OOPS, WHAT WAS I THINKING? HOW TO FIX A BOTCHED TRANSACTION

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1 OOPS, WHAT WAS I THINKING? HOW TO FIX A BOTCHED TRANSACTION THOMAS L. EVANS Kirkland & Ellis LLP Chicago, Illinois Tevans@Kirkland.com (312) State Bar of Texas 27 th ANNUAL ADVANCED TAX LAW COURSE August 27-28, 2009 Houston CHAPTER 9

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3 Thomas L. Evans Professional Profile Partner Chicago Phone: Fax: Practice Areas Tax Admissions 1984, Illinois 1994, Texas 2001, District of Columbia Thomas Evans is a partner in the Chicago office of Kirkland & Ellis LLP. He focuses his practice on the tax aspects of complex business transactions (including acquisitions, joint ventures, IPOs, LLC agreements, incorporation of partnerships), tax controversy and litigation, restructuring, and general tax advice and planning. His clients are engaged in financial services, telecommunications, energy, and manufacturing, among other industries. Mr. Evans is a frequent lecturer and speaker at tax-related seminars and conferences and has written numerous articles relating to his area of practice. Other Distinctions Certified Public Accountant (Arizona) Awards: Texas Excellence in Teaching Award - University of Texas Law School, 1991 Kugle, Byrne & Alworth Ethics Teaching Award - University of Texas Law School, 1993 Texas Excellence in Teaching Award - University of Texas Law School, 1997 Education University of Chicago Law School, J.D with Honors; Order of the Coif (top 10% of graduating class); Received the Isaiah H. Dorfman Prize for Outstanding Work in Labor Law University of Illinois, B.S., Finance 1976 with Honors Publications Evans, "The Evolution of Federal Income Tax Accounting - A Growing Trend Towards Mark-to-Market?" 67 Taxes 824 (December, 1989). This article was presented in the Fall of 1989 at the University of Chicago Federal Tax Conference. Papers presented at the Conference are traditionally published in the December issue of Taxes. Evans, "Accounting For Long-Term Contracts Under Section 460," University of Texas School of Law, 37th Annual Taxation Conference, October, Evans, "The Taxation of Multi-Period Projects: An Analysis of Competing Models," 69 Texas Law Review 1109 (1991). Evans, "The Taxation of Nonshareholder Contributions to Capital: An Economic Analysis," 45 Vanderbilt Law Review 1457 (1992). Evans, "The Realization Doctrine After Cottage Savings" 70 Taxes 897 (December, 1992). This article was presented in the Fall of 1992 at the

4 University of Chicago Federal Tax Conference. Papers presented at the Conference are traditionally published in the December issue of Taxes. Evans, "Lower of Cost or Market Method Needs Reform," 64 Tax Notes 1349 (September 5, 1994). Evans, "Clear Reflection of Income: Using Financial Product Principles in Other Areas of the Tax Law" 73 Taxes 659 (December, 1995). This article was presented in the Fall of 1995 at the University of Chicago Federal Tax Conference. Papers presented at the Conference are traditionally published in the December issue of Taxes. Evans, "Partnership Taxation - Recent Developments," University of Texas School of Law, 43rd Annual Taxation Conference, December, Evans, "Update on Income Tax: Current Developments," 12th Annual Tax Conference, Closely Held Businesses and Their Owners, Arizona Society of Certified Public Accountants, November, Evans, "Partnership Taxation - Recent Developments," Annual Tax Conference, Austin Chapter Texas Society of Certified Public Accountants, December, Kleinbard and Evans, "The Role of Mark-to-Market Accounting in a Realization-Based Tax System," 75 Taxes 788 (December, 1997). Evans, "Continuity of Interest and Continuity of Business Enterprise Doctrines in Corporate Reorganizations: The New Rules," University of Texas School of Law, 46th Annual Taxation Conference, November, Evans, "Respecting Foreign Mergers," Tax Notes (July 3, 2000). Evans, "Amortization of Intangible Assets Under Section 197-Application to Business Transactions," 35th Annual Southern Federal Tax Institute, September 19, Prior Experience Senior Tax Counsel - Cleary, Gottlieb, Steen & Hamilton, New York ( ) Professor of Law - University of Texas School of Law, Austin, Texas ( ) Associate Tax Legislative Counsel - U.S. Department of the Treasury, Office of Tax Policy (Tax Legislative Counsel) (From , Attorney-Advisor) Associate, Kirkland & Ellis, Chicago, Illinois

5 TABLE OF CONTENTS I. THE INCOME TAX IMPLICATIONS OF FIXING MISTAKES A. Introduction B. Summary of Conclusions II. THE DUTY TO CORRECT A DISCOVERED ERROR RELATING TO A PREVIOUS TAX RETURN A. Introduction B. Obligation of Client to File an Amended Return C. Ethical Obligations Regarding Amended Returns III. PROFESSIONAL STANDARDS APPLICABLE TO TAX PROFESSIONALS ADVISING CLIENTS ON POSITIONS TO BE TAKEN ON TAX RETURNS A. Introduction B. ABA Formal Opinion (July 7, 1985) History C. Substance of Opinion D. Is the Realistic Possibility of Success Standard Still Practical?... 6 E. The Same Realistic Possibility of Success Also Applies to Accountants F. Circular IV. UNWINDING OR RESCINDING A TRANSACTION THE PROBLEM A. The General Tax Rule For Rescissions According To The IRS B. Policy Behind Rules Claim of Right C. Revenue Ruling 80-58, C.B D. Recent Private Letter Rulings Allow Rescissions of Entity s Tax Form, Rescinding the Formation of C Corporations E. Other Rulings Dealing with Rescission F. Stock Options & Other Compensatory Rescissions Are Likely Protected Under Revenue Ruling G. The Status Quo Requirement H. What If the Parties Recognize the Transaction In Different Taxable Years? V. THE REFORMATION DOCTRINE A. Description of Reformation Doctrine B. The Majority Doctrine The IRS Is Not Bound By Retroactive Reformations C. The Minority Doctrine Which Respects Retroactive Reformations D. The Correction of Mistake Doctrine E. Tax Planning With Reformation Proceedings F. Strength of Reformation Argument A Reporting Position? G. When Will the Same-Year Rule the Rescission Doctrine Not Protect A Taxpayer? H. The IRS May Contend that the Issuance of Debt Cannot Be Rescinded I. The Same-Year Rule May Not Allow Taxpayers To Avoid Form Over Substance Arguments if the Rescission is not Clean J. The Rescission Doctrine Can t Be Used If the Agreement is to Not Return to the Status Quo VI. REQUESTING 9100 RELIEF UNDER TREASURY REG. SECTIONS THROUGH A. Introduction B. Definition of Election C. Automatic Extensions Relief D. General 6 Month Extensions - Not Automatic E. Other Examples of Alternative Relief F. Treas. Reg : Other Extensions i

6 VII. CHANGE IN METHOD OF ACCOUNTING OR CORRECTION OF ERROR A. Introduction B. Change in Method of Accounting VIII. SECTION 83(b) ELECTIONS A. Effect of Code B. Importance of Section 83(b) Election C. Strict Deadline for Section 83(b) Elections D. Solution for Late Section 83(b) Election E. Revoking 83(b) Elections ii

7 OOPS, WHAT WAS I THINKING? HOW TO FIX A BOTCHED TRANSACTION By: Thomas L. Evans Kirkland & Ellis LLP Chicago, Illinois I. THE INCOME TAX IMPLICATIONS OF FIXING MISTAKES. A. Introduction. Assume that you discover that a tax-related mistake has been made (by yourself, your client, or other persons) that affects your client. Perhaps there is a mistake that was made on a tax return. Or, perhaps a deadline for an important tax election has passed. Or, alternatively, perhaps a transaction itself is now viewed as a mistake and your client would like to unwind the entire transaction without that being tax inefficient. How do you fix this mistake in a manner that is ethical, in accordance with professional rules governing lawyers and accountants, and practical? B. Summary of Conclusions. This article discusses the following points regarding the correction of mistakes. 1. No Duty to File Amended Returns. First, as noted in Section II of this article, in general there is no obligation to correct a previously filed tax return, even if that return is in error. Although it appears that tax professionals are required to recommend that an amended return be filed, the client may ignore that advice and decide not to file an amended return. That decision not to amend, in and of itself, is not illegal and is a permissible exercise by a client of its discretion. 2. How Strong a Position Do You Need? Assume that you need to take affirmative action to fix a previous error --- how strong a tax position do you need to recommend that a client take such action and sign a tax return based on that action? Section III of this Article notes that the realistic possibility of success standard still, theoretically, governs the professional standards (under ABA and AICPA rules) for tax professionals. However, two developments have made these rules of questionable value. a. New Rules under Code 6694 and Circular 230. First, under the new provisions of Code 6694 (as amended by The Tax Extender and Alternative Minimum Tax Relief Act of 2008 signed into law by President Bush on October 3, 2008 as part of the bailout legislation), tax return preparers may be penalized for preparing returns with positions below the level of substantial authority. This standard had been more likely than not until Code 6694 was amended, retroactively, to require a substantial authority standard in the tax legislation signed into law on October 3. The IRS had announced that it will coordinate the application of the 6694 rules with the rules under of Circular 230 governing tax return preparers. Consistent with that position, that IRS had issued proposed regulations under of Circular 230 requiring that a more likely than not standard be adopted by tax return preparers. It is quite likely that the IRS will now issue new proposed regulations under of Circular 230 adopting the substantial authority standard. Note that for tax shelters (as defined in Section 6662(d)(2)(C)(ii) ( significant purpose of avoidance or evasion of tax) and reportable transactions, the more likely than not standard still applies. Thus, the realistic possibility of success standard is rapidly being obsolete. b. FIN 48. Second, the Financial Accounting Standards Board s Interpretation No. 48 ( FIN 48 ), Accounting for Uncertainty in Income Taxes FIN 48 effectively requires at least a more likely than not threshold in order to avoid having to account for a tax position as a total loser in establishing liabilities (reserves) for taxes in financial statements. If the position is not at least more likely than not, then FIN 48 dictates that a liability must be established as if the taxpayer owed the entire amount in question to the IRS. 3. Tax Rescission of a Transaction. A tax rescission of a transaction, discussed in Section IV, requires that the rescission or unwinding of the transaction occurs in the same taxable year in which the transaction took place, and that the parties are restored to status quo, i.e., the same position they were in before the transaction initially took place. Most, if not all, transactions can be rescinded if they qualify under these criteria, although it appears that the IRS National Office is of the view that a dividend cannot be rescinded. However, the same year rule generally means that a transaction cannot be unwound for tax purposes unless that unwinding occurs in the same taxable year as the initial transaction. 4. Reforming a Contract or Instrument When Rescission is not Possible. Because of the same year and status quo requirements of a tax rescission, in many situations it may not be possible to rescind a transaction. Reforming a contract or instrument, discussed in

8 Section V, may be done retroactively, but such reformation is generally not binding on the IRS. An exception exists for scrivener errors and other ministerial corrections of a document, which may be unwound, retroactively, including for tax purposes. 5. Utilizing 9100 Relief. As discussed in Section VI, Treas. Reg allows taxpayers who have missed deadlines for making certain tax elections, to make those elections retroactively. In addition, under these regulations taxpayers may (subject to certain limitations), change their method of accounting for prior years. Finally, taxpayers may obtain 9100 relief from certain penalties. 6. Change in Accounting Method vs. Correction of an Error. If the client is using a method of accounting for tax purposes, as discussed in Section VII, that method of accounting may be corrected or changed only on a prospective basis, and usually only with the consent of the IRS which is granted subject to terms and conditions that may be unattractive. However, if the reporting is not a method of accounting but only an error, then such an error may be corrected retroactively by filing an amended return. Similarly, if there is an underlying change in the taxpayer s facts or business operations, changes in the tax treatment may be made without those items being a change in a method of accounting. In general, an accounting method is something which only involves a timing matter as to when income or deductions will be incurred, and not a permanent difference such as a deduction being permanently disallowed. 7. Section 83(b) Elections. The Code itself provides a narrow 30-day window during which taxpayers receiving property in exchange for services are allowed to make a section 83(b) election. As discussed in Section VIII, this section 83(b) election allows a taxpayer to include the fair market value of the property into income currently, even though the property is unvested and subject to a substantial risk of forfeiture. A taxpayer who misses this 30 day deadline is not able to invoke 9100 relief to cure the late election. They are out of luck. This creates a very undesirable situation, in that the fair market value of the property as of the later date of vesting, will be included in ordinary income - at a subsequent fair market value that might be very high. This article discusses one technique for fixing this situation, which is to make the property transferable by the taxpayer, even though it is still subject to a substantial risk of forfeiture in the hands of the original recipient. This will result in the property being included into value at an earlier date at a presumably lower value, in a manner quite similar to what would have occurred had a section 83(b) election been made. Additionally, Section VIII discusses revoking an 83(b) election and the limited circumstances under which it can be done. II. THE DUTY TO CORRECT A DISCOVERED ERROR RELATING TO A PREVIOUS TAX RETURN. A. Introduction. Assume that you are advising a client regarding a federal income tax issue, and you discover that the client committed an error that was reflected in a federal income tax return already filed for a previous year. What are the client s legal and ethical duties with respect to this erroneous return? What duties are imposed on you, and what should you advise the client? B. Obligation of Client to File an Amended Return. The general rule is that there is no obligation imposed on the client to file an amended tax return. This result is confirmed by case law, discussed below, and by the language of the existing Treasury regulations. 1. Exceptions to the Rule. There may be isolated exceptions to this rule, where the IRS has maintained that taxpayer s were obligated to file amended returns, especially in cases of retroactive tax legislation. See, e.g., Internal Revenue News Release (April 19, 1989)(1989 CCH 6515) as modified by Ann , I.R.B. 36, where the IRS took the position that taxpayers were obligated to file amended returns to reflect a retroactive amendment to the alternative minimum tax, made in 1988 but effective beginning in 1987, that required taxpayers to treat personal exemptions as an item of tax preference. In addition, it may also be necessary for the taxpayer to file an amended return to obtain a particular tax benefit that would otherwise not be obtainable, such as in a situation where Congress or the IRS retroactively grants a tax benefit that can only be availed of by filing an amended return for a previous year. 2. Could Treasury Require Amended Returns? There is some debate over whether the Treasury Department could, if it chose, issue regulations requiring the filing of an amended return. Code 6011(a) provides that [w]hen required by regulations prescribed by the Secretary any person made liable for 2

9 any tax... shall make a return or statement according to the forms and regulations prescribed by the Secretary. This arguably gives the Treasury the authority to require the filing of amended returns, although a counter argument exists that this language only applies to current returns, and that requiring amended returns is therefore outside of Treasury s authority. 3. Precatory Language in Existing Regulations. In any event, Treasury has not exercised this purported authority, and has not issued regulations of a general scope which require the filing of amended returns. Typically, the existing regulations require that a taxpayer should file amended returns. Note, for example, the following language taken from Treas. Reg (a). If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, he should if within the period of limitation, file claim or credit or refund of any overpayment of tax arising therefrom. (empahsis added) For similar language using the precatory word should in regards to filing amended returns for erroneous timing of deductions, see Treas. Reg (a)(3). See also the Supreme Court s opinion in Badaracco v. Commissioner, 464 U.S. 386 (1984), where the court specifically noted that the regulations referring to amended returns do not require the filing of such returns. 4. Could Failure to Amend Be a Willful Failure to Pay Taxes? Some commentators have suggested that the failure to correct a discovered error relating to a past year s return may constitute the willful failure to pay taxes in violation of Code Case Law The Broadhead Decision. The case law confirms the absence of a general duty requiring the filing of amended returns. For example, in Broadhead v. Commissioner, 14 T.C.M. (CCH) 1284 (1955), aff d on other issues, 254 F.2d 169 (1958) the taxpayer, which owned and operated a lumber yard, filed its federal income tax return for 1946 in May of In June of 1947, a month after filing the return, an accountant hired by the taxpayer to prepare its return and audit its books discovered that an error had been made in the 1946 return, resulting in an understatement of lumber sales equal to approximately $55,000. The accountant told the taxpayer about the error, prepared an amended return for 1946, and sent the return to the taxpayer with the advice that the amended return be filed. The taxpayer never filed the amended return, and the error was discovered during an IRS audit. a. Attempt by IRS to Impose Penalties. The IRS imposed penalties on the taxpayer for what the court termed fraud, arguing that the taxpayer willfully and deliberately attempted to evade and defeat his income taxes when he refused to file the amended return after begin advised to do so by his accountant. b. Holding of Court in Favor of Taxpayer. The court refused to allow the imposition of this penalty, holding instead that (i) the taxpayer was not aware of the error until after the return was filed; and (ii) the taxpayer was not obligated by statute to file an amended return, and was acting legally when it refused to do so, even though an amended return had been prepared and offered to the taxpayer for filing. As a result, the court found that the taxpayer was not guilty of attempting to evade taxes. 6. Possible Benefits to Filing an Amended Return. The above discussion, suggesting that taxpayers are not under any legal obligation to file amended returns, does not mean that taxpayers may not benefit from filing an amended return. As an example, taxpayers may avoid penalties for negligence in filing a previously inaccurate return if they file correct amended returns. See Treas. Reg (c)(3) (providing for qualified amended returns which, if filed before the IRS contacts the taxpayer for audit, will allow the taxpayer to reduce the amount of underpayment of tax upon which the penalty is based). Similarly, filing amended returns may constitute a voluntary disclosure of a tax liability that could avoid criminal prosecution for tax fraud or other crimes, although such a strategy is based on IRS practice, and not on anything in the law which grants formal immunity to persons filing amended returns. However, the central issue here is not whether it may prove helpful for a taxpayer to file an amended return, but rather whether filing such a return is mandatory under the law. It appears that the answer to this latter question is no. C. Ethical Obligations Regarding Amended Returns. Having determined that there is generally no legal obligation to file amended returns, the question remains as to what a tax professional is ethically obligated to do when he or she discovers that a client s filed return contains errors. 3

10 1. Disclosure by Tax Professional of Error. There is general agreement that a lawyer must disclose the existence of the error to the client. E.g., Circular 230, provides that the lawyer must advise the client promptly of the fact of the error and must advise the client of the consequences of the error. Similar standards govern accountants. (See AICPA Statement on Standards for Tax Services, No. 6, stating that the accountant should inform the client of the existence of the error.) These rules would apply even if the lawyer or accountant had himself been responsible for the previous error. 2. Requirement to Advise that Amended Return be Filed. Having concluded that the professional is required to inform the client of the error, the next issue that arises is whether the professional must advise or recommend that the client correct the error by filing an amended return. This, again, may raise serious practical issues, since the professional may be concerned that the relationship with the client would be damaged or jeopardized, should the professional advise the client to do something that the client believes (perhaps quite correctly) is against the client s self interest. Circular 230 does not provide that a professional should or must recommend the filing of an amended return to the client (see Circular 230, 10.21). Similarly, the AICPA Statement on Standards for Tax Services, No. 6, does not specifically require that the accountant must recommend the filing of an amended return, although the Statement provides that a CPA should recommend appropriate measures to correct the error, while also requiring that the CPA take reasonable steps to ensure that the error is not repeated in preparing the current year s return. The rules governing lawyers are not as clear, and may require the lawyer to recommend that an amended return be filed. Those rules are discussed below. a. Rationale For Rule. Commentators generally believe that this omission is an acknowledgment that filing an amended return could possibly subject the client to criminal prosecution. In such a situation, a client might have a 5th Amendment right under the Constitution not to file an amended return, and a professional is under no obligation to recommend actions to the client that would contravene this Constitutional right. See, e.g., Corneel, Guidelines to Tax Practice (Second), 43 Tax Lawyer 297 (1990); Wolfman, Holden, & Harris, Standards of Tax Practice 126 (6th. Ed. 2006) (hereafter Wolfman, et. al. ). b. ABA Opinion 314 s Treatment. Notwithstanding these considerations, ABA Opinion No. 314 apparently requires that a lawyer advise a client to file an amended return, although the language used in the opinion is of a general nature, and not in any way focused on amended return in particular. ABA Opinion 314 contains the following paragraph: In all cases, with regard both to the preparation of returns and negotiating administrative settlements, the lawyer is under a duty not to mislead the Internal Revenue Service deliberately and affirmatively, either by misstatements or by silence or by permitting his client to mislead. The difficult problem arises where the client has in fact misled but without the lawyer s knowledge or participation. In that situation, upon discovery of the misrepresentation, the lawyer must advise the client to correct the statement; if the client refuses, the lawyer s obligation depends on all the circumstances. c. Interpretation of Above Language. Most commentators interpret this language as requiring that a lawyer recommend the filing of an amended return upon the discovery of a previous error, with the caveat that the recommendation does not likely apply in the unusual situation when 5th Amendment concerns were present. Wolfman, et. al. at What if Client Refuses to Amend Returns? If the client refuses to file an amended return (irrespective of whether such action was recommended by the lawyer), then, as ABA Opinion 314 phrases it, the lawyers obligation depends on all the circumstances. a. Lawyers May Not Disclose Error. First of all, it should be clear that the lawyer may not disclose the error, absent the consent of the client. ABA Model Rule 1.6 provides, for example, that a lawyer shall not reveal information relating to representation of a client unless the client consents after consultation, except that a lawyer may reveal information to the extent that the lawyer reasonably believes necessary to prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent death or substantial bodily harm, or to establish a claim or defense on behalf of the lawyer in controversy between the lawyer and the client. b. Accountants Under Similar Restrictions. Similarly, accountants may not inform the IRS of the error except where required by law. AICPA Statement on Standards for Tax Services, No. 6. 4

11 c. Lawyer May Not Be Associated With Future Filings. Second, it appears clear that the lawyer may not be involved or associated with the filing of a future tax return, or future filing of a tax document, that incorporates or continues the previous error. ABA Model Rule 4.1(a) and 8.4 provide that a lawyer may not make a false statement of a material fact or law or a fraudulent statement. This can be especially problematic where there is an error in the amount of an asset (such as inventory), and where that error will be carried forward, mechanically, in future returns. d. Accountants Also May Not Be Associated With Future Filings. CPAs also are required to take reasonable steps to assure that the error is not repeated in preparing tax returns in the future. Thus, they face the same difficulty in preparing tax returns that incorporate an error made in a previous return. AICPA Statement on Standards for Tax Services, No. 6. e. Future Dealings With the IRS (Such As Audits). Similar issues would arise if the tax professional was representing the client before the IRS, since Circular 230 ( 10.51(d)), prohibits giving false or misleading information to the IRS, as well as participating in any way in the giving of false or misleading information. (Circular 230, 10.51(d) terms such behavior as disreputable conduct for which a lawyer may be censured, disbarred or suspended from practice before the IRS.) If a professional knew about the existence of the error, it might be difficult to continue dealing with the IRS if the dealing involved the subject matter of the error, since the dealing itself might be viewed as providing false or misleading information to the IRS, or at least participating in that process. Under AICPA Statement on Standards for Tax Services, No. 7, a CPA representing a client before the IRS where the CPA is aware of an error in the return being audited, should consider withdrawing from representing the taxpayer if the client refuses to inform the IRS of the error. This language likely means that the CPA should withdraw unless the withdrawal itself could breach the client s confidentiality. III. PROFESSIONAL STANDARDS APPLICABLE TO TAX PROFESSIONALS ADVISING CLIENTS ON POSITIONS TO BE TAKEN ON TAX RETURNS. A. Introduction. How do you know whether an error has been committed on a return? What if the position taken has some merit, but is likely not to succeed if litigated? Is that an error? Similarly, in recommending that a client fix a previous error, what standards are applicable in determining whether the new position you are recommending is appropriate under law? In other words, how aggressive can you be in recommending or advising a client to take a position on a tax return? Can, for example, a tax professional recommend that a client take a certain position, even though the lawyer believes that it is likely the position would not prevail, on the merits, if it were picked up on audit and litigated? If the answer to this question is yes, how far can the professional go in recommending positions that would likely be losers if picked up by the IRS? B. ABA Formal Opinion (July 7, 1985) History. Opinion deals with the extent to which a lawyer may advise a client to take a tax return position which may be aggressive. Opinion was issued to replace the portions of Formal Opinion 314 (April 27, 1965) which had held that a lawyer could advise a client to take a position most favorable to the client as long as there is a reasonable basis for the position. Practitioners had come to interpret the language as allowing a position to be taken as long as there was a colorable claim to that position, thus allowing lawyers to bless return positions that were oriented towards taking advantage of the tax lottery. Although disavowing this particular interpretation, the ABA, in response to criticism, issued Opinion which effectively replaced the older Opinion 314 regarding return positions, although Opinion 314 remains outstanding in terms of providing guidance regarding the IRS-lawyer relationship, specifically the lawyer s responsibilities in negotiating and settling matters before the IRS. (Note Opinion does not apply to tax shelters. Instead, Formal Opinion 346 (Revised) issued in 1982 sets forth the ethical rules regarding tax shelter activity, and in general imposes a higher standard of care, including more diligence and inquiry, on lawyers providing tax shelter opinions. Opinion , discussed in this article, is inapplicable to such arrangements.) C. Substance of Opinion Opinion allows lawyers to be quite aggressive in advising clients regarding tax return positions. The Opinion allows a lawyer to recommend a position if there is some realistic possibility of success if the matter is litigated. In this regard, the position must be one which the lawyer in good faith believes is warranted in existing law or can be supported by a good faith argument for an extension, modification or reversal of existing law. There are several noteworthy features of the realistic possibility of success. 5

12 1. Quantification of Realistic Possibility of Success. The Report of the Special Task Force on Formal Opinion , reprinted in 39 Tax Lawyer 635 (1986) ( Special Task Force Report ), attempts to quantify what is meant by realistic possibility of success, although no such quantification is provided in the Opinion itself. The Special Task Force Report provides that a 5-10 percent likelihood of success if not sufficient to meet the standard, but that a likelihood approaching 1/3 should meet the requirement. 2. Test is Based on Litigation. It is also important to note that the 1/3 test is based on an assumption that the position is actually litigated. This prevents the lawyer from evaluating the position by taking into account the possibility that the IRS would not discover this on audit, and the additional possibility that the matter could be settled, through comprise, in negotiations before litigation occurred. The Special Task Force Report rejects both of these qualifications, which has the effect of raising the standard to which the opinion must adhere, since a lawyer can t use the audit lottery in determining whether the client has a 1/3 chance of prevailing on the position. 3. A Realistic Possibility of Success is not Substantial Authority. Opinion specifically says that a realistic possibility of success may exist, even though it is likely that the taxpayer would lose if the matter were litigated. Moreover, the Opinion makes clear that a realistic possibility of success may exist for a particular position, even though that position may not have substantial authority under the law, leading to the ironic situation that a lawyer, under the rules, may ethically advise a taxpayer to take a return position that would subject the taxpayer to penalties if the taxpayer were caught taking the position by the IRS. 4. What Must Be Done if the Position Has a Realistic Possibility of Success But Does Not Have Substantial Authority? Opinion makes it clear that, in advising a client, the lawyer should tell the client whether the position is likely to be sustained by a court if challenged by the IRS, and the potential penalty consequences to the client if the position is taken. Since penalties may apply if there is no substantial authority for a position, the Opinion also says that the lawyer should advise the client of the potential application of the penalty, and the opportunity to avoid the penalty by disclosing the position on the return. The Opinion says that [i]f after receiving such advice the client decides to risk the penalty by making no disclosure and to take the position initially advised by the lawyer in accordance with the standards stated above (i.e., the realistic possibility of success standard), the lawyer has met his or her ethical responsibility with respect to the advice. 5. What Must Be Done if the Position Does Not Have a Realistic Possibility of Success? If the position does not have a realistic possibility of success, then the professional may, if the position is nonfrivolous, advise the taxpayer to take the return position if the position is disclosed or flagged on the return. AICPA Statement on Standards for Tax Services No. 1; Letter from John Jones, ABA Tax Section Chairman, to Leslie Shapiro, Director of Practice (February 12, 1987). D. Is the Realistic Possibility of Success Standard Still Practical? Although the realistic possibility of success standard is still theoretically applicable, two developments suggest that the more likely than not standard is now the more important rule. One is a preparer penalty under 6694 generally requiring a substantial authority standard to avoid penalties of Circular 230, the IRS ethical rules governing persons practicing before the IRS, will also be conformed to require the same standard as The second one is the new GAAP provision in FIN 48 requiring a more likely than not standard to be applied to the reporting of tax positions for financial accounting purposes. E. The Same Realistic Possibility of Success Also Applies to Accountants. Accountants are allowed to recommend a return position if it meets the realistic possibility of success standards as well. Under AICPA Statement on Standards for Tax Services No. 1, a CPA is allowed to consider whether there is a realistic possibility of success that a position will be sustained either administratively (in IRS Appeals, for example) or judicially. In contrast, lawyers may only take into account whether a position will be maintained judicially. 1. Preparer Penalty. The 2007 Small Business Act, enacted on May 25, 2007 expanded the liabilities for a tax return preparer who prepares a return or claim for refund for which there is an understatement of liability which is an unreasonable position Small Business Act, Pub. L. No , 8246, codified in I.R.C

13 a. Preparer. The term tax return preparer was expanded from just those preparing income tax returns, to include those preparing estate, gift, employment, excise, and exempt organization returns. In other words, all preparers are subject to this rule, including non-signing return preparers who give advice with respect to positions that are taken on the return. b. Unreasonable Position. Before the amendments made to 6694 by The Tax Extender and Alternative Minimum Tax Relief Act of 2008 signed into law by President Bush on October 3, 2008 (the 2008 Act ), a position was unreasonable, generally, if it is a position (i) of which the preparer had, or should have had, knowledge; (ii) for which there was not a reasonable belief that the position would more likely than not be sustained on its merits; and (iii) either the position was not disclosed under 6662 or there was no reasonable basis for the position. No penalty will be imposed if there is reasonable cause for the understatement and the preparer acted in good faith. c. After 2008 Act. After the 2008 Act, the standard has been retroactively shifted from more likely than not to substantial authority. For disclosed positions (i.e., positions which are disclosed on a tax return such as by filing Form 8275), the standard (which is not changed by the 2008 Act) is that there must be a reasonable basis for the position (a percent likelihood that such position would prevail). However, for tax shelters (as defined in Section 6662(d)(2)(C)(ii) ( significant purpose of avoidance or evasion of tax) and reportable transactions, tax return preparers are still subject to the more likely than not standard, even after the amendments made by the 2008 Act. d. Penalty. The penalty for such an unreasonable position is assessed on each return prepared and is an amount which is the greater of (i) $1,000, or (ii) 50% of the fees for preparing the return or claim. The penalty rises for willful or reckless conduct on the party of the preparer to the greater of (i) $5,000, or (ii) 50% of the fees for preparing the return or claim. e. Effective Date. The change applies to tax returns prepared after May 25, f. Transitional Relief. Notice was issued to provide transitional relief to (i) all returns, amended returns, and refund claims due on or before December 31, 2007 (including extensions), (ii) 2007 estimated returns due on or before January 15, 2008, and (iii) 2007 employment and excise tax returns due on or before January 31, The relief is that income tax returns, amended returns, and refund claims will have the prior standards applied to them. For all other returns, amended returns, and refund claims, the reasonable basis standard under the 6662 regulations will be applied to determine whether the 6694(a) penalty will be imposed. No relief is provided under 6694(b) regarding willful or reckless conduct. 2. FIN 48. The Financial Accounting Standards Board s Interpretation No. 48 ( FIN 48 ), Accounting for Uncertainty in Income Taxes requires an enterprise to evaluate uncertainty and changes in uncertainty in determining whether [it] is entitled to the benefits of a particular tax position. FIN 48 requires that an uncertain tax position be taken only if it is more likely than not that a tax position will be sustained upon examination, based on the technical merits of the position. If more likely than not cannot be met for a position, the financial statements cannot recognize the benefit of the position. The purpose of FIN 48 is to reduce the diversity in accounting for income taxes by providing consistent criteria and measurement along with disclosure. The effective date is fiscal years beginning after December 15, Have The Rules Changed to Requiring a Substantial Authority Standard (More Likely Than Not ForTax Shelters?) In light of the changes introducted by FIN 48, the new penalties imposed on tax return preparers by 6694, and the proposed changes to Circular 230 (discussed below), one may argue that we are now, practically speaking, under a regime where the old realistic possibility of success standard is not practical. A tax return preparer may not safely rely on the realistic possibility of success standard, and a Company issuing financial statements under GAAP may not rely on that standard as well. F. Circular 230. Circular 230 (31 C.F.R. pt. 10) governs the recognition of attorneys, accountants, enrolled agents, and, in certain circumstances, other taxpayer representatives before the IRS. If a person, appearing before the IRS on behalf of a taxpayer, is engaged in practice, they must meet the requirements of Circular Practice Before the IRS. Practice before the Internal Revenue Service comprehends all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer's rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service. Such presentations include, 7

14 but are not limited to, preparing and filing documents, corresponding and communicating with the Internal Revenue Service, rendering written advice with respect to any entity, transaction, plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion, and representing a client at conferences, hearings and meetings. Circular No. 230, 10.2(a)(4). 2. Recent Changes. a. Final Regulations. On September 26, 2007, the Treasury Department adopted final regulations regarding changes to Circular 230. In particular, the definition of practice before the Internal Revenue Service was amended to include the rendering of written advice with respect to any entity, transaction, plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion. Circular No. 230, 10.2(a)(4). Despite comments on the proposed regulations to this section of Circular 230 that rendering tax advice was not, by itself, practice before the IRS, Treasury concluded that written advice is practice when it is provided by a practitioner and therefore issued the regulations in final form without change. See Preamble to Final Regulations Governing Practice Before the Internal Revenue Service, T.D (Sept ). b. New Proposed Regulations. On September 24, 2007, the IRS issued a Notice of Proposed Rule Making (REG ) proposing additional modifications to Circular 230, in particular, regarding standards in respect of tax returns. The preamble states that Treasury and the IRS determined that the professional standards of Circular 230 should conform to the civil penalty standards for return preparers under Therefore, the proposed regulations, provide that a practitioner may not sign a tax return unless he has reasonable belief that each position taken on a return meets a more likely than not standard. Additionally, a practioner may sign a return if the position has reasonable basis and is adequately disclosed to the IRS. The proposed regulations define more likely than not to mean the practitioner has analyzed the pertinent facts and authorities, and based on that analysis reasonably concludes, in good faith, that there is a greater than fifty-percent likelihood that the tax treatment will be sustained under an IRS challenge. Prop. Circular No. 230, 10.34(e)(1). Reasonable basis is defined to mean a position reasonably based on one or more of the authorities described in 26 CFR (d)(3)(iii), or any successor provision, of the substantial understatement penalty regulations. Prop. Circular No. 230, 10.34(e)(2). This means the positions is (i) not patently improper, (ii) greater than merely arguable, and (iii) greater than merely colorable. A practitioner may not take into account the possibility that (i) a return would not be audited, (ii) an issue would not be raised on audit, or (iii) an issue would be settled. Id. The IRS, however, did not define what constitutes adequate disclosure. Note to Reader - since the penalty standards under 6694 for tax return preparers have now been retroactively downgraded to substantial authority under the October, 2008 bailout legislation, it is expected that the proposed regulations under of Circular 230 will also be changed. IV. UNWINDING OR RESCINDING A TRANSACTION THE PROBLEM. One very useful way of fixing a mistake is to rescind it. The rescission doctrine allows a transaction to be unwound as long as it is unwound in the same taxable year in which it occurred, and as long as the parties are restored to the status quo. A. The General Tax Rule For Rescissions According To The IRS. Subject to a number of exceptions and nuances, the IRS view is that a transaction generally can be ignored and treated as if it never existed, for federal income tax purposes, if and only if two conditions are met: 1. The Same-Year Rule. First, the transaction must be rescinded in the same year in which it originally took place. If the transaction is rescinded in a subsequent taxable year, the weight of the authority is that the transaction cannot be ignored for federal income tax purposes - rather the original transaction and its rescission must be separately respected and reported, for federal income tax purposes, as discrete and separate transactions. 2. Restoration of the Status Quo. Second, the rescission of the transaction must restore both sides to the same position they had before the original transaction occurred. If either side is not restored to the status quo before the original deal, then the weight of the authority is that the transaction cannot be ignored for tax purposes. For example, if only one side is restored to status quo (but not the other side) then the transaction cannot be ignored by either side for tax purposes. B. Policy Behind Rules Claim of Right. The policy behind these rules is basically the same as the rationale underlying the claim of right doctrine. Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931). 8

15 Our tax system is based on annual reporting, and it is administratively necessary to determine tax liability based on events occurring within the taxable year, and not based on future developments. Both taxpayers and the IRS need to be able to determine taxable income, and taxpayers need to file tax returns, without having to refer to events occurring subsequent to the taxable year. C. Revenue Ruling 80-58, C.B Rev. Rul is the central IRS ruling that purports to state the law on rescission of contracts. This ruling deals with two situations. 1. Situation 1. Rescission Within Same Year. In February 1978, Seller sold a tract of land to Buyer for cash. The contract required Seller, at the request of Buyer, to accept reconveyance of the land from Buyer if any time within 9 months of the sale, Buyer was unable to have the land rezoned for Buyer s business purposes. The IRS states in the ruling that if there were a reconveyance under the contract, then Seller and Buyer would be placed in the same positions that they occupied prior to the sale. In October 1978, Buyer determined that it wasn t possible to have the land rezoned. As a result, the Buyer reconveyed the land back to Seller under the terms of the original contract, in October The tract of land was returned to Seller and Buyer received all of its money back. 2. Analysis of Situation 1 The Same-Year Rule. In situation 1, the IRS holds that the sale of the land is disregarded, since the sale was rescinded in the same taxable year in which it occurred and the taxpayers were placed in the same positions as they were before the original transaction was consummated. In effect, the transaction is treated as if it never occurred to begin with. The IRS cites Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940) where a taxpayer was allowed to ignore compensation paid him in 1931 under a stock benefit fund when the plan was rescinded in the same year and the taxpayer returned the benefits to his employer. In contrast, the court refused to allow the taxpayer to ignore compensation paid him under the fund for 1930, since the rescission of the plan and the return of the compensation in 1931 did not occur in the same taxable year as the original receipt of the compensation in Situation 2. Rescission Within Subsequent Taxable Year. In situation 2, the same facts exist except that the contract provided that Buyer could rescind the contract if Buyer was unable to obtain zoning within one year of the original sale. In situation 2, Buyer chose to rescind the contract in February 1979 (recall that the sale occurred in February 1978) and the parties were restored to the original status quo at that time. The IRS claims that this means that the transaction cannot be ignored instead the parties have to respect the sale in 1978 and view the 1979 transaction as a subsequent repurchase of the property. 4. Consequences of the Situation 2 Fact Pattern. The consequences of the IRS view that the transaction in situation 2 cannot be rescinded are quite adverse to Seller. Since the parties are forced to separately account for the 1978 sale, and the 1979 repurchase of the property, Seller must recognize gain (assuming the property is appreciated) from the 1978 sale and Seller is viewed as repurchasing the property in 1979 (which of course would not be deductible to Seller). So Seller is harmed here because of the tax liability resulting from the 1978 sale. Buyer, in contrast, is viewed as purchasing the property in 1978 and reselling it for the same price in 1979, which would not result in any net tax liability to the Buyer. (The 1979 transaction would not result in any gain, unless the Buyer had depreciated the property, which would mean that any gain recognized in 1979 would equal the total depreciation deductions taken on the property by Buyer before the 1979 sale. Thus, the net overall gain for both years together would be zero). 5. Revenue Ruling Is Not Confined To Rescissions Provided For In The Contract. The original contract of sale between the parties in Rev. Rul provided that Seller was obligated, at the request of Buyer, to accept reconveyance of the land if Buyer was unable to have the land rezoned for Buyer s business purposes. Is the rescission doctrine promulgated in Rev. Rul confined or limited to situations where the original contract between the parties expressly provides for a rescission scenario? The answer is no, based on the very broad language in the ruling which does not focus on the original terms of the contract. Consider the following language in the ruling: 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 C.B. at

16 6. Not Necessary That Language Be Provided in the Contract. This language strongly suggests that the rescission does not have to be provided in the contract for the doctrine to apply because the reference to one of the parties declaring rescission without the other party s consent or the application to a court for rescission, implies that the original contract itself did not provide for a rescission remedy. Thus, it seems clear that Rev. Rul allows parties, for any reason whatsoever, to extinguish a transaction by unwinding the transaction within the same taxable year in which is occurred. This is true even if the intention behind the unwinding is compensatory in nature, as noted below. 7. Revenue Ruling Is Not Confined To Sales Of Property Even The IRS Acknowledges This. The scope of Rev. Rul goes far beyond the actual facts of the ruling itself, which concerned the sale of property, and allows other types of transactions to qualify for the doctrine as well. Those transactions are listed below. a. The Payment of Compensation May be Rescinded. Revenue Ruling cites Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), which concerned compensation received by a taxpayer through a employer s compensatory stock plan, where the 4th Circuit Court of Appeals applied the rescission doctrine to the part of the compensation which was paid and then unwound during the same taxable year, thus allowing the taxpayers to treat the compensation as if it had never been paid to begin with. (In contrast, the court disallowed the rescission doctrine with respect to compensation which straddled taxable years before being unwound.) Thus, in embracing Penn v. Robertson and citing it with approval in Rev. Rul , the IRS clearly indicates that the rescission doctrine goes beyond sales contracts. Other cases have reached similar conclusions regarding compensation, i.e., if compensation is rescinded in the same year, it may be ignored for tax purposes. Clark v. Commissioner, 11 T.C. 672 (1948) (employee returns 1942 salary in same year by giving promissory note to employer not included in employee s income); Fulton v. Commissioner, 11 B.T.A. 641 (1928); Russel v. Commissioner, 35 B.T.A. 602, 604 (1937) (and cases cited therein). Hill v. Commissioner, 3 B.T.A. 761 (1926); Couch v. Commissioner, 1 B.T.A. 103 (1924). D. Recent Private Letter Rulings Allow Rescissions of Entity s Tax Form, Rescinding the Formation of C Corporations. 1. Rescission of Conversion of Partnership into Corporation (Private Letter Ruling) - Return to Partnership Tax Status. In PLR (December 16, 2005), an LLC, taxed as a partnership, had been converted into a C corporation by virtue of a statutory conversion under state law. (Although done through a statutory conversion, this conversion was treated as a section 351 transaction for tax purposes.) The conversion into a C corporation was done in anticipation of an IPO of the new corporation s stock. Unfortunately, after the conversion, the stock market went through a precipitous and unexpected deterioration, which meant the IPO was unattractive. The IRS allowed the corporation to convert back to a partnership in the same taxable year in which the initial conversion into a corporation had occurred. Without the IRS blessings of the rescission, a disincorporation of this entity back into a partnership would have resulted in a taxable liquidation, creating both corporate-level gain on the assets distributed in liquidation and shareholder-level gain as well. Note that there had been redemptions of the interests in the entity as a result of the death and separation from service of individuals in the taxpayer s management team. In addition, there had been tax distributions, made after the incorporation, to the owners of the business for the taxes incurred by them while the entity was still a partnership (before the incorporation). a. Status Quo Requirement. One might argue that the redemptions of interests in the entity, and the tax distributions made during the corporation s existence, prevented the parties from being restored to the status quo. However, the IRS reasoned that the parties were restored to the same relative positions they would have occupied had the corporation never occurred. In other words, the redemptions, and the tax distributions would have occurred even if the corporation had never existed. Therefore, the fact that these transactions occurred should not be viewed as an impediment to rescinding the transaction and restoring parties to the status quo. In other words, the status quo does not mean the same position that the parties were in before the first transaction was done. Instead, it means the same position the parties would have been in had the transaction not been done, which means that changes to their position that would have occurred anyway (regardless of whether the incorporation had ever occurred) are not impediments to the status quo requirement. 10

17 b. Distributions Were Not Repaid. The tax distributions made to the parties were not repaid here, on the grounds that the tax distributions would have been made had the entity always remained a partnership. Contrast this with Rev. Rul , C.B. 277 where the parties attempted to rescind a stock transfer agreement which was a type B reorganization because the shareholder of the target retained dividends that were distributed to the shareholder from the new corporate parent of the target during the interim period of the parent s ownership of target. These dividends were not returned. (The argument that these distributions could have been made anyway would not work in Rev. Rul , since if the transaction was rescinded, the shareholder receiving the dividends would not have owned the parent corporation stock which paid the dividend, and thus could not say that the dividends would have been paid anyway.) c. Material Restoration of Positions. The parties also represented to the IRS that the effect of the rescission was to cause the legal and financial arrangements between the owners and the taxpayer (the entity) to be identical in all material respects, from the date before of the conversion to a corporation to what would have existed had the conversion not occurred. Note that this allows for the fact that there were business operations inside the entity during this period, such as purchase and sales of assets, the payment of compensation to employees, and other business operations. The existence of these operations did not prevent the rescission from taking place, since those business operations were not being rescinded. What was being rescinded was the transaction between the owner and the entity - not the transactions occurring inside the entity during this period of time. d. Parties Will Report Transactions as if Transaction Never Occurred. Finally, the parties represented that, if the transaction were rescinded, they would file tax returns as if the entity had been a partnership all along (and never a corporation). That means, for example, that the owners would receive K-1 s from the partnership for the entire period in question, and the owners would report all of the redemptions and distributions as if they had been made by a partnership to its partners (and not a corporation to its shareholders). Note that this could result, for example, in a portion of the redemption proceeds being taxed as ordinary income under the hot asset rules of Code 751, instead of it being all capital gains which it would have been had there been a complete redemption of corporate stock. 2. Rescission of Conversion of S Corporation into C Corporation (Private Letter Ruling) - Return to S Corporation Tax Status. In PLR (April 28, 2005), an S corporation, after negotiations with a venture capital fund, decided to allow the venture capital fund to make an investment in the S corporation. (Note that this venture capital fund was comprised of partnerships, which could not own stock in an S corporation.) To allow for this investment, the S corporation issued preferred stock to three partnerships controlled by the venture capital fund. This terminated the S election and turned the corporation into a C corporation on the date of the sale, since now the corporation had two classes of stock, and also had partnerships as shareholders, each of which is prohibited for S status under Code A disagreement arose between the parties, and, in the same taxable year, the preferred stock was redeemed for the amount originally paid for the preferred stock. The IRS favorably ruled that the transaction could be rescinded for tax purposes, and that the S corporation would be treated as having remained an S corporation for the entire taxable year. a. No Dividends Paid on the Preferred Stock. The corporation paid no dividends on the preferred stock while it was outstanding, which was undoubtedly an important fact allowing to parties to satisfy the IRS that the status quo requirement was met. b. Redemption Price for Preferred Stock was Exactly Equal to Issue Price. Under the private letter ruling, the amount paid to redeem the preferred stock was exactly equal to the amount the preferred stock was initially issued for, thus ignoring any appreciation in the value of the stock, as well as time value of money concerns. This was also important in satisfying the status quo requirement. c. Shareholders Report S Corporation Income for Entire Period. As a result of the ruling, the original shareholders of the S corporation agreed to report the income from the S corporation for the entire year, as if the S corporation had never sold preferred stock to the investors. E. Other Rulings Dealing with Rescission. 1. Revenue Ruling Allows A Corporate Distribution of Stock Appreciation Rights To Be Rescinded. In Rev. Rul (cited with approval by the IRS in Rev. Rul ) the IRS held that a corporation could rescind the issuance of subscription rights to purchase its stock, even though at the time of the issuance the rights exceeded 15 percent of the 11

18 common stock s value and thus under section 307(b) required an adjustment in basis. By unwinding the transaction in the same year, the transaction could be ignored. Thus, Rev. Rul stands for the proposition that corporate distributions to shareholders, at least in some situations, may be ignored for tax purposes if they are rescinded in the same year. 2. Private Letter Ruling Allows Section 351 Contribution of Stock To Another Corporation To Be Rescinded. In PLR (April 21, 1998), the IRS held that taxpayers could rescind the contribution of S corporation stock to another S corporation when the taxpayers discovered that their contribution could have undesirable tax consequences and unwound the transaction in the same year. The IRS cited Rev. Rul and held that they could completely ignore the transaction, since the transaction had been unwound in the same taxable year. 3. Private Letter Ruling Allows Compensatory Transfers of Stock, And Section 83(b) Elections, To Be Revoked. In PLR (October 31, 1990) a corporation made compensatory transfers of stock to employees, who made section 83(b) elections. Subsequent to the transfers but within the same year, the corporation discovered that the book financial accounting for the transfers would result in a much larger compensation expense, decreasing earnings, and so the transactions were rescinded. The IRS cited Rev. Rul and said the transactions would be ignored. 4. Private Letter Ruling Allows Distributions of Earnings and Profits By S Corporation To Be Rescinded. In PLR (March 26, 1993) an S corporation made a special distribution where it elected to have the distribution treated as Subchapter C earnings and profits first, as opposed to first coming out of the accumulated adjustment account. There was a change in the tax law regarding the definition of passive income for S corporations resulting in the distribution being unnecessary. The IRS allowed the shareholders to effectively rescind this dividend to the extent that it was repaid back in the same taxable year. 5. Private Letter Ruling Allows Rescission of Attempted Termination of Sale/Leaseback Transaction. In PLR (July 15, 1991) a corporation sent a letter to its counterparty terminating an aircraft sale/leaseback it had entered into. The attempted termination was rescinded 8 days later. Since the termination and the rescission occurred in the same taxable year, and the parties were restored to the same economic position, the rescission of the termination was effective. Rev. Rul cited as authority for holding. F. Stock Options & Other Compensatory Rescissions Are Likely Protected Under Revenue Ruling The scope of Rev. Rul is quite broad, allowing rescissions to occur, even for compensatory purposes, without triggering recognition of taxable gain if the rescissions occur within the same taxable year. Because of the special importance of rescission of non-qualified stock options, this particular issue is discussed in detail below. 1. Stock Option Example. Assume that Executive receives a non-qualified stock option from Employer allowing Executive to purchase stock of Employer for $10. In Year 1 Executive exercises the option and pays $10 per share when the stock is worth $100. Under normal tax rules, this would result in $90 of ordinary income to Executive and a $90 deduction to Employer. Assume, however, that the stock s value plummets to $1 per share, and the parties agree to unwind the transaction with Executive giving back the stock and receiving the $10 per share originally paid. 2. Results if Rescission Occurs Within Same Year. Assume that the parties rescind the transaction in the same year that Executive initially purchased the stock. Since the rescission occurred in the same year, the parties may ignore these transactions and treat them as if they had never occurred. Thus, Executive recognizes no income, and Employer has no deduction for tax purposes. This is an astoundingly generous result which ignores the fact that the Executive has received compensation in effect, the Executive was given both a bargain option to call or purchase the stock as well as a bargain option to put or sell the stock, without triggering any income whatsoever. The generous results offered by the ruling can be illustrated by what occurs if the rescission does not occur within the same taxable year. 3. Results if Rescission Does Not Occur Within Same Year. Assume that Executive purchases the stock for $10 in Year 1, and in Year 2 the parties agree to rescind the transaction with Executive giving the stock back to Employer and receiving the initial payment of $10 per share. If the IRS is correct that this transaction may not be ignored for tax purposes, then the 12

19 following results occur: Executive recognizes $90 of ordinary income in Year 1 from purchasing stock worth $100 for $10 - Employer has $90 compensation deduction. In Year 2, Executive recognizes $9 ordinary income from selling property worth $1 for $10 to Employer Employer has $9 of compensation expense. In addition, when Executive sells back the stock for $1 ($10 is the nominal sales price but $9 of that is compensation), Executive recognizes a $99 capital loss. Thus, over the course of two years, Executive recognizes $99 of ordinary income and has a capital loss of $99, and Employer has a total of $99 in compensation expense. For Executive, this is a terrible outcome. G. The Status Quo Requirement. The requirement that both parties be restored to the status quo can be illustrated by Hutcheson v. Commissioner, 71 T.C.M (1996). In Hutcheson, an individual owned a substantial amount of WalMart stock. In 1989, the taxpayer called his Merrill Lynch agent and told her to sell 100,000 of Walmart stock. The taxpayer meant that his agent should sell enough stock to generate $100,000 of sales proceeds, or around 3,400 shares. The Merrill Lynch agent thought the taxpayer meant sell 100,000 shares of Walmart stock, which she did for over $3 million, thus triggering a huge amount of taxable gain. (The taxpayer s basis in each shares was 11 cents each share s fair market value was around $30. Recall also in 1989 that there was no preferential rate for capital gains.) In attempt to avoid paying taxes on all of this gain, the taxpayer repurchased shares of Walmart stock at the end of the same taxable year as the original sale, and filed a formal arbitration claim with Merrill Lynch. The taxpayer argued that he has meant the requirements for a unilateral rescission under the law, and therefore he was able to avoid the taxable gain from the sale. 1. Court Rejects Rescission Argument Because Status Quo Was Not Restored. The court rejected this argument because neither he nor the original buyer of the shares was restored to the same position occupied before the sale. Since the taxpayer sold the Walmart stock into the public market, he was not able to repurchase the shares from the same person(s) who had originally purchased the stock. Thus, the buyer(s) of the stock was not restored to the same position as before the original transaction, which by itself presumably would be fatal to the taxpayer in qualifying under the rescission doctrine. Moreover, the court also noted that the taxpayer himself was not restored to the status quo position, since the taxpayer had to borrow money from his father in order to purchase the shares at the end of the year, and the taxpayer had no such borrowings before the transaction had occurred. Thus, both parties flunked the status quo requirement that was necessary for the rescission doctrine to take place. Finally, the court holds that the mere filing of a suit was not sufficient to postpone the recognition of gain. 2. Sales of Publicly Traded Property Into The Market Won t Qualify as Rescissions. The requirement that both sides of the transaction be restored to the status quo suggests, as held by the Hutcheson case discussed immediately above, that a taxpayer which sells publicly traded property into the market can never qualify under the doctrine, since it is quite unlikely that the other side can be restored to status quo if the transaction is unwound. One has to ask why, as a matter of logic, one taxpayer s treatment of the transaction should be affected by the other side s treatment. Nevertheless, since the concept of rescission implies an unwinding of the transaction between the two parties, it seems that both parties have to be participating in the unwinding for it to be treated as a rescission, although the policy reason for such a requirement seems lacking. 3. Court Cites to Hutcheson in Bankruptcy Dispute, Applying Tax Rescission Doctrine. For an interesting bankruptcy decision relying on Hutcheson and the rescission doctrine in resolving a dispute among private parties, see In re Trico Marine Services, Inc, 343 B.R. 68 (Bkrtcy. S.D.N.Y., May 2006). In this decision, a bankruptcy judge rejected arguments that a bankruptcy reorganization could be rescinded (in a manner that would preserve certain tax benefits) by noting that the reorganization had involved the distribution of stock into the public markets, and under the authority of Hutcheson, the reorganization could therefore not be rescinded for tax purposes. H. What If the Parties Recognize the Transaction In Different Taxable Years? What result occurs under the tax laws if both parties unwind the transaction, but the parties have different taxable years, resulting in one of the parties qualifying under the same-year rule and the other party not qualifying under that rule? Three possible results may occur: both parties may flunk the rescission rules, only the party failing the same-year requirement may flunk the rules, or both parties may qualify under the rescission rules. Although the authority underlying this conclusion is scanty, as discussed below it seems that the party which meets the one-year rule will qualify under the doctrine, while the party not meeting the one-year rule will not qualify and will have to therefore account for each transaction separately. Note 13

20 that this is a perverse result, because it creates the possibilities of whipsaw one side to a transaction may ignore the transaction altogether, while the other side has to take it into account for the earlier year, and recognize the rescission the following year, thus defeating the policy underlying the claim of right doctrine. 1. The Fender Case And Different Taxable Years. In Fender Sales v. Commissioner, 22 T.C.M. 550 (1963), a bonus was accrued by a calendar-year corporation in 1955, and paid to the employee in In both times, Mr. Fender (who apparently was the founder of the Fender guitar) returned a portion of the bonus to the corporation in the same calendar year in which he received it, even though the accrual-method corporation had accrued and deducted the bonus for the previous taxable year. The IRS argued that the sameyear rule (which was phrased as an exception to the claim of right doctrine) did not apply when the corporation accrued the deduction in a year earlier than the inclusion of such amounts by a cash-method employee. The court, however, rejected this argument and held that Mr. Fender was not taxed on bonuses received and repaid during his same taxable year. Thus, Mr. Fender qualified under the rescission doctrine for amounts that were unwound during his same taxable year although such amounts took place in a separate taxable year for the corporation. Apparently, the corporation had to separately account for the transactions, with the accrued bonus deduction being respected for the earlier year, and the amount subsequently included in the corporation s income for the subsequent year. Thus, the Fender case stands for the proposition that the same-year rule applies only to the party seeking to qualify under the doctrine. For similar facts, see Clark v. Commissioner, 11 T.C. 672 (1948) involving an accrual-method corporation and a cash-method employee who returned the compensation in the same taxable year and was allowed rescission treatment, even though the corporation had accrued the compensation for the previous year. 2. More Guidance on the Different Year Problem - Private Letter Ruling Allows Compensatory Transfers of Stock Elections To Be Rescinded if Unwound in Employees Taxable Year. In PLR (October 31, 1990) a corporation made compensatory transfers of stock to employees, who made section 83(b) elections. The transactions were rescinded with the IRS blessing the rescission under Rev. Rul by noting that it occurred within the same taxable year of the employees. The implication of the ruling is that the taxable year of the corporate employer is not relevant to the ability of the employees to rescind the transaction for their own purposes, although presumably the taxable year of the corporation would be relevant for its own rescission treatment. 3. What About Rescissions In Different Taxable Years? Are there any exceptions to the same year rule? That is, is it possible to rescind a transaction in a later taxable year, and still treat the transaction as if it never occurred even for the earlier taxable year in which it originated? There are some exceptions to the same year rule, which may provide an ethical and practical basis upon which to report a transaction. These exceptions may be broken down into four categories: (i) reformations under state law; (ii) the constructive trust doctrine; (iii) corrections of mistakes; and (iv) dicta from old decisions and some commentators suggesting that the one-year rule may not be the law. These exceptions are discussed in more detail below. V. THE REFORMATION DOCTRINE. A. Description of Reformation Doctrine. When parties achieve reformation of a contract or agreement, the process usually involves having a court declare that the contract or agreement is to be reformed or amended with the effective date of this change typically being retroactive to the very inception of the agreement. In addition, many reformations are achieved through a nunc pro tunc order which purports to be retroactive in nature and which is typically issued by a state court upon request of the parties. Although the majority doctrine is to the contrary, a minority doctrine provides that state court reformations of arrangements may be retroactively effective for federal tax purposes in some situations, even though the reformations occur in a subsequent year. (Note to reader there is a separate doctrine, which is adopted by even the majority of courts, that correction of clerical errors by a court will be given retroactive effect. Although, frequently these errors may be corrected by a reformation, this doctrine is separately discussed below as the 3rd category of cases, since the scope of this 3rd category is more narrow.) B. The Majority Doctrine The IRS Is Not Bound By Retroactive Reformations. Under the majority doctrine which is adopted by most courts, the IRS is not bound by court-ordered reformations that purport to be retroactive in nature, even though the retroactive application of the reformation order may be binding on the private parties involved. The rationale for this doctrine is that otherwise the IRS would be vulnerable to collusive 14