What are the tax consequences of unwinding a transaction?

And just when, if ever, is a taxpayer entitled to the transactional equivalent of a mulligan—a do-over?  The ability to unwind a transaction depends upon the particular facts and circumstances of the transaction and the manner in which a transaction is unwound and documented.  But where the requirements are met, the so-called “rescission doctrine” offers a potential avenue to unwind a transaction without tax consequences.

Where it applies, the rescission doctrine returns the parties to their original position—the status quo ante.  When the necessary conditions are met, in other words, the transaction is disregarded for federal income tax purposes.  A rescission may potentially 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.”

The “annual accounting principle” requires that one must look at the transaction on an annual basis using the facts as they exist at the end of the year. That is, each taxable year is a separate unit for tax accounting purposes.

Moreover, under the so-called “claim of right doctrine,” amounts received under a claim of right and without restriction are generally immediately taxable, even if, in a later tax year, the taxpayer is required to return part or all of the money. [2]. The claim-of-right doctrine finds its origins in North American Oil Consolidated v. Burnet, 286 U.S. 417.

Both the annual accounting principle and the claim-of-right doctrine stand as potential roadblocks that may prevent the ability to unwind a transaction for tax purposes.

But under the right circumstances, the IRS has recognized the application of a helpful doctrine: the “rescission doctrine.” [3] The rescission doctrine effectively allows the parties to unwind a transaction back to the status quo ante.  A rescission is “an agreement to discharge all remaining duties of performance and terminating the contract, thus restoring the parties to their pre-contractual positions.” [4]

The IRS addressed a taxpayer’s ability to rescind transactions in Revenue Ruling 80-58.  In that Revenue Ruling, the IRS recognized defined a rescission as follows:

“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.” [5]

A taxpayer must satisfy at least two requirements in order to successfully rescind a transaction under the rescission doctrine: (1) the parties to the transaction must be returned to the status quo ante, meaning that they are returned to the same position they would have occupied had no contract existed; and (2) the restoration must be accomplished within the same tax year as the original transaction. [6]

The IRS has further outlined the nuances of these requirements in a series of Private Letter Rulings, including PLR 9408004, 9140487, and 9104039—detailing what is required to restore the status quo ante. [6] However, in 2013, the IRS signaled its intention to cease issuing private letter rulings on the application of the rescission doctrine. [7] In light of this, taxpayers should seek assistance from an experienced tax attorney whenever seeking to rescind a transaction for tax purposes.

Taxpayers should also exercise caution in applying the rescission doctrine.  For example, courts have found it inapplicable in certain contexts and have applied penalties.  See, Freeman Law Insight.  But again, where properly executed, the rescission doctrine offers a valuable mechanism to avoid unwanted tax consequences.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

[1] Security Flour Mills, Co. v. Commissioner, 321 U.S. 281 (1944).[2] Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931); North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932).[3] Penn v. Robertson, 115 F.2d 167 (4^th Cir. 1940); Estate of Crellin v. Commissioner, 17 T.C. 781 (1951)[4] Black’s Law Dictionary, 5^th ed. 1996[5] See Rev. Rul. 80-58[6] Id.[7] See Rev. Proc. 2013-3