Bar News - February 18, 2011
Tax Law: Unwinding Transactions Without Adverse Tax Consequences
By: Peter Beach
The deal has finally closed. Or has it? It is not unheard of for post-closing difficulties to rise to a level where the parties are sufficiently motivated to try to rescind a transaction. Potential adverse tax consequences generally present the greatest hurdles to such "do-overs." Unless a "do-over" is respected as a rescission for tax purposes, the tax law looks at both the original transaction and the unwinding transaction as separate, with each step generating its own tax consequences.
An example should help to illuminate the issues that a rescission can raise. Assume that:
In "lawyer speak," A and B are asking whether they can rescind the original transaction. If the IRS respects the rescission, the formation of the corporation will be ignored and there will be no gain recognition. In addition, any gain recognized on liquidation of the corporation (remember, the assets of the corporation have increased in value) will be ignored. However, if the IRS does not respect the rescission, there will be gain on both the formation and liquidation of the corporation. If either or both of the potential gains are significant, the "do-over" could be attractive to both A and B.
- A and B each contribute property to a newly-formed corporation and later discover that the contributions involved debt in excess of basis, causing A and B to recognize gain with respect to their contributed properties.
- After the contribution and before discovery of the tax issue, the property that A and B contributed to the corporation increases in value.
- If A and B had formed a limited liability company instead of a corporation, no gain would have been recognized on the contribution of property, and, in all other respects A and B would be satisfied with an LLC rather than a corporation.
- A and B approach you and ask if they can avoid gain recognition on the contributions to the corporation by liquidating the corporation and forming an LLC instead.
This issue has been around for a long time, generating quite a bit of authority. [See, e.g., Rev. Rul. 80-58, 1980-1 CB 181, and cases cited therein.] In that ruling, the IRS respected a rescission where the agreement with respect to a sale of real estate permitted rescission if the buyer could not rezone; the property was returned in the same tax year as the original sale and was in the same condition as when it had been received.
In the wake of Rev. Rul. 80-58, tax practitioners wondered whether the IRS used the facts involved there to limit the utility of rescission to situations in which the original transaction anticipated the possibility of rescission. In recent private letter rulings, however, the IRS has adopted a distinctly taxpayer-friendly attitude toward rescission. In PLR 200613027 a taxpayer wanted to rescind the conversion of an LLC into a corporation where the original incorporation was done in anticipation of an initial public offering that was unsuccessful. The IRS respected the rescission even though while in corporate form the LLC not only operated, but also redeemed the stock of certain shareholders. In PLR 200533002 the IRS permitted a C corporation to revert back to S corporation status after rescinding a sale of stock to an ineligible shareholder. In PLR 200923010 the IRS permitted restoration of a subsidiary as a member of an affiliated group after rescission of a stock sale that had caused the subsidiary to be disaffiliated from the group. In PLR 200952036 the IRS permitted a limited partnership that had converted into a corporation to undo the incorporation, but convert into an LLC rather than back into a limited partnership.
Despite these many favorable rulings, because the tax consequences of a failed rescission can be significant, many tax advisors recommend that a taxpayer only undertake a rescission based on its own private letter ruling. This can be problematic in rescissions that are proposed late in the tax year because it may not be possible to obtain a ruling in the same taxable year as the original transaction.
A review of the authorities reveals several requirements that must be satisfied before a "do-over" will qualify as a rescission for tax purposes (some authorities address only the first and last requirements discussed below).
(1) A rescission must occur within the same tax year as the original transaction. Making this determination is generally fairly simple but may generate some difficult conversations if a client doesnít understand why the IRS (and the law generally) takes a dim view of backdating documents.
(2) The rescission must be valid under the appropriate statesí laws. Most states, including New Hampshire, respect the partiesí rights to contract in this regard.
(3) The parties must clearly express their intent to rescind. This requirement can generally be satisfied by entering into a "Rescission Agreement" that expressly states the partiesí intent and, in particular, binds them to the steps intended to be undertaken to satisfy the final requirement below.
(4) The parties must take all steps necessary to restore the status quo. Although this sounds simple, the "details" can make this the most troublesome requirement in certain situations.
Despite the potential flexibility afforded in qualifying a "do-over" as a rescission for federal income tax purposes, there are limits that tax advisors need to be aware of. One issue that has not been fully addressed is whether parties can rescind just part of a transaction. Also, there are certain types of transactions that have been held to not qualify for rescission under any circumstances, such as the payment of corporate dividends. Finally, this article has only discussed the federal income tax aspects of rescission. A "do-over" that includes a transfer of real estate or interests in a real estate holding company will require a separate analysis under the NH real estate transfer tax (see, e.g., the requirements for a "corrective deed" to avoid tax on the corrective filing).
As always with tax matters, "donít try this at home." Always seek professional advice before rescinding a transaction.
Peter Beach is an attorney at Sheehan Phinney Bass + Green in Manchester. He has been a NH Bar member since 1990.