Rescinding transactions.

Fixing ill-advised or unsuccessful dealings.

CPAs often are asked to "fix" (or, at the very least, lessen) the tax effects of improperly thought-out or ill-advised sales, exchanges or elections. While they are certainly not able to remedy all the mistakes their clients make, there are some situations when they can be instrumental in helping clients rescind transactions and avoid potentially negative consequences.

RESCISSION

Legally, rescission refers to the canceling or voiding of a contract, with the legal effect of releasing the contracting parties from further obligations to each other and of restoring them to the relative positions they would have occupied had no contract been made. A rescission of a contract may be made by mutual agreement of the parties, by one of the parties without the consent of

the other party (if sufficient grounds exist) or by applying to a court for a decree of rescission.

Under certain circumstances, a taxpayer can ask the IRS to ignore a transaction and rescind his or her actions; if the IRS agrees, the transaction or election will be treated as having never occurred.

Two conditions must be satisfied for a rescission to be available. First, the parties to the transaction must be returned to the status quo; that is, both the buyer and the seller must be put back to their original legal and financial positions. Note that a taxpayer doing all in his or her power to restore both parties to their original positions will not meet this requirement if the parties are not restored completely to those original positions.

Second, the restoration must be completed in the tax year of the transaction. This requirement is based on Internal Revenue Code section 451, which provides that a taxpayer must determine his or her income as of the close of the current tax year without regard to subsequent events. Thus, if a transaction occurs in one year and a restoration occurs in the following year--or if conditions prevent a full settlement from occurring in the same year as the original transaction--a valid rescission will not have occurred. The IRS will treat the transactions in the different years as separate and unrelated.

EXAMPLES

* A calendar-year taxpayer sold land to a buyer for cash in February, agreeing that, if the buyer could not have the land rezoned within nine months, it would be reconveyed back for the original amount. In October, the buyer determined it was not possible to have the land rezoned. At that point, the buyer returned the land to the seller and received back all amounts spent in connection with the transaction.

Because the rescission of the sale occurred before the end of the taxpayer's year in which the sale occurred, it was disregarded totally and treated as if it never had happened.

* The shareholders of an S corporation contributed their stock to another S corporation owned by the same shareholders, intending to make a timely qualified subchapter S subsidiary election for the original corporation. After a question arose about the availability of the first corporation's tax benefits, the shareholders decided not to make this election, and the first corporation's stock was distributed back to the shareholders in the same proportions as it had been contributed originally.

Because the distribution was made in the same tax year in which the original contribution was made and because the shareholders were restored to the same relative positions (both legal and financial) they would have had if the stock never had been contributed, the IRS disregarded the transfer and the corporation was allowed to continue as an S corporation (which status otherwise would have been terminated).

For a discussion of developments in this and other areas, see the Tax Clinic, edited by Terence Kelly, in the May 1999 issue of The Tax Adviser.

--Nicholas Fiore, editor
The Tax Adviser