Santa Clara Law Santa Clara Law Digital Commons Faculty Publications Faculty Scholarship 2007 Unwinding Unwinding David M. Hasen Santa Clara University School of Law, [email protected] Follow this and additional works at: http://digitalcommons.law.scu.edu/facpubs Recommended Citation 57 Emory L.J. 871 This Article is brought to you for free and open access by the Faculty Scholarship at Santa Clara Law Digital Commons. It has been accepted for inclusion in Faculty Publications by an authorized administrator of Santa Clara Law Digital Commons. For more information, please contact [email protected]. UNWINDING UNWINDING David Hasen* "Unwinding" is a common, if not ubiquitous,feature of tax practice. In a successful unwind, parties to a prior transactionor arrangementback out of it by means of a later transaction and are treated for tax purposes as having engaged in no transactionsat all. In a failed unwind, the parties undertake the later transaction, but it is not treated as nullifying the effects of the first transaction;rather, two separate transactionsare deemed to have taken place, each with its own tax consequences. This Article develops the first unified theoreticalframework for analyzing tax unwinding. It also provides an organizing principle applicable to other kinds of corrective action that individuals or the government may undertake in the income tax context. These types include equitable recoupment, the tax benefit rule, and the claim of right doctrine. Each involves resolution of a different kind of excusable inconsistency in taxpayer or, sometimes, government conduct. In the case of unwinding, the inconsistency arises between the taxpayer's understanding of the circumstances in which she acts and the circumstances as they actually are; it concerns the possible efficacy of a chosen action to realize an end the taxpayer seeks to achieve. In some such cases, unwinding relief may be appropriate,but it is usually appropriate only where the relevant taxes are themselves transactionally based. In the non- transactionaltax context, more stringent requirements apply to the nature of the taxpayer's error, and administrative considerations militate against an expansive unwinding doctrine. Assistant Professor of Law, University of Michigan. I thank Reuven Avi-Yonah, Evan Caminker, Steve Croley, Diane Eisenberg, Barbara Fried, Joel Hasen, Don Herzog, Stephen Lind, Kyle Logue, Don Regan and participants at various colloquia for helpful comments and criticisms. Victor Fleischer suggested the title. The Cook Endowment at the University of Michigan Law School provided research support for this Article. I remain solely responsible for any errors. HeinOnline -- 57 Emory L.J. 871 2007-2008 EMORY LAW JOURNAL [Vol. 57 INTRODUCTION .............................................................................................. 873 I. UNW INDING ........................................................................................ 877 A. Unwinding in G eneral ................................................................ 877 B. IRS and Judicial Treatment of Unwinds ..................................... 879 1. Com m ercial Unw inds ........................................................... 879 a. Rescissions ..................................................................... 880 b. Retroactive M odifications .............................................. 884 2. Reformations ........................................................................ 885 3. Cancellationof a G ift ........................................................... 892 C. Sum m ary ..................................................................................... 894 II. U NW INDING AND ERRORS IN G ENERAL .............................................. 895 A. Conceptual Underpinnings of Unwinding .................................. 895 1. TransactionalVersus Incom e Taxes .................................... 895 2. Why the Income Tax Is Not a Tax on Transactions ............. 897 a. Haig-Sim m ons Income Concept .................................... 897 b. "W hen" Versus "W hether". ........................................... 899 3. Unwinding Under a Non-TransactionalTax ....................... 902 B. Tax Errors .................................................................................. 905 1. Logical Error-EquitableRecoupment/Mitigation ............. 907 2. FactualError-Tax Benefit Rule/Claim of Right ............... 910 a. Tax Benefi t Rule ............................................................ 910 b. Claim of Right ................................................................. 916 c. Observations on the TBR and Claim of Right ............... 918 3. Purposive Error-ContextualMistake ................................ 919 C. Observations ............................................................................... 921 D . "Reasonable" Excuse Generally ................................................ 929 III. U NW INDING IN PRACTICE ................................................................... 932 A. Substantive Issues ....................................................................... 933 1. Mistake of Law ..................................................................... 933 2. Tax Motivation ..................................................................... 936 B. Tax Administration and the Problem of Government "W hipsaw". ................................................................................ 940 CONCLUSION .................................................................................................. 942 HeinOnline -- 57 Emory L.J. 872 2007-2008 2008] UNWINDING UNWINDING INTRODUCTION The problem of "unwinding," or nullifying, transactions has bedeviled the tax law from its inception. Simply stated, it is as follows: Under what circumstances should taxpayers be permitted to undo the tax consequences of previously consummated transactions, and under what circumstances not? Put more concretely, when will a transaction that purports to negate or unwind a prior transaction be respected as such, and when will it be treated as a separate transaction with its own separate tax consequences? In the former case, nothing has happened for tax purposes. In the latter case, two things have happened. A simple example illustrates the issue.' Suppose that Seller (S) sells Blackacre to Buyer (B) for cash at time to. Sometime later, at time tl, the parties decide they want to "cancel" the sale and return themselves to the status quo ante. At that time, B reconveys Blackacre to S, and S transfers an amount of cash equal to the sales price (possibly plus interest) to B. From the parties' perspectives, the second transaction is intended as an unwind of the first, designed to render the original sale as far as possible a nullity-something that, in essence, never happened. From the perspective of the tax law, much hangs on whether effect is given to this intention. If the reconveyance is treated as an unwind, then there are no income tax consequences to the two transactions. S recognizes no gain or loss, takes her original basis in Blackacre, and tacks her holding period; B likewise recognizes no gain or loss, receiving her money back. If the reconveyance is not respected as an unwind, then two sale transactions have occurred, the first at to, and a second at ti, each with its own 2 tax consequences. The sale-cancellation case represents a common type of unwind, but it is by no means the only one. Other recurring unwind situations include retroactive modifications of divorce decrees,3 cancellations of dividends,4 and revocations 1 This example is the discussion model used in Sheldon I. Banoff's article, Unwinding or Rescinding a Transaction:Good Tax Planningor Tax Fraud?, 62 TAXES 942,944 (1984) [hereinafter Banoff, Unwinding]. 2 Under the facts of the example, the income tax consequences to B are likely to be less drastic than to S under any scenario. B could recognize gain on the sale if the transaction were not unwound if, for example, B had taken depreciation deductions on the property, but if the transaction were unwound, B would have to reverse the deductions anyway. Note that other taxes may be at issue as well, such as land transfer or property taxes. 3 See, e.g., Rev. Rul. 71-416, 1971-2 C.B. 83 (giving retroactive effect to modification nunc pro tunc of a divorce decree two years after the degree was entered, where the purpose of the modification was to correct a computational error). HeinOnline -- 57 Emory L.J. 873 2007-2008 EMORY LAW JOURNAL [Vol. 57 of tax elections, 5 among a host of others. Moreover, although the focus here is on the tax context, the problem of unwinds is ubiquitous throughout the law, and indeed beyond. For example, the transactions between B and S may raise the question of whether the law will view B as an owner in the chain of title, potentially liable for environmental or other torts that occurred on the property during or before the time that B held it. 6 More generally, countless transactions purport to operate as cancellations of prior transactions or arrangements, and in principle the same questions arise in each case. Is the reconveyance of property to a bankruptcy estate the reversal of a preference or the separate transfer to it of ."new value"?7 Should the termination of a marriage be treated as an annulment or a divorce? Is the retraction of a promise reprehensible reneging or an excusable change of course? In each case, what is sought is some principle by which to determine