Neither the tax code nor the regulations to the tax code answer the question whether a transaction purporting to unwind or rescind an earlier transaction will be given effect so that neither transaction will be treated as having occurred for federal income tax purposes. This area of the income tax law has been the subject of dispute for a long period of time with only limited government guidance. Recently, the IRS announced it was studying the issue and planned to release guidance concerning the scope and application of the doctrine. Because an effective rescission can be a powerful tool for taxpayers to undo transactions that present adverse or unanticipated economic or tax consequences, understanding the requirements for successful rescission relief is important for taxpayers.
Where the rescission doctrine applies, taxpayers can unwind or substantially modify an already closed and completed transaction for both non-tax and tax-related reasons without tax consequences. Typical non-tax motivations include mistakes as to the underlying transaction, the occurrence of unanticipated events, or even the unwinding of a sale of property that was alleged to be voidable under state law. Tax-motivated reasons can also prompt a rescission including, for example, the failure to properly anticipate the taxpayerâ€"s tax circumstances prior to carrying out the transaction.
Under its current view, the IRS permits the rescission of an earlier transaction even though the principal, and maybe sole, motivation is tax-based. There is no particular form or document needed to accomplish a rescission. It is not even clear whether a rescission transaction need be identified as such by the taxpayer. In practice, however, taxpayers usually document the unwinding by entering into a document that somewhere contains the statement the transaction is a rescission of an earlier transaction. Under the case law and IRS rulings, if a rescission occurs within the same tax year as the year of the transaction being unwound, e.g., a sale of property, the subsequent reconveyance of the property is effective on a retroactive basis so that it is as if the initial transaction never occurred. On the other hand, where the year of sale has already closed, a subsequent rescission transaction, even where the buyer and seller are placed in exactly the same position as the status quo ante, is treated as a separate taxable event with its own separate tax consequences to the parties. This is true even where the right to rescind is provided explicitly in the initial agreement.
IRS GUIDANCE
The existing IRS published authority provides very limited guidance for what will constitute a successful rescission. In Rev. Rul. 80-58, the IRS determined whether a rescission transaction involving the sale of land and its reconveyance by the seller to the buyer under the terms of the contract of sale constituted a successful rescission for federal income tax purposes. Relying on Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), the IRS concluded, where the rescission placed the seller and buyer at the end of the taxable year of sale in the same positions as they were prior to the sale, the original sale would be disregarded "because the rescission extinguished any taxable income for that year with regard to the transaction." Where the rescission occurred in the following year, however, the IRS concluded both the original sale transaction in the first year, and the later reconveyance, were given independent effect for income tax purposes. In reaching these conclusions, the IRS relied on the annual accounting period principle that "requires the determination of income at the close of the taxable year without regard to subsequent events." On its face, Rev. Rul. 80-58 has two simple conditions. The parties to the transaction must be returned to the status quo ante, and the restoration must be accomplished within the same taxable year as the original transaction.
"Importantly, these rulings clarified that hindsight as to the tax consequences of the original transaction is not a bar to successful rescission relief."
The IRS has applied Rev. Rul. 80-58 in a series of private letter rulings. Importantly, these rulings clarified that hindsight as to the tax consequences of the original transaction is not a bar to successful rescission relief. For example, where the S election of a corporation was terminated by the issuance of a class of convertible prefer red stock to three separate partnerships and, within the same taxable period, the preferred stock was cancelled and the parties returned to the status quo ante, the IRS ruled the corporation's Selection was unaffected. In another case, where a parent corporation acquired stock in a subsidiary corporation (Old Sub) for cash and liquidated that corporation, it realized (belatedly) the liquidation may have been imprudent for tax purposes. Within the same taxable year, it formed a new subsidiary (New Sub) and transferred all of the assets and liabilities of Old Sub to New Sub. The IRS ruled that the liquidation and reincorporation of Old Sub and New Sub should be disregarded as a successful rescission of the initial transaction.
These rulings provide helpful, but hardly expansive, guidance concerning the parameters of the rescission doctrine. For example, a taxpayer was required to recognize gain from the unauthorized sale of a portion of the stock held in his brokerage account by his broker. The taxpayer purchased replacement shares of stock within the same taxable year as the fi rst sale, paying a substantially higher price than paid for the shares sold. In the subsequent taxable year, the stockholder and his broker entered into a rescission and settlement agreement and the broker paid damages. The IRS refused to treat the later acquisition of shares as a valid rescission because the taxpayer was unable to unilaterally return to the status quo ante. Further, the later rescission agreement was not effective within the same taxable year as the original sale.
The willingness of the IRS to grant rescission relief in the income tax context stands in contrast to its approach to attempted rescissions in the gift tax context. Generally, a successful rescission for gift tax purposes requires that there have been a mistake of fact at the time that the purported gift was made. Where the taxpayer was mistaken as to the application of the gift tax law, the attempted rescission was unsuccessful.
INTERPRETING THE STATUS QUO ANTE REQUIREMENT
In Rev. Rul. 80-58, the taxpayer was able to satisfy the status quo ante requirement by re-conveying the land following the failure to achieve zoning approval within the same taxable year as the first transaction. How the status quo ante requirement applies where, for example, the item originally transferred was an operating business and, prior to the rescission, the operating business remained an ongoing, income-producing business activity, is unclear and creates uncertainty when planning a successful rescission.
In its private letter rulings, the IRS treats this requirement as satisfied where the parties are returned to the positions they would have occupied if the first transaction had not occurred. This condition assumes, without stating so, that: (i) the original parties to the transaction are the parties that participate in the rescission transaction and (ii) no consideration is paid in order to induce one or the other of the parties to assent to the rescission transaction. As noted above, where the legal existence of one of the entities was terminated, the IRS has permitted the "resurrection" of that entity by the formation of a new entity under state law.
A more troublesome issue is the IRS's view, expressed in its letter ruling policy, that no consideration can be paid in connection with the unwinding transaction in order to induce the cooperation of the parties. To the extent that one of the parties to the transaction involving parties acting at arms length cannot be provided with an inducement to rescind an otherwise closed transaction, the availability of the rescission doctrine would be limited to transactions solely among parties that are members of the same economic unit. In that case, the reach and utility of the rescission doctrine would be greatly limited.
CONCLUSION
The rescission doctrine is a powerful, taxpayer-friendly doctrine that permits the parties to a transaction to unwind bilateral transactions after the fact where the circumstances warrant. The precise mechanics for the unwinding in the case of operating businesses are unclear, however, and resort to the doctrine requires careful attention to the economic underpinnings of the original transaction and the positions of the parties. Practitioners remain hopeful the IRS follows through on its plan to issue more robust guidance in this area.
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