Presto Change-o: Unwinding Transactions in the Face of Uncertainty; It's all about the rescission doctrine.

AuthorJacobs, Kevin M.

With tax reform on the horizon, many companies are actively considering how the various proposals could impact their business and how they should structure their operations. However, many companies do not want to go all in and pull the trigger on a transaction based on what may amount to an educated guess about where tax law will ultimately lie. To address some of those concerns, companies should be aware of the rescission doctrine and its potential uses. Generally viewed as a last resort, the rescission doctrine may allow companies to retroactively unwind a transaction they have entered into, as long as they are aware of the open questions and potential limitations attached to this course of action.

History of the Rescission Doctrine

Neither the Internal Revenue Code nor any Treasury Regulations describe the rescission doctrine, but its genesis and application in the tax realm can be traced to Penn v. Robertson} In that case, Charles A. Penn was a vice president and director of the American Tobacco Company (ATC). In 1929, the company directors passed a resolution that resulted in the sale of 10,000 shares of ATC stock to Penn in exchange for a note, in which dividends on the stock would be credited to the note. In 1931, in response to litigation, the directors of ATC passed a resolution to rescind and cancel the 1929 sale and the dividends that were credited in 1930 and 1931. The court, based on annual income tax accounting, required Penn to recognize dividend income with respect to the 1930 dividend, but allowed the rescission of the 1931 dividend.

Forty years later, in Revenue Ruling 80-58,2 the Internal Revenue Service acknowledged that rescission could be accomplished by mutual agreement, by one party's declaration of rescission of the contract without the other's consent if sufficient grounds exist, or by court order. However, the IRS required that:

* the parties to the original transaction are the same parties that entered into the rescission;

* the parties be returned to the "relative positions that they would have occupied had no contract been made"; and

* the rescission and restoration occur within the same taxable year as the original transaction.

It is important to note that, in formulating these requirements, the IRS did not refer to a nontax business purpose in order to apply the rescission doctrine. In fact, the IRS has issued numerous private letter rulings allowing taxpayers to rescind a transaction in order to obtain a better tax result or to correct a tax error, including:

* unwinding a liquidation or merger to restore the shareholder's basis in the...

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