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

Transcription

OOPS, WHAT WAS I THINKING?
HOW TO FIX A BOTCHED TRANSACTION
THOMAS L. EVANS
Kirkland & Ellis LLP
Chicago, Illinois
[email protected]
(312) 862-2196
State Bar of Texas
27 ANNUAL ADVANCED TAX LAW COURSE
August 27-28, 2009
Houston
th
CHAPTER 9
Thomas L. Evans
Professional Profile
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
Partner
practice.
Chicago
Phone: +1 312-862-2196
Fax: +1 312-862-2200
[email protected] Other Distinctions
Certified Public Accountant (Arizona)
Practice Areas
Awards:
Tax
Texas Excellence in Teaching Award - University of Texas Law School, 1991
Admissions
1984, Illinois
Kugle, Byrne & Alworth Ethics Teaching Award - University of Texas Law
School, 1993
1994, Texas
2001, District of Columbia
Education
University of Chicago Law
School, J.D. 1983 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
Texas Excellence in Teaching Award - University of Texas Law School, 1997
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, 1989.
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
www.kirkland.com
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, 1995.
Evans, "Update on Income Tax: Current Developments," 12th Annual Tax
Conference, Closely Held Businesses and Their Owners, Arizona Society of
Certified Public Accountants, November, 1996.
Evans, "Partnership Taxation - Recent Developments," Annual Tax
Conference, Austin Chapter Texas Society of Certified Public Accountants,
December, 1996.
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, 1998.
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, 2000.
Prior Experience
Senior Tax Counsel - Cleary, Gottlieb, Steen & Hamilton, New York
(1997-2001)
Professor of Law - University of Texas School of Law, Austin, Texas
(1989-2001)
Associate Tax Legislative Counsel - U.S. Department of the Treasury, Office
of Tax Policy (Tax Legislative Counsel) (From 1985-1987, Attorney-Advisor)
Associate, Kirkland & Ellis, Chicago, Illinois
www.kirkland.com
Oops, What Was I Thinking? How to Fix a Botched Transaction
Chapter 9
TABLE OF CONTENTS
I.
THE INCOME TAX IMPLICATIONS OF FIXING MISTAKES. ....................................................................... 1
A. Introduction. .................................................................................................................................................... 1
B. Summary of Conclusions. ............................................................................................................................... 1
II.
THE DUTY TO CORRECT A DISCOVERED ERROR RELATING TO A PREVIOUS TAX RETURN. ........ 2
A. Introduction. .................................................................................................................................................... 2
B. Obligation of Client to File an Amended Return. ........................................................................................... 2
C. Ethical Obligations Regarding Amended Returns........................................................................................... 3
III. PROFESSIONAL STANDARDS APPLICABLE TO TAX PROFESSIONALS ADVISING CLIENTS ON
POSITIONS TO BE TAKEN ON TAX RETURNS. ............................................................................................. 5
A. Introduction. .................................................................................................................................................... 5
B. ABA Formal Opinion 85-352 (July 7, 1985) – History. ................................................................................. 5
C. Substance of Opinion 85-352. ......................................................................................................................... 5
D. Is the Realistic Possibility of Success Standard Still Practical? ...................................................................... 6
E. The Same Realistic Possibility of Success Also Applies to Accountants. ...................................................... 6
F. Circular 230. .................................................................................................................................................... 7
IV. UNWINDING OR RESCINDING A TRANSACTION –THE PROBLEM. ......................................................... 8
A. The General Tax Rule For Rescissions – According To The IRS. .................................................................. 8
B. Policy Behind Rules – Claim of Right. ........................................................................................................... 8
C. Revenue Ruling 80-58, 1980-1 C.B. 181. ....................................................................................................... 9
D. Recent Private Letter Rulings Allow Rescissions of Entity’s Tax Form, Rescinding the
Formation of C Corporations......................................................................................................................... 10
E. Other Rulings Dealing with Rescission. ........................................................................................................ 11
F. Stock Options & Other Compensatory Rescissions Are Likely Protected Under Revenue
Ruling 80-58. ................................................................................................................................................. 12
G. The Status Quo Requirement......................................................................................................................... 13
H. What If the Parties Recognize the Transaction In Different Taxable Years?................................................ 13
V. THE REFORMATION DOCTRINE. ................................................................................................................... 14
A. Description of Reformation Doctrine. ........................................................................................................... 14
B. The Majority Doctrine – The IRS Is Not Bound By Retroactive Reformations. .......................................... 14
C. The Minority Doctrine Which Respects Retroactive Reformations. ............................................................. 15
D. The Correction of Mistake Doctrine.............................................................................................................. 16
E. Tax Planning With Reformation Proceedings. .............................................................................................. 17
F. Strength of Reformation Argument – A Reporting Position? ....................................................................... 17
G. When Will the Same-Year Rule the Rescission Doctrine Not Protect A Taxpayer? .................................... 18
H. The IRS May Contend that the Issuance of Debt Cannot Be Rescinded....................................................... 19
I. The Same-Year Rule May Not Allow Taxpayers To Avoid Form Over Substance Arguments
if the Rescission is not “Clean.” .................................................................................................................... 19
J. The Rescission Doctrine Can’t Be Used If the Agreement is to Not Return to the Status Quo. ................... 19
VI. REQUESTING “9100 RELIEF” UNDER TREASURY REG. SECTIONS 301.9100-1
THROUGH 301.9100-3 ........................................................................................................................................ 19
A. Introduction. .................................................................................................................................................. 19
B. Definition of Election. ................................................................................................................................... 19
C. Automatic Extensions - 9100 Relief.............................................................................................................. 20
D. General 6 Month Extensions - Not Automatic. ............................................................................................. 21
E. Other Examples of Alternative Relief. .......................................................................................................... 23
F. Treas. Reg. § 301.9100-3: Other Extensions. ................................................................................................ 23
i Oops, What Was I Thinking? How to Fix a Botched Transaction
VII.
VIII.
CHANGE IN METHOD OF ACCOUNTING OR CORRECTION OF ERROR. ....................................... 26
A. Introduction. ........................................................................................................................................... 26
B. Change in Method of Accounting. .......................................................................................................... 26
SECTION 83(b) ELECTIONS. ..................................................................................................................... 28
A. Effect of Code § 83................................................................................................................................. 28
B. Importance of Section 83(b) Election. .................................................................................................... 28
C. Strict Deadline for Section 83(b) Elections. ........................................................................................... 28
D. Solution for Late Section 83(b) Election. ............................................................................................... 28
E. Revoking § 83(b) Elections.................................................................................................................................29
ii Chapter 9
Chapter 9
“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 § 10.34 of Circular 230 governing tax
return preparers. Consistent with that position, that
IRS had issued proposed regulations under § 10.34 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 § 10.34 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.
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. 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.
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.
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.
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.
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
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 2008
1 Oops, What Was I Thinking? How to Fix a Botched Transaction
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.
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.
5.
Utilizing 9100 Relief.
As discussed in Section VI, Treas. Reg. §
301.9100 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.
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?
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.
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 89-48 (April 19, 1989)(1989 CCH
¶6515) as modified by Ann. 89-90, 1989-29 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.
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
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 Chapter 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.
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.”
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. § 1.451-1(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. §
1.461-1(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.
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. § 1.6664-2(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.
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 § 7203.
5.
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 1947. 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
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 Chapter 9
1.
Chapter 9
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:
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, § 10.21 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.
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.
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.
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 125-26.
3.
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.
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. 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.
b. ABA Opinion 314’s Treatment. Notwithstanding
these considerations, ABA Opinion No. 314 apparently
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.
Chapter 9
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 85-352 (July 7, 1985) –
History.
Opinion 85-352 deals with the extent to which a
lawyer may advise a client to take a tax return position
which may be aggressive. Opinion 85-352 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 85-352 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 85-352 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 85-352, discussed in this article, is
inapplicable to such arrangements.)
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.
C. Substance of Opinion 85-352.
Opinion 85-352 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.
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
1.
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.”
Quantification of Realistic Possibility of Success.
The Report of the Special Task Force on Formal
Opinion 85-352, 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.
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).
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.
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. §
10.34 of Circular 230, the IRS ethical rules governing
persons practicing before the IRS, will also be
conformed to require the same standard as § 6694. 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.
3.
A Realistic Possibility of Success is not
Substantial Authority.
Opinion 85-352 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.
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.
4.
What Must Be Done if the Position Has a
Realistic Possibility of Success But Does Not
Have Substantial Authority?
Opinion 85-352 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
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.” 2007 Small Business Act,
Pub. L. No. 110-28, § 8246, codified in I.R.C. § 6694.
6 Chapter 9
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.
Chapter 9
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, 2006.
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 10-20 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.
3.
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.
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.
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
230.
e. Effective Date. The change applies to tax returns
prepared after May 25, 2007.
f. Transitional Relief. Notice 2007-54 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, 2008. The relief is that income tax
returns, amended returns, and refund claims will have
1.
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,
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).
“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 § 10.34 of Circular 230 will also be changed.
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. 9359 (Sept. 26. 2007).
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:
b. New Proposed Regulations. On September 24,
2007, the IRS issued a Notice of Proposed Rule
Making (REG-138637-07) proposing additional
modifications to Circular 230, § 10.34 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 § 6694. 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 1.6662-4(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)
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 Chapter 9
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.
Chapter 9
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).
C. Revenue Ruling 80-58, 1980-1 C.B. 181.
Rev. Rul. 80-58 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 1978. The tract of land was
returned to Seller and Buyer received all of its money
back.
5.
Revenue Ruling 80-58 Is Not Confined To
Rescissions Provided For In The Contract.
The original contract of sale between the parties in
Rev. Rul. 80-58 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. 80-58 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. 1980-1 C.B. at 181-82.
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 1930.
3.
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
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. 80-58 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.
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 200613027 (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).
7.
Revenue Ruling 80-58 Is Not Confined To Sales
Of Property – Even The IRS Acknowledges This.
The scope of Rev. Rul. 80-58 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 80-58 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. 8058, 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).
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 Chapter 9
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. 78-119,
1978-1 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. 78-119, 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.)
2.
Rescission of Conversion of S Corporation into C
Corporation (Private Letter Ruling) - Return to S
Corporation Tax Status.
In PLR 200533002 (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 § 1361. 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.
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.
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.
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.
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.
1.
Other Rulings Dealing with Rescission.
Revenue Ruling 74-501 Allows A Corporate
Distribution of Stock Appreciation Rights To Be
Rescinded.
In Rev. Rul. 74-501 (cited with approval by the
IRS in Rev. Rul. 80-58) 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 Chapter 9
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. 74-501 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.
Chapter 9
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. 80-58 cited as authority for
holding.
F.
Stock Options & Other Compensatory
Rescissions Are Likely Protected Under
Revenue Ruling 80-58.
The scope of Rev. Rul. 80-58 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.
2.
Private Letter Ruling Allows Section 351
Contribution of Stock To Another Corporation To
Be Rescinded.
In PLR 9829044 (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.
80-58 and held that they could completely ignore the
transaction, since the transaction had been unwound in
the same taxable year.
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.
3.
Private Letter Ruling Allows Compensatory
Transfers of Stock, And Section 83(b) Elections,
To Be Revoked.
In PLR 9104039 (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. 80-58 and
said the transactions would be ignored.
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.
4.
Private Letter Ruling Allows Distributions of
Earnings and Profits By S Corporation To Be
Rescinded.
In PLR 9312027 (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.
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
5.
Private Letter Ruling Allows Rescission of
Attempted Termination of Sale/Leaseback
Transaction.
In PLR 9141038 (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
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.
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.
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. 2425 (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.
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.
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
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 Chapter 9
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.
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.
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 1956.
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.
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.)
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 9104039 (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. 80-58 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
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 Chapter 9
state-court actions where private parties might
persuade a court to change an agreement or contract for
tax motivated reasons, without the IRS having any
involvement in the process. Thus, most courts provide
that, for federal income tax purposes, a retroactive
reformation that extends back to a previous year has no
effect for federal income tax purposes.
Flitcroft, discussed below, to the extent it requires the
IRS to give retroactive effect to a reformation.
b. Hayes v. Commissioner, 101 T.C. 593 (1993). A
divorce decree entered into in 1986 created tax
problems for the husband since it obligated him to
purchase his wife’s stock and he lacked the funds to do
so, forcing him into a constructive dividend situation if
he had his closely held corporation redeem the stock
from his wife directly. The parties had the 1986
agreement “corrected” by a nunc pro tunc order
entered into by state court in 1987 which provided that
the wife was directly obligated to sell the stock back to
the corporation. The Tax Court refused to follow the
nunc pro tunc order and held that the husband had
dividend treatment in 1986, finding that the nunc pro
tunc order was invalid and contrary to Ohio law since
it was more than just the correction of a error in
recording the judgment.
1.
The Leading Case Establishing the Majority
Doctrine.
In Commissioner v. Estate of Bosch, 387 U.S. 456
(1967), the Supreme Court dealt with the federal estate
laws and their interaction with state law. In one of the
cases decided under Bosch the issue was whether a
release by a wife of a general power of appointment
turning the power into a special power was invalid, as
the wife later claimed, under state law. (If the release
was invalid, then she would have had a general power
of appointment which would have qualified her for the
marital deduction with respect to her husband’s estate.)
The Supreme Court held that the IRS was not obligated
to follow the decision of a lower state court which
found in favor of the taxpayer by holding that the
release was invalid. Instead, the court held that where
the IRS was not made a party to the state proceedings,
the findings of a state trial court was not conclusive
and binding on the application of a federal statue (here
the computation of the federal estate tax). Thus,
federal authorities only must give proper regard to the
relevant rulings of lower state courts (and not blind
obedience), in situations where the highest court of the
state has not spoken on a matter. Note that this case
did not say that the IRS could not defer to the lower
state court’s ruling – the case simply said that the IRS
was not conclusively bound by the findings of the state
court. The IRS has arguably misinterpreted this case
by claiming that it is not supposed to follow these state
court decisions where they purport to have retroactive
effect.
c. American Nurseryman Publishing Co. v.
Commissioner, 75 T.C. 271 (Nov. 17, 1980). In 1975,
shareholder of an S corporation transfers her stock to a
grantor trust. (This was before grantor trusts were
eligible S corporation shareholders). This mistake is
discovered in 1976, by the shareholder’s executor, and
the private parties persuade a state circuit court to order
that her 1975 transfer was void, in order to preserve the
S election for the corporation. The Tax Court holds for
IRS by not following the state court’s determination thus the corporation was taxed as a C corporation after
the 1975 transfer.
d. Emerson Institute v. U.S. 356 F.2d 824 (D.C. Cir.
1966). IRS succeeds in avoiding state court order
which retroactively held that certificate of corporate
dissolution and agreement of partnership was void. As
a result of IRS victory, individual was subject to tax in
prior year as a consequence of the certificate of
dissolution.
Court holds that nunc pro tunc
proceedings in which the IRS is not a party are not
retroactively binding on third parties – instead, state
court order is effective only from the date it is issued.
2.
Representative Cases Following The Majority
Doctrine.
For cases following the majority doctrine see the
following items set forth below:
e. Piel v. Commissioner, 340 F.2d 887 (2d Cir.
1965). Court refuses to apply a 1961 nunc pro tunc
amendment of a Nevada divorce decree that would
have rechacterized a 1957 transfer by the husband to
allow him an alimony deduction for the year in
question;
a. Revenue Ruling 93-79, 1993-2 C.B. 269. IRS
states that a 1993 state court order reforming a trust
instrument retroactively to 1991, thus making a trust
eligible to be an S corporation shareholder, will not be
respected. IRS flatly states that “retroactive changes of
the legal effects of a transaction through judicial
nullification or judicial reformation of a document do
not have retroactive effect for federal tax purposes.”
See the ruling for additional cites to cases supporting
this doctrine. The IRS expressly declines to follow
C. The Minority Doctrine Which Respects
Retroactive Reformations.
There is, however, a minority line of cases which
provide that in some situations, retroactive state court
15 Chapter 9
reformations will be respected for federal income tax
purposes. Note that the IRS is hostile to this doctrine
(as announced in Revenue Ruling 93-79, 1993-2 C.B.
269) and thus a taxpayer who takes such a position
may become embroiled in a dispute with the Service.
Nevertheless, depending on the facts, if the reformation
is structured properly, in some situations the taxpayer
position may be strong enough so that it meets the
ethical requirements applicable to tax practitioners, as
well as meeting the substantial authority rules.
Chapter 9
4.
Spiva v. Commissioner.
In Spiva v. Commissioner, 43 B.T.A. 1174 (1941)
a Missouri state court decision was held to provide
retroactive effect regarding the irrevocable nature of
trusts for federal tax purposes, contrary to IRS
arguments.
D. The Correction of Mistake Doctrine.
Another theory that allows taxpayers to achieve
retroactive rescissions for tax purposes, even though
not satisfying the same-year rule, is that a mistake was
made in the earlier year and all that is happening in the
subsequent year is that the mistake is being corrected
or that the original intent of the parties is being
effected.
1.
The Flitcroft Decision.
In Flitcroft v. Commissioner, 328 F.2d 449 (9th
Cir. 1964), a California court ordered trust instruments
to be reformed retroactively, so that the trusts were
treated as irrevocable from their original inception and
thus produced the desired federal tax consequences of
shifting the trust income away from the grantors. The
IRS took its customary position that it was not bound
by the retroactive application of the state order.
However, the taxpayers had the IRS District Director
served with a complaint so he was a party defendant in
the state court reformation hearings.
Moreover,
although the IRS succeeded in getting the action
against the District Director dismissed, the IRS was
still aware of the state court proceedings. The 9th
Circuit refused to find that the state court judgment
was collusive, and held that the state court order was to
be respected, retroactively, for tax purposes, thus
producing a victory for the taxpayer.
1.
Correction of Divorce Decree - Johnson v.
Commissioner, 45 T.C. 530 (1966).
In 1956 the taxpayer was divorced from her
husband, with the divorce decree providing that she
was to be paid $75 per week for alimony and for child
support. (Because no amounts were allocated between
the two categories, this would cause the entire amount
to be taxed as alimony.) In 1964, the IRS contended
that the taxpayer had received alimony, and later in
1964 the Circuit Court of Cook County entered an
order saying that the petitioner waived alimony rights
at trial, and because of a clerical error this was omitted
from the decree. The court retroactively amended the
divorce decree to correct this error. The Tax Court
held for the taxpayer here, and respected the retroactive
nature of the reformation, on the grounds that it made
the decree conform to the original intention of the
parties at the time the decree was entered.
2.
Practice Point.
A critical point, in the author’s view, regarding
this case is that the IRS was served with notice of the
state court proceedings. Keeping the IRS fully
informed of the proceedings, and attempting to have
the IRS joined as a party defendant is very important to
avoid the charge that the lawsuit is collusive. Thus, if
parties intend to take the position that a state ordered
reformation is retroactively binding for tax purposes,
they should make every effort to have the IRS involved
in the process from “day one” in order to avoid the
charge that they have engaged in a collusive lawsuit
with state authorities against the IRS.
2.
Correction of Section 83(b) Election - Private
Letter Ruling 9240018 (July 2, 1992).
In this private letter ruling the IRS blessed a
retroactive modification of a section 83 election, when
the parties transferred more shares of stock than
intended in a compensatory transfer to an employee.
The IRS held that this was a correction of the original
election, and not a revocation of the election.
3.
IRS Itself Wins on Retroactive Application of
Reformation Order - Newman v. Commissioner,
68 T.C. 494 (1977).
In this case involving a divorce, the divorce
decree initially entered into in 1967 provided for
monthly payments to be made to the wife for her
support. However, technically, the payments were two
months short of lasting for a 10 year period, and under
the tax law at that time, that meant they were not
alimony. The husband petitioned the state court
several years later in 1973 to issue a order nunc pro
3.
Miller v. Commissioner.
In Miller v. Commissioner (T.C. Memo 1963215), a case cited with approval by the 9th Circuit in
Flitcroft, the Tax Court gave retroactive effect to a
judgment by a Texas state court declaring a trust to be
irrevocable. The Tax Court refused to agree with the
IRS, without any evidence, that the state court was
necessarily collusive, and found it important that the
parties had invited the IRS to intervene or participate in
the state court action.
tunc correcting the divorce decree so that the payments
lasted the requisite 10 years in duration, and thus
would qualify as alimony. This was supposedly the
intent of the court at the time of the original decree,
i.e., to create alimony for tax purposes. The IRS itself
argued for retroactive application of pro nunc tunc
order that created taxable alimony. The Tax Court
agreed that the order was reflecting the original intent,
and therefore should be retroactively respected, while
distinguishing other cases where the order is actually
reflecting an intent originating only after the original
date and should not be respected retroactively
Chapter 9
would be optimal, but usually the IRS will succeed in
getting itself dropped as a defendant based on statutes
protecting the IRS from state suits (e.g., the antiinjunction rules).
2.
Have The State Court Use the Words “Nunc Pro
Tunc” In Its Order.
The words “nunc pro tunc” basically mean
retroactive, and under the law of most states, nunc pro
tunc orders can be granted. It is important to persuade
the state court to use these magic words – their use will
not guarantee a taxpayer victory, but the failure to use
them has resulted in a number of courts holding that
the reformation was not to be given retroactive effect
for tax purposes, because it was not intended to be
retroactive by the state court. See, e.g., Hummel v.
Commissioner,
28
T.C.
1131
(1957)
(“recommendation” and “confirmation” state court
orders denied retroactive effect – they were not nunc
pro tunc orders); Turkoglu v. Commissioner, 36 T.C.
552 (1961) (order was called a “modification,” not a
nunc pro tunc – IRS prevails in denying retroactive
effect to the order); Wilson v. Commissioner, 49 T.C. 1
(1967) (failure to use a nunc pro tunc order results in
the “amendment” having only prospective effect);
Cothran v. Commissioner, 57 T.C. 296 (1971) (order
does not purport to cure mistake retroactively, so
taxpayer loses).
4.
Other Cases Allowing Retroactive Corrections of
Error.
See Vargason v. Commissioner, 22 T.C. 100
(1954) (divorce case where husband was ordered to
pay wife for her support – state court later held that this
was a mistake and that the judge intended for the
husband to pay child support. Taxpayer wins and
decree was retroactively altered.)
Sklar v.
Commissioner, 21 T.C. 349 (1953) (nunc pro tunc
order was respected in favor of taxpayer on grounds
that it corrected error).
5.
Caution – Tax Court Case Says That This
Doctrine Only Applies to Correction of Clerical
Errors, not Judicial Errors (at least in Kentucky).
In Graham v. Commissioner, 79 T.C. 415 (1982)
the court refused to honor a retroactive Kentucky state
court nunc pro tunc order amending a divorce decree to
provide that the payments made under the decree were
child support. The tax court refused to follow the state
court decree, holding that it was issued in violation of
Kentucky law (the order corrected a judicial error, and
supposedly in Kentucky nunc pro tunc orders may only
correct clerical errors). However, the court did say that
if the court had issued a genuine nunc pro tunc order
that corrected a decree which failed to reflect the true
intention of the court, then the order would have been
given effect for federal income tax purposes.
3.
Tax Planning With Reformation Proceedings.
Based on the foregoing analysis, how can a
taxpayer maximize the chances of a reformation being
retroactive for federal income tax purposes? The
following steps should be taken:
Have the Court Correct An Error in Order to
Reflect Its Original Intent.
Federal judges are suspicious of state courts using
after-the-fact knowledge in reformations (even nunc
pro tunc orders) to manipulate earlier state court
decisions or orders in an effort to create favorable
federal tax consequences. As a result, federal courts
may hold that these reformations do not have
retroactive effect, unless those courts are persuaded
that the reformation reflects the original intent of the
judge, and serves to clarify or correct an earlier decree
that did not reflect that intent. See the discussion of
above regarding Johnson v. Commissioner, 45 T.C.
530 (1966). So, it is important to use one’s best efforts
to persuade the state court to phrase its reformation in
terms of “correcting” the initial order or transaction in
order to reflect the original intent of the judge or the
parties involved in the original transaction.
1.
F.
E.
Keep the IRS Notified and Informed of the
Proceedings (Make the IRS a Party, if Possible).
As noted above in the discussion of Flitcroft v.
Commissioner, 328 F.2d 449 (9th Cir. 1964), courts
look more favorably on a state law reformation if the
IRS was made aware of all the proceedings and invited
to participate. (If the IRS could be made a party that
Strength of Reformation Argument – A
Reporting Position?
If an clerical error is being corrected, then a
reformation of the document should clearly be
provided retroactive effect. In situations where there is
more than just a clerical error which the parties are
attempting to unwind, then if a taxpayer follows the
recommendations noted immediately above and
attempts reformation of a document (such as a trust
instrument or divorce decree), then there is a good
chance that there is at least “substantial authority” for
the taxpayer to take the position that the transaction
will have retroactive effect for federal tax purposes. It
is unclear, in the author’s view, as to whether the tax
position here would be “more likely than not” to
prevail on the merits if challenged, which would be
important for the financial reportiong rules under FIN
48, which requires a more likely than not standard of
support.
Chapter 9
federal tax-hand to suit their convenience.” Instead,
the repayment of the amounts back to the corporation
was a voluntary contribution to capital.
b. The IRS also cites Staats v. Biograph Co., 236 F.
454 (2d. Cir. 1916) in the FSA, although that case dealt
with the repayment of dividends in a year subsequent
to the year of receipt, and is thus not on point,
notwithstanding the court’s comments there that
dividends could not be rescinded.
c. Finally, the lower court in Estate of Lloyd Crellin
cited United States v. Southwestern Portland Cement
Co., 97 F.2d 413 (9th Cir. 1938) as setting forth the
proposition that dividends cannot be rescinded (having
once been declared) because a debtor cannot rescind its
debt.
G. When Will the Same-Year Rule the Rescission
Doctrine Not Protect A Taxpayer?
1. The IRS Apparently Contends that Most
Dividends May Not Be Rescinded!
Surprisingly, the IRS seems to believe that the
rescission doctrine does not apply to dividends paid to
shareholders, even though the dividends may be
unwound in the same year by the shareholders
returning them to the corporation. The IRS claims that
the rescission doctrine does not apply when the
repayment of the dividends to the corporation is
“voluntary.” Rather, according to the IRS, the doctrine
only applies when the shareholder is legally obligated
to return the dividends to the corporation. The IRS has
set forth this position in Field Service Advice
Memorandum (“FSA”) 200124008 (March 14, 2001).
See also Rev. Rul. 75-375, 1975-2 C.B. 266 (voluntary
payment of previous year’s dividend by shareholders
did not alter the consequences of the previous year’s
dividend – note however that the “rescission” here
occurred in the subsequent year). The author believes
that this IRS position is incorrect, and that the
rescission doctrine is available for dividends as well as
for other transactions. The authority for the IRS
position is discussed, and then critiqued, below.
3.
Criticism of the IRS Position.
The IRS position here seems wrong and
inconsistent with more recent developments, including
Rev. Rul. 80-58. At the very least, it appears that
taxpayers have a reporting position (substantial
authority) in maintaining that dividends may be
rescinded (and therefore ignored) if repaid in the same
year, and tax practitioners seem to be on strong ethical
grounds in recommending such positions to clients.
There are several arguments in favor of this
conclusion, set forth below.
a. Revenue Ruling 80-58’s Language Does Not
Exclude Dividends. The language of Rev. Rul. 80-58 is
quite broad, and refers to the “abrogation, canceling, or
voiding of a contract” that “may be effected by mutual
agreement of the parties.” Certainly, if shareholders
and the corporation agree to cancel or void a dividend
by repaying it in the same year, there is nothing to
suggest in Rev. Rul. 80-58 does not apply to that
rescission.
2.
Support For the IRS Position.
There is case law suggesting that dividends cannot
be rescinded, although the law is quite old.
b. Revenue Ruling 74-501 Applies The Rescission
Doctrine to Corporate Distributions. As previously
noted, Rev. Rul. 74-501 applies the rescission doctrine
to corporate distributions, by providing that when a
corporation issued rights to purchase its stock, that
issuance might be disregarded by the taxpayer if it was
rescinded. Although the distribution in the revenue
ruling might not technically be a dividend, by applying
the rescission doctrine to corporate distributions, the
ruling suggests that dividends would be included under
the doctrine as well. See also Private Letter Ruling
9312027 (March 26, 1993) (S corporation dividend of
earnings and profits to shareholders is allowed to be
rescinded).
a. In Estate of Lloyd Crellin v. Commissioner, 203
F.2d 812 (9th Cir. 1953) (cited as authority in the FSA
above) dividends were paid in the mistaken belief that
a personal holding company tax would otherwise be
incurred by the corporation. Upon discovering that no
such tax would apply, the shareholders willingly repaid
the dividends paid in the same year. The court held
that the dividend repayment back to the corporation
was not mandatory, and that the original payment of
dividends was not invalid – only a mistake had been
made. Therefore, the dividend was not viewed as
rescinded, because otherwise taxpayers could “lift the
c. The Authorities Suggesting That Dividends
Cannot Be Rescinded Have Been Misinterpreted. The
Tax Court in Estate of Lloyd Crellin improperly
focused on precedent holding that dividends, once
having been paid, could not be rescinded by the
corporation without the consent of the stockholders. 17
T.C. at 784-785. But if the shareholders consent to the
rescission, then those authorities do not apply, and it
seems that dividends could therefore be rescinded by
mutual consent. Moreover, the IRS, in the FSA,
incorrectly focused on only the claim of right doctrine,
and the exception to the doctrine when amounts are
received subject to a liability to repay. The IRS did not
even acknowledge the rescission doctrine, which also
trumps the claim of right doctrine when the transaction
is unwound in the same year. Thus, the IRS analysis
and logic in the FSA is faulty since it is incomplete and
excludes a major line of authority providing an
additional exception to the claim of right doctrine.
I.
The Same-Year Rule May Not Allow
Taxpayers To Avoid Form Over Substance
Arguments if the Rescission is not “Clean.”
As noted by other commentators, the same-year
rule may not allow taxpayers to rescind agreements
made in the same year, and then enter into other
agreements, with the prior agreement being ignored in
determining the tax consequences of the structure.
Banoff, “Unwinding or Rescinding A Transaction:
Good Tax Planning or Tax Fraud?” Taxes 942, 948-49
(December, 1984). A classic case of this is the famous
case of Court Holding Co. v. Commissioner, 324 U.S.
331 (1945). In this case, a corporation agreed to sell
assets to a third party, and then at the last minute that
contract was rescinded and the shareholder of the
corporation agreed to sell the assets to the same third
party (after receiving them as a distribution from the
corporation).
The Supreme Court held that, in
substance, the corporation was still the seller of the
assets for tax purposes.
Thus, the corporation
recognized the gain from the sale notwithstanding the
last minute changes to the agreement.
d. Private Letter Ruling Allows Distributions of
Earnings and Profits By S Corporation To Be
Rescinded. As previously noted, in PLR 9312027
(March 26, 1993) an S corporation was allowed to
rescind 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. This was an example
of the IRS, in effect, blessing the rescission of a
dividend for tax purposes, although admittedly it was a
special kind of dividend provided for under the rules
for S corporations.
J.
The Rescission Doctrine Can’t Be Used If the
Agreement is to Not Return to the Status Quo.
A “clean” rescission, where the transaction is
unwound and no other related transactions take place,
should be safe from scrutiny under this doctrine.
However, a rescission accompanied by another
transaction could easily be attacked as not being a true
rescission, since the parties were not genuinely
reverted to the status quo. Taxpayers should be aware
of this and sensitive to how the overall transaction
appears to outsiders when rescinding contracts and
then shortly thereafter engaging in other transactions
that relate to the transaction previously rescinded.
H. The IRS May Contend that the Issuance of
Debt Cannot Be Rescinded
As noted above, the lower court in Estate of Lloyd
Crellin cited United States v. Southwestern Portland
Cement Co., 97 F.2d 413 (9th Cir. 1938) as setting
forth the proposition that dividends cannot be
rescinded because a debtor cannot rescind its debt.
(That case, however, only dealt with a fact pattern
where a corporation might unilaterally attempt to
rescind its debt – the transaction in that case was not a
rescission where all parties involved agreed to unwind
the transaction, which would be the actual fact pattern
under Rev. Rul. 80-58.) Although it is not clear, it is
possible that the IRS could use this argument to
contend that debt instruments cannot be rescinded for
tax purposes, even though the rescission takes place in
the same taxable year as the issuance. In the author’s
view, such a position would be incorrect. Nothing in
Rev. Rul. 80-58 suggests that its provisions do not
apply to debt instruments. Therefore, debt instruments
should eligible for rescission if the rescission occurs in
the same taxable year as the debt was originally issued.
VI. REQUESTING “9100 RELIEF” UNDER
TREASURY REG. SECTIONS 301.9100-1
THROUGH 301.9100-3
A. Introduction.
Assume that your client failed to make a tax
election by the due date for the election. Are you out
of luck? What options does your client have? The
good news is that your client may be able to obtain
“9100 relief” under Treas. Reg. § 301.9100. The bad
news is, unless you fall under the rules for “automatic”
9100 relief, that the taxpayer is required to get a private
letter ruling from the IRS (which requires payment of a
user fee) as a condition of getting 9100 relief.
B.
Definition of Election.
Another bit of good news is that the term
“election” for which 9100 relief is available, is defined
more broadly than what most taxpayers would think.
19 Chapter 9
The term is defined as “an application for relief in
respect of tax, a request to adopt, change, or retain an
accounting method or accounting period.” Treas. Reg.
§ 301.9100-1(b). However, the term “election” does
not include an application for an extension of time to
file a return.
taxpayer had obtained a six-month extension of time to
file the return (so that the return would be due on
September 15, 2007, with extensions), then the
taxpayer would filed an amended return by September
15, 2008 (12 months from the September 15, 2007
extended due date of the return).
c. What Elections Are Covered? The automatic 12month extension only applies to regulatory elections
under the following sections:
C. Automatic Extensions - 9100 Relief.
Automatic six and twelve month extensions are
available under the existing Treasury regulations,
meaning that the taxpayer does not have to get a
private letter ruling to receive an extension or pay user
fees to request such a ruling. These are only available
if the taxpayer takes corrective action during the
extension period.
(1) Section 444 (the election to use a taxable
year other the required year);
(2) Section 472 (the election to use the LIFO
inventory method);
(3) Sections 505 and 508 (requirement that
certain types of tax-exempt organizations
notify the IRS of their claims for taxexemption within 15 months of their
operations and file exemption applications
under Sections 501(c)(9), 501(c)(17),
501(c)(20), and 501(c)(3));
(4) Section 528 (the election to be treated as
homeowners association);
(5) Section 754 (the election to make adjustment
of basis on partnership transfers and
distributions);
(6) Section 2032A(d)(1) (the election to
specially value qualified real property where the IRS has not yet begun an
examination of the filed return); and
(7) Sections 2701(c)(3)(C)(i) and (ii) (chapter 14
gift tax elections regarding qualified
payments in the case of transfers of interests
in corporate stock or partnerships).
1.
The Automatic 12-Month Extension For
Regulatory Elections.
An automatic 12-month extension is available for
certain regulatory elections. A regulatory election is
“an election whose due date is prescribed by a
regulation published in the Federal Register, or a
revenue ruling, revenue procedure, notice, or
announcement published in the Internal Revenue
Bulletin.” In other words, a regulatory election is not
provided in the Internal Revenue Code itself - an
election provided in the Code is a “statutory” election
and is not eligible for the automatic 12-month
extension - only for the 6-month extension discussed
later in this outline.
a. What Does the Automatic 12-Month Extension
Mean? This is an automatic (i.e., no private letter
ruling required) extension of 12 months from the due
date for making an regulatory election. For a taxpayer
who has not extended the due date of the return, the
due date for making an election (remember, the
deadline granted under this regulation is 12 months
past this date) is the due date of the return. For
taxpayers who have obtained extensions of time to file
the return, the due date for making an election is the
due date of the return including extensions (again, the
deadline under this regulation is 12 months past this
date). This extension is available regardless of whether
the taxpayer timely filed its return for the year the
election should have been made.
d. Additional Procedures To Be Filed Under 12Month Extension. In order to take advantage of the 12Month Extension, “corrective action” is required to be
taken.
(1) Corrective Action.
Corrective action means
taking the necessary steps to file the election in
accordance with the statute, regulation or other
published ruling. For elections required to be filed
with a return, it includes filing an original or amended
return for the year the election should have been made
and attaching the appropriate election documentation.
The IRS may invalidate the election if the return is
filed in a manner inconsistent with the election or if the
taxpayer has not complied with all other requirements
for making the election for the year the election should
have been made and all affected years.
b. Examples of Due Dates and 12-Month
Extensions. A taxpayer files its return on March 15,
2007 its due date, and fails to make an election. The
election is required to be made with the return.
Assuming that the election is the type listed in the 12month categories, then the taxpayer may file an
amended return by March 15, 2008, 12 months from
the March 15 due date of the return. If, instead, the
20 Chapter 9
(2) Procedure. The document filed to obtain an
automatic extension must contain the statement
“FILED PURSUANT TO § 301.9100-2” at the top and
must be sent to the same address the filing to make the
election would have been made if it had been timely.
A ruling request is not required for an automatic
extension.
Chapter 9
good faith of the taxpayer and the conclusion that the
extension of the election deadline will not prejudice the
interests of the government, need to be made before the
IRS will grant this extension. Extensions may not be
granted under certain subtitles of the Code (excise
taxes, Joint Committee on Taxation, presidential
campaigns, and trust funds). Finally, these general
rules do not apply for elections which are expressly
excepted for relief, or where alternative relief is
available from a statute, a regulation, or other
published rulings. Treas. Reg. § 301.9100-1.
2.
The 6-Month Automatic Extension For and
Statutory Regulatory Elections.
An automatic 6 month extension is available for
certain regulatory or statutory elections.
1.
Example of 6-Month Extension for Mark-toMarket Election.
A trader in securities may make a election to use a
mark-to-market method of accounting with respect to
its securities under Code § 475(f). That election for a
current year must be made by April 15 of that current
year. Under this general provision, a trader missing the
election would have until October 15 of the current
year (6 months past the due date), to file a private letter
ruling request for relief for the late election. Since this
general extension provision is not automatic, a private
letter ruling must be received by the IRS in order to
obtain relief and the taxpayer must pay a user fee to the
IRS in order to request this relief.
a. What Does the Automatic 6-Month Extension
Mean?
This is an automatic 6-month extension
granted for either regulatory or statutory elections
whose due dates are the due date of the return or the
due date of the return including extensions. The
extension is for 6 months from the due date of a return
excluding extensions. This 6-month extension is only
available if the return was timely filed for the year the
election should have been made. (Note that the 12month extension did not require the timely filing of a
return.) (The 6-month extension does not apply to
elections that must be made by the due date of the
return excluding extensions.)
b. Examples of Due Dates and 6-Month Extensions.
A taxpayer files its return on March 15, 2007, its due
date, and fails to make an election. The election is
required to be made with the return. The taxpayer may
file an amended return by September 15, 2007, 6
months from the March 15 due date of the return.
2.
a.
b.
c. The 6-Month Extension is Very Modest. This 6month extension is not particularly generous - it seems
mainly oriented towards taxpayers who file early and
fail to make an election that was required to be made
when they filed their return. It basically allows those
taxpayers to file an amended return, making the
election, no later than the time they initially had to file
the return if they had requested an extension of their
return.
c.
d.
e.
f.
g.
d. Corrective Actions and Procedures are Required.
The same corrective actions and procedures are
required for the 6-month extension as are required for
the 12-month extension.
h.
i.
D. General 6 Month Extensions - Not Automatic.
The Commissioner may make a reasonable
extension of time for an election, which cannot exceed
more than 6 months (unless the taxpayer is outside the
United States which might justify a longer election).
All of the requirements discussed below, including the
j.
k.
21 Examples of 9100 Relief Granted Since July 1,
2007.
Qualified low-income housing project. (§
42);
Posting of disposition bonds under §42(j)(6).
(§ 42)
Application for certification of historic
status. (§ 47)
Election not to deduct additional first year
depreciation. (§ 168)
Election to deduct qualified environmental
remediation expenditures. (§ 198)
Furnish IRS notice of nonrecognition transfer
required by 1.1445-5(b)(2)(ii) with respect to
liquidation of taxpayer. (§ 332)
Filing of a “§1.337(d)-2(c)” statement to
recognize some or all of a loss upon the
disposition of stock of a subsidiary. (§ 337)
Filing of 338(g) election. (§ 338)
Furnish IRS notice of nonrecognition transfer
required by Reg.§1.1445-2(d)(2). (§§ 368 &
897)
Election to restore value under Reg. §1.3828(h). (§ 382)
Recharacterization of Roth IRAs as
traditional IRAs. (§ 408A)
Chapter 9
l.
m.
n.
o.
p.
q.
r.
s.
t.
u.
v.
w.
x.
y.
z.
aa.
bb.
cc.
dd.
ee.
ff.
gg.
hh.
ii.
jj.
kk. Election to treat a marital trust as 2 separate
trusts. (§ 2652)
ll. Election to be classified as a disregarded
entity. (§ 7701)
mm. Entity classification election. (§ 7701)
File notice to be treated as operating
qualified separate lines of business. (§ 414)
Form 1128 to change annual accounting
period (Application to Adopt, Change, or
Retain a Tax Year). (§ 442)
File form 3115, Application for Change in
Accounting Method. (§ 446)
Relation back election under Reg. §1.468B1(j)(2). (§ 468B)
Election under §469(c)(7)(A) to treat all
interests as single activity. (§ 469)
Mark to market method of accounting. (§
475)
Consent dividend elections. (§ 565)
Adjust basis of partnership property. (§ 754)
Election under §856(c) to elect REIT status.
(§ 856)
Election described in 865(h)(2)(A) to treat
gain from sale of stock in foreign companies
as foreign source income. (§ 865)
Time to furnish entities and IRS statements
and notices required by Reg. §§ 1.897-2(g),
1.897-2(h), 1.1445-2(c)(3) and 1.14455(b)(4)(iii). (§§ 897 & 1445)
Election and shareholder consent statements
required under Reg. § 1.921-1T(b)(1) and
Reg. § 1.992-2(a)(l)(i) to be treated as
interest charge DISC. (§§ 921 & 992)
Election to be treated as a domestic
corporation for US tax purposes.
S Corporation election. (§ 1362)
QSub election. (§ 1362)
Election to file consolidated return. (§ 1502)
Election
under
Reg.
§
1.150221T(b)(3)(ii)(B) to relinquish, with respect to
all consolidated net operating losses
attributable to Parent and its subsidiaries, the
portion of the carryback period for which
Parent and its subsidiaries were members of
another consolidated group. (§ 1502)
Election to treat loss subgroup parent
requirement as satisfied. (§ 1502)
Ratable allocation election. (§ 1502)
File elections and agreements under Reg.
§1.1503-2(g)(2)(i) with respect to dual
consolidated losses. (§ 1503)
Alternate valuation election. (§ 2032)
Allocation of generation-skipping transfer
exemption. (§ 2032)
Partial Q-TIP election. (§ 2056)
Allocation
of
decedent’s
available
generation-skipping transfer exemption. (§
2642)
Reverse QTIP election. (§ 2642)
3.
Taxpayers May Contest the Denial of 9100 Relief
by the IRS in Court.
See L. S. Vines v. Commissioner, 126 T.C. 279
(2006), where a trader was denied mark-to-market
accounting on account of a late election, resulting in
capital losses (not ordinary losses) on securities trades
he had made. (Had a mark-to-market election been
made, the losses would have been ordinary.) The
trader was not aware of the ability to elect mark-tomarket treatment and as a result failed to make the
election by April 15 of the year in which the election
was to be made (as noted above). The court found that
the taxpayer should be allowed 9100 relief because he
acted reasonably and in good faith, and the interests of
the government were not prejudiced by the granting of
such relief.
a. Facts. The taxpayer was an attorney who decided
to wind down his law practice after 34 years and start a
new career in securities trading. He used margin
borrowing as part of his securities trading strategy. In
the spring of 2000 he was forced to liquidate one of his
brokerage accounts due to a failure to cover a margin
call. He had substantial trading losses. The taxpayer’s
long-time accountant helped him obtain an automatic
extension of time to file his tax return, but did not
enclose a § 475(f) election to mark to market and
obtain ordinary losses, or advise the taxpayer of the
availability of such election. The taxpayer learned of
such an election from a friend and discovered that the
election was required to be filed by the due date of his
return, without extensions. The taxpayer filed for 9100
relief with the assistance of tax counsel. Relief was
denied for “lack of unusual and compelling
circumstance.”
b. Opinion. The Tax Court found: (i) no prejudice to
the Government; (ii) the taxpayer did not realize any
gains or suffer any additional losses between the time
the election should have been filed and the actual filing
of the election; and (iii) the taxpayer would not be
entitled to any more than he would have been entitled
had the election been timely filed (the purpose of 9100
relief). The court concluded that the taxpayer was
entitled to 9100 relief because he acted reasonably and
in good faith with no prejudice to the interests of the
Government. Thus, the taxpayer was permitted to the
benefits of the § 475(f) election as if it has been timely
filed.
E.
Chapter 9
check-the-box filing.
It avoids Treas. Reg. §
301.9100-1 through 3, and the user fee requirements
for getting a private letter ruling. However, taxpayers
who are not eligible for relief under Rev. Proc. 200259 can still request 9100 relief by requesting a letter
ruling.
Other Examples of Alternative Relief.
In addition to 9100 relief, the Code and
Regulations provide other examples of relief from late
elections provided under provisions besides the general
rules of Treas. Reg. § 301-9100.
1.
Late S Elections.
Assume you form a corporation for a client, who
tells you that it should be an S corporation. You
believe that the accountants are going to file Form
2553 by March 15 of the year, which is required to
make the S election for the corporation. Unfortunately,
the accountants think you are going to file the Form by
that date. As a result, the Form isn’t filed, which you
discover at the end of the taxable year. Do you have a
C corporation now? Probably you can get relief for the
late S election. Code § 1362(b)(5) provided that the
IRS may grant relief from a late S election if it is
determined that there was reasonable cause for making
the late election. Reasonable cause is defined broadly,
and includes, for example, confusion among a
taxpayer’s lawyers and accountants as to who was
supposed to file the necessary papers with the IRS.
Rev. Proc. 2003-43, 2003-1 C.B. 998 contains
extensive procedures for receiving automatic
extensions allowing the filing of late S election.
F.
Treas. Reg. § 301.9100-3: Other Extensions.
Taxpayers who wish to receive an extension of
time for making regulatory elections which don’t
comply with the rules for automatic relief must come
under this provision of the regulations. (Note that only
regulatory elections are covered under this provision statutory elections cannot be extended here.) The
taxpayer must provide evidence to establish that the
taxpayer acted reasonably and in good faith, and that
the grant of relief will not prejudice the interests of the
Government. The taxpayer must obtain a private letter
ruling from the IRS and pay a user fee for requesting
the ruling.
1.
Reasonable Action and Good Faith.
The reasonableness and good faith standards are
met if the taxpayer:
a.
2.
Late Check the Box Elections.
Assume your client owns a domestic LLC and
wishes the LLC to be taxed as a corporation. This
requires an affirmative “check the box” election under
those rules, since the “default” rule for a domestic LLC
is that it is either a partnership (two or more owners) or
disregarded entity (one owner), and not a tax
corporation. Normally, the check the box election
must be made on Form 8832 no later than 75 days from
the date that you wish the election to go into effect.
Treas. Reg. § 301.7701-3(c)(1). If your client was late
in electing to treat the LLC as a corporation for tax
purposes, Rev. Proc. 2002-15, 2002-1 C.B. 490, and
Rev. Proc. 2002-59, 2002-2 C.B. 615, provide
automatic procedures for obtaining an extension of the
deadline for the filing. Eligibility for a late filing is
available under these Revenue Procedures if the entity
(i) failed to obtain the desired classification solely
because it did not timely file Form 8832; (ii) the due
date for the tax return of the entity’s default
classification (excluding extensions) for the tax year
beginning with the date of the entity’s formation did
not pass; and (iii) the entity had reasonable cause for
its failure to file Form 8832 timely.
b.
c.
d.
e.
2.
No Reasonable Action or Good Faith.
A taxpayer is deemed to have not acted
reasonably or in good faith if the taxpayer:
a.
3.
Check the Box Rules Supplement 9100 Relief.
Rev. Proc. 2002-59 is intended to provide a more
taxpayer-friendly way to obtain IRS approval of a late
23 Requests relief prior to IRS discovery of the
failure to make the regulatory election;
Failed to make the election due to
intervening events beyond the taxpayer’s
control;
Failed to make the election because, after
exercising reasonable diligence (accounting
for the taxpayer’s experience and complexity
of the issue), the taxpayer was unaware of the
necessity for the election;
Reasonably relied on the written advice of
the IRS; or
Reasonably relied on a qualified tax
professional who failed to make, or to advise
the taxpayer to make, the election. If the
taxpayer knew or should have known that the
professional was not competent to provide
advice regarding the regulatory election or
was unaware of all relevant information,
reasonable reliance on a tax professional is
unavailable.
Seeks to alter a return position for which a
Section 6662 accuracy-related penalty has
been or could be imposed at the time of the
relief request and the new position requires
Chapter 9
b.
c.
an impermissible method of accounting that is under
examination, appeals, or a federal court and the change
would provide a more favorable method or terms and
conditions than if the change were made as part of an
examination or provides a more favorable method of
accounting or terms and conditions if the election is
made by a certain date or taxable year.
or permits a regulatory election for which
relief is requested;
Chose not to file the election and was
informed, in all material respects, of the
required
election
and
related
tax
consequences; or
Uses hindsight in requesting relief.
Hindsight means that specific facts have
changed since the due date for making the
election that make the election advantageous
to the taxpayer. Strong proof is required to
show that the decision to seek relief did not
involve hindsight.
e. Accounting Period Regulatory Election. The
interests of the Government are deemed to be
prejudiced (except in unusual and compelling
circumstances) if an election is an accounting period
regulatory election other than a Code § 444 election,
and the request is filed more than 90 days after the due
date for filing the Form 1128.
3.
No Prejudice to the Interests of the Government.
The Commissioner will grant a reasonable
extension only when the interests of the Government
will not be prejudiced by the relief.
4.
Extension of the Period of Limitations on
Assessment.
A taxpayer waives any objection to a second
examination of the issues subject to the relief request
(and any correlative adjustments) if an extension of
time is granted.
The period of limitations for
assessment is not tolled upon the filing of a relief
request and thus, the IRS may require the taxpayer to
consent to an extension of the period of limitations for
the year in which the regulatory election should have
been made (and any affected years).
a. Lower Tax Liability Than if Timely Election. If
granting the relief will result in a lower tax liability (in
the aggregate) for all years affected by the election,
than if a timely election had been made, the interests of
the Government are prejudiced. (Note that this does
not provide that prejudice exists if the relief will reduce
the taxpayers’ taxes --- instead, this only applies if the
tax liability is lower than if a timely election had been
made.) The time value of money is taken into account
in determining whether a lower tax liability results.
Additionally, if more than one taxpayer’s
consequences are affected, the Government’s interests
are prejudiced if granting the extension may result in
those taxpayers (in the aggregate), having a lower tax
liability than if the election had been timely.
5.
Procedure.
A relief request is a request for a letter ruling and
must be submitted in accordance with the letter ruling
requirements, including an applicable user fee. See
Rev. Proc. 2007-1.
a. Taxpayer Affidavit.
A detailed affidavit
describing the failure to make a timely election and the
discovery of the failure must be submitted and signed
by a person with personal knowledge of the facts and
circumstances. If a qualified professional was relied
upon, the affidavit must describe the engagement and
responsibilities of that person and the extent of the
taxpayer’s reliance on them. The affidavit must
include a penalty of perjury statement.
b. Closed Years. If the year in which the election
should have been made (or any years affected thereby)
is closed prior to receipt of a ruling granting relief, the
interests of the Government are prejudiced.
c. Independent Auditor. The IRS may condition
relief on receiving a statement from an independent
auditor certifying that the interests of the Government
are not prejudiced.
b. Knowledgeable Person Affidavits. The taxpayer
must submit detailed affidavits from individuals
possessing knowledge or information about the failure
to make a valid regulatory election and the discovery
of that failure. Included among these individuals are
the taxpayer’s return preparer, any individual
substantially contributing to the preparation of the
return, and any accountant or attorney, knowledgeable
in tax matters, who advised the taxpayer regarding the
election. The engagement and responsibilities of the
affiant, and any advice they provided to the taxpayer
d. Accounting Method Regulatory Election. The
interests of the Government are deemed to be
prejudiced (except in unusual and compelling
circumstances) if the accounting method regulatory
election requires advance written consent of the
Commissioner or a Code § 481(a) adjustment (or such
an adjustment would be required if the change
occurred in a later taxable year to the taxable year it
should have been made). Additionally, prejudice is
deemed if such an election would permit a change from
must be included along with the individual’s name,
current address, and taxpayer identification number of
the individual. Again, a penalties of perjury statement
must be included.
including attaching an affidavit from Taxpayer’s
professional stating that the professional failed to
advise Taxpayer that the election was necessary.
Because Taxpayer reasonably relied on a qualified
professional and the professional failed to advise
Taxpayer to make the election, Taxpayer is deemed to
have acted reasonably and in good faith. Therefore,
Taxpayer may be eligible for relief from the late
election. Treas. Reg. § 301.9100-3(f)(Example 2).
(Note that this example does not deal with the separate
issue of whether granting relief will prejudice the
interest of the government, which could be a separate
bar from actually obtaining relief here.)
c. Other Information Required. The taxpayer must
include additional information in the relief request such
as whether the year the election should have been made
(or any affected years) is under examination by a
district director, appeals office or federal court. If an
examination is commenced while the relief request is
pending, the taxpayer must notify the IRS office
considering the request. The taxpayer must state when
the applicable documentation for making the election
was required to be filed and when it was actually filed.
Additionally, the taxpayer must provide copies of any
documents referring to the election, and if requested, a
copy of the taxpayer’s return for any year for which the
taxpayer requests an election extension, as well as any
return effected by the election.
Finally, when
applicable, the taxpayer must also submit a copy any
other taxpayers’ returns who are affected by the
election.
f. Example of Taxpayer Reporting in a Manner that
Triggers the Accuracy Penalty - Taxpayer Has Failed
to Act in Good Faith. Taxpayer reports income on its
2007 tax return in a manner that is contrary to Treasury
regulations. In 2008, during an IRS audit, the IRS
raises the issue regarding the 2007 return and asserts
the accuracy-related penalty under Code § 6662.
Taxpayer requests 9100 relief to elect an alternative
method of reporting the income for 2007. Taxpayer is
deemed to have not acted reasonably and in good faith
because Taxpayer seeks to alter a return position for
which an accuracy-related penalty could be imposed
under Code § 6662.
Treas. Reg. § 301.91003(f)(Example 3).
d. Example of Taxpayer Discovering Own Error 2
Years Later - Taxpayer Has Acted in Good Faith.
Taxpayer prepares its 2007 return and is unaware that a
certain regulatory election is available to report a
transaction in a certain manner. Taxpayer files its
return without making the election. Two years later, in
2009, Taxpayer hires a professional to prepare
Taxpayer’s 2009 tax return.
The professional
discovers that Taxpayer did not make the election.
Assuming that Taxpayer requested relief before the
failure to make the election was discovered by the IRS,
then Taxpayer is deemed to have acted reasonably and
in good faith. Therefore, Taxpayer may be eligible for
relief from the late election. Treas. Reg. § 301.91003(f)(Example1). (Note that this example does not deal
with the separate issue of whether granting relief will
prejudice the interest of the government, which could
be a separate bar from actually obtaining relief here.)
g. Example of Taxpayer Electing Accounting
Method Late, Which Involves Cut-Off Method;
Interests of the Government are not Prejudiced.
Taxpayer prepares its own return for 2007. Taxpayer
is unaware that a particular accounting method
regulatory election is available, and fails to make the
election. Instead, another permissible accounting
method if chosen. The underlying accounting method
regulation provides that the particular accounting
method is made on a cut-off basis, without an election
under Code § 481. In 2008, Taxpayer requests 9100
relief to make the this accounting method election late.
If Taxpayer were granted an extension of time to make
the election, Taxpayer would pay not less than if the
election had been timely made. The interests of the
government are deemed not to be prejudiced because
the election does not require an adjustment under Code
§ 481. Treas. Reg. § 301.9100-3(f)(Example 4).
e. Example of Taxpayer Relying on Professional in
Good Faith - Taxpayer Has Acted in Good Faith.
Taxpayer hires a professional, who is competent, to
prepare its 2007 return, and Taxpayer provides the
professional with all relevant facts. The Professional
fails to advise Taxpayer that an election is necessary in
order to report the transaction in a certain manner and
no election is made. Nevertheless, Taxpayer reports
the income for 2007 in a manner consistent with
having made the election. In 2010, IRS audits the
Taxpayer’s 2007 return and discovers that the election
has not been filed. Taxpayer promptly files for relief,
h. Same Facts As Immediately Above, Except
Change in Method of Accounting Involves Section 481
Adjustment; Interests of the Government are
Prejudiced. Same facts as immediately above, i.e.,
Taxpayer prepares its own return for 2007 and
overlooks the fact that a particular accounting method
regulatory election is available,
The underlying
25 Chapter 9
Chapter 9
accounting method regulation provides that the
particular accounting method election requires an
adjustment under Code § 481. The interests of the
government are deemed to be prejudiced except in
unusual or compelling circumstances because the
election does not require an adjustment under Code §
481. Treas. Reg. § 301.9100-3(f)(Example 5).
VII. CHANGE IN METHOD OF ACCOUNTING
OR CORRECTION OF ERROR.
A. Introduction.
Assume you discover that an error has been made
in reporting items of income or expense in your client’s
tax return for a previous year. May you correct that
error by filing an amended return, if the statute of
limitations is still open? The answer is generally “no”
if the error constitutes a method of accounting - such
methods generally must be corrected prospectively,
typically with IRS consent which is provided subject to
various terms and conditions. (See the discussion
above regarding 9100 relief which provides limited
exceptions to these rules and which may allow a
retroactive change in methods of accounting in certain
situations.) On the other hand, if there is no method of
accounting involved, you may be able to correct the
error by filing an amended return.
d.
2.
Changes in Underlying Facts.
The following items have been found to be
changes in underlying facts that did not constitute a
change in method of accounting:
a.
Switch from Non-Vested to Vested Vacation Pay.
A change in a non-vested vacation pay plan to a
vested plan is a change in underlying facts and not a
change in method of accounting. Therefore, when the
taxpayer begins to deduct the accrued vacation pay at
year-end under the new vested plan (pursuant to Code
§ 404), that is not a change in method of accounting
and no IRS consent is required. Treas. Reg. § 1.4461(e)(2)(iii) (Example 3).
B.
Change in Method of Accounting.
How is a change in method of accounting
defined? A method of accounting involves the rules
under which a taxpayer determines when to include an
item into income, or when to take a deduction. A
method of accounting essentially involves timing.
Treasury Reg. section 1.446-1(e)(2)(ii)(a) states that a
change in the method of accounting includes a change
in the overall plan of accounting for gross income or
deductions or a change in the treatment of any material
item used in such overall plan.
b.
Change in Time of Billing - Revenue Recognition
Follows Billing (Decision, Inc).
A taxpayer providing advertising to customers and
recognizes income under the accrual method when it
bills the customers. Previously, it billed the customers
in advance of providing the advertising (and thus
recognized the income in advance of providing the
advertising).
The taxpayer changes its business
practice and now only bills its customer as the
advertisements are published (and thus recognized the
income at this later date). The Tax Court held that this
was not a change in method of accounting, but rather it
was a change in the underlying facts. The court stated
that the taxpayer recognized the income when it billed
the customers - it simply changed the time at which it
billed the customers which was a change in the
underlying facts. Decision Inc. v. Commissioner, 47
T.C. 58 (1966), acq., 1967-2 C.B. 2.
1.
What is Not a Change in Method of Accounting.
The following items are not a change in method of
accounting, and therefore, can be corrected without
having to go through the procedures for a change in
method of accounting.
a.
b.
c.
Change in underlying facts, including the
way a company may do business. Treas.
Reg. § 1.446-1(e)(2)(ii)(b);
Correction of an error, such as math error or
a posting error;
A change in the character of an item. The
regulations provide that a change of method
of accounting does not include items which
do not involve the proper time for the
inclusion of income or deduction. As a
26 example, the regulations provide that
corrections of items which are deducted as
interest or salary, but which are in fact
payments of dividends, and deductions of
items as business expenses which are in fact
personal expenses, are not changes in method
of accounting.
Treas. Reg. § 1.4461(e)(2)(b). See also Coulter Electric Inc. v.
Commissioner, 59 T.C.M. (CCH) 350 (1990)
(characterization issue of items as sales or
pledges for loan is not a change in method of
accounting involving timing but rather a
question of characterization); and
Changes that have historically not been
viewed as changes in method of accounting,
such as changing the useful life of
depreciable property (if depreciation is
determined under Code § 167) or
adjustments to a bad debt reserve. Treas.
Reg. §§
1.446-1(e)(2)(ii)(b), 1.4461(e)(2)(ii)(d)(3).
c.
to accrue and deduct the liability for sick pay and that
the taxpayer had not changed its method of accounting.
Thriftimart, Inc. v. Commissioner, 59 T.C. 598 (1973).
Changes in Financing Arrangements Requires
Change in Recognition of Service Fee Income and
is Not a Change in Method of Accounting
(Federated Department Stores).
In terms of sales made to customers on credit, the
taxpayer’s previous practice had been to retain
ownership of the customer accounts receivable. Under
that system, the taxpayer charged a service fee to its
customers which it included in income as the payments
were received. The taxpayer changed the nature of its
financing agreements and decided to sell the
receivables. The controversy was whether the change
in the financing arrangement resulted in a change in
method of accounting with respect to the service fee
income. At issue before the court was whether the fee
income could continue to be deferred or whether the
income now had to be recognized at the time the
receivables were sold. The Tax Court held that, in light
of the new arrangement where the receivables were
sold, the service fee income had to be recognized
earlier in time, when the receivables were sold. The
taxpayer then argued that this was a change in method
of accounting and it was entitled to a section 481
adjustment. The Court rejected that argument and held
that this was not a change in method of accounting.
The Sixth Circuit affirmed the Tax Court’s decision on
the grounds that to have a change in method of
accounting the item itself must be basically the same as
an item previously accounted for with the present
method of accounting, Unless the transactions are
basically the same, the accounting treatment would not
be a `change’ of accounting but only a `new’
accounting method for a different transaction.” Both
courts found that the transactions in this case were so
different that no change in accounting method had
occurred. As a result, the taxpayer was not entitled to a
section 481 adjustment. Federated Department Stores
v. Commissioner, 51 T.C. 500 (1968), aff’d 426 F.2d
417 (6th Circ. 1970).
3.
Correction of an Error.
Treas. Reg. § 1.446-1T(e)(2)(ii)(B) provides that a
change in method of accounting does not include
correction of mathematical or posting errors, or errors
in the computation of tax liability (such as errors im
computation of the foreign tax credit, net operating
loss, percentage depletion or investment credit). A
mathematical error has been defined by the Tax Court
as a error in arithmetic, such as an error in addition,
subtraction, multiplication or division. Huffman v.
Commissioner, 126 T.C. 322 (2006).
a. A Different Result Applies To An Incorrect
Accounting Method. What if the item in question is
not an isolated error, but an erroneous method of
accounting? In that situation, the taxpayer generally
cannot correct the erroneous method without the
correction itself being the adoption of a new
accounting method.
b. Difference Between Error vs. Erroneous
Accounting Method. An erroneous accounting method
involves the systematic application of an error, over a
regular period of time. In contrast, an isolated error is
not an accounting method. As an example, if a mistake
was made by a business in making a physical count of
its inventory at year-end, resulting in an erroneously
low inventory, this would be an error. However, if, in
contrast, the same error in including ending inventory
was made for several years, then that is likely to be an
accounting method, and therefore the taxpayer would
have to get IRS approval before correcting it. Hartley
v. Commissioner, 23 T.C. 353 (1954).
c. Taxpayers Have a One-Year Reprieve to Correct
an Erroneous Method. A taxpayer may correct its
adoption in its initial tax return and use of an
impermissible method of accounting by filing an
amended return, but only if the amended return is filed
before the incorrect method has been used in a return
for the immediately succeeding taxable year. Rev.
Proc. 92-20, 1992-1 C.B. 685.
d.
Changes in New Collective Bargaining
Agreement Requiring Compensation for Unused
Sick Leave; Not a Change in Method of
Accounting (Thriftimart).
A taxpayer entered into a new agreement with its
union under which employees were entitled to
compensation for unused sick leave accrued as of the
employees’ anniversary date. Under the previous
collective bargaining agreement, employees were not
entitled to accumulate sick leave from year to year, nor
were they entitled to any compensation for unused sick
leave. In light of this new agreement, the taxpayer
began to accrue and deduct its liability for unused sick
leave. The Tax Court held that as a result of the terms
of the new union agreement, the taxpayer was entitled
d. Inadvertent Capitalization of Contract Losses was
a Posting Error, Not a Method of Accounting
(Northern States Power Co). The taxpayer entered into
government contracts for uranium enrichment services,
but later realized that it had overstated its needs for
enrichment. At the same time, the market price for
uranium dropped below the contract price the taxpayer
had agreed to pay, which caused the taxpayer very
27 Chapter 9
substantial losses. For three years the taxpayer
capitalized the contract losses by including them in the
cost basis of its nuclear fuel assemblies. This result
caused the losses to be depreciated over the lives of the
assemblies. Several years later, the taxpayer filed for
refunds on the later two years, but after the first year
had closed, taking the position that the losses should
have been currently deducted and that capitalization
had been an error. The Eighth Circuit overruled the
district court, and found for the taxpayer stating that
the mistake was a posting error. The refund claims
were an effort to treat the losses in the same manner as
it had consistently treated similar losses on other
contracts. Thus, it was not a change in method of
accounting. Northern States Power Co. v. United
States, 151 F.3d 876 (8th Cir. 1998).
C. Strict Deadline for Section 83(b) Elections.
In order for a section 83(b) election to be
effective, it must be made on or before the date that is
30 days after the property is transferred to the
employee. If the election is late it is not effective,
which means the employee is facing the prospects of a
huge amount of ordinary income when the property
vests in a later year at a time when the property has
substantially appreciated from its earlier value.
D. Solution for Late Section 83(b) Election.
There is no obvious solution for making a late
Section 83(b) election - the IRS will not grant “9100
relief” with respect to a late Section 83(b) election.
Moreover, most tax advisors believe it is not effective
to rescind the grant of property, and make another
grant of property that would be accompanied by a
timely made section 83(b) election. This strategy
likely does not work for tax purposes because the first
grant would not be actually rescinded under the law.
The IRS and courts would likely view this as an
attempt, that is devoid of economic substance, to cure a
late section 83(b) election. Moreover, the rescission of
the first grant of property would fail to pass the “status
quo” requirement because the rescission did not really
restore the parties to the position they were in before
the rescission occurred, because, as part of the same
arrangement or understanding, a new grant of property
was made to the employee.
VIII.
A.
SECTION 83(B) ELECTIONS.
Effect of Code § 83.
Code § 83(a) provides that when property is
transferred to a service provider in connection with the
performance of services, the excess of the fair market
value of the property transferred over the amount paid
for such property by the service provider is included in
the gross income of the service provider in the first
taxable year in which the rights of the person having
the beneficial interest in such property are
“transferable” or are not subject to a “substantial risk
of forfeiture.” Property is “transferable” within the
meaning of Code § 83 only if the rights in such
property of any transferee are not subject to a
substantial risk of forfeiture. Code § 83(c)(2) and
Treas. Reg. § 1.83-3(d).
1.
Example of Failed Attempt to Cure Section 83(b)
Election.
Employer grants Blackacre to service provider in
return for services on June 1, with the grant being
subject to a future vesting requirement. The parties
inadvertently forget to make a Section 83(b) election
within 30 days of grant. They “rescind” the first grant
of Blackacre, and Employer makes another grant to
service provider of Blackacre as of July 15, and service
provider makes a timely section 83(b) election. It is
likely that this tax planning technique does not work,
and service provider will be viewed as owning
Blackacre without a timely section 83(b) election. The
first rescission will not likely be respected because it
lacked economic substance and failed to satisfy the
“status quo” requirement for a rescission. (It failed to
satisfy the status quo requirement because it is likely
that the second grant would be part of the overall
arrangement, and under the second grant, service
provider ends up owning Blackacre as opposed to
being restored to the status quo where service provider
owned nothing).
B.
Importance of Section 83(b) Election.
If a person receives property in return for the
provision of services that is subject to a substantial risk
of forfeiture, and is not transferable, then the property
is included in taxable income (at ordinary income
rates) at the earlier of the date that the substantial risk
of forfeiture expires or the date the property becomes
transferable. (In other words, the fair market value of
the property is included into income when the property
“vests.”) This can result in substantial amounts of
ordinary income, if the property appreciates so that its
value is substantial as of the date that vesting
subsequently occurs. If a employee or independent
contractor makes a timely section 83(b) election, then
the fair market value of the property is included into
income on the date of its receipt, not the later date
when it vests. The results can be substantial tax
savings to the service provider.
28 Chapter 9
2.
fact as to the underlying transaction.” Treas. Reg. §
1.83-2(f). Additionally, even if a “mistake of fact”
exists, revocation must be requested within 60 days of
when the mistake first becomes known to the taxpayer
who made the election. To obtain the IRS consent of
the revocation of such an election, the taxpayer must
file a private letter ruling request with the IRS.
Solution - Make Property Transferable.
A solution to this problem is to make the property
transferable by the service provider, so that the service
provider can convey the property to a transferee. That
results in the fair market value of the property being
included, immediately, in the service provider’s
income, at presumably at low fair market value. The
later expiration of what would have been the service
provider’s substantial risk of forfeiture is irrelevant. In
effect, a result very similar to a timely section 83(b)
election has been achieved.
1.
Revocation before due date of election.
Although revocation of an election requires
consent of the IRS, if the taxpayer requests revocation
of an election already made prior to the expiration of
the 30-day period for making the election, the request
will generally be granted without the need to show a
mistake of fact. Rev. Proc. 2006-31, §§ 2.08, 5
Example 2.
a. Terms of Transferability. The service provider
would be allowed to transfer Blackacre to any
transferee, and the transferee would take the property
without being subject to any risk of forfeiture.
However, the agreement would provide that service
provider would have to pay damages to Employer
equal to the fair market value of Blackacre if any acts
occurred which, had the service provider still owned
Blackacre, would have resulted in a forfeiture of the
property. In other words, although the transferee
receives Blackacre without any forfeiture risk, if
something occurs that would have otherwise been a
forfeiture, the service provider has to pay Employer the
fair market value of Blackacre on that later date, since
those were the damages the Employer suffered by
virtue of service provider transferring the property.
2.
Mistake of Fact.
A mistake of fact is “an unconscious ignorance of
a fact that is material to the transaction.” Rev. Proc.
2006-31, § 2.05. It must concern a fact that forms the
basis of the transaction, and not a collateral matter.
See PLR 8224047 (consent denied where employee
relied
on
employer’s
officers’
alleged
misrepresentations regarding continued employment
and ability to revoke election if employment were
terminated).
a. Not A Mistake of Fact. The IRS states that the
following are not mistakes of fact and therefore do not
allow a § 83(b) election to be revoked. (See Rev. Proc.
2006-31, §§ 2.04, 2.06, 2.07):
b. Example in Regulations. On November 1, 1978, X
corporation sells to E, an employee, 100 shares of X
corporation stock at $10 per share. At the time of such
sale the fair market value of the X corporation stock is
$100 per share. Under the terms of the sale each share
of stock is subject to a substantial risk of forfeiture
which will not lapse until November 1, 1988. In
addition, under the terms, on November 1, 1985, each
share of stock of X corporation in E’s hands could as a
matter of law be transferred to a bona fide purchaser
who would not be required to forfeit the stock if the
risk of forfeiture materialized. In the event, however,
that the risk materializes, E would be liable in damages
to X. On November 1, 1985, the fair market value of
the X corporation stock is $230 per share. Since E’s
stock is transferable within the meaning of § 1.83-3(d)
in 1985, the stock is substantially vested and E must
include $22,000 (100 shares of X corporation stock x
$230 fair market value per share less $10 price paid by
E for each share) as compensation for 1985. Treas.
Reg. § 1.83-1(f) Example (2).
(1) mistake as to value, or decline in value, of
the property for which the election was
made;
(2) failure of anyone to perform an act
contemplated at the time of transfer of the
property;
(3) a service provider’s failure to understand the
substantial risk of forfeiture associated with
the property tranferred; or
(4) a service provider’s failure to understand the
tax consequences of making a § 83(b)
election.
b. Example of a Mistake of Fact Allowing
Revocation. The IRS states that the following is a
mistake of fact and therefore would qualify for
revocation of a § 83(b) election. Rev. Proc. 2006-31,
§5 (Example 3). In this example, an employee begins
work for a Company under a contract that provides that
he will receive Class A common stock. Later, the
Company transfers Class B comon stock to the
employee. The employee makes a section 83(b)
E.
Revoking § 83(b) Elections.
Revocation of a § 83(b) election requires IRS
consent. § 83(b)(2), Treas. Reg. § 1.83-2(f). Consent
may only be obtained if there has been a “mistake of
29 Chapter 9
election with respect to this stock. He later discovers
that he was mistaken as to the stock transferred (he
thought it was Class A), and files a request for ruling
from the IRS allowing him to revoke the election. The
IRS holds that the employee may revoke the election
because it was based on a mistake of fact as to the
underlying transaction -- B did not receive the property
he expected to receive in the transfer. Because he
requested the relief from the IRS within 60 days of
discovering the mistake, his request was timely made had the request not been made within this 60 day
deadline, the IRS would have denied relief (Example
4).
c. Mistake of Law. A mistake of law, where a
person does not know of, or concludes erroneously
regarding, the legal effect of the facts, is not a mistake
of fact. If for example, a taxpayer relied on misleading
and inaccurate advice from counsel regarding the tax
consequences of the election that would be a mistake
of law. All the facts were known and the mistake was
an erroneous conclusion regarding legal consequences,
with the result that revocation of the § 83(b) election
would not be allowed.
30 Chapter 9

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

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