On the golf course, it is called a mulligan. On the playground, it is a "do-over." And in the contract arena, its name is (or can sometimes be) rescission. Formally, Black's Law Dictionary defines "rescission" as "annulling or abrogation or unmaking of the contract and the placing of the parties to it in status quo." More colloquially, a rescission occurs when parties to a transaction agree essentially to turn back the clock and simply void a transaction, treating the situation not as two events (the original deal and the subsequent "unwinding," each potentially with its own consequences) but as no transaction at all.
Permitting the parties to walk away and pretend that the original deal never occurred can be advantageous, especially when it is prompted by a misunderstanding of the facts or law, the occurrence of unanticipated events, or the failure of anticipated events to occur.
The rescission doctrine has its genesis in contract law but in certain circumstances has clear application in the tax world. Neither the Internal Revenue Code nor the Treasury regulations address when a rescission is given effect for tax purposes, but the history of the federal tax doctrine of rescission reaches back three-quarters of a century. It was first confirmed in an appellate court decision 75 years ago. Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), scrutinized the tax consequences of a shareholder derivative suit requiring the return in 1931 of dividends credited to a taxpayer in two years (1930 and 1931).
Although the IRS sought to tax both the 1930 and 1931 dividends in the years they were received, the Fourth Circuit demurred. It awarded the taxpayer a partial victory, holding that even though the return of the 1930 dividends in the following year did not vitiate their taxability in 1930, the taxpayer could escape tax on the 1931 dividends. The distinction was based on the so-called annual accounting principle, which dictates that because of the need for certainty in the tax system, a transaction cannot remain "open" indefinitely. In other words, because each tax year is a separate unit for tax accounting purposes, events in subsequent years will generally not affect the tax consequences of a transaction occurring in an earlier year (see Security Flour Mills Co., 321 U.S. 281 (1944)).
A taxpayer's ability to rescind transactions for tax purposes formally found expression in Rev. Rul. 80-58. In that ruling, A sold land to B, but the sale contract obligated A to take the land back at B's option if the land could not be rezoned. When the applicable government authorities refused to rezone the property, B exercised its option, and the parties rescinded the transaction: B returned the land to A during the same tax year as the initial sale and in return received the purchase price. The ruling concludes that the rescission would be respected for tax purposes. Accordingly, A did not recognize gain on the initial sale, and B did not recognize gain on the unwinding.
Under Rev. Rul. 80-58, a successful tax rescission has two prerequisites:
- The parties to the transaction must be returned to the status quo ante (i.e., the relative positions they would have occupied had no contract been made); and
- The restoration must be accomplished within the same tax year as the original transaction.
The ruling elaborates that a rescission "may be effected 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."
Whether the conditions for a valid rescission are satisfied is an inherently factual question, and, over the years since Rev. Rul. 80-58 was issued, the IRS has issued numerous private letter rulings confirming the effectiveness of numerous rescissions. While these rulings do not carry precedential weight, they do offer guidance to taxpayers. Stated generally, the taxpayer's motives for undertaking a rescission are irrelevant. Thus, rescissions have been respected when the parties are related and when the rescission did not occur pursuant to a right spelled out in the original contract. For example, the IRS has issued taxpayer-favorable rulings dealing with distributions, transfers, and issuances of stock (Letter Ruling 200923010); revocation of a Sec. 83(b) election (Letter Ruling 9104039); sale of stock that terminated S corporation status (Letter Ruling 200533002); merger of a target corporation (Letter Ruling 200911004); and conversion from a limited liability corporation taxed as a partnership into an entity taxed as a corporation (Letter Ruling 200613027).
Moreover, significant nonprecedential support permits taxpayers to rescind a transaction to reverse-engineer their way to better tax results. Specifically, a private letter ruling has approved the merger of a target corporation into the parent to restore the parent's cost basis in target stock, even though a principal purpose for the rescission seems to have been a federal tax reason (Letter Ruling 200701019). The IRS has even approved voiding some steps of a restructuring plan to eliminate "springing debt" (which would be taxable as boot) even though other steps of the plan remained in effect (Letter Ruling 201021002).
Some questions exist over the full scope and current vitality of the tax rescission doctrine, especially when the "unwinding" has a principal purpose of tax reduction or when only some steps but not all of the original transaction are voided by parties. After placing "guidance on the scope and application of the rescission doctrine" on the IRS and Treasury's priority guidance plan at the end of 2010, the IRS announced in Rev. Proc. 2012-3 (Section 5.02) that, pending a study, it was no longer issuing private letter rulings in the area. Shortly afterward, a senior official of the IRS Office of Chief Counsel announced that the guidance project was being dropped, but the no-ruling policy maintained. The no-ruling policy was formalized in Rev. Proc. 2014-3 (Section 3.02(8)) and reaffirmed in Rev. Proc. 2015-3 (Section 3.02(8)).
The IRS's current no-ruling position notwithstanding, the tax rescission doctrine remains in effect by virtue of Rev. Rul. 80-58. What is more, the IRS itself has not so much signaled strong antipathy to the rescission doctrine as suggested that in the current budget climate, scarce resources could not be devoted to providing "comfort" rulings on the topic (see Elliott, "IRS Ends Rescission Study, Leaving No-Rule in Effect," 2013 TNT 127-1 (July 2, 2013) (remarks of IRS associate chief counsel, corporate)). Thus, while a public letter ruling might be preferred, an attempted but unsuccessful rescission may leave the taxpayer no worse off than it would have been if the rescission had not been attempted. In such a case, the taxpayer's ability to realize the results of the rescission for financial reporting purposes would depend on the confidence level of any advice it received, whether the IRS has examined the issue, or the running of the statute of limitation. (It might also affect the prudence of disclosing the rescission on its tax return.)
Ultimately, then, rather than stew endlessly over an error, it might be prudent for the taxpayer to consider its eligibility for a tax mulligan.
Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.