaction, and instead focus predominantly on whether the rescission occurs in the same tax year and puts all parties back to their original positions. However, it should also be noted that most cases in which a rescission has been approved arose because of inherent business or legal factors that made the rescission necessary.

Practically speaking, the parties to a transaction can probably almost always identify a “business purpose” for a rescission, since a rescission necessarily involves a meaningful change in economic position, if only back to the original (pre-transaction) position. This humble observer believes that, so long as the Rev. Rul. 80-58 criteria are met (no simple task, as will be discussed below), rescission treatment should be allowed regardless of the motivation underlying the rescission.

The general principle under U.S. contract law is that consenting parties can enter into any legal arrangement they so choose, including an “agreement to unagree.” Rev. Rul. 80-58 incorporates as a limitation on that flexibility the fundamental principle of tax law that all taxpayers must be assessed based on an annual accounting period (a sacrosanct principle because revenues must be assessed and collected each year). However, so long as the unwinding occurs within the same tax year, and so long as all parties are voluntarily restored to their original positions, it seems reasonable to argue that no harm is visited to the core principles of income taxation.

Muddying Waters by Re-Negotiation

Assuming a transaction can be unwound, the question is often, “What next?” Sometimes unwinding a deal-gone-bad provides enough benefit to make everyone happy, but other times there is an irresistible desire to redo the transaction “the right way.”

However, there can be a problem if the “right way” is also the “same way.” In Dunlap v. Commissioner, a sale of bank stock in 1969 was conditioned on approval by the Federal Reserve Board. When the F.R.B. disapproved the deal in 1971, the transaction was nominally “rescinded” but the “rescission” agreement was only entered into simultaneously with a new sales agreement at the same basic price, plus added compensation for the delay in payment. The court concluded that, in practical terms, the 1969 agreement survived the “rescission” and the concurrent 1971 purchase agreement, being modified only to the extent required by the F.R.B, represented a re-negotiation rather than a rescission.

Practical Considerations

Often, the hardest part of rescinding a transaction is returning the parties to their original positions in the same tax year. Realistically, putting everyone back in the same position sounds easy, but is often difficult and sometimes impossible. Take a “simple” sale of real estate. The buyer may have bank financing, and the bank may balk, or may require pre-payment penalties. The buyer may have received rents from a tenant, may have started renovations with a contractor, and almost certainly will have paid (or at least accrued) property taxes. There may also be risks associated with interim ownership-who is liable, for example, if there is a slip-and-fall accident on the property during this period?

Rescission is the tax-planning equivalent of the “Hail Mary” pass in football: You really don’t want to be in a position to use it, but sometimes you have no other choice. As this article illustrates, it is usually not an easy transaction (or pass) to complete, but under the right set of circumstances it can be successful-which is why everyone continues to try it.

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Joe Darby, a tax law expert, is also the author of Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition, published by The National Underwriter Company, a division of ALM Media.  ThinkAdvisor readers can get this resource at a 10% discount. Go there now.