Taxpayers who have completed a transaction during 2010 may have an opportunity to “undo” or “unwind” the transaction before year end for United States federal income tax purposes, and to treat the transaction as if it had never occurred. This principle of law, known as “rescission,” was established approximately seventy years ago in the landmark case of Penn v. Robertson, and the Internal Revenue Service later acknowledged this principle in Rev. Rul. 80-58. In each of these precedents, taxpayers who completed transactions, but who subsequently desired or needed to unwind the transactions, were permitted to do so and to report their overall tax results as if the transactions had never occurred.1
Recently, the IRS has issued several private letter rulings addressing the application of this rescission principle to particular situations, providing additional guidance to taxpayers who have entered into transactions that they now wish to undo. The authorities prescribe two basic principles for effecting a valid rescission:
- Both the initial transaction and the unwind must occur within a single taxable year; and
- All parties to the transaction must be returned to the “status quo” (that is, the place they were before the initial transaction).
While on their face these two elements seem relatively straightforward and achievable, there remain ambiguities surrounding their application. For example, with respect to the single taxable year requirement, it is not clear which taxable year applies if applicable parties to the transaction have different taxable years. In addition, although several of the authorities apply a helpful materiality standard in determining whether the parties have returned to the status quo, potential issues remain regarding items which simply cannot be undone, for example, transaction costs and non-financial items such as interim stock votes.
Taxpayers may have varying motives for rescinding a transaction, including a desire to correct a mistake in the original transaction or because the original transaction resulted in an unanticipated business or tax consequence. Under the existing authorities, it appears that a taxpayer’s reasons for undertaking a rescission are generally irrelevant. Accordingly, taxpayers may be able to rescind a transaction even if motivated by the desire to undo an unanticipated adverse result of the initial transaction, thus potentially permitting a degree of retroactive business and tax planning.
Particular areas where the IRS has allowed taxpayers to unwind a transaction and treat it as a nullity for United States federal income tax purposes include:
- sales of property;
- distributions, transfers, and issuances of stock;
- ultra vires dividends or dividends paid due to a scrivener’s error;
- sale of stock that terminated S corporation status;
- conversion of an LLC taxed as a partnership into a corporation;
- liquidation of a corporate subsidiary;
- merger of two corporations;
- amalgamation of foreign subsidiaries; and
- transfer of assets and employees between corporations.
Despite the pro-taxpayer aspects of the rescission doctrine, its boundaries are not limitless. For example, it is hotly debated whether a taxpayer can unwind a transaction only to “do over” the original transaction by entering into a third transaction with the same or substantially similar economic effects.2 Additionally, a taxpayer’s ability to rescind certain unilateral actions, such as dividends, tax elections, and completed gifts, may also be limited in some cases.