United States: Insatiable: Estate Of Kechijian Limits Application Of Tax Rescission Doctrine

By Mark Leeds & Minju Kim¹

Shakespeare is credited with creating the meme "gilding the lily,"² which means to add unnecessary adornment to something that is already beautiful. This phrase is particularly apt to describe the tax planning addressed by the US Court of Appeals for the Fourth Circuit in Estate of Kechijian v. Commissioner in its decision released on June 23, 2020.³ The taxpayers in this case artfully executed an S corporation employee stock ownership plan ("ESOP") that resulted in the deferral of a substantial amount of federal income tax and the tax-free creation of $174 million in asset basis. Their tax planning, however, was substantially unwound when their intrigues to turn the deferral into permanent tax exemptions were challenged by the Internal Revenue Service (the "IRS") and substantial tax penalties were imposed. Further footfalls during the litigation limited the ability of the taxpayers to use net operating loss ("NOL") carryback claims to reduce the tax bite. This Legal Update explores the decision and its implications for the use of the rescission doctrine in tax planning.

I. Background

The taxpayers, two individuals, operated a successful distressed debt trading and recovery business through limited liability companies ("LLCs") that appeared to have been taxable as partnerships for federal income tax purposes. In 1998, the taxpayers transferred their interests in the LLCs to a newlyformed "S corporation"⁴ in exchange for the stock in the S corporation in a non-taxable transaction.⁵ Although each taxpayer owned his interests in the LLCs without restriction, they each attached a "substantial risk of forfeiture" to the stock of the S corporation.⁶ Specifically, each taxpayer agreed to forfeit all or a portion of his S corporation stock if he left the business within five years of the date of the transfer of the LLC interests to the S corporation. Neither taxpayer made an election to include the excess of the value of the S corporation stock over the amount paid for such stock in income.⁷

In December of 1998, the taxpayers created an ESOP and the ESOP purchased stock in the S corporation. Under the tax rules in effect at that time, the S corporation did not pass through any income on the stock that was subject to a substantial risk of forfeiture. Since the ESOP (which was tax-exempt) was the only S corporation shareholder who held unrestricted stock, all of the S corporation's taxable income was allocated to the ESOP. As a result, no one paid any tax on the income earned by the S corporation in 2000 through 2003. Congress eliminated this scheme of taxation, effective beginning in 2005.

In response to the then-prospective change in law, the S corporation sold all of its assets, at a profit of $174.6 million, to a newly-formed limited liability company ("Holdings") owned by the two taxpayers. Since the sale occurred prior to the law change, all of the gain from the sale was allocated to the ESOP. Holdings paid for the S corporation's assets by issuing its promissory note with a face amount of $190 million to the S corporation. The sale enabled the taxpayers to increase the bases of the assets held in the distressed debt trading business by $174.2 million without any tax being due and payable. So far, pretty good.

In 2004, the substantial risks of forfeiture applicable to the stock of the S corporation expired. If nothing else had happened, the taxpayers would each have recognized approximately $45.9 million in ordinary income (the fair market value of the S corporation stock at that time). In order to prevent this income recognition, each taxpayer voluntarily surrendered his stock back to the S corporation. Immediately following the stock surrender, however, each taxpayer purchased back stock from the S corporation by issuing a $41.5 million promissory note to the S corporation. The taxpayers reported the $4.4 million difference between the value of the stock that he purchased and the price paid as ordinary compensation income. Also in 2004, the S corporation redeemed the stock held by the ESOP, leaving the two taxpayers as the sole S corporation shareholders.

The business continued to operate until 2008. In 2008, the business failed in the financial crisis that occurred in such year. The taxpayers incurred substantial losses as their business failed.

II. Tax Reporting

The taxpayers did not report income equal to the fair market value of the S corporation stock when the substantial risks of forfeiture expired in 2004, as required by Code § 83(a). They argued that since they surrendered the stock in the same year in which the stock vested, the rescission doctrine allowed them to treat the vesting of the stock as a nullity. The court refused to allow the taxpayers to use the rescission doctrine on two separate grounds. First, the court held that the doctrine was inapplicable because the services had been performed in a tax year prior to the year in which they voluntarily forfeited the stock. Second, the court held that the surrender, coupled with stock purchase, lacked any economic substance.⁸

III. The Rescission Doctrine

Applicable federal income tax principles allow taxpayers to treat transactions as though they never occurred if they are rescinded in the year in which they are entered into and certain other requirements are satisfied. Prior to Estate of Kechijian, the application of the rescission doctrine to compensatory payments had been limited to arrangements in which employees were contractually bound to return unearned compensation.⁹ In Estate of Kechijian, the fourth circuit found these cases were inapposite because the taxpayers were not obligated to return the S corporation stock. Furthermore, the court refused to look to the year in which the substantial risks of forfeiture expired in the determining when the original transaction took place. The court concluded that the original transaction took place over the years in which services were rendered, even though the stock was subject to "cliff vesting," that is, all of the stock vested in 2004. We'll explore these holdings in light of the prior authorities applying the rescission doctrine.

The case that established that a taxpayer has the right to rescind a transaction and treat it as void ab initio is Penn v. Robertson, 115 F.2d 167 (4^th Cir. 1940). Interestingly, this case involved stock transferred in connection with the performance of services. In Penn v. Robertson, the taxpayer purchased stock at below its value from his employer in 1930 and 1931. The stock purchase plan had not been approved by shareholders. Certain shareholders sued to enjoin the operation of the plan and the estate of the employee sold the stock back to his employer in 1931.¹⁰ (The estate also returned amounts paid to the employee as dividends on the stock.) The IRS asserted that the employee recognized income from each stock grant and dividends and the estate was entitled to a deduction for the return of the stock and cash when they were returned. The taxpayer, however, asserted that the stock purchases and resales should be void ab initio and the dividends and the returns thereof should not have any federal income tax effects.

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Footnotes

1. Mark (mleeds@mayerbrown.com; (212) 506-2499) and Minju (mkim@mayerbrown.com; (212) 506-2169) are both tax lawyers with the New York office of Mayer Brown LLP. The authors thank Mr. Robert Shapiro, managing director and head of US Tax at Societe Generale, SA, for his thoughtful comments on an earlier draft of this Legal Update. Mistakes and omissions, however, remain the sole responsibility of the authors.

2. The Life and Death of King John (4:2): "To gild refined gold, to paint the lily ... is wasteful and ridiculous excess."

3. No. 18-2277 (June 23, 2020), aff'g Tax Court No. 8967-10.

4. See Section 1361 of the Internal Revenue Code of 1986, as amended (the "Code").

5. See Code § 351(a).

6. See Code § 83(a).

7. See Code § 83(b).

8. A discussion of the business purpose analysis is beyond the scope of this Legal Update.

9. Russell v. Comm'r, 35 BTA 602 (1937); Rev. Rul. 79-311, 19879-2 CB 25.

10. The actual taxpayer died before the employer rescinded the stock purchase plan. The taxpayer's estate returned the stock and the dividends paid on the stock.

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