Transactions may take on separate lives for tax and corporate purposes even if they never close. For example, the shareholders of an S corporation may inadvertently bring in a non-resident alien investor or issue two separate classes of stock having different economic interests (that is, preferred and common stock). Either of those events would terminate the corporation’s S election resulting in C Corp status. This in turn would cause the money earned by the corporation to be taxed twice: once at the corporate level as earnings and profits and again on the shareholder level as dividends when received.
In inadvertent S termination may be corrected by seeking a waiver from the IRS pursuant to Section 1362 (f). But this would require obtaining the signatures of all the persons that owned the corporation’s stock during the pre-termination period. This can be a problem if someone refuses to do so or cannot do so for some reason. The solution in such a case is to unwind the transaction, or rescind it, pursuant to IRS Rev. Rul. 80-58.
Rev. Rul. 80-58 permits a taxpayer to rescind a transaction (and thereby pretend that it did not occur for tax purposes) provided that: (1) the rescission occurs in the same tax year as the underlying transaction; and (2) the parties to the transaction are returned to the status quo ante, that is, they must be restored to “the relative positions that they would have occupied had no contract been made.” The rescission may be done by the way of a rescission agreement, reformation or reconveyance action, the invocation of a savings clause, warranties, or a conditional sale clause, options, or put rights. A state law determination that a transaction should be unwound has no bearing upon the IRS’ determination that the transaction should be disregarded for tax purposes. An example would be where a court orders that the transaction be rescinded. State law may put the parties back in their respective pre-closing position but if the court order is not in the same tax year as the closing date the parties will still have to bear the tax ramifications that resulted from the transaction: income and gain to the selling party. So, the seller would have the asset back but also would have to pay tax on the gain from the “sale” that was rescinded with money out of his pocket given that the buyer would have to be paid all of the purchase price in order to place her back into her pre-closing financial position. But what does it mean to return the parties to the status quo ante? How close do you have to get? The answer appears to be that the parties have to be returned to the exact financial and legal positions they had prior to the moment of closing. This means both assets and liabilities. This presents fundamental challenges to “asset over” transfers where the assets are different in number, kind or character at the time of the rescission transaction. (But see Ltr. rul. 9829044 where the IRS allowed an “assets-over” sale of stock – not an ongoing business – to be rescinded.)
In short, rescission transactions are a wonderful tool to accomplish a “do over” transaction when the underlying deal just did not work out for some reason so long as Rev. Rul. 80-58 is followed. But there are traps for the unwary.« Back to news