Oops, What Was I Thinking? How to Fix a Botched Transaction

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 27th ANNUAL ADVANCED TAX LAW COURSE August 27-28, 2009 Houston

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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 Partner conferences and has written numerous articles relating to his area of Chicago practice. 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 Kugle, Byrne & Alworth Ethics Teaching Award - University of Texas Law 1984, Illinois School, 1993 1994, Texas 2001, District of Columbia Texas Excellence in Teaching Award - University of Texas Law School, 1997

Education Publications University of Chicago Law School, J.D. 1983 with Evans, "The Evolution of Federal Income Tax Accounting - A Growing Trend Honors; Order of the Coif (top 10% of graduating class); Towards Mark-to-Market?" 67 Taxes 824 (December, 1989). This article Received the Isaiah H. was presented in the Fall of 1989 at the University of Chicago Federal Tax Dorfman Prize for Outstanding Conference. Papers presented at the Conference are traditionally published Work in Labor Law in the December issue of Taxes. University of Illinois, B.S., Finance 1976 with Honors 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

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VII. CHANGE IN METHOD OF ACCOUNTING OR CORRECTION OF ERROR...... 26 A. Introduction...... 26 B. Change in Method of Accounting...... 26

VIII. 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

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OOPS, WHAT WAS I THINKING? “bailout” legislation), tax return preparers may be HOW TO FIX A BOTCHED penalized for preparing returns with positions below the level of “substantial authority.” This standard had TRANSACTION been “more likely than not” until Code § 6694 was amended, retroactively, to require a substantial By: authority standard in the tax legislation signed into law Thomas L. Evans on October 3. The IRS had announced that it will Kirkland & Ellis LLP coordinate the application of the § 6694 rules with the Chicago, Illinois rules under § 10.34 of Circular 230 governing tax return preparers. Consistent with that position, that I. THE INCOME TAX IMPLICATIONS OF IRS had issued proposed regulations under § 10.34 of FIXING MISTAKES. Circular 230 requiring that a more likely than not A. Introduction. standard be adopted by tax return preparers. It is quite Assume that you discover that a tax-related likely that the IRS will now issue new proposed mistake has been made (by yourself, your client, or regulations under § 10.34 of Circular 230 adopting the other persons) that affects your client. Perhaps there is substantial authority standard. Note that for tax a mistake that was made on a tax return. Or, perhaps a shelters (as defined in Section 6662(d)(2)(C)(ii) deadline for an important tax election has passed. Or, (“significant purpose” of avoidance or evasion of tax) alternatively, perhaps a transaction itself is now viewed and reportable transactions, the more likely than not as a mistake and your client would like to unwind the standard still applies. Thus, the “realistic possibility of entire transaction without that being tax inefficient. success standard” is rapidly being obsolete. How do you fix this mistake in a manner that is ethical, in accordance with professional rules governing b. FIN 48. Second, the Financial Accounting lawyers and accountants, and practical? Standards Board’s Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes FIN 48 B. Summary of Conclusions. effectively requires at least a “more likely than not” This article discusses the following points threshold in order to avoid having to account for a tax regarding the correction of mistakes. position as a total “loser” in establishing liabilities (reserves) for taxes in financial statements. If the 1. No Duty to File Amended Returns. position is not at least “more likely than not,” then FIN First, as noted in Section II of this article, in 48 dictates that a liability must be established as if the general there is no obligation to correct a previously taxpayer owed the entire amount in question to the filed tax return, even if that return is in error. Although IRS. it appears that tax professionals are required to recommend that an amended return be filed, the client 3. Tax Rescission of a Transaction. may ignore that advice and decide not to file an A tax rescission of a transaction, discussed in amended return. That decision not to amend, in and of Section IV, requires that the rescission or unwinding of itself, is not illegal and is a permissible exercise by a the transaction occurs in the same taxable year in client of its discretion. which the transaction took place, and that the parties are restored to “status quo,” i.e., the same position they 2. How Strong a Position Do You Need? were in before the transaction initially took place. Assume that you need to take affirmative action to Most, if not all, transactions can be rescinded if they fix a previous error --- how strong a tax position do qualify under these criteria, although it appears that the you need to recommend that a client take such action IRS National Office is of the view that a dividend and sign a tax return based on that action? Section III cannot be rescinded. However, the “same year” rule of this Article notes that the “realistic possibility of generally means that a transaction cannot be unwound success” standard still, theoretically, governs the for tax purposes unless that unwinding occurs in the professional standards (under ABA and AICPA rules) same taxable year as the initial transaction. for tax professionals. However, two developments have made these rules of questionable value. 4. Reforming a Contract or Instrument When Rescission is not Possible. a. New Rules under Code § 6694 and Circular 230. Because of the “same year’ and “status quo” First, under the new provisions of Code § 6694 (as requirements of a tax rescission, in many situations it amended by The Tax Extender and Alternative may not be possible to rescind a transaction. Minimum Tax Relief Act of 2008 signed into law by “Reforming” a contract or instrument, discussed in President Bush on October 3, 2008 as part of the 2008 1

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Section V, may be done retroactively, but such recipient. This will result in the property being reformation is generally not binding on the IRS. An included into value at an earlier date at a presumably exception exists for scrivener errors and other lower value, in a manner quite similar to what would ministerial corrections of a document, which may be have occurred had a section 83(b) election been made. unwound, retroactively, including for tax purposes. Additionally, Section VIII discusses revoking an 83(b) election and the limited circumstances under which it 5. Utilizing 9100 Relief. can be done. As discussed in Section VI, Treas. Reg. § 301.9100 allows taxpayers who have missed deadlines II. THE DUTY TO CORRECT A DISCOVERED for making certain tax elections, to make those ERROR RELATING TO A PREVIOUS TAX elections retroactively. In addition, under these RETURN. regulations taxpayers may (subject to certain A. Introduction. limitations), change their method of accounting for Assume that you are advising a client regarding a prior years. Finally, taxpayers may obtain 9100 relief federal income tax issue, and you discover that the from certain penalties. client committed an error that was reflected in a federal income tax return already filed for a previous year. 6. Change in Accounting Method vs. Correction of What are the client’s legal and ethical duties with an Error. respect to this erroneous return? What duties are If the client is using a “method of accounting” for imposed on you, and what should you advise the tax purposes, as discussed in Section VII, that method client? of accounting may be corrected or changed only on a prospective basis, and usually only with the consent of B. Obligation of Client to File an Amended the IRS which is granted subject to terms and Return. conditions that may be unattractive. However, if the The general rule is that there is no obligation reporting is not a “method of accounting” but only an imposed on the client to file an amended tax return. “error,” then such an error may be corrected This result is confirmed by case law, discussed below, retroactively by filing an amended return. Similarly, if and by the language of the existing Treasury there is an underlying change in the taxpayer’s facts or regulations. business operations, changes in the tax treatment may be made without those items being a change in a 1. Exceptions to the Rule. method of accounting. In general, an accounting There may be isolated exceptions to this rule, method is something which only involves a timing where the IRS has maintained that taxpayer’s were matter as to when income or deductions will be obligated to file amended returns, especially in cases of incurred, and not a “permanent” difference such as a retroactive tax legislation. See, e.g., Internal Revenue deduction being permanently disallowed. News Release 89-48 (April 19, 1989)(1989 CCH ¶6515) as modified by Ann. 89-90, 1989-29 I.R.B. 36, 7. Section 83(b) Elections. where the IRS took the position that taxpayers were The Code itself provides a narrow 30-day window obligated to file amended returns to reflect a during which taxpayers receiving property in exchange retroactive amendment to the alternative minimum tax, for services are allowed to make a section 83(b) made in 1988 but effective beginning in 1987, that election. As discussed in Section VIII, this section required taxpayers to treat personal exemptions as an 83(b) election allows a taxpayer to include the fair item of tax preference. In addition, it may also be market value of the property into income currently, necessary for the taxpayer to file an amended return to even though the property is unvested and subject to a obtain a particular tax benefit that would otherwise not substantial risk of forfeiture. A taxpayer who misses be obtainable, such as in a situation where Congress or this 30 day deadline is not able to invoke 9100 relief to the IRS retroactively grants a tax benefit that can only cure the late election. They are out of luck. This be availed of by filing an amended return for a creates a very undesirable situation, in that the fair previous year. market value of the property as of the later date of vesting, will be included in ordinary income - at a 2. Could Treasury Require Amended Returns? subsequent fair market value that might be very high. There is some debate over whether the Treasury This article discusses one technique for “fixing” this Department could, if it chose, issue regulations situation, which is to make the property transferable by requiring the filing of an amended return. Code § the taxpayer, even though it is still subject to a 6011(a) provides that “[w]hen required by regulations substantial risk of forfeiture in the hands of the original prescribed by the Secretary any person made liable for

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 any tax ... shall make a return or statement according to amended return be filed. The taxpayer never filed the the forms and regulations prescribed by the Secretary.” amended return, and the error was discovered during This arguably gives the Treasury the authority to an IRS audit. require the filing of amended returns, although a counter argument exists that this language only applies a. Attempt by IRS to Impose Penalties. The IRS to current returns, and that requiring amended returns imposed penalties on the taxpayer for what the court is therefore outside of Treasury’s authority. termed “fraud,” arguing that the taxpayer “willfully and deliberately attempted to evade and defeat his 3. Precatory Language in Existing Regulations. income taxes when he refused to file the amended In any event, Treasury has not exercised this return after begin advised to do so by his accountant.” purported authority, and has not issued regulations of a general scope which require the filing of amended b. Holding of Court in Favor of Taxpayer. The court returns. Typically, the existing regulations require that refused to allow the imposition of this penalty, holding a taxpayer “should” file amended returns. Note, for instead that (i) the taxpayer was not aware of the error example, the following language taken from Treas. until after the return was filed; and (ii) the taxpayer Reg. § 1.451-1(a). “If a taxpayer ascertains that an was not obligated by statute to file an amended return, item should have been included in gross income in a and was acting legally when it refused to do so, even prior taxable year, he should, if within the period of though an amended return had been prepared and limitation, file an amended return and pay any offered to the taxpayer for filing. As a result, the court additional tax due. Similarly, if a taxpayer ascertains found that the taxpayer was not guilty of attempting to that an item was improperly included in gross income evade taxes. in a prior taxable year, he should if within the period of limitation, file claim or credit or refund of any 6. Possible Benefits to Filing an Amended Return. overpayment of tax arising therefrom.”(empahsis The above discussion, suggesting that taxpayers added) For similar language using the precatory word are not under any legal obligation to file amended “should” in regards to filing amended returns for returns, does not mean that taxpayers may not benefit erroneous timing of deductions, see Treas. Reg. § from filing an amended return. As an example, 1.461-1(a)(3). See also the Supreme Court’s opinion taxpayers may avoid penalties for negligence in filing a in Badaracco v. Commissioner, 464 U.S. 386 (1984), previously inaccurate return if they file correct where the court specifically noted that the regulations amended returns. See Treas. Reg. § 1.6664-2(c)(3) referring to amended returns do not require the filing of (providing for qualified amended returns which, if filed such returns. before the IRS contacts the taxpayer for audit, will allow the taxpayer to reduce the amount of 4. Could Failure to Amend Be a Willful Failure to underpayment of tax upon which the penalty is based). Pay Taxes? Similarly, filing amended returns may constitute a Some commentators have suggested that the failure to voluntary disclosure of a tax liability that could avoid correct a discovered error relating to a past year’s criminal prosecution for tax fraud or other crimes, return may constitute the willful failure to pay taxes in although such a strategy is based on IRS practice, and violation of Code § 7203. not on anything in the law which grants formal immunity to persons filing amended returns. However, 5. Case Law – The Broadhead Decision. the central issue here is not whether it may prove The case law confirms the absence of a general helpful for a taxpayer to file an amended return, but duty requiring the filing of amended returns. For rather whether filing such a return is mandatory under example, in Broadhead v. Commissioner, 14 T.C.M. the law. It appears that the answer to this latter (CCH) 1284 (1955), aff’d on other issues, 254 F.2d question is no. 169 (1958) the taxpayer, which owned and operated a lumber yard, filed its federal income tax return for C. Ethical Obligations Regarding Amended 1946 in May of 1947. In June of 1947, a month after Returns. filing the return, an accountant hired by the taxpayer to Having determined that there is generally no legal prepare its return and audit its books discovered that an obligation to file amended returns, the question error had been made in the 1946 return, resulting in an remains as to what a tax professional is ethically understatement of lumber sales equal to approximately obligated to do when he or she discovers that a client’s $55,000. The accountant told the taxpayer about the filed return contains errors. error, prepared an amended return for 1946, and sent the return to the taxpayer with the advice that the

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1. Disclosure by Tax Professional of Error. requires that a lawyer advise a client to file an There is general agreement that a lawyer must amended return, although the language used in the disclose the existence of the error to the client. E.g., opinion is of a general nature, and not in any way Circular 230, § 10.21 provides that the lawyer “must focused on amended return in particular. ABA advise the client promptly of the fact” of the error and Opinion 314 contains the following paragraph: must advise the client of the consequences of the error. Similar standards govern accountants. (See AICPA In all cases, with regard both to the Statement on Standards for Tax Services, No. 6, stating preparation of returns and negotiating that the accountant should inform the client of the administrative settlements, the lawyer is existence of the error.) These rules would apply even under a duty not to mislead the Internal if the lawyer or accountant had himself been Revenue Service deliberately and responsible for the previous error. affirmatively, either by misstatements or by silence or by permitting his client to mislead. 2. Requirement to Advise that Amended Return be The difficult problem arises where the client Filed. has in fact misled but without the lawyer’s Having concluded that the professional is required knowledge or participation. In that situation, to inform the client of the error, the next issue that upon discovery of the misrepresentation, the arises is whether the professional must advise or lawyer must advise the client to correct the recommend that the client correct the error by filing an statement; if the client refuses, the lawyer’s amended return. This, again, may raise serious obligation depends on all the circumstances. practical issues, since the professional may be concerned that the relationship with the client would be c. Interpretation of Above Language. Most damaged or jeopardized, should the professional advise commentators interpret this language as requiring that the client to do something that the client believes a lawyer recommend the filing of an amended return (perhaps quite correctly) is against the client’s self upon the discovery of a previous error, with the caveat interest. Circular 230 does not provide that a that the recommendation does not likely apply in the professional should or must recommend the filing of an unusual situation when 5th Amendment concerns were amended return to the client (see Circular 230, § present. Wolfman, et. al. at 125-26. 10.21). Similarly, the AICPA Statement on Standards for Tax Services, No. 6, does not specifically require 3. What if Client Refuses to Amend Returns? that the accountant must recommend the filing of an If the client refuses to file an amended return amended return, although the Statement provides that a (irrespective of whether such action was recommended CPA “should” recommend “appropriate measures” to by the lawyer), then, as ABA Opinion 314 phrases it, correct the error, while also requiring that the CPA “the lawyers obligation depends on all the take reasonable steps to ensure that the error is not circumstances.” repeated in preparing the current year’s return. The rules governing lawyers are not as clear, and may a. Lawyers May Not Disclose Error. First of all, it require the lawyer to recommend that an amended should be clear that the lawyer may not disclose the return be filed. Those rules are discussed below. error, absent the consent of the client. ABA Model Rule 1.6 provides, for example, that a lawyer shall not a. Rationale For Rule. Commentators generally reveal information relating to representation of a client believe that this omission is an acknowledgment that unless the client consents after consultation, except that filing an amended return could possibly subject the a lawyer may reveal information to the extent that the client to criminal prosecution. In such a situation, a lawyer reasonably believes necessary to prevent the client might have a 5th Amendment right under the client from committing a criminal act that the lawyer Constitution not to file an amended return, and a believes is likely to result in imminent death or professional is under no obligation to recommend substantial bodily harm, or to establish a claim or actions to the client that would contravene this defense on behalf of the lawyer in controversy between Constitutional right. See, e.g., Corneel, “Guidelines to the lawyer and the client. Tax Practice” (Second), 43 Tax Lawyer 297 (1990); Wolfman, Holden, & Harris, Standards of Tax Practice b. Accountants Under Similar Restrictions. 126 (6th. Ed. 2006) (hereafter “Wolfman, et. al.”) . Similarly, accountants may not inform the IRS of the error “except where required by law.” AICPA b. ABA Opinion 314’s Treatment. Notwithstanding Statement on Standards for Tax Services, No. 6. these considerations, ABA Opinion No. 314 apparently

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 c. Lawyer May Not Be Associated With Future recommending is appropriate under law? In other Filings. Second, it appears clear that the lawyer may words, how aggressive can you be in recommending or not be involved or associated with the filing of a future advising a client to take a position on a tax return? tax return, or future filing of a tax document, that Can, for example, a tax professional recommend that a incorporates or continues the previous error. ABA client take a certain position, even though the lawyer Model Rule 4.1(a) and 8.4 provide that a lawyer may believes that it is likely the position would not prevail, not make a false statement of a material fact or law or a on the merits, if it were picked up on audit and fraudulent statement. This can be especially litigated? If the answer to this question is “yes,” how problematic where there is an error in the amount of an far can the professional go in recommending positions asset (such as inventory), and where that error will be that would likely be losers if picked up by the IRS? carried forward, mechanically, in future returns. B. ABA Formal Opinion 85-352 (July 7, 1985) – d. Accountants Also May Not Be Associated With History. Future Filings. CPAs also are required to take Opinion 85-352 deals with the extent to which a reasonable steps to assure that the error is not repeated lawyer may advise a client to take a tax return position in preparing tax returns in the future. Thus, they face which may be aggressive. Opinion 85-352 was issued the same difficulty in preparing tax returns that to replace the portions of Formal Opinion 314 (April incorporate an error made in a previous return. AICPA 27, 1965) which had held that a lawyer could advise a Statement on Standards for Tax Services, No. 6. client to take a position most favorable to the client as long as there is a “reasonable basis” for the position. e. Future Dealings With the IRS (Such As Audits). Practitioners had come to interpret the language as Similar issues would arise if the tax professional was allowing a position to be taken as long as there was a representing the client before the IRS, since Circular “colorable” claim to that position, thus allowing 230 (§ 10.51(d)), prohibits giving false or misleading lawyers to bless return positions that were oriented information to the IRS, as well as participating in any towards taking advantage of the tax lottery. Although way in the giving of false or misleading information. disavowing this particular interpretation, the ABA, in (Circular 230, § 10.51(d) terms such behavior as response to criticism, issued Opinion 85-352 which “disreputable conduct” for which a lawyer may be effectively replaced the older Opinion 314 regarding censured, disbarred or suspended from practice before return positions, although Opinion 314 remains the IRS.) If a professional knew about the existence of outstanding in terms of providing guidance regarding the error, it might be difficult to continue dealing with the IRS-lawyer relationship, specifically the lawyer’s the IRS if the dealing involved the subject matter of the responsibilities in negotiating and settling matters error, since the dealing itself might be viewed as before the IRS. (Note – Opinion 85-352 does not providing false or misleading information to the IRS, apply to “tax shelters.” Instead, Formal Opinion 346 or at least participating in that process. Under AICPA (Revised) issued in 1982 sets forth the ethical rules Statement on Standards for Tax Services, No. 7, a CPA regarding tax shelter activity, and in general imposes a representing a client before the IRS where the CPA is higher standard of care, including more diligence and aware of an error in the return being audited, should inquiry, on lawyers providing tax shelter opinions. consider withdrawing from representing the taxpayer if Opinion 85-352, discussed in this article, is the client refuses to inform the IRS of the error. This inapplicable to such arrangements.) language likely means that the CPA should withdraw unless the withdrawal itself could breach the client’s C. Substance of Opinion 85-352. confidentiality. Opinion 85-352 allows lawyers to be quite aggressive in advising clients regarding tax return III. PROFESSIONAL STANDARDS positions. The Opinion allows a lawyer to recommend APPLICABLE TO TAX PROFESSIONALS a position if there is “some realistic possibility of ADVISING CLIENTS ON POSITIONS TO success if the matter is litigated.” In this regard, the BE TAKEN ON TAX RETURNS. position must be one which the lawyer in good faith A. Introduction. believes is warranted in existing law or can be How do you know whether an “error” has been supported by a good faith argument for an extension, committed on a return? What if the position taken has modification or reversal of existing law. There are some merit, but is likely not to succeed if litigated? Is several noteworthy features of the realistic possibility that an error? Similarly, in recommending that a client of success. fix a previous error, what standards are applicable in determining whether the new position you are

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9

1. Quantification of Realistic Possibility of Success. disclosure and to take the position initially advised by The Report of the Special Task Force on Formal the lawyer in accordance with the standards stated Opinion 85-352, reprinted in 39 Tax Lawyer 635 above (i.e., the realistic possibility of success (1986) (“Special Task Force Report”), attempts to standard), the lawyer has met his or her ethical quantify what is meant by “realistic possibility of responsibility with respect to the advice.” success,” although no such quantification is provided in the Opinion itself. The Special Task Force Report 5. What Must Be Done if the Position Does Not provides that a 5-10 percent likelihood of success if not Have a Realistic Possibility of Success? sufficient to meet the standard, but that a likelihood If the position does not have a realistic possibility approaching 1/3 should meet the requirement. of success, then the professional may, if the position is nonfrivolous, advise the taxpayer to take the return 2. Test is Based on Litigation. position if the position is disclosed or “flagged” on the It is also important to note that the 1/3 test is return. AICPA Statement on Standards for Tax based on an assumption that the position is actually Services No. 1; Letter from John Jones, ABA Tax litigated. This prevents the lawyer from evaluating the Section Chairman, to Leslie Shapiro, Director of position by taking into account the possibility that the Practice (February 12, 1987). IRS would not discover this on audit, and the additional possibility that the matter could be settled, D. Is the Realistic Possibility of Success Standard through comprise, in negotiations before litigation Still Practical? occurred. The Special Task Force Report rejects both Although the realistic possibility of success of these qualifications, which has the effect of raising standard is still theoretically applicable, two the standard to which the opinion must adhere, since a developments suggest that the “more likely than not” lawyer can’t use the audit lottery in determining standard is now the more important rule. One is a whether the client has a 1/3 chance of prevailing on the preparer penalty under § 6694 generally requiring a position. “substantial authority” standard to avoid penalties. § 10.34 of Circular 230, the IRS ethical rules governing 3. A Realistic Possibility of Success is not persons practicing before the IRS, will also be Substantial Authority. conformed to require the same standard as § 6694. The Opinion 85-352 specifically says that a realistic second one is the new GAAP provision in FIN 48 possibility of success may exist, even though it is requiring a “more likely than not” standard to be likely that the taxpayer would lose if the matter were applied to the reporting of tax positions for financial litigated. Moreover, the Opinion makes clear that a accounting purposes. realistic possibility of success may exist for a particular position, even though that position may not have E. The Same Realistic Possibility of Success Also “substantial authority” under the law, leading to the Applies to Accountants. ironic situation that a lawyer, under the rules, may Accountants are allowed to recommend a return ethically advise a taxpayer to take a return position that position if it meets the realistic possibility of success would subject the taxpayer to penalties if the taxpayer standards as well. Under AICPA Statement on were caught taking the position by the IRS. Standards for Tax Services No. 1, a CPA is allowed to consider whether there is a realistic possibility of 4. What Must Be Done if the Position Has a success that a position will be sustained either Realistic Possibility of Success But Does Not administratively (in IRS Appeals, for example) or Have Substantial Authority? judicially. In contrast, lawyers may only take into Opinion 85-352 makes it clear that, in advising a account whether a position will be maintained client, the lawyer should tell the client whether the judicially. position is likely to be sustained by a court if challenged by the IRS, and the potential penalty 1. Preparer Penalty. consequences to the client if the position is taken. The 2007 Small Business Act, enacted on May 25, Since penalties may apply if there is no substantial 2007 expanded the liabilities for a tax return preparer authority for a position, the Opinion also says that the who prepares a return or claim for refund for which lawyer should advise the client of the potential there is an understatement of liability which is an application of the penalty, and the opportunity to avoid “unreasonable position.” 2007 Small Business Act, the penalty by disclosing the position on the return. Pub. L. No. 110-28, § 8246, codified in I.R.C. § 6694. The Opinion says that “[i]f after receiving such advice the client decides to risk the penalty by making no

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 a. Preparer. The term “tax return preparer” was the prior standards applied to them. For all other expanded from just those preparing income tax returns, returns, amended returns, and refund claims, the to include those preparing estate, gift, employment, reasonable basis standard under the § 6662 regulations excise, and exempt organization returns. In other will be applied to determine whether the 6694(a) words, all preparers are subject to this rule, including penalty will be imposed. No relief is provided under § non-signing return preparers who give advice with 6694(b) regarding willful or reckless conduct. respect to positions that are taken on the return. 2. FIN 48. b. Unreasonable Position. Before the amendments The Financial Accounting Standards Board’s made to § 6694 by The Tax Extender and Alternative Interpretation No. 48 (“FIN 48”), Accounting for Minimum Tax Relief Act of 2008 signed into law by Uncertainty in Income Taxes requires “an enterprise to President Bush on October 3, 2008 (the “2008 Act”), a evaluate uncertainty and changes in uncertainty in position was unreasonable, generally, if it is a position determining whether [it] is entitled to the benefits of a (i) of which the preparer had, or should have had, particular tax position.” FIN 48 requires that an knowledge; (ii) for which there was not a reasonable uncertain tax position be taken only if “it is more likely belief that the position would more likely than not be than not that a tax position will be sustained upon sustained on its merits; and (iii) either the position was examination, … based on the technical merits of the not disclosed under § 6662 or there was no reasonable position.” If “more likely than not” cannot be met for basis for the position. No penalty will be imposed if a position, the financial statements cannot recognize there is reasonable cause for the understatement and the benefit of the position. The purpose of FIN 48 is to the preparer acted in good faith. reduce the diversity in accounting for income taxes by providing consistent criteria and measurement along c. After 2008 Act. After the 2008 Act, the standard with disclosure. The effective date is fiscal years has been retroactively shifted from more likely than beginning after December 15, 2006. not to “substantial authority.” For disclosed positions (i.e., positions which are disclosed on a tax return such 3. Have The Rules Changed to Requiring a as by filing Form 8275), the standard (which is not “Substantial Authority” Standard (More Likely changed by the 2008 Act) is that there must be a Than Not ForTax Shelters?) reasonable basis for the position (a 10-20 percent In light of the changes introducted by FIN 48, the likelihood that such position would prevail). However, new penalties imposed on tax return preparers by § for tax shelters (as defined in Section 6662(d)(2)(C)(ii) 6694, and the proposed changes to Circular 230 (“significant purpose” of avoidance or evasion of tax) (discussed below), one may argue that we are now, and reportable transactions, tax return preparers are practically speaking, under a regime where the old still subject to the more likely than not standard, even “realistic possibility of success” standard is not after the amendments made by the 2008 Act. practical. A tax return preparer may not safely rely on the realistic possibility of success standard, and a d. Penalty. The penalty for such an unreasonable Company issuing financial statements under GAAP position is assessed on each return prepared and is an may not rely on that standard as well. amount which is the greater of (i) $1,000, or (ii) 50% of the fees for preparing the return or claim. The F. Circular 230. penalty rises for willful or reckless conduct on the Circular 230 (31 C.F.R. pt. 10) governs the party of the preparer to the greater of (i) $5,000, or (ii) recognition of attorneys, accountants, enrolled agents, 50% of the fees for preparing the return or claim. and, in certain circumstances, other taxpayer representatives before the IRS. If a person, appearing e. Effective Date. The change applies to tax returns before the IRS on behalf of a taxpayer, is engaged in prepared after May 25, 2007. practice, they must meet the requirements of Circular 230. f. Transitional Relief. Notice 2007-54 was issued to provide transitional relief to (i) all returns, amended 1. Practice Before the IRS. returns, and refund claims due on or before December “Practice before the Internal Revenue Service 31, 2007 (including extensions), (ii) 2007 estimated comprehends all matters connected with a presentation returns due on or before January 15, 2008, and (iii) to the Internal Revenue Service or any of its officers or 2007 employment and excise tax returns due on or employees relating to a taxpayer's rights, privileges, or before January 31, 2008. The relief is that income tax liabilities under laws or regulations administered by the returns, amended returns, and refund claims will have Internal Revenue Service. Such presentations include,

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 but are not limited to, preparing and filing documents, “not patently improper,” (ii) greater than “merely corresponding and communicating with the Internal arguable,” and (iii) greater than “merely colorable.” A Revenue Service, rendering written advice with respect practitioner may not take into account the possibility to any entity, transaction, plan or arrangement, or other that (i) a return would not be audited, (ii) an issue plan or arrangement having a potential for tax would not be raised on audit, or (iii) an issue would be avoidance or evasion, and representing a client at settled. Id. The IRS, however, did not define what conferences, hearings and meetings.” Circular No. constitutes “adequate disclosure.” Note to Reader - 230, § 10.2(a)(4). since the penalty standards under § 6694 for tax return preparers have now been retroactively downgraded to 2. Recent Changes. substantial authority under the October, 2008 bailout a. Final Regulations. On September 26, 2007, the legislation, it is expected that the proposed regulations Treasury Department adopted final regulations under § 10.34 of Circular 230 will also be changed. regarding changes to Circular 230. In particular, the definition of “practice before the Internal Revenue IV. UNWINDING OR RESCINDING A Service” was amended to include the rendering of TRANSACTION –THE PROBLEM. “written advice with respect to any entity, transaction, One very useful way of fixing a mistake is to plan or arrangement, or other plan or arrangement rescind it. The rescission doctrine allows a transaction having a potential for tax avoidance or evasion.” to be unwound as long as it is unwound in the same Circular No. 230, § 10.2(a)(4). Despite comments on taxable year in which it occurred, and as long as the the proposed regulations to this section of Circular 230 parties are restored to the status quo. that rendering tax advice was not, by itself, “practice before the IRS,” Treasury concluded that written A. The General Tax Rule For Rescissions – advice is “practice” when it is provided by a According To The IRS. practitioner and therefore issued the regulations in final Subject to a number of exceptions and nuances, form without change. See Preamble to Final the IRS view is that a transaction generally can be Regulations Governing Practice Before the Internal ignored and treated as if it never existed, for federal Revenue Service, T.D. 9359 (Sept. 26. 2007). 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 1. The Same-Year Rule. Making (REG-138637-07) proposing additional First, the transaction must be rescinded in the modifications to Circular 230, § 10.34 in particular, same year in which it originally took place. If the regarding standards in respect of tax returns. The transaction is rescinded in a subsequent taxable year, preamble states that Treasury and the IRS determined the weight of the authority is that the transaction that the professional standards of Circular 230 should cannot be ignored for federal income tax purposes - conform to the civil penalty standards for return rather the original transaction and its rescission must preparers under § 6694. Therefore, the proposed be separately respected and reported, for federal regulations, provide that a practitioner may not sign a income tax purposes, as discrete and separate tax return unless he has “reasonable belief” that each transactions. position taken on a return meets a “more likely than not” standard. Additionally, a practioner may sign a 2. Restoration of the Status Quo. return if the position has “reasonable basis” and is Second, the rescission of the transaction must “adequately disclosed” to the IRS. The proposed restore both sides to the same position they had before regulations define “more likely than not” to mean the the original transaction occurred. If either side is not practitioner has analyzed “the pertinent facts and restored to the status quo before the original deal, then authorities, and based on that analysis reasonably the weight of the authority is that the transaction concludes, in good faith, that there is a greater than cannot be ignored for tax purposes. For example, if fifty-percent likelihood that the tax treatment” will be only one side is restored to status quo (but not the other sustained under an IRS challenge. Prop. Circular No. side) then the transaction cannot be ignored by either 230, § 10.34(e)(1). “Reasonable basis” is defined to side for tax purposes. mean a position “reasonably based on one or more of the authorities described in 26 CFR 1.6662-4(d)(3)(iii), B. Policy Behind Rules – Claim of Right. or any successor provision, of the substantial The policy behind these rules is basically the same understatement penalty regulations.” Prop. Circular as the rationale underlying the claim of right doctrine. No. 230, § 10.34(e)(2). This means the positions is (i) Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931).

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9

Our tax system is based on annual reporting, and it is of the original sale. In situation 2, Buyer chose to administratively necessary to determine tax liability rescind the contract in February 1979 (recall that the based on events occurring within the taxable year, and sale occurred in February 1978) and the parties were not based on future developments. Both taxpayers and restored to the original status quo at that time. The IRS the IRS need to be able to determine taxable income, claims that this means that the transaction cannot be and taxpayers need to file tax returns, without having ignored – instead the parties have to respect the sale in to refer to events occurring subsequent to the taxable 1978 and view the 1979 transaction as a subsequent year. repurchase of the property.

C. Revenue Ruling 80-58, 1980-1 C.B. 181. 4. Consequences of the Situation 2 Fact Pattern. Rev. Rul. 80-58 is the central IRS ruling that The consequences of the IRS view that the purports to state the law on rescission of contracts. transaction in situation 2 cannot be rescinded are quite This ruling deals with two situations. adverse to Seller. Since the parties are forced to separately account for the 1978 sale, and the 1979 1. Situation 1. Rescission Within Same Year. “repurchase” of the property, Seller must recognize In February 1978, Seller sold a tract of land to gain (assuming the property is appreciated) from the Buyer for cash. The contract required Seller, at the 1978 sale and Seller is viewed as repurchasing the request of Buyer, to accept reconveyance of the land property in 1979 (which of course would not be from Buyer if any time within 9 months of the sale, deductible to Seller). So Seller is harmed here because Buyer was unable to have the land rezoned for Buyer’s of the tax liability resulting from the 1978 sale. Buyer, business purposes. The IRS states in the ruling that if in contrast, is viewed as purchasing the property in there were a reconveyance under the contract, then 1978 and reselling it for the same price in 1979, which Seller and Buyer would be placed in the same positions would not result in any net tax liability to the Buyer. that they occupied prior to the sale. In October 1978, (The 1979 transaction would not result in any gain, Buyer determined that it wasn’t possible to have the unless the Buyer had depreciated the property, which land rezoned. As a result, the Buyer reconveyed the would mean that any gain recognized in 1979 would land back to Seller under the terms of the original equal the total depreciation deductions taken on the contract, in October 1978. The tract of land was property by Buyer before the 1979 sale. Thus, the net returned to Seller and Buyer received all of its money overall gain for both years together would be zero). back. 5. Revenue Ruling 80-58 Is Not Confined To 2. Analysis of Situation 1 – The Same-Year Rule. Rescissions Provided For In The Contract. In situation 1, the IRS holds that the sale of the The original contract of sale between the parties in land is disregarded, since the sale was rescinded in the Rev. Rul. 80-58 provided that Seller was obligated, at same taxable year in which it occurred and the the request of Buyer, to accept reconveyance of the taxpayers were placed in the same positions as they land if Buyer was unable to have the land rezoned for were before the original transaction was consummated. Buyer’s business purposes. Is the rescission doctrine In effect, the transaction is treated as if it never promulgated in Rev. Rul. 80-58 confined or limited to occurred to begin with. The IRS cites Penn v. situations where the original contract between the Robertson, 115 F.2d 167 (4th Cir. 1940) where a parties expressly provides for a rescission scenario? taxpayer was allowed to ignore compensation paid him The answer is “no,” based on the very broad language in 1931 under a stock benefit fund when the plan was in the ruling which does not focus on the original terms rescinded in the same year and the taxpayer returned of the contract. Consider the following language in the the benefits to his employer. In contrast, the court ruling: refused to allow the taxpayer to ignore compensation The legal concept of rescission refers to the paid him under the fund for 1930, since the rescission abrogation, canceling, or voiding of a contract that has of the plan and the return of the compensation in 1931 the effect of releasing the contracting parties from did not occur in the same taxable year as the original further obligations to each other and restoring the receipt of the compensation in 1930. parties to the relative positions that they would have occupied had no contract been made. A rescission may 3. Situation 2. Rescission Within Subsequent be effected by mutual agreement of the parties, by one Taxable Year. of the parties declaring a rescission of the contract In situation 2, the same facts exist except that the without the consent of the other if sufficient grounds contract provided that Buyer could rescind the contract exist, or by applying to the court for a decree of if Buyer was unable to obtain zoning within one year rescission. 1980-1 C.B. at 181-82.

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9

6. Not Necessary That Language Be Provided in the D. Recent Private Letter Rulings Allow Contract. Rescissions of Entity’s Tax Form, Rescinding This language strongly suggests that the rescission the Formation of C Corporations. does not have to be provided in the contract for the 1. Rescission of Conversion of Partnership into doctrine to apply because the reference to one of the Corporation (Private Letter Ruling) - Return to parties declaring rescission without the other party’s Partnership Tax Status. consent or the application to a court for rescission, In PLR 200613027 (December 16, 2005), an LLC, implies that the original contract itself did not provide taxed as a partnership, had been converted into a C for a rescission remedy. Thus, it seems clear that Rev. corporation by virtue of a statutory conversion under Rul. 80-58 allows parties, for any reason whatsoever, state law. (Although done through a statutory to extinguish a transaction by unwinding the conversion, this conversion was treated as a section transaction within the same taxable year in which is 351 transaction for tax purposes.) The conversion into occurred. This is true even if the intention behind the a C corporation was done in anticipation of an IPO of unwinding is compensatory in nature, as noted below. the new corporation’s stock. Unfortunately, after the conversion, the stock market went through a 7. Revenue Ruling 80-58 Is Not Confined To Sales “precipitous and unexpected” deterioration, which Of Property – Even The IRS Acknowledges This. meant the IPO was unattractive. The IRS allowed the The scope of Rev. Rul. 80-58 goes far beyond the corporation to convert back to a partnership in the actual facts of the ruling itself, which concerned the same taxable year in which the initial conversion into a sale of property, and allows other types of transactions corporation had occurred. Without the IRS blessings to qualify for the doctrine as well. Those transactions of the rescission, a disincorporation of this entity back are listed below. into a partnership would have resulted in a taxable liquidation, creating both corporate-level gain on the a. The Payment of Compensation May be assets distributed in liquidation and shareholder-level Rescinded. Revenue Ruling 80-58 cites Penn v. gain as well. Note that there had been redemptions of Robertson, 115 F.2d 167 (4th Cir. 1940), which the interests in the entity as a result of the death and concerned compensation received by a taxpayer separation from service of individuals in the taxpayer’s through a employer’s compensatory stock plan, where management team. In addition, there had been tax the 4th Circuit Court of Appeals applied the rescission distributions, made after the incorporation, to the doctrine to the part of the compensation which was owners of the business for the taxes incurred by them paid and then unwound during the same taxable year, while the entity was still a partnership (before the thus allowing the taxpayers to treat the compensation incorporation). as if it had never been paid to begin with. (In contrast, the court disallowed the rescission doctrine with a. Status Quo Requirement. One might argue that respect to compensation which straddled taxable years the redemptions of interests in the entity, and the tax before being unwound.) Thus, in embracing Penn v. distributions made during the corporation’s existence, Robertson and citing it with approval in Rev. Rul. 80- prevented the parties from being restored to the status 58, the IRS clearly indicates that the rescission doctrine quo. However, the IRS reasoned that the parties were goes beyond sales contracts. Other cases have reached restored to the “same relative positions they would similar conclusions regarding compensation, i.e., if have occupied” had the corporation never occurred. In compensation is rescinded in the same year, it may be other words, the redemptions, and the tax distributions ignored for tax purposes. Clark v. Commissioner, 11 would have occurred even if the corporation had never T.C. 672 (1948) (employee returns 1942 salary in same existed. Therefore, the fact that these transactions year by giving promissory note to employer – not occurred should not be viewed as an impediment to included in employee’s income); Fulton v. rescinding the transaction and restoring parties to the Commissioner, 11 B.T.A. 641 (1928); Russel v. status quo. In other words, the “status quo” does not Commissioner, 35 B.T.A. 602, 604 (1937) (and cases mean the same position that the parties were in before cited therein). Hill v. Commissioner, 3 B.T.A. 761 the first transaction was done. Instead, it means the (1926); Couch v. Commissioner, 1 B.T.A. 103 (1924). 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.

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 b. Distributions Were Not Repaid. The tax 2. Rescission of Conversion of S Corporation into C distributions made to the parties were not repaid here, Corporation (Private Letter Ruling) - Return to S on the grounds that the tax distributions would have Corporation Tax Status. been made had the entity always remained a In PLR 200533002 (April 28, 2005), an S corporation, partnership. Contrast this with Rev. Rul. 78-119, after negotiations with a venture capital fund, decided 1978-1 C.B. 277 where the parties attempted to rescind to allow the venture capital fund to make an investment a stock transfer agreement which was a type B in the S corporation. (Note that this venture capital reorganization because the shareholder of the target fund was comprised of partnerships, which could not retained dividends that were distributed to the own stock in an S corporation.) To allow for this shareholder from the new corporate parent of the target investment, the S corporation issued preferred stock to during the interim period of the parent’s ownership of three partnerships controlled by the venture capital target. These dividends were not returned. (The fund. This terminated the S election and turned the argument that these distributions could have been made corporation into a C corporation on the date of the sale, anyway would not work in Rev. Rul. 78-119, since if since now the corporation had two classes of stock, and the transaction was rescinded, the shareholder also had partnerships as shareholders, each of which is receiving the dividends would not have owned the prohibited for S status under Code § 1361. A parent corporation stock which paid the dividend, and disagreement arose between the parties, and, in the thus could not say that the dividends would have been same taxable year, the preferred stock was redeemed paid anyway.) for the amount originally paid for the preferred stock. The IRS favorably ruled that the transaction could be c. Material Restoration of Positions. The parties rescinded for tax purposes, and that the S corporation also represented to the IRS that the effect of the would be treated as having remained an S corporation rescission was to “cause the legal and financial for the entire taxable year. arrangements between the owners and the taxpayer (the entity) to be identical in all material respects,” from the a. No Dividends Paid on the Preferred Stock. The date before of the conversion to a corporation to what corporation paid no dividends on the preferred stock would have existed had the conversion not occurred. while it was outstanding, which was undoubtedly an Note that this allows for the fact that there were important fact allowing to parties to satisfy the IRS that business operations inside the entity during this period, the status quo requirement was met. such as purchase and sales of assets, the payment of compensation to employees, and other business b. Redemption Price for Preferred Stock was Exactly operations. The existence of these operations did not Equal to Issue Price. Under the private letter ruling, prevent the rescission from taking place, since those the amount paid to redeem the preferred stock was business operations were not being rescinded. What exactly equal to the amount the preferred stock was was being rescinded was the transaction between the initially issued for, thus ignoring any appreciation in owner and the entity - not the transactions occurring the value of the stock, as well as time value of money inside the entity during this period of time. 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, c. Shareholders Report S Corporation Income for if the transaction were rescinded, they would file tax Entire Period. As a result of the ruling, the original returns as if the entity had been a partnership all along shareholders of the S corporation agreed to report the (and never a corporation). That means, for example, income from the S corporation for the entire year, as if that the owners would receive K-1’s from the the S corporation had never sold preferred stock to the partnership for the entire period in question, and the investors. owners would report all of the redemptions and distributions as if they had been made by a partnership E. Other Rulings Dealing with Rescission. to its partners (and not a corporation to its 1. Revenue Ruling 74-501 Allows A Corporate shareholders). Note that this could result, for example, Distribution of Stock Appreciation Rights To Be in a portion of the redemption proceeds being taxed as Rescinded. ordinary income under the hot asset rules of Code § In Rev. Rul. 74-501 (cited with approval by the 751, instead of it being all capital gains which it would IRS in Rev. Rul. 80-58) the IRS held that a have been had there been a complete redemption of corporation could rescind the issuance of subscription corporate stock. rights to purchase its stock, even though at the time of the issuance the rights exceeded 15 percent of the

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 common stock’s value and thus under section 307(b) termination and the rescission occurred in the same required an adjustment in basis. By unwinding the taxable year, and the parties were restored to the same transaction in the same year, the transaction could be economic position, the rescission of the termination ignored. Thus, Rev. Rul. 74-501 stands for the was effective. Rev. Rul. 80-58 cited as authority for proposition that corporate distributions to shareholders, holding. at least in some situations, may be ignored for tax purposes if they are rescinded in the same year. F. Stock Options & Other Compensatory Rescissions Are Likely Protected Under 2. Private Letter Ruling Allows Section 351 Revenue Ruling 80-58. Contribution of Stock To Another Corporation To The scope of Rev. Rul. 80-58 is quite broad, Be Rescinded. allowing rescissions to occur, even for compensatory In PLR 9829044 (April 21, 1998), the IRS held purposes, without triggering recognition of taxable that taxpayers could rescind the contribution of S gain if the rescissions occur within the same taxable corporation stock to another S corporation when the year. Because of the special importance of rescission taxpayers discovered that their contribution could have of non-qualified stock options, this particular issue is undesirable tax consequences and unwound the discussed in detail below. transaction in the same year. The IRS cited Rev. Rul. 80-58 and held that they could completely ignore the 1. Stock Option Example. transaction, since the transaction had been unwound in Assume that Executive receives a non-qualified the same taxable year. stock option from Employer allowing Executive to purchase stock of Employer for $10. In Year 1 3. Private Letter Ruling Allows Compensatory Executive exercises the option and pays $10 per share Transfers of Stock, And Section 83(b) Elections, when the stock is worth $100. Under normal tax rules, To Be Revoked. this would result in $90 of ordinary income to In PLR 9104039 (October 31, 1990) a corporation Executive and a $90 deduction to Employer. Assume, made compensatory transfers of stock to employees, however, that the stock’s value plummets to $1 per who made section 83(b) elections. Subsequent to the share, and the parties agree to unwind the transaction transfers but within the same year, the corporation with Executive giving back the stock and receiving the discovered that the “book” financial accounting for the $10 per share originally paid. transfers would result in a much larger compensation expense, decreasing earnings, and so the transactions 2. Results if Rescission Occurs Within Same Year. were rescinded. The IRS cited Rev. Rul. 80-58 and Assume that the parties rescind the transaction in said the transactions would be ignored. the same year that Executive initially purchased the stock. Since the rescission occurred in the same year, 4. Private Letter Ruling Allows Distributions of the parties may ignore these transactions and treat them Earnings and Profits By S Corporation To Be as if they had never occurred. Thus, Executive Rescinded. recognizes no income, and Employer has no deduction In PLR 9312027 (March 26, 1993) an S for tax purposes. This is an astoundingly generous corporation made a special distribution where it elected result which ignores the fact that the Executive has to have the distribution treated as Subchapter C received compensation – in effect, the Executive was earnings and profits first, as opposed to first coming given both a bargain option to “call” or purchase the out of the accumulated adjustment account. There was stock as well as a bargain option to “put” or sell the a change in the tax law regarding the definition of stock, without triggering any income whatsoever. The passive income for S corporations resulting in the generous results offered by the ruling can be illustrated distribution being unnecessary. The IRS allowed the by what occurs if the rescission does not occur within shareholders to effectively rescind this dividend to the the same taxable year. extent that it was repaid back in the same taxable year. 3. Results if Rescission Does Not Occur Within 5. Private Letter Ruling Allows Rescission of Same Year. Attempted Termination of Sale/Leaseback Assume that Executive purchases the stock for Transaction. $10 in Year 1, and in Year 2 the parties agree to In PLR 9141038 (July 15, 1991) a corporation rescind the transaction with Executive giving the stock sent a letter to its counterparty terminating an aircraft back to Employer and receiving the initial payment of sale/leaseback it had entered into. The attempted $10 per share. If the IRS is correct that this transaction termination was rescinded 8 days later. Since the may not be ignored for tax purposes, then the

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 following results occur: Executive recognizes $90 of taxpayer had no such borrowings before the transaction ordinary income in Year 1 from purchasing stock had occurred. Thus, both parties flunked the status quo worth $100 for $10 - Employer has $90 compensation requirement that was necessary for the rescission deduction. In Year 2, Executive recognizes $9 doctrine to take place. Finally, the court holds that the ordinary income from selling property worth $1 for mere filing of a suit was not sufficient to postpone the $10 to Employer – Employer has $9 of compensation recognition of gain. expense. In addition, when Executive sells back the stock for $1 ($10 is the nominal sales price but $9 of 2. Sales of Publicly Traded Property Into The that is compensation), Executive recognizes a $99 Market Won’t Qualify as Rescissions. capital loss. Thus, over the course of two years, The requirement that both sides of the transaction Executive recognizes $99 of ordinary income and has a be restored to the status quo suggests, as held by the capital loss of $99, and Employer has a total of $99 in Hutcheson case discussed immediately above, that a compensation expense. For Executive, this is a terrible taxpayer which sells publicly traded property into the outcome. market can never qualify under the doctrine, since it is quite unlikely that the other side can be restored to G. The Status Quo Requirement. status quo if the transaction is unwound. One has to The requirement that both parties be restored to ask why, as a matter of logic, one taxpayer’s treatment the status quo can be illustrated by Hutcheson v. of the transaction should be affected by the other side’s Commissioner, 71 T.C.M. 2425 (1996). In Hutcheson, treatment. Nevertheless, since the concept of an individual owned a substantial amount of WalMart rescission implies an unwinding of the transaction stock. In 1989, the taxpayer called his Merrill Lynch between the two parties, it seems that both parties have agent and told her to sell “100,000” of Walmart stock. to be participating in the unwinding for it to be treated The taxpayer meant that his agent should sell enough as a rescission, although the policy reason for such a stock to generate $100,000 of sales proceeds, or around requirement seems lacking. 3,400 shares. The Merrill Lynch agent thought the taxpayer meant sell 100,000 shares of Walmart stock, 3. Court Cites to Hutcheson in Bankruptcy Dispute, which she did for over $3 million, thus triggering a Applying Tax Rescission Doctrine. huge amount of taxable gain. (The taxpayer’s basis in For an interesting bankruptcy decision relying on each shares was 11 cents – each share’s fair market Hutcheson and the rescission doctrine in resolving a value was around $30. Recall also in 1989 that there dispute among private parties, see In re Trico Marine was no preferential rate for capital gains.) In attempt Services, Inc, 343 B.R. 68 (Bkrtcy. S.D.N.Y., May to avoid paying taxes on all of this gain, the taxpayer 2006). In this decision, a bankruptcy judge rejected repurchased shares of Walmart stock at the end of the arguments that a bankruptcy reorganization could be same taxable year as the original sale, and filed a rescinded (in a manner that would preserve certain tax formal arbitration claim with Merrill Lynch. The benefits) by noting that the reorganization had involved taxpayer argued that he has meant the requirements for the distribution of stock into the public markets, and a unilateral rescission under the law, and therefore he under the authority of Hutcheson, the reorganization was able to avoid the taxable gain from the sale. could therefore not be rescinded for tax purposes.

1. Court Rejects Rescission Argument Because H. What If the Parties Recognize the Transaction Status Quo Was Not Restored. In Different Taxable Years? The court rejected this argument because neither What result occurs under the tax laws if both he nor the original buyer of the shares was restored to parties unwind the transaction, but the parties have the same position occupied before the sale. Since the different taxable years, resulting in one of the parties taxpayer sold the Walmart stock into the public market, qualifying under the same-year rule and the other party he was not able to repurchase the shares from the same not qualifying under that rule? Three possible results person(s) who had originally purchased the stock. may occur: both parties may flunk the rescission rules, Thus, the buyer(s) of the stock was not restored to the only the party failing the same-year requirement may same position as before the original transaction, which flunk the rules, or both parties may qualify under the by itself presumably would be fatal to the taxpayer in rescission rules. Although the authority underlying qualifying under the rescission doctrine. Moreover, the this conclusion is scanty, as discussed below it seems court also noted that the taxpayer himself was not that the party which meets the one-year rule will restored to the status quo position, since the taxpayer qualify under the doctrine, while the party not meeting had to borrow money from his father in order to the one-year rule will not qualify and will have to purchase the shares at the end of the year, and the therefore account for each transaction separately. Note

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 that this is a perverse result, because it creates the employees to rescind the transaction for their own possibilities of whipsaw – one side to a transaction purposes, although presumably the taxable year of the may ignore the transaction altogether, while the other corporation would be relevant for its own rescission side has to take it into account for the earlier year, and treatment. recognize the rescission the following year, thus defeating the policy underlying the claim of right 3. What About Rescissions In Different Taxable doctrine. Years? Are there any exceptions to the same year rule? 1. The Fender Case And Different Taxable Years. That is, is it possible to rescind a transaction in a later In Fender Sales v. Commissioner, 22 T.C.M. 550 taxable year, and still treat the transaction as if it never (1963), a bonus was accrued by a calendar-year occurred even for the earlier taxable year in which it corporation in 1955, and paid to the employee in 1956. originated? There are some exceptions to the same In both times, Mr. Fender (who apparently was the year rule, which may provide an ethical and practical founder of the Fender guitar) returned a portion of the basis upon which to report a transaction. These bonus to the corporation in the same calendar year in exceptions may be broken down into four categories: which he received it, even though the accrual-method (i) reformations under state law; (ii) the constructive corporation had accrued and deducted the bonus for the trust doctrine; (iii) corrections of “mistakes;” and (iv) previous taxable year. The IRS argued that the same- dicta from old decisions and some commentators year rule (which was phrased as an exception to the suggesting that the one-year rule may not be the law. claim of right doctrine) did not apply when the These exceptions are discussed in more detail below. corporation accrued the deduction in a year earlier than the inclusion of such amounts by a cash-method V. THE REFORMATION DOCTRINE. employee. The court, however, rejected this argument A. Description of Reformation Doctrine. and held that Mr. Fender was not taxed on bonuses When parties achieve “reformation” of a contract received and repaid during his same taxable year. or agreement, the process usually involves having a Thus, Mr. Fender qualified under the rescission court declare that the contract or agreement is to be doctrine for amounts that were unwound during his reformed or amended with the effective date of this same taxable year although such amounts took place in change typically being retroactive to the very inception a separate taxable year for the corporation. of the agreement. In addition, many reformations are Apparently, the corporation had to separately account achieved through a “nunc pro tunc” order which for the transactions, with the accrued bonus deduction purports to be retroactive in nature and which is being respected for the earlier year, and the amount typically issued by a state court upon request of the subsequently included in the corporation’s income for parties. Although the majority doctrine is to the the subsequent year. Thus, the Fender case stands for contrary, a minority doctrine provides that state court the proposition that the same-year rule applies only to reformations of arrangements may be retroactively the party seeking to qualify under the doctrine. For effective for federal tax purposes in some situations, similar facts, see Clark v. Commissioner, 11 T.C. 672 even though the reformations occur in a subsequent (1948) involving an accrual-method corporation and a year. (Note to reader – there is a separate doctrine, cash-method employee who returned the compensation which is adopted by even the majority of courts, that in the same taxable year and was allowed rescission correction of clerical errors by a court will be given treatment, even though the corporation had accrued the retroactive effect. Although, frequently these errors compensation for the previous year. may be corrected by a reformation, this doctrine is separately discussed below as the 3rd category of 2. More Guidance on the Different Year Problem - cases, since the scope of this 3rd category is more Private Letter Ruling Allows Compensatory narrow.) Transfers of Stock Elections To Be Rescinded if Unwound in Employees Taxable Year. B. The Majority Doctrine – The IRS Is Not Bound In PLR 9104039 (October 31, 1990) a corporation By Retroactive Reformations. made compensatory transfers of stock to employees, Under the majority doctrine which is adopted by who made section 83(b) elections. The transactions most courts, the IRS is not bound by court-ordered were rescinded with the IRS blessing the rescission reformations that purport to be retroactive in nature, under Rev. Rul. 80-58 by noting that it occurred even though the retroactive application of the within the same taxable year of the employees. The reformation order may be binding on the private parties implication of the ruling is that the taxable year of the involved. The rationale for this doctrine is that corporate employer is not relevant to the ability of the otherwise the IRS would be vulnerable to collusive

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 state-court actions where private parties might Flitcroft, discussed below, to the extent it requires the persuade a court to change an agreement or contract for IRS to give retroactive effect to a reformation. tax motivated reasons, without the IRS having any involvement in the process. Thus, most courts provide b. Hayes v. Commissioner, 101 T.C. 593 (1993). A that, for federal income tax purposes, a retroactive divorce decree entered into in 1986 created tax reformation that extends back to a previous year has no problems for the husband since it obligated him to effect for federal income tax purposes. purchase his wife’s stock and he lacked the funds to do so, forcing him into a constructive dividend situation if 1. The Leading Case Establishing the Majority he had his closely held corporation redeem the stock Doctrine. from his wife directly. The parties had the 1986 In Commissioner v. Estate of Bosch, 387 U.S. 456 agreement “corrected” by a nunc pro tunc order (1967), the Supreme Court dealt with the federal estate entered into by state court in 1987 which provided that laws and their interaction with state law. In one of the the wife was directly obligated to sell the stock back to cases decided under Bosch the issue was whether a the corporation. The Tax Court refused to follow the release by a wife of a general power of appointment nunc pro tunc order and held that the husband had turning the power into a special power was invalid, as dividend treatment in 1986, finding that the nunc pro the wife later claimed, under state law. (If the release tunc order was invalid and contrary to Ohio law since was invalid, then she would have had a general power it was more than just the correction of a error in of appointment which would have qualified her for the recording the judgment. marital deduction with respect to her husband’s estate.) The Supreme Court held that the IRS was not obligated c. American Nurseryman Publishing Co. v. to follow the decision of a lower state court which Commissioner, 75 T.C. 271 (Nov. 17, 1980). In 1975, found in favor of the taxpayer by holding that the shareholder of an S corporation transfers her stock to a release was invalid. Instead, the court held that where grantor trust. (This was before grantor trusts were the IRS was not made a party to the state proceedings, eligible S corporation shareholders). This mistake is the findings of a state trial court was not conclusive discovered in 1976, by the shareholder’s executor, and and binding on the application of a federal statue (here the private parties persuade a state circuit court to order the computation of the federal estate tax). Thus, that her 1975 transfer was void, in order to preserve the federal authorities only must give proper regard to the S election for the corporation. The Tax Court holds for relevant rulings of lower state courts (and not blind IRS by not following the state court’s determination - obedience), in situations where the highest court of the thus the corporation was taxed as a C corporation after state has not spoken on a matter. Note that this case the 1975 transfer. did not say that the IRS could not defer to the lower state court’s ruling – the case simply said that the IRS d. Emerson Institute v. U.S. 356 F.2d 824 (D.C. Cir. was not conclusively bound by the findings of the state 1966). IRS succeeds in avoiding state court order court. The IRS has arguably misinterpreted this case which retroactively held that certificate of corporate by claiming that it is not supposed to follow these state dissolution and agreement of partnership was void. As court decisions where they purport to have retroactive a result of IRS victory, individual was subject to tax in effect. prior year as a consequence of the certificate of dissolution. Court holds that nunc pro tunc 2. Representative Cases Following The Majority proceedings in which the IRS is not a party are not Doctrine. retroactively binding on third parties – instead, state For cases following the majority doctrine see the court order is effective only from the date it is issued. following items set forth below: e. Piel v. Commissioner, 340 F.2d 887 (2d Cir. a. Revenue Ruling 93-79, 1993-2 C.B. 269. IRS 1965). Court refuses to apply a 1961 nunc pro tunc states that a 1993 state court order reforming a trust amendment of a Nevada divorce decree that would instrument retroactively to 1991, thus making a trust have rechacterized a 1957 transfer by the husband to eligible to be an S corporation shareholder, will not be allow him an alimony deduction for the year in respected. IRS flatly states that “retroactive changes of question; the legal effects of a transaction through judicial nullification or judicial reformation of a document do C. The Minority Doctrine Which Respects not have retroactive effect for federal tax purposes.” Retroactive Reformations. See the ruling for additional cites to cases supporting There is, however, a minority line of cases which this doctrine. The IRS expressly declines to follow provide that in some situations, retroactive state court

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 reformations will be respected for federal income tax 4. Spiva v. Commissioner. purposes. Note that the IRS is hostile to this doctrine In Spiva v. Commissioner, 43 B.T.A. 1174 (1941) (as announced in Revenue Ruling 93-79, 1993-2 C.B. a Missouri state court decision was held to provide 269) and thus a taxpayer who takes such a position retroactive effect regarding the irrevocable nature of may become embroiled in a dispute with the Service. trusts for federal tax purposes, contrary to IRS Nevertheless, depending on the facts, if the reformation arguments. is structured properly, in some situations the taxpayer position may be strong enough so that it meets the D. The Correction of Mistake Doctrine. ethical requirements applicable to tax practitioners, as Another theory that allows taxpayers to achieve well as meeting the substantial authority rules. retroactive rescissions for tax purposes, even though not satisfying the same-year rule, is that a mistake was 1. The Flitcroft Decision. made in the earlier year and all that is happening in the In Flitcroft v. Commissioner, 328 F.2d 449 (9th subsequent year is that the mistake is being corrected Cir. 1964), a California court ordered trust instruments or that the original intent of the parties is being to be reformed retroactively, so that the trusts were effected. treated as irrevocable from their original inception and thus produced the desired federal tax consequences of 1. Correction of Divorce Decree - Johnson v. shifting the trust income away from the grantors. The Commissioner, 45 T.C. 530 (1966). IRS took its customary position that it was not bound In 1956 the taxpayer was divorced from her by the retroactive application of the state order. husband, with the divorce decree providing that she However, the taxpayers had the IRS District Director was to be paid $75 per week for alimony and for child served with a complaint so he was a party defendant in support. (Because no amounts were allocated between the state court reformation hearings. Moreover, the two categories, this would cause the entire amount although the IRS succeeded in getting the action to be taxed as alimony.) In 1964, the IRS contended against the District Director dismissed, the IRS was that the taxpayer had received alimony, and later in still aware of the state court proceedings. The 9th 1964 the Circuit Court of Cook County entered an Circuit refused to find that the state court judgment order saying that the petitioner waived alimony rights was collusive, and held that the state court order was to at trial, and because of a clerical error this was omitted be respected, retroactively, for tax purposes, thus from the decree. The court retroactively amended the producing a victory for the taxpayer. divorce decree to correct this error. The Tax Court held for the taxpayer here, and respected the retroactive 2. Practice Point. nature of the reformation, on the grounds that it made A critical point, in the author’s view, regarding the decree conform to the original intention of the this case is that the IRS was served with notice of the parties at the time the decree was entered. state court proceedings. Keeping the IRS fully informed of the proceedings, and attempting to have 2. Correction of Section 83(b) Election - Private the IRS joined as a party defendant is very important to Letter Ruling 9240018 (July 2, 1992). avoid the charge that the lawsuit is collusive. Thus, if In this private letter ruling the IRS blessed a parties intend to take the position that a state ordered retroactive modification of a section 83 election, when reformation is retroactively binding for tax purposes, the parties transferred more shares of stock than they should make every effort to have the IRS involved intended in a compensatory transfer to an employee. in the process from “day one” in order to avoid the The IRS held that this was a correction of the original charge that they have engaged in a collusive lawsuit election, and not a revocation of the election. with state authorities against the IRS. 3. IRS Itself Wins on Retroactive Application of 3. Miller v. Commissioner. Reformation Order - Newman v. Commissioner, In Miller v. Commissioner (T.C. Memo 1963- 68 T.C. 494 (1977). 215), a case cited with approval by the 9th Circuit in In this case involving a divorce, the divorce Flitcroft, the Tax Court gave retroactive effect to a decree initially entered into in 1967 provided for judgment by a Texas state court declaring a trust to be monthly payments to be made to the wife for her irrevocable. The Tax Court refused to agree with the support. However, technically, the payments were two IRS, without any evidence, that the state court was months short of lasting for a 10 year period, and under necessarily collusive, and found it important that the the tax law at that time, that meant they were not parties had invited the IRS to intervene or participate in alimony. The husband petitioned the state court the state court action. several years later in 1973 to issue a order nunc pro

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 tunc correcting the divorce decree so that the payments would be optimal, but usually the IRS will succeed in lasted the requisite 10 years in duration, and thus getting itself dropped as a defendant based on statutes would qualify as alimony. This was supposedly the protecting the IRS from state suits (e.g., the anti- intent of the court at the time of the original decree, injunction rules). i.e., to create alimony for tax purposes. The IRS itself argued for retroactive application of pro nunc tunc 2. Have The State Court Use the Words “Nunc Pro order that created taxable alimony. The Tax Court Tunc” In Its Order. agreed that the order was reflecting the original intent, The words “nunc pro tunc” basically mean and therefore should be retroactively respected, while retroactive, and under the law of most states, nunc pro distinguishing other cases where the order is actually tunc orders can be granted. It is important to persuade reflecting an intent originating only after the original the state court to use these magic words – their use will date and should not be respected retroactively not guarantee a taxpayer victory, but the failure to use them has resulted in a number of courts holding that 4. Other Cases Allowing Retroactive Corrections of the reformation was not to be given retroactive effect Error. for tax purposes, because it was not intended to be See Vargason v. Commissioner, 22 T.C. 100 retroactive by the state court. See, e.g., Hummel v. (1954) (divorce case where husband was ordered to Commissioner, 28 T.C. 1131 (1957) pay wife for her support – state court later held that this (“recommendation” and “confirmation” state court was a mistake and that the judge intended for the orders denied retroactive effect – they were not nunc husband to pay child support. Taxpayer wins and pro tunc orders); Turkoglu v. Commissioner, 36 T.C. decree was retroactively altered.) Sklar v. 552 (1961) (order was called a “modification,” not a Commissioner, 21 T.C. 349 (1953) (nunc pro tunc nunc pro tunc – IRS prevails in denying retroactive order was respected in favor of taxpayer on grounds effect to the order); Wilson v. Commissioner, 49 T.C. 1 that it corrected error). (1967) (failure to use a nunc pro tunc order results in the “amendment” having only prospective effect); 5. Caution – Tax Court Case Says That This Cothran v. Commissioner, 57 T.C. 296 (1971) (order Doctrine Only Applies to Correction of Clerical does not purport to cure mistake retroactively, so Errors, not Judicial Errors (at least in Kentucky). taxpayer loses). In Graham v. Commissioner, 79 T.C. 415 (1982) the court refused to honor a retroactive Kentucky state 3. Have the Court Correct An Error in Order to court nunc pro tunc order amending a divorce decree to Reflect Its Original Intent. provide that the payments made under the decree were Federal judges are suspicious of state courts using child support. The tax court refused to follow the state after-the-fact knowledge in reformations (even nunc court decree, holding that it was issued in violation of pro tunc orders) to manipulate earlier state court Kentucky law (the order corrected a judicial error, and decisions or orders in an effort to create favorable supposedly in Kentucky nunc pro tunc orders may only federal tax consequences. As a result, federal courts correct clerical errors). However, the court did say that may hold that these reformations do not have if the court had issued a genuine nunc pro tunc order retroactive effect, unless those courts are persuaded that corrected a decree which failed to reflect the true that the reformation reflects the original intent of the intention of the court, then the order would have been judge, and serves to clarify or correct an earlier decree given effect for federal income tax purposes. that did not reflect that intent. See the discussion of above regarding Johnson v. Commissioner, 45 T.C. E. Tax Planning With Reformation Proceedings. 530 (1966). So, it is important to use one’s best efforts Based on the foregoing analysis, how can a to persuade the state court to phrase its reformation in taxpayer maximize the chances of a reformation being terms of “correcting” the initial order or transaction in retroactive for federal income tax purposes? The order to reflect the original intent of the judge or the following steps should be taken: parties involved in the original transaction.

1. Keep the IRS Notified and Informed of the F. Strength of Reformation Argument – A Proceedings (Make the IRS a Party, if Possible). Reporting Position? As noted above in the discussion of Flitcroft v. If an clerical error is being corrected, then a Commissioner, 328 F.2d 449 (9th Cir. 1964), courts reformation of the document should clearly be look more favorably on a state law reformation if the provided retroactive effect. In situations where there is IRS was made aware of all the proceedings and invited more than just a clerical error which the parties are to participate. (If the IRS could be made a party that attempting to unwind, then if a taxpayer follows the

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 recommendations noted immediately above and federal tax-hand to suit their convenience.” Instead, attempts reformation of a document (such as a trust the repayment of the amounts back to the corporation instrument or divorce decree), then there is a good was a voluntary contribution to capital. chance that there is at least “substantial authority” for the taxpayer to take the position that the transaction b. The IRS also cites Staats v. Biograph Co., 236 F. will have retroactive effect for federal tax purposes. It 454 (2d. Cir. 1916) in the FSA, although that case dealt is unclear, in the author’s view, as to whether the tax with the repayment of dividends in a year subsequent position here would be “more likely than not” to to the year of receipt, and is thus not on point, prevail on the merits if challenged, which would be notwithstanding the court’s comments there that important for the financial reportiong rules under FIN dividends could not be rescinded. 48, which requires a more likely than not standard of support. c. Finally, the lower court in Estate of Lloyd Crellin cited United States v. Southwestern Portland Cement G. When Will the Same-Year Rule the Rescission Co., 97 F.2d 413 (9th Cir. 1938) as setting forth the Doctrine Not Protect A Taxpayer? proposition that dividends cannot be rescinded (having 1. The IRS Apparently Contends that Most once been declared) because a debtor cannot rescind its Dividends May Not Be Rescinded! debt. Surprisingly, the IRS seems to believe that the rescission doctrine does not apply to dividends paid to 3. Criticism of the IRS Position. shareholders, even though the dividends may be The IRS position here seems wrong and unwound in the same year by the shareholders inconsistent with more recent developments, including returning them to the corporation. The IRS claims that Rev. Rul. 80-58. At the very least, it appears that the rescission doctrine does not apply when the taxpayers have a reporting position (substantial repayment of the dividends to the corporation is authority) in maintaining that dividends may be “voluntary.” Rather, according to the IRS, the doctrine rescinded (and therefore ignored) if repaid in the same only applies when the shareholder is legally obligated year, and tax practitioners seem to be on strong ethical to return the dividends to the corporation. The IRS has grounds in recommending such positions to clients. set forth this position in Field Service Advice There are several arguments in favor of this Memorandum (“FSA”) 200124008 (March 14, 2001). conclusion, set forth below. See also Rev. Rul. 75-375, 1975-2 C.B. 266 (voluntary payment of previous year’s dividend by shareholders a. Revenue Ruling 80-58’s Language Does Not did not alter the consequences of the previous year’s Exclude Dividends. The language of Rev. Rul. 80-58 is dividend – note however that the “rescission” here quite broad, and refers to the “abrogation, canceling, or occurred in the subsequent year). The author believes voiding of a contract” that “may be effected by mutual that this IRS position is incorrect, and that the agreement of the parties.” Certainly, if shareholders rescission doctrine is available for dividends as well as and the corporation agree to cancel or void a dividend for other transactions. The authority for the IRS by repaying it in the same year, there is nothing to position is discussed, and then critiqued, below. 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 b. Revenue Ruling 74-501 Applies The Rescission be rescinded, although the law is quite old. Doctrine to Corporate Distributions. As previously noted, Rev. Rul. 74-501 applies the rescission doctrine a. In Estate of Lloyd Crellin v. Commissioner, 203 to corporate distributions, by providing that when a F.2d 812 (9th Cir. 1953) (cited as authority in the FSA corporation issued rights to purchase its stock, that above) dividends were paid in the mistaken belief that issuance might be disregarded by the taxpayer if it was a personal holding company tax would otherwise be rescinded. Although the distribution in the revenue incurred by the corporation. Upon discovering that no ruling might not technically be a dividend, by applying such tax would apply, the shareholders willingly repaid the rescission doctrine to corporate distributions, the the dividends paid in the same year. The court held ruling suggests that dividends would be included under that the dividend repayment back to the corporation the doctrine as well. See also Private Letter Ruling was not mandatory, and that the original payment of 9312027 (March 26, 1993) (S corporation dividend of dividends was not invalid – only a mistake had been earnings and profits to shareholders is allowed to be made. Therefore, the dividend was not viewed as rescinded). rescinded, because otherwise taxpayers could “lift the

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 c. The Authorities Suggesting That Dividends I. The Same-Year Rule May Not Allow Cannot Be Rescinded Have Been Misinterpreted. The Taxpayers To Avoid Form Over Substance Tax Court in Estate of Lloyd Crellin improperly Arguments if the Rescission is not “Clean.” focused on precedent holding that dividends, once As noted by other commentators, the same-year having been paid, could not be rescinded by the rule may not allow taxpayers to rescind agreements corporation without the consent of the stockholders. 17 made in the same year, and then enter into other T.C. at 784-785. But if the shareholders consent to the agreements, with the prior agreement being ignored in rescission, then those authorities do not apply, and it determining the tax consequences of the structure. seems that dividends could therefore be rescinded by Banoff, “Unwinding or Rescinding A Transaction: mutual consent. Moreover, the IRS, in the FSA, Good Tax Planning or Tax Fraud?” Taxes 942, 948-49 incorrectly focused on only the claim of right doctrine, (December, 1984). A classic case of this is the famous and the exception to the doctrine when amounts are case of Court Holding Co. v. Commissioner, 324 U.S. received subject to a liability to repay. The IRS did not 331 (1945). In this case, a corporation agreed to sell even acknowledge the rescission doctrine, which also assets to a third party, and then at the last minute that trumps the claim of right doctrine when the transaction contract was rescinded and the shareholder of the is unwound in the same year. Thus, the IRS analysis corporation agreed to sell the assets to the same third and logic in the FSA is faulty since it is incomplete and party (after receiving them as a distribution from the excludes a major line of authority providing an corporation). The Supreme Court held that, in additional exception to the claim of right doctrine. substance, the corporation was still the seller of the assets for tax purposes. Thus, the corporation d. Private Letter Ruling Allows Distributions of recognized the gain from the sale notwithstanding the Earnings and Profits By S Corporation To Be last minute changes to the agreement. Rescinded. As previously noted, in PLR 9312027 (March 26, 1993) an S corporation was allowed to J. The Rescission Doctrine Can’t Be Used If the rescind a special distribution where it elected to have Agreement is to Not Return to the Status Quo. the distribution treated as Subchapter C earnings and A “clean” rescission, where the transaction is profits first, as opposed to first coming out of the unwound and no other related transactions take place, accumulated adjustment account. This was an example should be safe from scrutiny under this doctrine. of the IRS, in effect, blessing the rescission of a However, a rescission accompanied by another dividend for tax purposes, although admittedly it was a transaction could easily be attacked as not being a true special kind of dividend provided for under the rules rescission, since the parties were not genuinely for S corporations. reverted to the status quo. Taxpayers should be aware of this and sensitive to how the overall transaction H. The IRS May Contend that the Issuance of appears to outsiders when rescinding contracts and Debt Cannot Be Rescinded then shortly thereafter engaging in other transactions As noted above, the lower court in Estate of Lloyd that relate to the transaction previously rescinded. Crellin cited United States v. Southwestern Portland Cement Co., 97 F.2d 413 (9th Cir. 1938) as setting VI. REQUESTING “9100 RELIEF” UNDER forth the proposition that dividends cannot be TREASURY REG. SECTIONS 301.9100-1 rescinded because a debtor cannot rescind its debt. THROUGH 301.9100-3 (That case, however, only dealt with a fact pattern A. Introduction. where a corporation might unilaterally attempt to Assume that your client failed to make a tax rescind its debt – the transaction in that case was not a election by the due date for the election. Are you out rescission where all parties involved agreed to unwind of luck? What options does your client have? The the transaction, which would be the actual fact pattern good news is that your client may be able to obtain under Rev. Rul. 80-58.) Although it is not clear, it is “9100 relief” under Treas. Reg. § 301.9100. The bad possible that the IRS could use this argument to news is, unless you fall under the rules for “automatic” contend that debt instruments cannot be rescinded for 9100 relief, that the taxpayer is required to get a private tax purposes, even though the rescission takes place in letter ruling from the IRS (which requires payment of a the same taxable year as the issuance. In the author’s user fee) as a condition of getting 9100 relief. view, such a position would be incorrect. Nothing in Rev. Rul. 80-58 suggests that its provisions do not B. Definition of Election. apply to debt instruments. Therefore, debt instruments Another bit of good news is that the term should eligible for rescission if the rescission occurs in “election” for which 9100 relief is available, is defined the same taxable year as the debt was originally issued. more broadly than what most taxpayers would think.

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The term is defined as “an application for relief in taxpayer had obtained a six-month extension of time to respect of tax, a request to adopt, change, or retain an file the return (so that the return would be due on accounting method or accounting period.” Treas. Reg. September 15, 2007, with extensions), then the § 301.9100-1(b). However, the term “election” does taxpayer would filed an amended return by September not include an application for an extension of time to 15, 2008 (12 months from the September 15, 2007 file a return. extended due date of the return).

C. Automatic Extensions - 9100 Relief. c. What Elections Are Covered? The automatic 12- Automatic six and twelve month extensions are month extension only applies to regulatory elections available under the existing Treasury regulations, under the following sections: meaning that the taxpayer does not have to get a private letter ruling to receive an extension or pay user (1) Section 444 (the election to use a taxable fees to request such a ruling. These are only available year other the required year); if the taxpayer takes corrective action during the (2) Section 472 (the election to use the LIFO extension period. inventory method); (3) Sections 505 and 508 (requirement that 1. The Automatic 12-Month Extension For certain types of tax-exempt organizations Regulatory Elections. notify the IRS of their claims for tax- An automatic 12-month extension is available for exemption within 15 months of their certain regulatory elections. A regulatory election is operations and file exemption applications “an election whose due date is prescribed by a under Sections 501(c)(9), 501(c)(17), regulation published in the Federal Register, or a 501(c)(20), and 501(c)(3)); revenue ruling, revenue procedure, notice, or (4) Section 528 (the election to be treated as announcement published in the Internal Revenue homeowners association); Bulletin.” In other words, a regulatory election is not (5) Section 754 (the election to make adjustment provided in the Internal Revenue Code itself - an of basis on partnership transfers and election provided in the Code is a “statutory” election distributions); and is not eligible for the automatic 12-month (6) Section 2032A(d)(1) (the election to extension - only for the 6-month extension discussed specially value qualified real property - later in this outline. where the IRS has not yet begun an examination of the filed return); and a. What Does the Automatic 12-Month Extension (7) Sections 2701(c)(3)(C)(i) and (ii) (chapter 14 Mean? This is an automatic (i.e., no private letter gift tax elections regarding qualified ruling required) extension of 12 months from the due payments in the case of transfers of interests date for making an regulatory election. For a taxpayer in corporate stock or partnerships). who has not extended the due date of the return, the due date for making an election (remember, the d. Additional Procedures To Be Filed Under 12- deadline granted under this regulation is 12 months Month Extension. In order to take advantage of the 12- past this date) is the due date of the return. For Month Extension, “corrective action” is required to be taxpayers who have obtained extensions of time to file taken. the return, the due date for making an election is the due date of the return including extensions (again, the (1) Corrective Action. Corrective action means deadline under this regulation is 12 months past this taking the necessary steps to file the election in date). This extension is available regardless of whether accordance with the statute, regulation or other the taxpayer timely filed its return for the year the published ruling. For elections required to be filed election should have been made. with a return, it includes filing an original or amended return for the year the election should have been made b. Examples of Due Dates and 12-Month and attaching the appropriate election documentation. Extensions. A taxpayer files its return on March 15, The IRS may invalidate the election if the return is 2007 its due date, and fails to make an election. The filed in a manner inconsistent with the election or if the election is required to be made with the return. taxpayer has not complied with all other requirements Assuming that the election is the type listed in the 12- for making the election for the year the election should month categories, then the taxpayer may file an have been made and all affected years. amended return by March 15, 2008, 12 months from the March 15 due date of the return. If, instead, the

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(2) Procedure. The document filed to obtain an good faith of the taxpayer and the conclusion that the automatic extension must contain the statement extension of the election deadline will not prejudice the “FILED PURSUANT TO § 301.9100-2” at the top and interests of the government, need to be made before the must be sent to the same address the filing to make the IRS will grant this extension. Extensions may not be election would have been made if it had been timely. granted under certain subtitles of the Code (excise A ruling request is not required for an automatic taxes, Joint Committee on Taxation, presidential extension. campaigns, and trust funds). Finally, these general rules do not apply for elections which are expressly 2. The 6-Month Automatic Extension For and excepted for relief, or where alternative relief is Statutory Regulatory Elections. available from a statute, a regulation, or other An automatic 6 month extension is available for published rulings. Treas. Reg. § 301.9100-1. certain regulatory or statutory elections. 1. Example of 6-Month Extension for Mark-to- a. What Does the Automatic 6-Month Extension Market Election. Mean? This is an automatic 6-month extension A trader in securities may make a election to use a granted for either regulatory or statutory elections mark-to-market method of accounting with respect to whose due dates are the due date of the return or the its securities under Code § 475(f). That election for a due date of the return including extensions. The current year must be made by April 15 of that current extension is for 6 months from the due date of a return year. Under this general provision, a trader missing the excluding extensions. This 6-month extension is only election would have until October 15 of the current available if the return was timely filed for the year the year (6 months past the due date), to file a private letter election should have been made. (Note that the 12- ruling request for relief for the late election. Since this month extension did not require the timely filing of a general extension provision is not automatic, a private return.) (The 6-month extension does not apply to letter ruling must be received by the IRS in order to elections that must be made by the due date of the obtain relief and the taxpayer must pay a user fee to the return excluding extensions.) IRS in order to request this relief. b. Examples of Due Dates and 6-Month Extensions. 2. Examples of 9100 Relief Granted Since July 1, A taxpayer files its return on March 15, 2007, its due 2007. date, and fails to make an election. The election is required to be made with the return. The taxpayer may a. Qualified low-income housing project. (§ file an amended return by September 15, 2007, 6 42); months from the March 15 due date of the return. b. Posting of disposition bonds under §42(j)(6). (§ 42) c. The 6-Month Extension is Very Modest. This 6- c. Application for certification of historic month extension is not particularly generous - it seems status. (§ 47) mainly oriented towards taxpayers who file early and d. Election not to deduct additional first year fail to make an election that was required to be made depreciation. (§ 168) when they filed their return. It basically allows those e. Election to deduct qualified environmental taxpayers to file an amended return, making the remediation expenditures. (§ 198) election, no later than the time they initially had to file f. Furnish IRS notice of nonrecognition transfer the return if they had requested an extension of their required by 1.1445-5(b)(2)(ii) with respect to return. liquidation of taxpayer. (§ 332) g. Filing of a “§1.337(d)-2(c)” statement to d. Corrective Actions and Procedures are Required. recognize some or all of a loss upon the The same corrective actions and procedures are disposition of stock of a subsidiary. (§ 337) required for the 6-month extension as are required for h. Filing of 338(g) election. (§ 338) the 12-month extension. i. Furnish IRS notice of nonrecognition transfer required by Reg.§1.1445-2(d)(2). (§§ 368 & D. General 6 Month Extensions - Not Automatic. 897) The Commissioner may make a reasonable j. Election to restore value under Reg. §1.382- extension of time for an election, which cannot exceed 8(h). (§ 382) more than 6 months (unless the taxpayer is outside the k. Recharacterization of Roth IRAs as United States which might justify a longer election). traditional IRAs. (§ 408A) All of the requirements discussed below, including the

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l. File notice to be treated as operating kk. Election to treat a marital trust as 2 separate qualified separate lines of business. (§ 414) trusts. (§ 2652) m. Form 1128 to change annual accounting ll. Election to be classified as a disregarded period (Application to Adopt, Change, or entity. (§ 7701) Retain a Tax Year). (§ 442) mm. Entity classification election. (§ 7701) n. File form 3115, Application for Change in Accounting Method. (§ 446) 3. Taxpayers May Contest the Denial of 9100 Relief o. Relation back election under Reg. §1.468B- by the IRS in Court. 1(j)(2). (§ 468B) See L. S. Vines v. Commissioner, 126 T.C. 279 p. Election under §469(c)(7)(A) to treat all (2006), where a trader was denied mark-to-market interests as single activity. (§ 469) accounting on account of a late election, resulting in q. Mark to market method of accounting. (§ capital losses (not ordinary losses) on securities trades 475) he had made. (Had a mark-to-market election been r. Consent dividend elections. (§ 565) made, the losses would have been ordinary.) The s. Adjust basis of partnership property. (§ 754) trader was not aware of the ability to elect mark-to- t. Election under §856(c) to elect REIT status. market treatment and as a result failed to make the (§ 856) election by April 15 of the year in which the election u. Election described in 865(h)(2)(A) to treat was to be made (as noted above). The court found that gain from sale of stock in foreign companies the taxpayer should be allowed 9100 relief because he as foreign source income. (§ 865) acted reasonably and in good faith, and the interests of v. Time to furnish entities and IRS statements the government were not prejudiced by the granting of and notices required by Reg. §§ 1.897-2(g), such relief. 1.897-2(h), 1.1445-2(c)(3) and 1.1445- 5(b)(4)(iii). (§§ 897 & 1445) a. Facts. The taxpayer was an attorney who decided w. Election and shareholder consent statements to wind down his law practice after 34 years and start a required under Reg. § 1.921-1T(b)(1) and new career in securities trading. He used margin Reg. § 1.992-2(a)(l)(i) to be treated as borrowing as part of his securities trading strategy. In interest charge DISC. (§§ 921 & 992) the spring of 2000 he was forced to liquidate one of his x. Election to be treated as a domestic brokerage accounts due to a failure to cover a margin corporation for US tax purposes. call. He had substantial trading losses. The taxpayer’s y. S Corporation election. (§ 1362) long-time accountant helped him obtain an automatic z. QSub election. (§ 1362) extension of time to file his tax return, but did not aa. Election to file consolidated return. (§ 1502) enclose a § 475(f) election to mark to market and bb. Election under Reg. § 1.1502- obtain ordinary losses, or advise the taxpayer of the 21T(b)(3)(ii)(B) to relinquish, with respect to availability of such election. The taxpayer learned of all consolidated net operating losses such an election from a friend and discovered that the attributable to Parent and its subsidiaries, the election was required to be filed by the due date of his portion of the carryback period for which return, without extensions. The taxpayer filed for 9100 Parent and its subsidiaries were members of relief with the assistance of tax counsel. Relief was another consolidated group. (§ 1502) denied for “lack of unusual and compelling cc. Election to treat loss subgroup parent circumstance.” requirement as satisfied. (§ 1502) dd. Ratable allocation election. (§ 1502) b. Opinion. The Tax Court found: (i) no prejudice to ee. File elections and agreements under Reg. the Government; (ii) the taxpayer did not realize any §1.1503-2(g)(2)(i) with respect to dual gains or suffer any additional losses between the time consolidated losses. (§ 1503) the election should have been filed and the actual filing ff. Alternate valuation election. (§ 2032) of the election; and (iii) the taxpayer would not be gg. Allocation of generation-skipping transfer entitled to any more than he would have been entitled exemption. (§ 2032) had the election been timely filed (the purpose of 9100 hh. Partial Q-TIP election. (§ 2056) relief). The court concluded that the taxpayer was ii. Allocation of decedent’s available entitled to 9100 relief because he acted reasonably and generation-skipping transfer exemption. (§ in good faith with no prejudice to the interests of the 2642) Government. Thus, the taxpayer was permitted to the jj. Reverse QTIP election. (§ 2642) benefits of the § 475(f) election as if it has been timely filed.

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E. Other Examples of Alternative Relief. check-the-box filing. It avoids Treas. Reg. § In addition to 9100 relief, the Code and 301.9100-1 through 3, and the user fee requirements Regulations provide other examples of relief from late for getting a private letter ruling. However, taxpayers elections provided under provisions besides the general who are not eligible for relief under Rev. Proc. 2002- rules of Treas. Reg. § 301-9100. 59 can still request 9100 relief by requesting a letter ruling. 1. Late S Elections. Assume you form a corporation for a client, who F. Treas. Reg. § 301.9100-3: Other Extensions. tells you that it should be an S corporation. You Taxpayers who wish to receive an extension of believe that the accountants are going to file Form time for making regulatory elections which don’t 2553 by March 15 of the year, which is required to comply with the rules for automatic relief must come make the S election for the corporation. Unfortunately, under this provision of the regulations. (Note that only the accountants think you are going to file the Form by regulatory elections are covered under this provision - that date. As a result, the Form isn’t filed, which you statutory elections cannot be extended here.) The discover at the end of the taxable year. Do you have a taxpayer must provide evidence to establish that the C corporation now? Probably you can get relief for the taxpayer acted reasonably and in good faith, and that late S election. Code § 1362(b)(5) provided that the the grant of relief will not prejudice the interests of the IRS may grant relief from a late S election if it is Government. The taxpayer must obtain a private letter determined that there was reasonable cause for making ruling from the IRS and pay a user fee for requesting the late election. Reasonable cause is defined broadly, the ruling. and includes, for example, confusion among a taxpayer’s lawyers and accountants as to who was 1. Reasonable Action and Good Faith. supposed to file the necessary papers with the IRS. The reasonableness and good faith standards are Rev. Proc. 2003-43, 2003-1 C.B. 998 contains met if the taxpayer: extensive procedures for receiving automatic extensions allowing the filing of late S election. a. Requests relief prior to IRS discovery of the failure to make the regulatory election; 2. Late Check the Box Elections. b. Failed to make the election due to Assume your client owns a domestic LLC and intervening events beyond the taxpayer’s wishes the LLC to be taxed as a corporation. This control; requires an affirmative “check the box” election under c. Failed to make the election because, after those rules, since the “default” rule for a domestic LLC exercising reasonable diligence (accounting is that it is either a partnership (two or more owners) or for the taxpayer’s experience and complexity disregarded entity (one owner), and not a tax of the issue), the taxpayer was unaware of the corporation. Normally, the check the box election necessity for the election; must be made on Form 8832 no later than 75 days from d. Reasonably relied on the written advice of the date that you wish the election to go into effect. the IRS; or Treas. Reg. § 301.7701-3(c)(1). If your client was late e. Reasonably relied on a qualified tax in electing to treat the LLC as a corporation for tax professional who failed to make, or to advise purposes, Rev. Proc. 2002-15, 2002-1 C.B. 490, and the taxpayer to make, the election. If the Rev. Proc. 2002-59, 2002-2 C.B. 615, provide taxpayer knew or should have known that the automatic procedures for obtaining an extension of the professional was not competent to provide deadline for the filing. Eligibility for a late filing is advice regarding the regulatory election or available under these Revenue Procedures if the entity was unaware of all relevant information, (i) failed to obtain the desired classification solely reasonable reliance on a tax professional is because it did not timely file Form 8832; (ii) the due unavailable. date for the tax return of the entity’s default classification (excluding extensions) for the tax year 2. No Reasonable Action or Good Faith. beginning with the date of the entity’s formation did A taxpayer is deemed to have not acted not pass; and (iii) the entity had reasonable cause for reasonably or in good faith if the taxpayer: its failure to file Form 8832 timely. a. Seeks to alter a return position for which a 3. Check the Box Rules Supplement 9100 Relief. Section 6662 accuracy-related penalty has Rev. Proc. 2002-59 is intended to provide a more been or could be imposed at the time of the taxpayer-friendly way to obtain IRS approval of a late relief request and the new position requires

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or permits a regulatory election for which an impermissible method of accounting that is under relief is requested; examination, appeals, or a federal court and the change b. Chose not to file the election and was would provide a more favorable method or terms and informed, in all material respects, of the conditions than if the change were made as part of an required election and related tax examination or provides a more favorable method of consequences; or accounting or terms and conditions if the election is c. Uses hindsight in requesting relief. made by a certain date or taxable year. Hindsight means that specific facts have changed since the due date for making the e. Accounting Period Regulatory Election. The election that make the election advantageous interests of the Government are deemed to be to the taxpayer. Strong proof is required to prejudiced (except in unusual and compelling show that the decision to seek relief did not circumstances) if an election is an accounting period involve hindsight. regulatory election other than a Code § 444 election, and the request is filed more than 90 days after the due 3. No Prejudice to the Interests of the Government. date for filing the Form 1128. The Commissioner will grant a reasonable extension only when the interests of the Government 4. Extension of the Period of Limitations on will not be prejudiced by the relief. Assessment. A taxpayer waives any objection to a second a. Lower Tax Liability Than if Timely Election. If examination of the issues subject to the relief request granting the relief will result in a lower tax liability (in (and any correlative adjustments) if an extension of the aggregate) for all years affected by the election, time is granted. The period of limitations for than if a timely election had been made, the interests of assessment is not tolled upon the filing of a relief the Government are prejudiced. (Note that this does request and thus, the IRS may require the taxpayer to not provide that prejudice exists if the relief will reduce consent to an extension of the period of limitations for the taxpayers’ taxes --- instead, this only applies if the the year in which the regulatory election should have tax liability is lower than if a timely election had been been made (and any affected years). made.) The time value of money is taken into account in determining whether a lower tax liability results. 5. Procedure. Additionally, if more than one taxpayer’s A relief request is a request for a letter ruling and consequences are affected, the Government’s interests must be submitted in accordance with the letter ruling are prejudiced if granting the extension may result in requirements, including an applicable user fee. See those taxpayers (in the aggregate), having a lower tax Rev. Proc. 2007-1. liability than if the election had been timely. a. Taxpayer Affidavit. A detailed affidavit b. Closed Years. If the year in which the election describing the failure to make a timely election and the should have been made (or any years affected thereby) discovery of the failure must be submitted and signed is closed prior to receipt of a ruling granting relief, the by a person with personal knowledge of the facts and interests of the Government are prejudiced. circumstances. If a qualified professional was relied upon, the affidavit must describe the engagement and c. Independent Auditor. The IRS may condition responsibilities of that person and the extent of the relief on receiving a statement from an independent taxpayer’s reliance on them. The affidavit must auditor certifying that the interests of the Government include a penalty of perjury statement. are not prejudiced. b. Knowledgeable Person Affidavits. The taxpayer d. Accounting Method Regulatory Election. The must submit detailed affidavits from individuals interests of the Government are deemed to be possessing knowledge or information about the failure prejudiced (except in unusual and compelling to make a valid regulatory election and the discovery circumstances) if the accounting method regulatory of that failure. Included among these individuals are election requires advance written consent of the the taxpayer’s return preparer, any individual Commissioner or a Code § 481(a) adjustment (or such substantially contributing to the preparation of the an adjustment would be required if the change return, and any accountant or attorney, knowledgeable occurred in a later taxable year to the taxable year it in tax matters, who advised the taxpayer regarding the should have been made). Additionally, prejudice is election. The engagement and responsibilities of the deemed if such an election would permit a change from affiant, and any advice they provided to the taxpayer

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 must be included along with the individual’s name, including attaching an affidavit from Taxpayer’s current address, and taxpayer identification number of professional stating that the professional failed to the individual. Again, a penalties of perjury statement advise Taxpayer that the election was necessary. must be included. Because Taxpayer reasonably relied on a qualified professional and the professional failed to advise c. Other Information Required. The taxpayer must Taxpayer to make the election, Taxpayer is deemed to include additional information in the relief request such have acted reasonably and in good faith. Therefore, as whether the year the election should have been made Taxpayer may be eligible for relief from the late (or any affected years) is under examination by a election. Treas. Reg. § 301.9100-3(f)(Example 2). district director, appeals office or federal court. If an (Note that this example does not deal with the separate examination is commenced while the relief request is issue of whether granting relief will prejudice the pending, the taxpayer must notify the IRS office interest of the government, which could be a separate considering the request. The taxpayer must state when bar from actually obtaining relief here.) the applicable documentation for making the election was required to be filed and when it was actually filed. f. Example of Taxpayer Reporting in a Manner that Additionally, the taxpayer must provide copies of any Triggers the Accuracy Penalty - Taxpayer Has Failed documents referring to the election, and if requested, a to Act in Good Faith. Taxpayer reports income on its copy of the taxpayer’s return for any year for which the 2007 tax return in a manner that is contrary to Treasury taxpayer requests an election extension, as well as any regulations. In 2008, during an IRS audit, the IRS return effected by the election. Finally, when raises the issue regarding the 2007 return and asserts applicable, the taxpayer must also submit a copy any the accuracy-related penalty under Code § 6662. other taxpayers’ returns who are affected by the Taxpayer requests 9100 relief to elect an alternative election. method of reporting the income for 2007. Taxpayer is deemed to have not acted reasonably and in good faith d. Example of Taxpayer Discovering Own Error 2 because Taxpayer seeks to alter a return position for Years Later - Taxpayer Has Acted in Good Faith. which an accuracy-related penalty could be imposed Taxpayer prepares its 2007 return and is unaware that a under Code § 6662. Treas. Reg. § 301.9100- certain regulatory election is available to report a 3(f)(Example 3). transaction in a certain manner. Taxpayer files its return without making the election. Two years later, in g. Example of Taxpayer Electing Accounting 2009, Taxpayer hires a professional to prepare Method Late, Which Involves Cut-Off Method; Taxpayer’s 2009 tax return. The professional Interests of the Government are not Prejudiced. discovers that Taxpayer did not make the election. Taxpayer prepares its own return for 2007. Taxpayer Assuming that Taxpayer requested relief before the is unaware that a particular accounting method failure to make the election was discovered by the IRS, regulatory election is available, and fails to make the then Taxpayer is deemed to have acted reasonably and election. Instead, another permissible accounting in good faith. Therefore, Taxpayer may be eligible for method if chosen. The underlying accounting method relief from the late election. Treas. Reg. § 301.9100- regulation provides that the particular accounting 3(f)(Example1). (Note that this example does not deal method is made on a cut-off basis, without an election with the separate issue of whether granting relief will under Code § 481. In 2008, Taxpayer requests 9100 prejudice the interest of the government, which could relief to make the this accounting method election late. be a separate bar from actually obtaining relief here.) If Taxpayer were granted an extension of time to make the election, Taxpayer would pay not less than if the e. Example of Taxpayer Relying on Professional in election had been timely made. The interests of the Good Faith - Taxpayer Has Acted in Good Faith. government are deemed not to be prejudiced because Taxpayer hires a professional, who is competent, to the election does not require an adjustment under Code prepare its 2007 return, and Taxpayer provides the § 481. Treas. Reg. § 301.9100-3(f)(Example 4). professional with all relevant facts. The Professional fails to advise Taxpayer that an election is necessary in h. Same Facts As Immediately Above, Except order to report the transaction in a certain manner and Change in Method of Accounting Involves Section 481 no election is made. Nevertheless, Taxpayer reports Adjustment; Interests of the Government are the income for 2007 in a manner consistent with Prejudiced. Same facts as immediately above, i.e., having made the election. In 2010, IRS audits the Taxpayer prepares its own return for 2007 and Taxpayer’s 2007 return and discovers that the election overlooks the fact that a particular accounting method has not been filed. Taxpayer promptly files for relief, regulatory election is available, The underlying

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 accounting method regulation provides that the example, the regulations provide that particular accounting method election requires an corrections of items which are deducted as adjustment under Code § 481. The interests of the interest or salary, but which are in fact government are deemed to be prejudiced except in payments of dividends, and deductions of unusual or compelling circumstances because the items as business expenses which are in fact election does not require an adjustment under Code § personal expenses, are not changes in method 481. Treas. Reg. § 301.9100-3(f)(Example 5). of accounting. Treas. Reg. § 1.446- 1(e)(2)(b). See also Coulter Electric Inc. v. VII. CHANGE IN METHOD OF ACCOUNTING Commissioner, 59 T.C.M. (CCH) 350 (1990) OR CORRECTION OF ERROR. (characterization issue of items as sales or A. Introduction. pledges for loan is not a change in method of Assume you discover that an error has been made accounting involving timing but rather a in reporting items of income or expense in your client’s question of characterization); and tax return for a previous year. May you correct that d. Changes that have historically not been error by filing an amended return, if the statute of viewed as changes in method of accounting, limitations is still open? The answer is generally “no” such as changing the useful life of if the error constitutes a method of accounting - such depreciable property (if depreciation is methods generally must be corrected prospectively, determined under Code § 167) or typically with IRS consent which is provided subject to adjustments to a bad debt reserve. Treas. various terms and conditions. (See the discussion Reg. §§ 1.446-1(e)(2)(ii)(b), 1.446- above regarding 9100 relief which provides limited 1(e)(2)(ii)(d)(3). exceptions to these rules and which may allow a retroactive change in methods of accounting in certain 2. Changes in Underlying Facts. situations.) On the other hand, if there is no method of The following items have been found to be accounting involved, you may be able to correct the changes in underlying facts that did not constitute a error by filing an amended return. change in method of accounting:

B. Change in Method of Accounting. a. Switch from Non-Vested to Vested Vacation Pay. How is a change in method of accounting A change in a non-vested vacation pay plan to a defined? A method of accounting involves the rules vested plan is a change in underlying facts and not a under which a taxpayer determines when to include an change in method of accounting. Therefore, when the item into income, or when to take a deduction. A taxpayer begins to deduct the accrued vacation pay at method of accounting essentially involves timing. year-end under the new vested plan (pursuant to Code Treasury Reg. section 1.446-1(e)(2)(ii)(a) states that a § 404), that is not a change in method of accounting change in the method of accounting includes a change and no IRS consent is required. Treas. Reg. § 1.446- in the overall plan of accounting for gross income or 1(e)(2)(iii) (Example 3). 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). 1. What is Not a Change in Method of Accounting. A taxpayer providing advertising to customers and The following items are not a change in method of recognizes income under the accrual method when it accounting, and therefore, can be corrected without bills the customers. Previously, it billed the customers having to go through the procedures for a change in in advance of providing the advertising (and thus method of accounting. recognized the income in advance of providing the advertising). The taxpayer changes its business a. Change in underlying facts, including the practice and now only bills its customer as the way a company may do business. Treas. advertisements are published (and thus recognized the Reg. § 1.446-1(e)(2)(ii)(b); income at this later date). The Tax Court held that this b. Correction of an error, such as math error or was not a change in method of accounting, but rather it a posting error; was a change in the underlying facts. The court stated c. A change in the character of an item. The that the taxpayer recognized the income when it billed regulations provide that a change of method the customers - it simply changed the time at which it of accounting does not include items which billed the customers which was a change in the do not involve the proper time for the underlying facts. Decision Inc. v. Commissioner, 47 inclusion of income or deduction. As a T.C. 58 (1966), acq., 1967-2 C.B. 2.

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 c. Changes in Financing Arrangements Requires to accrue and deduct the liability for sick pay and that Change in Recognition of Service Fee Income and the taxpayer had not changed its method of accounting. is Not a Change in Method of Accounting Thriftimart, Inc. v. Commissioner, 59 T.C. 598 (1973). (Federated Department Stores). In terms of sales made to customers on credit, the 3. Correction of an Error. taxpayer’s previous practice had been to retain Treas. Reg. § 1.446-1T(e)(2)(ii)(B) provides that a ownership of the customer accounts receivable. Under change in method of accounting does not include that system, the taxpayer charged a service fee to its correction of mathematical or posting errors, or errors customers which it included in income as the payments in the computation of tax liability (such as errors im were received. The taxpayer changed the nature of its computation of the foreign tax credit, net operating financing agreements and decided to sell the loss, percentage depletion or investment credit). A receivables. The controversy was whether the change mathematical error has been defined by the Tax Court in the financing arrangement resulted in a change in as a error in arithmetic, such as an error in addition, method of accounting with respect to the service fee subtraction, multiplication or division. Huffman v. income. At issue before the court was whether the fee Commissioner, 126 T.C. 322 (2006). income could continue to be deferred or whether the income now had to be recognized at the time the a. A Different Result Applies To An Incorrect receivables were sold. The Tax Court held that, in light Accounting Method. What if the item in question is of the new arrangement where the receivables were not an isolated error, but an erroneous method of sold, the service fee income had to be recognized accounting? In that situation, the taxpayer generally earlier in time, when the receivables were sold. The cannot correct the erroneous method without the taxpayer then argued that this was a change in method correction itself being the adoption of a new of accounting and it was entitled to a section 481 accounting method. adjustment. The Court rejected that argument and held that this was not a change in method of accounting. b. Difference Between Error vs. Erroneous The Sixth Circuit affirmed the Tax Court’s decision on Accounting Method. An erroneous accounting method the grounds that to have a change in method of involves the systematic application of an error, over a accounting the item itself must be basically the same as regular period of time. In contrast, an isolated error is an item previously accounted for with the present not an accounting method. As an example, if a mistake method of accounting, Unless the transactions are was made by a business in making a physical count of basically the same, the accounting treatment would not its inventory at year-end, resulting in an erroneously be a `change’ of accounting but only a `new’ low inventory, this would be an error. However, if, in accounting method for a different transaction.” Both contrast, the same error in including ending inventory courts found that the transactions in this case were so was made for several years, then that is likely to be an different that no change in accounting method had accounting method, and therefore the taxpayer would occurred. As a result, the taxpayer was not entitled to a have to get IRS approval before correcting it. Hartley section 481 adjustment. Federated Department Stores v. Commissioner, 23 T.C. 353 (1954). v. Commissioner, 51 T.C. 500 (1968), aff’d 426 F.2d 417 (6th Circ. 1970). c. Taxpayers Have a One-Year Reprieve to Correct an Erroneous Method. A taxpayer may correct its d. Changes in New Collective Bargaining adoption in its initial tax return and use of an Agreement Requiring Compensation for Unused impermissible method of accounting by filing an Sick Leave; Not a Change in Method of amended return, but only if the amended return is filed Accounting (Thriftimart). before the incorrect method has been used in a return A taxpayer entered into a new agreement with its for the immediately succeeding taxable year. Rev. union under which employees were entitled to Proc. 92-20, 1992-1 C.B. 685. compensation for unused sick leave accrued as of the employees’ anniversary date. Under the previous d. Inadvertent Capitalization of Contract Losses was collective bargaining agreement, employees were not a Posting Error, Not a Method of Accounting entitled to accumulate sick leave from year to year, nor (Northern States Power Co). The taxpayer entered into were they entitled to any compensation for unused sick government contracts for uranium enrichment services, leave. In light of this new agreement, the taxpayer but later realized that it had overstated its needs for began to accrue and deduct its liability for unused sick enrichment. At the same time, the market price for leave. The Tax Court held that as a result of the terms uranium dropped below the contract price the taxpayer of the new union agreement, the taxpayer was entitled had agreed to pay, which caused the taxpayer very

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9 substantial losses. For three years the taxpayer C. Strict Deadline for Section 83(b) Elections. capitalized the contract losses by including them in the In order for a section 83(b) election to be cost basis of its nuclear fuel assemblies. This result effective, it must be made on or before the date that is caused the losses to be depreciated over the lives of the 30 days after the property is transferred to the assemblies. Several years later, the taxpayer filed for employee. If the election is late it is not effective, refunds on the later two years, but after the first year which means the employee is facing the prospects of a had closed, taking the position that the losses should huge amount of ordinary income when the property have been currently deducted and that capitalization vests in a later year at a time when the property has had been an error. The Eighth Circuit overruled the substantially appreciated from its earlier value. district court, and found for the taxpayer stating that the mistake was a posting error. The refund claims D. Solution for Late Section 83(b) Election. were an effort to treat the losses in the same manner as There is no obvious solution for making a late it had consistently treated similar losses on other Section 83(b) election - the IRS will not grant “9100 contracts. Thus, it was not a change in method of relief” with respect to a late Section 83(b) election. accounting. Northern States Power Co. v. United Moreover, most tax advisors believe it is not effective States, 151 F.3d 876 (8th Cir. 1998). to rescind the grant of property, and make another grant of property that would be accompanied by a VIII. SECTION 83(B) ELECTIONS. timely made section 83(b) election. This strategy A. Effect of Code § 83. likely does not work for tax purposes because the first Code § 83(a) provides that when property is grant would not be actually rescinded under the law. transferred to a service provider in connection with the The IRS and courts would likely view this as an performance of services, the excess of the fair market attempt, that is devoid of economic substance, to cure a value of the property transferred over the amount paid late section 83(b) election. Moreover, the rescission of for such property by the service provider is included in the first grant of property would fail to pass the “status the gross income of the service provider in the first quo” requirement because the rescission did not really taxable year in which the rights of the person having restore the parties to the position they were in before the beneficial interest in such property are the rescission occurred, because, as part of the same “transferable” or are not subject to a “substantial risk arrangement or understanding, a new grant of property of forfeiture.” Property is “transferable” within the was made to the employee. meaning of Code § 83 only if the rights in such property of any transferee are not subject to a 1. Example of Failed Attempt to Cure Section 83(b) substantial risk of forfeiture. Code § 83(c)(2) and Election. Treas. Reg. § 1.83-3(d). Employer grants Blackacre to service provider in return for services on June 1, with the grant being B. Importance of Section 83(b) Election. subject to a future vesting requirement. The parties If a person receives property in return for the inadvertently forget to make a Section 83(b) election provision of services that is subject to a substantial risk within 30 days of grant. They “rescind” the first grant of forfeiture, and is not transferable, then the property of Blackacre, and Employer makes another grant to is included in taxable income (at ordinary income service provider of Blackacre as of July 15, and service rates) at the earlier of the date that the substantial risk provider makes a timely section 83(b) election. It is of forfeiture expires or the date the property becomes likely that this tax planning technique does not work, transferable. (In other words, the fair market value of and service provider will be viewed as owning the property is included into income when the property Blackacre without a timely section 83(b) election. The “vests.”) This can result in substantial amounts of first rescission will not likely be respected because it ordinary income, if the property appreciates so that its lacked economic substance and failed to satisfy the value is substantial as of the date that vesting “status quo” requirement for a rescission. (It failed to subsequently occurs. If a employee or independent satisfy the status quo requirement because it is likely contractor makes a timely section 83(b) election, then that the second grant would be part of the overall the fair market value of the property is included into arrangement, and under the second grant, service income on the date of its receipt, not the later date provider ends up owning Blackacre as opposed to when it vests. The results can be substantial tax being restored to the status quo where service provider savings to the service provider. owned nothing).

Oops, What Was I Thinking? How to Fix a Botched Transaction Chapter 9

2. Solution - Make Property Transferable. fact as to the underlying transaction.” Treas. Reg. § A solution to this problem is to make the property 1.83-2(f). Additionally, even if a “mistake of fact” transferable by the service provider, so that the service exists, revocation must be requested within 60 days of provider can convey the property to a transferee. That when the mistake first becomes known to the taxpayer results in the fair market value of the property being who made the election. To obtain the IRS consent of included, immediately, in the service provider’s the revocation of such an election, the taxpayer must income, at presumably at low fair market value. The file a private letter ruling request with the IRS. later expiration of what would have been the service provider’s substantial risk of forfeiture is irrelevant. In 1. Revocation before due date of election. effect, a result very similar to a timely section 83(b) Although revocation of an election requires election has been achieved. consent of the IRS, if the taxpayer requests revocation of an election already made prior to the expiration of a. Terms of Transferability. The service provider the 30-day period for making the election, the request would be allowed to transfer Blackacre to any will generally be granted without the need to show a transferee, and the transferee would take the property mistake of fact. Rev. Proc. 2006-31, §§ 2.08, 5 without being subject to any risk of forfeiture. Example 2. However, the agreement would provide that service provider would have to pay damages to Employer 2. Mistake of Fact. equal to the fair market value of Blackacre if any acts A mistake of fact is “an unconscious ignorance of occurred which, had the service provider still owned a fact that is material to the transaction.” Rev. Proc. Blackacre, would have resulted in a forfeiture of the 2006-31, § 2.05. It must concern a fact that forms the property. In other words, although the transferee basis of the transaction, and not a collateral matter. receives Blackacre without any forfeiture risk, if See PLR 8224047 (consent denied where employee something occurs that would have otherwise been a relied on employer’s officers’ alleged forfeiture, the service provider has to pay Employer the misrepresentations regarding continued employment fair market value of Blackacre on that later date, since and ability to revoke election if employment were those were the damages the Employer suffered by terminated). virtue of service provider transferring the property. a. Not A Mistake of Fact. The IRS states that the b. Example in Regulations. On November 1, 1978, X following are not mistakes of fact and therefore do not corporation sells to E, an employee, 100 shares of X allow a § 83(b) election to be revoked. (See Rev. Proc. corporation stock at $10 per share. At the time of such 2006-31, §§ 2.04, 2.06, 2.07): sale the fair market value of the X corporation stock is $100 per share. Under the terms of the sale each share (1) mistake as to value, or decline in value, of of stock is subject to a substantial risk of forfeiture the property for which the election was which will not lapse until November 1, 1988. In made; addition, under the terms, on November 1, 1985, each (2) failure of anyone to perform an act share of stock of X corporation in E’s hands could as a contemplated at the time of transfer of the matter of law be transferred to a bona fide purchaser property; who would not be required to forfeit the stock if the (3) a service provider’s failure to understand the risk of forfeiture materialized. In the event, however, substantial risk of forfeiture associated with that the risk materializes, E would be liable in damages the property tranferred; or to X. On November 1, 1985, the fair market value of (4) a service provider’s failure to understand the the X corporation stock is $230 per share. Since E’s tax consequences of making a § 83(b) stock is transferable within the meaning of § 1.83-3(d) election. in 1985, the stock is substantially vested and E must include $22,000 (100 shares of X corporation stock x b. Example of a Mistake of Fact Allowing $230 fair market value per share less $10 price paid by Revocation. The IRS states that the following is a E for each share) as compensation for 1985. Treas. mistake of fact and therefore would qualify for Reg. § 1.83-1(f) Example (2). revocation of a § 83(b) election. Rev. Proc. 2006-31, §5 (Example 3). In this example, an employee begins E. Revoking § 83(b) Elections. work for a Company under a contract that provides that Revocation of a § 83(b) election requires IRS he will receive Class A common stock. Later, the consent. § 83(b)(2), Treas. Reg. § 1.83-2(f). Consent Company transfers Class B comon stock to the may only be obtained if there has been a “mistake of employee. The employee makes a section 83(b)

Oops, What Was I Thinking? How to Fix a Botched Transaction 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.