Turning back the clock: taxpayers avoid general utilities repeal through rescission.

The Internal Revenue Service published two noteworthy private letter rulings within the last year granting rescission relief for taxpayers seeking to unwind their conversion to a subchapter C corporation without suffering the unfavorable double tax consequences otherwise associated with such an unwind. (1) Remarkably, the IRS granted these rulings even though the taxpayers were unable to restore absolutely their relative positions that existed prior to the conversions.

Rescission of LLC Conversion to C Corporation

In LTR 200613027, the taxpayer (Taxpayer), a limited liability company (LLC) treated as a partnership for federal income tax purposes, filed a certificate of conversion and a certificate of incorporation with its domestic state. As a result, Taxpayer's two sole owners became the sole shareholders of a C corporation.

The conversion occurred in anticipation of an initial public offering (IPO). Subsequent to the conversion, Taxpayer cancelled the IPO owing to an unexpected deterioration in market conditions. Consequently, Taxpayer desired to revert to LLC status (and to be taxed as a partnership) without suffering the double tax consequences normally associated with such conversion. In order to return to an LLC, Taxpayer proposed to file a certificate of conversion with its domestic state. This "reconversion" was planned to occur before the end of Taxpayer's taxable year in which the original conversion occurred.

During its time as a C corporation, Taxpayer made "tax-related" distributions to its two principal owners on account of their prior position as LLC members. (2) Taxpayer also made certain redemptions of its outstanding stock as a result of the death or separation from service of members of its management team, even though this seems inconsistent with the indication that LLC had only two owners (more on that later).

The facts of the ruling provide that Taxpayer had no further plans, at least in the "near future," to attempt another IPO. In addition, Taxpayer represented that it had no current intention or plan to make an election to be classified as an association after converting back into a limited liability company. Taxpayer further represented the following:

   [T]he Rescission Agreement is intended to restore the legal
   and financial arrangements between the owners and the Taxpayer
   as would have existed had the taxpayer not converted
   from a limited liability company taxable as a partnership into
   a corporation taxable under subchapter C of the Code....
   [T]he effect of the Rescission Agreement is to cause the legal
   and financial arrangements between the owners and the Taxpayer
   to be identical in all material respects, from the date
   immediately before the conversion, to such arrangements as
   would have existed had the conversion not occurred.

Based on Taxpayer's representations, the IRS rules that (i) Taxpayer will be treated as a partnership for the entire year; (ii) Taxpayer's sole owners will be treated as partners of Taxpayer during such period; and (iii) the conversion of the Taxpayer from a corporation into an LLC will not be treated as a liquidation. Taxpayers and its owners successfully avoided taxation on the reconversion under the rescission doctrine.

Rescission of S Corporation Conversion to C Corporation

In LTR 200533002, Taxpayer, a subchapter S corporation (S corporation), issued convertible preferred stock to three partnerships controlled by a venture capital fund. As a result, Taxpayer's S election was terminated because it no longer met the definition of a small business corporation as defined by section 1362(b)(1). (3)

After the issuance of convertible preferred stock, a disagreement arose between the original shareholders of Taxpayer and the partnerships. The disagreement was significant enough that the parties determined to rescind the investment through a "stock rescission agreement." Pursuant to this agreement, Taxpayer returned the investment proceeds to the partnerships, and the convertible preferred stock was cancelled. In this ruling, unlike the prior ruling, the Taxpayer undertook the rescission first and then went to the IRS for a ruling.

The stock rescission agreement absolved the parties from any liability or obligation arising from the original agreement, with the exception of the original liability indemnification clause executed in favor of the partnerships and their representatives, which remained in effect. Taxpayer also represented that it made no distributions to the partnerships during the period for which its Selection was terminated. Neither the facts nor Taxpayer's representations indicate that the Taxpayer has any intentions of going back to obtain additional investment funds.

Except for the five-year prohibition on reelection, the unwind allowed Taxpayer to qualify once again as an S corporation. (4) Taxpayer requested a ruling from the IRS to rescind the investment transaction, thus allowing for a restoration of Taxpayer's status as an S corporation. The IRS ruled that the parties to the transaction were restored to their relative positions before the investment transaction. As in the other ruling, the restoration was achieved within the same taxable year, and consequently, Taxpayer retained its S corporation status.

Conditions for Rescission

Rev. Rul. 80-58 establishes two primary preconditions to disregarding a transaction for federal income tax purposes under the rescission doctrine. First, the parties must be restored to the relative positions that they would have occupied had no such transaction occurred. Second, the restoration must be achieved within the taxable year of the transaction. The IRS also considers additional factors, including but not limited to (i) the cause and steps taken for the rescission, (5) (ii) circumstances that are outside the control of the parties, (6) (iii) whether the rescission occurs under state law, (7) and (iv) whether the unwind occurs pursuant to a prearranged understanding among the parties. (8)

The two rescission rulings this past year provide additional insight on the IRS's view of how taxpayers may meet the requirements for rescission. First, it is instructive to examine the motivation behind the taxpayers' rescission request. Both taxpayers converted from a pass-through entity to a taxable entity then back again to a pass-through entity. The taxpayers were well aware of the tax consequences of their transactions, which resulted in the loss of their pass-through entity status, and both desired to rescind their transaction to return to pass-through status and to do so without suffering the unfavorable double tax consequences that would otherwise obtain.

As for the preconditions for rescission, both taxpayers apparently satisfied the second primary condition of Rev. Rul. 80-58--restoration was achieved within the taxable of year of the original conversion. The analysis of the other condition--restoration of the taxpayers to their relative positions before the transaction--is more complicated.

The taxpayer in LTR 200613027(LLC) represented to the IRS that the effect of the reconversion was to cause the legal and financial arrangements between the owners and the taxpayer to be identical in all material respects. While LLC was a C corporation, however, it made certain redemptions of its outstanding stock (presumably, employee-held stock) and apparently took no action to unwind these redemptions? No doubt, it would have been highly impractical, perhaps impossible, to unwind a cash payment to former employees.

LLC represented that each owner would report the amounts received in the redemptions consistent with having been a limit liability company. (10) Apparently, the IRS is comfortable with rescission if a taxpayer reports the consequences of the transaction under its original form, even where the taxpayer is unable to completely restore the parties back to their relative position.

The taxpayer in LTR 200533002 (S Corp) rescinded its preferred stock in order to regain S corporation status. Because S Corp had free use of the proceeds from the preferred stock sale, an interesting question comes to light: Should S Corp be required to provide additional consideration to the partnership for the use of its funds while it was a C corporation? Absolute restoration would seemingly require some sort of replacement for the opportunity cost (e.g., interest income) associated with the invested funds. Obviously, there is no way to restore the partnerships to their actual financial circumstance that would have occurred in the absence of any such investment. Indeed, the actual financial circumstances existing in the absence of any legal transaction are unknowable. While the IRS overlooked these items in the ruling, certain courts have applied a strict standard. (11)

The LLC also distributed money to its previous partners while it was a C corporation. The partners were entitled to the distribution when LLC was treated as a limited liability company. The partners were not apparently required to unwind this distribution by returning the funds to the LLC. (12) S Corp represented that it made no distributions while its S election was terminated. On the other hand, LLC merely represented that it had not made any other distributions to its equity holders and that it had not taken any actions with respect to, or engaged in any transaction with, its owners that would have been inconsistent with the actions had it remained a partnership. This approach seems inconsistent with Rev. Rul. 78-119, (13) in which the IRS ruled that a rescission did not apply because both taxpayers retained the dividend distributed to them during the interim period.

Finally, what about the indemnification clause that S Corp executed in connection with the rescission? LLC does not have any further obligations with any other parties or at least it was not addressed in the letter ruling. An indemnification clause would seem to be problematic with respect to S Corp's rescission. Indeed, the IRS states, in its description of a legal rescission that "the parties cannot have any further obligations to each other." In fact, the S Corp created potential future obligations to the partnerships through the indemnification agreement.

Notwithstanding these issues, the IRS ruled that the doctrine of rescission applied to both transactions. In the IRS's view, the taxpayers satisfied the two primary conditions for rescission: the rescissions occurred within the same taxable year, and the parties were restored back to their relative position. LTR 200533002 provides some additional insight into what constitutes a proper and complete restoration. In that ruling, the taxpayer represented that neither the owners nor the taxpayer itself had taken or would take any material position inconsistent with the position that would have existed had the conversion not occurred; thus the reconversion caused the legal and financial arrangements between the taxpayer and its owners to be identical in all material respects.

Apparently, the IRS is comfortable in applying the doctrine of rescission to taxpayers that can meet the two primary conditions of Rev. Rul. 80-58, even though the taxpayers may be unable to return all parties back to their true and absolute positions. Thus, these letter rulings may signal a liberalization of the IRS's position in Rev. Rul. 80-58. In any case, this practical approach to the rescission doctrine is a welcome development for taxpayers that desire to unwind a transaction.

(1.) In general, two taxes are due under sections 336 and 301 of the Internal Revenue Code upon dissolution of a C corporation because of the repeal of the so-called General Utilities doctrine by Tax Reform Act of 1986. (All references to sections are to the Internal Revenue Code of 1986, as amended, and to the associated regulations.)

(2.) It is unclear how a C corporation would make retroactive distributions.

(3.) Section 1361(b)(1) provides the term "small business corporation" means a domestic corporation that is not an ineligible corporation and that does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in Section 1361(c)(2), or an organization described in section 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than I class of stock. Consequently, the issuance of preferred shares to partnership investors terminated the S status of Taxpayer because of (i) ineligible shareholders and (ii) two classes of stock.

(4.) Section 1362(g) provides that if a small business corporation has made an election under section 1362(a) and if such election has been terminated under section 1362(d), such corporation (and any successor corporation) will not be eligible to make an election under section 1362(a) for any taxable year before its fifth taxable year beginning after the first taxable year for which such termination is effective, unless the Secretary consents to such election.

(5.) See LTR 9408004 (the doctrine of rescission does not apply to relieve the taxpayer from the unauthorized sale of stock by his broker).

(6.) See LTR 7802003 (the exercise of the right to purchase found to be involuntary and not within the control of the taxpayer weighed in favor of treating the whole transaction as a nullity).

(7.) See LTR 200309009 (the valid rescission under state law of a quit claim deed appeared to weigh in favor of rescission treatment).

(8.) See Rev. Rul. 80-58, 1980-1 C.B. 181, in which the taxpayer had an obligation to accept reconveyance of the land if buyer was unable to obtain rezoning of the land rezoned for business purpose.

(9.) Section 317(b) provides that stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.

(10.) Section 731(a) provides that, upon a distribution by an LLC in partial redemption of a member's interest, no gain shall be recognized to such member, except to the extent that any money distributed exceeds the adjusted basis of such member's interest in the LLC. Section 736(b) provides payments made in liquidation of the interest of a retiring member or deceased member shall be made in exchange for the interest of such member in LLC property.

(11.) See Reeves v. United States, 173 F. Supp. 799 (D. Ala. 1959), in which the court held there was no rescission of the sale of the taxpayer's partnership interest when, after three days, the taxpayer repurchased the interest. The court reasoned that the circumstances had changed to a significant extent because the original purchasers of the partnership interest had to pay an additional amount to effect an unwind of the sale.

(12.) Query: If the IRS had not applied the doctrine of rescission and treated the taxpayer as a partnership at all times during the tax year, what would have been the tax consequences to the LLC owners from the distribution?

(13.) 1978-1 C.B. 277.

ANDREW CORDDONNIER is the Corporate Tax Practice Leader and partner in the National Tax Office of Grant Thornton LLP in Washington, D.C. Mr. Cordonnier provides firm-wide consultation regarding various corporate and transactional tax matters, and is the author of article in various publications. Before joining Grant Thornton, Mr. Cordonnier worked at Arthur Andersen and GE Capital Corporation. A graduate of both the University of Texas -Austin and Southern Methodist University, he is a certified public accountant and a member of the American Institute of Certified Public Accountants. He may be reached at [e-mail]

KAGNEY PETERSEN is a Senior Associate in Grant Thornton LLP's National Tax Office in Washington, D.C. where he is part of the Corporate Tax Group. He focuses primarily on corporate taxation, but also works on international taxation, partnership taxation, and other business tax matters. He received his master of taxation from the University of Denver and is licensed as a certified public accountant. He may be reached at [e-mail].