Rescission doctrine provides opportunity for tax do-overs.

• Author: McCormally, Timothy J.

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...