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Tax Do-Overs: Unwinding a Transaction under the Rescission Doctrine

By Christopher C. Weeg on October 20, 2016

Growing up my Mom used to say “You’ve made your bed, now lie in it.” Luckily for taxpayers, my Mom is not the IRS.

The IRS understands that mistakes happen, conditions change, and deals sour. Under the rescission doctrine, a taxpayer may unwind a transaction and avoid federal income tax consequences flowing from the rescinded transaction. Common transactions eligible for rescission are the issuance or redemption of stock, entity formation, or a sale or exchange of property. For example, in Private Letter Ruling 200613027, an LLC converted to a corporation to effect an IPO. After the IPO was cancelled due to changed market conditions, the parties sought to rescind the conversion and revert back to the LLC form in order to regain single level taxation. As a result of the rescission, the IRS ruled that the LLC would remain an LLC at all times during the year, and the reversion from the corporation back to the LLC would not be treated as a corporate liquidation for tax purposes.

What is a Valid Rescission?

Revenue Ruling 80-58, which relies on the annual accounting period principle and Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), is the chief IRS guidance on the rescission doctrine. Under the ruling, the IRS will generally respect a rescission if (1) it puts the parties in the same positions they were in before the underlying transaction, and (2) it occurs in the same taxable year as the transaction. A properly executed rescission operates to extinguish otherwise taxable income flowing from the rescinded transaction. The parties’ reason for the rescission may be for business or tax purposes (perhaps as a result of poor planning or bad advice).

If you think you may need a tax mulligan or have any questions on rescinding a transaction, contact Chris Weeg at (214) 749-2430 or cweeg@meadowscollier.com.