On occasion, I come across interesting ideas involving taxation. It will be fun to share some of these ideas, and I will be doing a few more articles about some quirky areas of the tax law. Those "quirks" can help you achieve some results that you would normally not think were possible.
The concept of "rescission" is one such topic. Many areas of taxation impose extremely specific requirements. For example, to benefit from a Section 1031 exchange, you need to identify a certain number of replacement properties, specifically and in writing, by the 45th day after you sell your old property. Identify too many replacement properties? You lose and have to pay the tax. Identify the properties on the 46th day? You lose and have to pay the tax. Don’t identify the properties correctly? You lose and have to pay the tax.
That’s why it’s surprising that the Internal Revenue Service ("IRS") has blessed the concept of "rescission". Think of rescission as a tax time machine that lets you go back in time and fix a problem with a transaction. When you think about it, that’s pretty powerful. For you golfers, some writers have termed the rescission concept a "tax mulligan".
"Rescission" is not defined in the Internal Revenue Code or the Treasury Regulations, which are the source of most of the rules we advise clients they must follow. Rescission is a concept which some courts have allowed, and the IRS has blessed, in Revenue Ruling 80-58. The IRS has also issued private letter rulings blessing the application of the rescission doctrine to specific fact patterns, although the IRS no longer issues such rulings.
Here is an example of rescission. Let’s say on January 1, 2019, I sell a parcel of land to my neighbor for $10,000,000 cash. I transfer the land, and I deposit my $10,000,000. But on December 31, 2019, as I’m on the way to a New Year’s party, I run into my neighbor and we both agree that we want to rescind the transaction. The IRS allows us to treat the sale as if it never happened, as long as I receive the property back from my neighbor, and my neighbor receives the $10,000,000 cash back from me, all before the clock strikes midnight on December 31, 2019. When a rescission occurs in the same tax year, the main requirement of Revenue Ruling 80-58 is that my neighbor and I return to the exact same position that we were in prior to the sale.
The rescission doctrine has been favorably applied in a number of circumstances in IRS private letter rulings. Taxpayers have been able to reverse mergers, cure transactions that resulted in the loss of S elections, and void taxable transactions generated by stock distributions. In fact, the rescission doctrine is applied, even if avoiding taxes that would otherwise be due is part of the reason for the rescission.
Here’s where things get interesting—Revenue Ruling 80-58 dealt with rescissions that occurred both in the same tax year, and a later tax year. Both the IRS and the cases require the parties to respect whatever happened in the year of the transaction—that aspect can’t be changed once the tax year is done. But the transaction can be rescinded in the following year, and the tax consequences flowing from the later rescission will be respected.
The ability to rescind a transaction after the close of the tax year in which it occurs is potentially very powerful. Let’s go back to my original example—a sale of property by me in 2019 to my neighbor for $10,000,000. If my neighbor paid cash, I’m stuck with paying the full tax on the sale in 2019 if we don’t rescind the sale in 2019. But let’s assume that instead of $10,000,000 cash, my neighbor paid me $100,000 cash, and gave me a $9,900,000 promissory note.
In that case, if we rescind the transaction in 2020, I’m stuck with paying the gain on the $100,000 payment I received in 2019. But if I get the property back in 2020, and cancel the note, that $100,000 gain is the only consequence.
The ability to change transactions after they have closed, even if in a different tax year, is why the rescission doctrine is like a tax time machine. It’s surprising because, unlike many areas of the tax law, it’s liberal and pro taxpayer if you can meet the requirements.
In my next article, I’ll talk about another "tax time machine"— another way to change tax consequences that have already occurred in a way that is blessed by the IRS.
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