Matthew B. Edwards and Jeffrey K. Gurney.
Many attorneys encounter (new or existing) clients who want to change, recast, alter, or otherwise rescind a transaction that has already taken place. Typically, these attorneys’ first and only instincts are how to change, recast, alter, or otherwise rescind such transaction under state law or the underlying agreement. Often neglected from these analyses are the tax effects of the attorneys’ chosen solutions. The means and mechanisms used to “fx” unwanted transactions, and the timing of those remedies, may affect a client’s ability to change the tax effects of the unwanted transaction and create new and undesirable tax consequences.
This article introduces the area of tax law known as “tax rescission.” Tax rescission refers to the ability of a taxpayer to treat a completed transaction as if it never occurred (or occurred as modified or recast) for federal tax purposes. Tax rescission and contractual rescission are not synonymous.1 A contractual rescission is typically a necessary component of tax rescission. This article aims to provide the reader with a basic understanding of the location of potential landmines that are laid in the feld of tax rescission.
Penn v. Robertson and Revenue Ruling 80-58
The tax rescission doctrine owes its foundational roots to the Fourth Circuit’s decision in Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940). In Penn, the board of directors of American Tobacco Company approved a stock benefit fund for officers without shareholder approval. The taxpayer, Penn, received earnings under the fund in 1930 and 1931. Shareholders fled lawsuits against the directors, and the directors rescinded the stock benefit fund in 1931. The taxpayer returned the earnings in 1931. The taxpayer argued that the earnings should not be includible as taxable income in 1930 or 1931. The Internal Revenue Service (IRS) argued that the earnings should be taxable to the taxpayer in each year.
The Fourth Circuit examined two general tax principles: (1) the claim of right doctrine; and (2) the annual accounting principle, to determine whether the earnings were taxable income to the taxpayer, and in what years. Under the claim of right doctrine, “[i]f a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”2 Under the annual accounting principle, “one must look at the transaction on an annual basis using the facts as they exist at the end of the year. That is, each taxable year is a separate unit for tax accounting purposes.”3
Based on these two principles, the Fourth Circuit held that the rescission in 1931 extinguished the taxable income for 1931. However, the 1931 rescission was not effective to rescind the 1930 taxable income because the annual accounting period rule required that each taxable year was to be considered without regard to subsequent events.
Forty years after Penn, the IRS issued guidance that taxpayers could rely upon in tax rescission cases. In 1980, the IRS published Revenue Ruling 80-58 to provide taxpayers with a safe harbor for tax rescission. That Ruling considered two situations:
Situation 1: In February 1978, A, a calendar year taxpayer, sold a tract of land to B and received cash for the entire purchase price. The contract of sale obligated A, at the request of B, to accept reconveyance of the land from B if at any time within nine months of the date of sale, B was unable to have the land rezoned for B’s business purposes. If there were a reconveyance under the contract, A and B would be placed in the same positions they were prior to the sale.
In October 1978, B determined that it was not possible to have the land rezoned and notified A of its intention to recovery the land pursuant to the terms of the contract of sale. The reconveyance was consummated during October 1978, and the tract of land was returned to A, and B received back all amounts expended in connection with the transaction.
Situation 2: Same as above, except that the period within which B could reconvey the property to A was one year. In January 1979, B determined that it was not possible to have the land rezoned and notified A of its intention to reconvey the land pursuant to the terms of the contract of sale. The reconveyance was consummated during February 1979, and the tract of land was returned to A. B received back all amounts expended in connection with the transaction.4
The IRS examined the annual accounting principle and Penn to reach its conclusions. In Situation 1, the IRS determined that A would not recognize any taxable income on the sale of property because the parties returned to their status quo in the year of the original transaction. However, in Situation 2, the IRS determined...