The rescission principle.

Often, tax advisers are asked to fix the tax effects of an ill-tax advised or unsuccessful transaction. Letter Ruling 9829044 serves as a reminder of the rescission principle described in Rev. Rul. 80-58, which, under the proper facts, can be a useful remedy.

Rev. Rul. 80-58

In Rev. Rul. 80-58, a calendar-year taxpayer sold land to a buyer for cash, agreeing that, if the buyer could not have the land rezoned within nine months after the sale, it would be reconveyed for the amount originally expended. Based on the annual accounting concept, the IRS ruled that if, for Federal income tax purposes, the rescission of the sale occurred before the end of the taxpayer's year in which the sale occurs, it would be treated as never having occurred. However, if the reconveyance occurred in a subsequent tax year, both the sale and reconveyance would be respected as separate transactions, resulting in the taxpayer recognizing gain on the sale and a new cost basis on the subsequent repurchase. Rev. Rul. 80-58 describes the legal concept of rescission as follows:

The legal concept of rescission refers to the abrogation, canceling, or voiding of a contract that has the effect of releasing the contracting parties from further obligations to each other and restoring the parties to the relative positions that they would have occupied had no contract been made. A rescission may be effected by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other if sufficient grounds exist, or by applying to the court for a decree of rescission.

Letter Ruling 9829044

In Letter Ruling 9829044, the shareholders of an S corporation (X) contributed their stock to Y, another S corporation owned by the same shareholders. Y intended to make a timely qualified subchapter S subsidiary (QSSS) election for X following the contribution. However, after becoming concerned that X's suspended loss could disappear if a QSSS election was nude, Y distributed the X stock to the shareholders in the same proportions it had been contributed by them. The distribution was made in the same tax year of the shareholders in which the original contribution was made; all parties were returned to the same legal and financial position as before the contribution.

On these facts, the Service concluded that the rescission doctrine applied to disregard the original transfer of the X stock to Y and prevent the termination of X's 8 status.

Other examples of the rescission principle include the following:

Example 1: A bank agrees to lend Corporation X $500,000 for a proposed project if its shareholder first contributes $100,000 as additional capital. After the capital contribution is made, unforeseen circumstances cause the corporation to abandon the project. The X shareholder wants his capital contribution back, but has been advised that because he will continue to own 100% of X's stock after the distribution, it will not be treated as a sale or exchange to which he can use his stock basis to offset the amount distributed. Rather, because X has earnings and profits in excess of $100,000, the distribution could be taxed as a dividend.

If the capital contribution is rescinded before the end of the shareholder's tax year in which the capital contribution was made, it will be treated as if it never occurred.

Example 2: Corporation X merges into Corporation Y in a tax-free corporate reorganization under Sec. 368(a)(1)(A). Y began its business three years ago. Shortly after the merger, it becomes obvious to the shareholders it is not working. The shareholders want to separate Y back to X and Y, but the prior X shareholders have been advised that their exchange of Y stock for new X stock will not qualify as a tax-free division, because X will not meet the Sec. 355 five-year trade or business requirement.

If the merger is rescinded before the end of the X shareholders' tax year, it will be treated as if it never occurred.

Example 3: An error in the bookkeeping for a personal service corporation resulted in the payment of a bonus to the sole employee/shareholder in excess of the corporation's correct net income. The bookkeeping error was discovered before the end of the corporation's tax year in which the bonus was paid and the employee/ shareholder's tax year in which the bonus was received.

The bonus can be rescinded before the end of the employee/shareholder's tax year, either by the shareholder returning the bonus to the corporation (see Fender Sales, Inc., TC Memo 1963-110) or by issuing the corporation a promissory note for the bonus (see Willis W Clark, 11 TC 672 0948)).

Caution: To be effective, the rescission principle requires the right facts. For example, in Hutcheson, TC Memo 1996-127, Merrill Lynch attempted to correct a misunderstanding that resulted in its sale of 100,000 shares of WalMart stock for a taxpayer, instead of $100,000 of WalMart stock. The Tax Court held that Merrill Lynch's attempt to correct the misunderstanding by purchasing and returning WalMart stock to the taxpayer before the end of the taxpayer's year did not satisfy the rescission principle of Rev. Rul. 80-58, because Merrill Lynch was not the buyer, merely the selling agent. For a rescission to be effective, both buyer and seller must be put back to their original positions.

FROM LORIN D. LUCHS, J.D., LL.M., CPA, WASHINGTON, DC, AND MICHAEL WHITACRE, CPA, ATLANTA, GA