New Irs Rulings Approve Rescission Transactions That Change An Entity's Tax Status.qxp 21023

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PARTNERSHIPS, S CORPORATIONS, & LLCs

New IRS Rulings Approve Rescission
Transactions that Change an Entity's Tax Status
Author: By Sheldon I. Banoff
SHELDON I. BANOFF, P.C., is a partner in the Chicago office of Katten Muchin Rosenman
LLP. He is co-editor of The Journal's Shop Talk column and a frequent contributor.
Copyright © 2006 Sheldon I. Banoff.
For various non-tax reasons (including IPOs), owners of pass-through entities might consider converting those entities into a C corporation. If they think the better of it in time—within the same tax
year—they may be able to "undo" that move in the tax law's equivalent of not taking your hand off
that chess piece you put into the path of the queen.

recurring issue is whether taxpayers can
unwind or rescind transfers of ownership
interests that effectively change the tax status of the entities themselves (e.g., from C corporation to S corporation or to partnership tax status). If
they can, in what circumstances? Moreover, what
are the tangential tax consequences to all of the
entity's owners?

nouncement) provide limited but helpful guidance
as to rescission transactions that change the tax
status of the entities involved. Nevertheless, tangential tax consequences involving such rescissions remain unclear.

To answer these questions, we will first identify the
policy tensions that arise in determining whether
rescissions and similar unwindings of transactions
should be given tax effect, and then discuss the law
applicable to valid rescissions for federal income
tax purposes. Next, we analyze four types of
rescissions that can favorably affect an entity's tax
classification, with emphasis on attaining or retaining pass-through entity status or avoiding C corporation (potential double taxation) treatment. We will
address rescissions resulting in C corporations
being taxed as (1) S corporations, (2) REITs, and
(3) partnerships. Finally, we will cover rescissions of
pass-through entities into something else altogether, i.e., rescissions of partnerships into tenanciesin-common.

The question of whether an unwinding or rescission
of an initial transaction will be given retroactive
effect for federal income tax purposes has been the
subject of controversy and litigation for more than
65 years.1 Neither the Code nor the Regulations
give guidance as to when a second (unwinding or
rescission) transaction will be given effect, such
that neither the first nor the second transaction will
be deemed to have ever occurred for federal
income tax purposes. Indeed, the boundaries are
far from clear in determining (1) effective unwindings, (2) ineffective unwindings where both the first
and the second transactions are given substantive
tax effect, but with no further penalties or sanctions,
or (3) ineffective unwindings which may constitute
civil or criminal fraud.2

Two letter rulings issued in the past year, Ltr. Ruls.
200533002 and 200613027, provide the focal
points for this analysis. These favorable letter rulings were issued to taxpayers seeking to rescind
transfers of ownership interests in corporations and
partnerships, respectively, with the result that the
entities involved in the rulings were able to reestablish favorable entity-level tax treatment. The
rulings, which build on Rev. Rul. 80-58, 1980-1 CB
181 (the Service's well-known "rescissions" pro-

Taxpayers may wish to unwind, rescind, or substantially modify a transaction for non-tax and/or taxrelated reasons. Non-tax motivations may include a
mistake of law or of fact, including the failure of certain anticipated events to materialize, and, conversely, the occurrence of unanticipated events.
Tax-motivated reasons to unwind may include the
desire to minimize or avoid income or transfer taxes
that have arisen due to faulty tax planning (or the
lack of tax planning altogether), the failure of certain

A

UNWINDINGS AND RESCISSIONS:
COLLIDING POLICIES

1

events to materialize, the promulgation of retroactively effective legislation, Regulations or Rulings,
and the failure to properly anticipate the taxpayer's
tax profile prior to the occurrence of the transaction.

indefinitely. Therefore, unwindings should not be
recognized retroactively if not completed in the
same tax year as that of the initial transaction.
There also are at least four strong arguments that
favor retroactive unwindings (again, in no particular
order):

Because of the many types of transactions that
arise in today's sophisticated business and investment world, it is often difficult to predict which types
of unwinding events will be given effect for tax purposes, and under what conditions or situations.
Indeed, the devices that may cause an unwinding
to occur include:
•
•
•
•
•
•
•
•

(1) The tax law should be interpreted reasonably and mirror commercial reasonableness. It
is commercially reasonable for people in business to have a transaction remain "open" for
economic purposes. Thus, the tax law should
reflect flexibility to recognize unwindings as of
the original transaction.

Rescission agreements.
Reformation or reconveyance actions.
Savings clauses.
Escrows.
Warranties.
Conditional sales.
Options.
Put rights.3

(2) If tax-motivated unwindings are of concern,
arguably a transaction that has some valid nontax purpose (i.e., is not solely for tax-avoidance
purposes) should be acceptable.
(3) Admittedly, state law determinations that are
retroactively applied are not controlling on the
IRS for tax purposes. Nevertheless, the government should defer to state law as to recognition
of property and legal rights, and then apply federal tax law standards thereto. If state law gives
retroactive effect to a transaction, the tax laws
should respect that holding, unless it is based
on collusion or some procedural finding not germane to the unwinding.

In all these situations, the tax advisor's dilemma in
unwinding a transaction is to avoid the "kryptonite"
of the Code—mainly Sections 6653, 7201, and
7206, the civil and criminal fraud penalty
sanctions4—and 18 U.S.C. section 1001.5
As a conceptual matter, there are a variety of policy
concerns that are in tension with respect to permitting transactions to be unwound or substantially
modified on a retroactive basis. These tensions in
turn are reflected in the sometimes inconsistent
positions taken by the courts (and occasionally the
Service). Arguments (typically raised by the IRS)
against permitting retroactive unwindings include
the following (in no particular order):

(4) As to the annual accounting principle, why
shouldn't the relevant timeframe be based on
whether the statute of limitations has expired
(and not on the end of the tax year in which the
initial transaction occurred), since one can (and
perhaps should or must) amend the tax return
retroactively within that limitation period in certain situations, anyway?

(1) The substance over form doctrine requires
the tax law to determine "what really happened?" Retroactivity brings a different result
from what really happened.

The annual accounting principle is the basis for
much of the Service's concern about approving
rescissions. As observed by the Supreme Court in
Burnet v. Sanford & Brooks Co., 9 AFTR 603, 282
US 359, 75 L Ed 383 (1931), "[i]t is the essence of
any system of taxation that it should produce revenue ascertainable, and payable to the government,
at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply
methods of accounting, assessment, and collection
capable of practical operation." Thus, a transaction
cannot remain "open" indefinitely for tax purposes
without violation of the annual accounting principle.
Stated another way, it is fairly well established that in
determining the year in which income should be
reported, consideration cannot be given as to what
may or may not happen in a subsequent year.6

(2) Approval of retroactive unwindings that are
tax motivated permits taxpayers to play the
audit lottery: If you are audited, only then do
you unwind to avoid adverse tax results.
(3) Retroactive unwindings that are based on
state law determinations (e.g., by court-ordered
reformation of an agreement or by mutual
agreement of the parties) do not affect the
rights of third parties retroactively. The IRS is
such a third party, i.e., its collections would be
adversely affected by the retroactivity.
(4) Even if some retroactive unwindings are
appropriate, the annual accounting principle
precludes transactions from remaining "open"

2

As a matter of administration, the recognition or denial
of retroactive unwindings must take into consideration
additional concerns, e.g., (1) inconsistent positions
being taken by the parties to the transaction (e.g.,
seller and buyer) as to whether the initial sale or event
has occurred, (2) similar inconsistencies as to who is
taxed on the income (or given the benefit of tax losses
or depreciation deductions) during the interim, and (3)
administrative uncertainty as to the Service's position
on unwindings.
From the taxpayer's viewpoint, commercial practices
and business exigencies may cause the parties to
complete a transaction that has some potential for
being substantially modified or unwound at a later
date. The IRS has shown some administrative uncertainty (in audits, rulings and litigation) as to when
unwinding is acceptable.7

Thus, the 1931 rescission was disregarded for purposes of determining 1930 income.
As to 1931 income, the court concluded that the
rescission was effective for tax purposes. The court
reasoned that the rescission in 1931, before the
close of the calendar year, extinguished what otherwise would have been taxable income to Penn for
that year. The government contended that the
rescission was not a genuine rescission but really a
re-sale of the stock. This was refuted by the facts
and findings of the district judge, however. The
appellate court concluded that in no sense could it
properly be termed a re-sale.10
After Penn, several cases were litigated that generally applied the "same-year-only rescission" holding
of Penn—but not always.11 Moreover, even if a
transaction is modified or purportedly rescinded in
the same tax year that it occurred, there is no guarantee that tax consequences will not arise from the
initial transaction.12

VALID UNWINDINGS AND RESCISSIONS
FOR TAX PURPOSES
In appropriate circumstances a transaction can be
effectively unwound for tax purposes without a formal
finding of rescission.8 Taxpayers, however, often seek
to characterize their unwindings as rescissions
because of real or perceived tax benefits pertaining
thereto.9 As a general rule, if a "true" rescission occurs
within the same tax year as the year of the initial sale
or other transaction, the reconveyance will be effective retroactively and the initial sale or transaction will
be unwound as of the original transaction. Conversely,
if the year of sale has already passed, a subsequent
rescission will be treated as a separate event, the initial buyer will be treated as owner (and taxed on
income and loss from the property) between the time
of the original sale and the date of reconveyance, and
the reconveyance will have its own tax consequences
as a second transaction.
This dichotomy appears to have originated in Penn v.
Robertson, 25 AFTR 940, 115 F2d 167 (CA-4, 1940),
the first appellate decision dealing directly with rescission. In Penn, the taxpayer was a participant in an
employees' stock benefit fund created by the directors
of the company without shareholder approval. Under
the plan the taxpayer was credited with earnings from
the fund for 1930 and 1931. In 1931, however, as a
result of shareholder lawsuits, the company's directors
passed a resolution whereby the plan would be
rescinded as to all participants in the plan who would
agree to relinquish their previous rights and credits.
The Fourth Circuit held that although the plan was
void for 1931, the annual accounting period principle
required the determination of income at the close of
the tax year without regard to subsequent events.

3

Against this background, in Rev. Rul. 80-58 the IRS
chose to follow Penn where a valid rescission has
occurred, and the parties are placed in the same
positions as they were prior to the initial sale. What
constitutes a "valid rescission" and whether the parties are "placed in the same positions as they were
prior to the initial sale" are important components of
the Revenue Ruling that come into play in Ltr. Ruls.
200533002 and 200613027, discussed below. But
first, an analysis of Rev. Rul. 80-58 is in order.

The 1980 Ruling
In Rev. Rul. 80-58, the Service was asked to rule
on the federal income tax consequences of a
reconveyance to a taxpayer of property previously
sold by the taxpayer, under two factual situations.
In situation 1, A, a calendar-year taxpayer, sold a
parcel of land in February 1978 to B solely for
cash. The sale contract obligated A, at the request
of B, to accept reconveyance of the land from B if
at any time within nine months of the date of sale
B was unable to have the land rezoned for B's
business purposes. If there were a reconveyance
under the contract, A and B would be placed in the
same positions they were in prior to the sale.
In October 1978, B determined that it was not possible to have the land rezoned and notified A of its
intention to reconvey the land pursuant to the
terms of the contract of sale. The reconveyance
was consummated during October 1978, and the
parcel was returned to A, with B receiving back
from A all amounts expended in connection with
the transaction.

The facts in situation 2 were similar, except that
the period within which B could reconvey the
property to A was one year. In January 1979, B
reconveyed the property, for the same non-tax
reasons as described above. B received back
from A all amounts B expended in connection with
the transaction.

RESCISSIONS AFFECTING ENTITY TAX
CLASSIFICATION
Although Rev. Rul. 80-58 and other rulings and
cases generally involve successful or failed rescissions or unwindings of sales of property, the issue
of the tax treatment of (attempted) unwindings or
rescissions can arise in many other types of transactions, including unilateral awards of employer
stock or stock benefit fund credits to employees,
gifts by a donor to donees, transfers in divorce pursuant to nunc pro tunc orders (i.e., retroactive property rights modifications), transfers into and out of
trust, and payments of dividends by a corporation
to its shareholders.15 It is by no means clear that
Rev. Rul. 80-58 or, more broadly, the principles
referred to therein will be dispositive as to whether
any given attempted unwinding will be effective for
federal tax purposes.

IRS ruled that in situation 1 no gain on the sale
would be recognized by A, but in situation 2 A
must report the sale for 1978. In 1979, when the
property was reconveyed to A, A acquired a new
basis in the property, which was the price A paid
to B for such reconveyance.
In the Ruling, the Service stated the legal concept
of rescission refers to the abrogation, cancelling,
or voiding of a contract that has the effect of
releasing the contracting parties from further obligations to each other and restoring the parties to
the relative positions that they would have occupied had no contract been made (i.e., the "status
quo ante" requirement13). Anything less will not
suffice.14 The Ruling states a rescission may be
effected by mutual agreement of the parties, by
one of the parties declaring a rescission of the
contract without the consent of the other if sufficient grounds exist, or by applying to the court for
a decree of rescission.

Given this uncertainty, should retroactive effect be
given to attempts to change the tax status of an
entity by rescinding certain transactions involving
the ownership interests of the entity? In answering
this question, to what extent should potential (substantial) income tax savings at the entity level affect
or preclude giving effect to transactions attempting
to unwind or rescind an initial transaction which
generated adverse entity-level tax consequences?16

Paying heed to the annual accounting concept
and following Penn v. Robertson, Rev. Rul. 80-58
concludes that in situation 1 the rescission of the
sale during 1978 placed A and B at the end of the
tax year in the same positions as they were in
prior to the sale. Thus, in light of Penn, the original sale was disregarded for federal income tax
purposes because the rescission extinguished
any taxable income for that year with regard to
that transaction (i.e., it met the "same-year-only
rescission" requirement) and did not violate the
annual accounting period principle.

This question did not arise in Rev. Rul. 80-58 or in
Penn or other cases, all of which focused on the
transferor and transferee taxpayers. Thus, in Rev.
Rul. 80-58, at issue was whether the owner of the
property (akin to the owner of stock or a partnership
interest) recognized gain or loss on the initial sale
or other disposition, followed by a taxable reconveyance back to that owner (via repurchase).
Instead, our current focus is whether an entity's tax
classification (whether intentionally or inadvertently
adversely affected by its owners' transactions) can
be rehabilitated through rescission of the initial
transaction that triggered the adverse entity-level
tax consequences.

In situation 2, as in situation 1, there was a completed sale in 1978. Unlike Situation 1, however,
because only the sale and not the rescission
occurred in 1978, at the end of 1978 A and B
were not in the same positions as they were prior
to the sale. Again following Penn, the IRS ruled
that the rescission in 1979 was disregarded with
respect to the taxable events occurring in 1978.
Thus, the annual accounting principle was held in
both situations 1 and 2 of Rev. Rul. 80-58 to
require the determination of income at the close
of the tax year (1978) without regard to subsequent events.

The question has recently arisen in two very different fact patterns, but in each the Service's answer
turned on the application of Rev. Rul. 80-58. In Ltr.
Rul. 200533002, the question was whether revocation of an S election (and imposition of corporate
taxation on what now would be classified as a C
corporation) could be reversed by rescinding the
issuance of a class of preferred stock to three limited partnerships that wished to invest in the corporation. In Ltr. Rul. 200613027, at issue was whether a
corporation (formed through a statutory conversion

4

of an LLC), which otherwise would be taxable as a
C corporation, could be treated as a nullity for tax
purposes from its beginning, so that the corporation's subsequent conversion back into an LLC
(taxable as a partnership) would not be treated as a
taxable liquidation. While the IRS reached favorable conclusions in both, the rulings do not discuss
the tangential but potentially significant tax consequences that may flow from the approved rescissions.

gain (without cash proceeds to pay the tax, A having used her sale proceeds to repurchase the
shares from XYZ). In addition, since A's sale to
XYZ terminated the S corporation's election, the
entity likely would be precluded from re-electing S
corporation status for five years pursuant to Section
1362(g), absent IRS consent to an earlier re-election. Again there is a potential silver lining to A: her
basis in the stock will be increased to equal the
amount she paid XYZ (i.e., a new cost basis).20

THE CONSEQUENCES OF FAILURE:
INEFFECTIVE ‘RESCISSIONS’

What are the potentially adverse consequences if
an S corporation issues a second class of stock
(e.g., convertible preferred) for cash to a shareholder (as occurred in Ltr. Rul. 200533002), and the
corporation reacquires the stock for cash in a second transaction that does not constitute a valid
rescission for tax purposes? First, loss of the S corporation's status will result (absent other qualification for relief or reinstatement by IRS). In addition,
the preferred shareholder will recognize gain or loss
on the repurchase of his stock, which presumably
will be characterized as a Section 301 dividendtype distribution (unless the payment qualifies as a
redemption under Section 302).

In analyzing the two letter rulings, we should keep
the stakes in mind. What are the potential adverse
tax consequences if the rescission under consideration is not respected for tax purposes, i.e., if the
second transaction is given independent tax effect?
If the second transaction involves a C corporation
converting back into an entity taxable as a partnership (as in Ltr. Rul. 200613027), a failed rescission
would cause the C corporation to be deemed to
have made a taxable liquidation. This would result in
classic double taxation, i.e., recognition of all built-in
gain at the corporate level, and then additional capital gain at the shareholder level (long term or short
term, depending on each hapless shareholder's
holding period).17 The corporate assets would then
be deemed to be contributed by the shareholders to
the partnership, in a transaction governed by
Section 721. (The sole silver lining is that the partnership would take a carryover basis in the assets
deemed contributed, which in the aggregate should
equal the amount realized by the shareholders on
the corporation's deemed liquidation.)

All of the above illustrates that much may be at
stake if the attempted unwinding is not treated as a
valid rescission for federal income tax purposes.

RESCISSIONS: C CORPORATIONS INTO
S CORPORATIONS
Section 1361(a) grants "S corporation" status to a
small business corporation for which an election
under Section 1362(a) is in effect for the tax year.
Section 1361(b) provides that a "small business
corporation" is a domestic corporation that, among
other things, does not have its shares owned by an
impermissible shareholder (such as a partnership)
and does not have more than one class of stock.
Section 1362(d)(2)(A) provides that a Subchapter S
election will be terminated whenever such corporation ceases to be a small business corporation (i.e.,
at any time on or after the first day of the first tax
year for which the corporation is an S corporation).

If the second transaction involves the shareholders
of a C corporation attempting to rescind a stock
transfer (to an ineligible shareholder) that had terminated the corporation's S election, what are the
adverse tax consequences if the attempted rescission is not respected for tax purposes, such that
the second transfer is treated as a separate transaction? Assume individual A initially transferred her
S corporation stock to ineligible shareholder XYZ,
thus terminating the corporation's S election, and A
then repurchases the stock from XYZ in a second
transaction that fails to qualify as a rescission for
tax purposes. A initially will have recognized gain
on the sale of her stock to XYZ under Section
1001.18 XYZ's resale back to A, treated as a second
sale governed by Section 1001, will not eliminate
A's prior recognition of gain.19 Thus, A will hold (typically illiquid) stock but will have recognized taxable

An S corporation's status can be terminated intentionally or unintentionally, with the result that the
entity becomes taxable as a C corporation. An S
corporation faced with an inadvertent termination
may qualify for relief by seeking a waiver from the
Service pursuant to Section 1362(f). Obtaining a
waiver of an inadvertent termination requires the
cooperation of all of the persons that owned stock
during the affected period.21

5

In some situations, an S corporation's shareholders
may prefer another alternative if the inadvertent termination is due to a transfer of stock to an ineligible
shareholder. The shareholders may wish to comply
with Rev. Rul. 80-58 so that the reacquisition of the
stock is a valid rescission for tax purposes. (This
would not require IRS approval, unlike either
Section 1362(f) or (g).) Your author is unaware of
any IRS rulings or guidance involving this fact pattern (i.e., an inadvertent termination, followed by a
good rescission) in the S corporation context, but
there is no reason why the principles of Rev. Rul.
80-58 should not apply here, as well.22

entered into a stock rescission agreement "which
was consummated as of" Date2, in the same tax
year as the initial Date1 issuance of the preferred
stock. The terms of the agreement provided that X
remit $N to the partnerships. On the execution of
the agreement and delivery of the $N (i.e., Date2),
the issuance of X's convertible preferred stock
would be deemed rescinded. The agreement
required that X promptly cancel the issuance of the
convertible preferred stock. It also provided for the
resignation of the partnerships' representative from
X's board of directors. In addition, the agreement
released all parties from any liability or obligation
that arose from the original stock purchase agreement, with the exception that the indemnification
clauses for the partnerships and their representative remained in effect. X represented that during
the period that the preferred stock was outstanding
until the rescission agreement date (i.e., from
Date1 to Date2), X did not make any distributions
to the partnerships (i.e., presumably X paid no preferred stock dividends).24

Will a rescission be respected by IRS to reinstate
an S election that was not lost inadvertently? In Ltr.
Rul. 8304134, the Service ruled that S corporation
status that had terminated in 1980 (because all the
S shares were sold to another corporation) could
not be reinstated (retroactively) as a result of a
court-ordered 1982 rescission of the stock sale.
There was no indication in that ruling that the transferors in 1980 expected to return to S corporation
status, given the ineligible corporate shareholder.
The requirements of Rev. Rul. 80-58 are incorporated into Ltr. Rul. 8304134, but curiously the letter
ruling makes no reference to the Revenue Ruling.

In Ltr. Rul. 200533002 the IRS ruled favorably for X
and its original shareholders. The letter ruling quoted from Rev. Rul. 80-58, which provides the aforementioned general legal principles pertaining to the
doctrine of rescission. The letter ruling stated that
Rev. Rul. 80-58 requires at least two conditions that
must be satisfied for the remedy of rescission to
apply to disregard a transaction for federal income
tax purposes:

If the S election was intentionally terminated by
transfer of stock to an ineligible shareholder, would
timely rescission reinstate the election? Ltr. Rul.
8304134 implies that had the rescission occurred in
1980 (the tax year of sale), S corporation status
would have been preserved. In Ltr. Rul.
200533002, the Service was asked to rule that the
rescission of the issuance of convertible preferred
stock, as part of the unwinding of the original purchase of such stock, would be given effect so as to
preserve a corporation's S election. There, the
shareholders of X corporation made an S election
(assumed to be valid for purposes of the ruling).
Subsequently, X entered into discussions with a
venture capital fund for the sale of n shares of X
stock to the fund. On a date believed to be in 2004
("Date1"), X sold n shares of newly issued convertible preferred X stock to three limited partnerships
controlled by the fund, for $N. This sale terminated
X's S election under Section 1362(d)(2) because X
no longer met the definition of a small business corporation in Section 1361(b)(1).23

(1) The parties to the transaction must return to
the status quo ante,25 that is, they must be
restored to "the relative positions they would
have occupied had no contract been made."
Ltr. Rul. 200533002 concluded that X, X's original shareholders, and the three limited partnerships all were restored to the relative positions
they would have occupied if the X stock had
never been sold to the partnerships.
(2) This restoration (to the status quo ante)
must be achieved within the tax year of the
transaction. Ltr. Rul. 200533002 concluded that
the restoration was achieved within the same
tax year. (Thus, Date2 presumably was in
2004, also.)
Therefore, having met the conditions of Rev. Rul.
80-58, the legal doctrine of rescission was held to
apply so as to (1) disregard the creation of convertible preferred stock and X's issuance of that stock
to the partnerships, and (2) prevent the termination
of X's S corporation status.

In the months following the sale, disagreements
arose between X's original shareholders and the
partnerships. These disagreements led X and the
partnerships to agree to unwind the partnerships'
original stock purchases. X and the partnerships

6

Based on the above, in Ltr. Rul. 200533002 the IRS
ruled as follows:

No dividends or other distributions were made on
the preferred stock during the interim. The letter ruling does not state whether the convertible preferred
stock had a cumulative dividend to which the preferred shareholders (i.e., the three partnerships)
would have been entitled, but for the rescission.
Although your author has no additional knowledge
of the facts underlying the ruling, one can speculate
that here the tax tail may have wagged the dog,
and the remittance price was set to be equal to the
original purchase price, without an interest component, yield factor, or other pricing adjustment, to
meet the status quo ante requirement.

• X would be treated as continuing to be an S
corporation during the period from Date1 to
Date2 and thereafter, provided that X's S
election was valid and was not otherwise terminated under Section 1362(d).
• During the period from Date1 to Date2, X's
original shareholders would be treated as the
shareholders of X. X's original shareholders
had to include in income their pro rata shares
of the separately and non-separately stated
items of X as provided in Section 1366 and
had to make any adjustments to stock basis
as provided in Section 1367 and take into
account any distributions made by X as provided in Section 1368.26

RESCISSIONS: C CORPORATIONS INTO
REITs
Section 856(a)(6) provides that an entity seeking to
qualify for or retain REIT status cannot be "closely
held." An entity is closely held if more than 50% of
the value of its shares is owned directly or indirectly
by or for five or fewer individuals at any time during
the last half of the REIT's tax year.29 A sale or transfer of an excessive amount of shares to one individual can thus jeopardize REIT status, in the same
fashion that a transfer to an ineligible shareholder
as defined under Section 1361 can terminate S corporation status.

Ltr. Rul. 200533002 reaches the proper result, and
fits within the requirements of Rev. Rul. 80-58.
Although not stated in the ruling, it is highly likely
that the parties involved in the letter ruling knew
that the initial transfer would terminate S election
status, and the original and new shareholders (i.e.,
the limited partnerships) would be willing to have
the entity taxed as a C corporation. If this speculation is correct, it was only the falling out of X's original shareholders and the new shareholders that led
to the reconveyance of the stock.

A valid rescission of the transfer of the REIT stock
(via repurchase by or retransfer to the original
shareholder) should be effective to retain REIT status. Your author is unaware of any cases or rulings
on point, unlike transfers to ineligible S corporation
shareholders.30 Nevertheless, there is no reason
why IRS would not apply the principles of Rev. Rul.
80-58 to REIT stock rescissions, just as the Service
has done in the S corporation stock rescission letter
rulings discussed above. Moreover, a favorable letter ruling should be obtainable even if the sole purpose of the rescission is to reinstate the favorable
tax treatment afforded REITs.31

The shareholders' falling out undoubtedly was a
valid non-tax reason (should one be needed27)for
giving effect to the reconveyance, and the initial
issuance and reconveyance together cannot be
characterized as a tax-motivated sham.
Nevertheless, the importance of Ltr. Rul.
200533002 may lie in the remittance price, which
happened to be the exact amount of the original
purchase price. This identity in amounts, of course,
gives no effect to the time value of money, to any
appreciation or depreciation in the value of the
underlying corporation (X), or to X's profitability (or
lack thereof) during the interim. Rather, one could
speculate that the $N remittance price was selected
to be exactly equal to the initial purchase price in
order to meet Rev. Rul. 80-58's admonition that the
unwinding must have the effect of placing the parties in the same positions as they were in prior to
the initial transaction.28

As an alternative method of retaining REIT status
and not violating the closely held ownership rule of
Section 856(h), the REIT's governing documents
may contain a restriction (e.g., an "excess share"
provision) that is designed to treat the acquisition
by a person of REIT shares in excess of a specified
percentage as being void to begin with.32 Under
such provision, if any person acquires REIT shares
in excess of the specified percentage, the excess
shares are deemed to be transferred to a trust and
the acquiror is not entitled to voting rights or dividends on such shares and is not entitled to any
portion of the gain realized on the disposition of

But for the Revenue Ruling's requirement and the
tax-oriented purpose of qualifying the rescission so
that S corporation status could be retained (and
double taxation as a C corporation avoided), would
the pricing of the rescission have been different?

7

As Corp would not make a public offering of its
stock, the parties desired that Corp convert back
into an LLC taxable as a partnership (referred to as
LLC2) before the end of Corp's tax year that included the original conversion, so that it and A and B
again would be subject to only a single level of federal income taxation. The proposed reversion of
Corp into an LLC was referred to as the "rescission
transaction" in the letter ruling38 and would be conducted pursuant to a rescission agreement that the
parties would enter into beforehand. The rescission
transaction would be effected by filing a certificate
of conversion with state Z. The "taxpayer" (meaning
collectively LLC1 and Corp) represented that the
incorporation transaction "constituted a transaction
qualifying under §351"39 and that the current tax
years of A, B, and the taxpayer all would end on
December 31 (of a redacted year, most likely
2005). Date1 fell within the current tax year of each
party that ends on that December 31.

such shares. IRS has ruled that, should a person
acquire REIT shares in violation of the "excess
share" provision, such person will not be considered
the owner of the excess shares for federal income
tax purposes if the restrictions on such excess transfers are valid under state law and the REIT uses its
best efforts to enforce such transfer restrictions.33
The result of the "excess share" transfer restriction—as void to begin with—is not a true rescission.34 Nonetheless, the restriction may permit the
entity to retain (or reinstate) REIT status by having
the initial transfer of stock treated as if that transfer
had never occurred—similar to the desired objective of S corporation stock transfer restrictions, also
favorably ruled on by IRS, as discussed above.35
RESCISSIONS: C CORPORATIONS INTO
PARTNERSHIPS
In Ltr. Rul. 200613027, IRS permitted a partnership
that had become taxable as a corporation to revert
to partnership tax status, pursuant to a successful
rescission before year-end. There, LLC1, a domestic LLC (treated for federal tax purposes as a partnership) statutorily converted into Corp (taxable as
a C corporation) by filing a certificate of conversion
and a certificate of incorporation under state Z law.
As a result, A and B, the sole owners of LLC1,
became the sole shareholders of Corp.

The taxpayer made several other representations,
presumably required by IRS, including the following:
(1) Prior to the incorporation transaction, the
taxpayer was an LLC taxable as a partnership
for federal income tax purposes.
(2) Other than the redemptions made as a
result of the death or separation from service of
certain members of the taxpayer's management
team and the LLC1 tax distribution payment,
the taxpayer had not made any distributions to
its equity holders since the date of the incorporation transaction.

The statutory conversion (referred to in the letter
ruling as the "incorporation transaction"), which
occurred pursuant to a contract previously entered
into among A, B, and LLC1, took place on Date1.
After Date1, Corp redeemed some of its outstanding stock as a result of the death or separation from
service of members of its management team.
Although not disclosed in the ruling, it appears that
certain employees of Corp were granted corporation stock after Date136 and had their stock
redeemed all within the same tax year. Separately,
after Date1 Corp paid A and B an "LLC tax distribution payment" (which was provided for in LLC1's
operating agreement and was intended to help
cover A's and B's tax liabilities on their allocable
share of LLC1's taxable income), to which they
were entitled for the period through Date1.37

(3) Since Date1, the taxpayer had not taken
any actions with respect to, or engaged in any
transactions with, A or B that were inconsistent
with the actions and transactions the taxpayer
would have undertaken had it remained a partnership for federal income tax purposes at all
relevant times, except that the taxpayer had not
distributed certain amounts to A and B with
respect to each member's share of allocated
net income since Date1 (i.e., tax distributions)
that it would have distributed had the taxpayer
remained a partnership for federal income tax
purposes. If the rescission transaction became
effective, the taxpayer would make these tax
distributions to A and B in accordance with the
operating agreement that governed the relationship among A, B, and LLC1.

The ruling states that the incorporation transaction
was effected in anticipation of making an initial public offering (IPO) of Corp's stock. As a result of a
"precipitous and unexpected deterioration in market
conditions" following the incorporation transaction,
however, the IPO was cancelled shortly thereafter
(as of Date2). There was no plan to attempt another IPO "in the near future."

(4) If the rescission transaction became effective, the taxpayer would file its federal income
tax return as if it was a partnership during all of

8

the calendar year (again, presumably 2005),
and A and B each would include in income its
allocable share of the taxpayer's items of
income, deduction, gain, and loss for that year.
A and B each would report the amounts
received in the redemptions (of the taxpayer's
management team) consistently with the taxpayer's having been an LLC taxable as a partnership during all of that tax year (2005).

Ltr. Rul. 200613027 is of interest for several reasons, discussed below.
Rescissions include statutory conversions and
re-conversions. The ruling is apparently the first
IRS ruling—published or private—to deal with the
issue of whether a statutory conversion of an entity
and its re-conversion constitutes a rescission for
federal income tax purposes. A statutory conversion
is one that is recognized through a simple filing with
the appropriate state office and which typically provides that on the conversion, title to any real or personal property, and all liabilities, are deemed transferred to and vested in the new entity without any
further act.40 The rescissionary act in Ltr. Rul.
200613027 was "the proposed conversion back into
an LLC," which (as noted above) was referred to in
the ruling as the "rescission transaction" and was to
be conducted pursuant to the parties' "rescission
agreement." One might assume that the "conversion back" is also by statutory conversion, if state Z
(like a majority of other states41) also permits "opposite direction" statutory conversions, i.e., from corporations to LLCs, just as it permits such conversions of LLCs into corporations.

(5) On the rescission transaction's becoming
effective, the relationship among A, B, and
LLC2 would be governed by the same operating agreement that governed the relationship
among A, B and LLC1 (although the agreement
would be re-executed).
(6) The rescission agreement was intended to
restore the legal and financial arrangements
between the owners and the taxpayer as they
would have existed had the taxpayer not converted from an LLC taxable as a partnership
into a corporation taxable under Subchapter C.
(7) The effect of the rescission agreement
would be to cause the legal and financial
arrangements between the owners and the taxpayer to be identical in all material respects,
from the date immediately before the conversion, to such arrangements as would have
existed had the conversion not occurred.

It would appear that the rescission should be
respected for tax purposes even if the rescission
transaction was not via a statutory conversion, so
long as the status quo ante requirement (discussed
below) was met. The fact that substance matters
(i.e., is given effect for tax purposes) when a corporation terminates and its shareholders become partners42 supports this conclusion in the corporation-toLLC rescission scenario. As a broader principle,
however, even where form controls (if the second
transaction should be given tax effect),43 the focus
is on the bedrock question of whether the parties
were restored to the status quo ante—not how they
were so restored.

(8) Neither A, B, nor the Taxpayer have taken
or would take any material position inconsistent
with the position that would have existed had
the conversion not occurred.
Based on the facts and aforementioned representations and the parties' restoration by December 31
(2005) of the relative positions they would have occupied if the incorporation transaction had not occurred,
IRS (citing Rev. Rul. 80-58) ruled in Ltr. Rul.
200613027 that, for federal income tax purposes:

The status quo ante requirement. As stated
above, the status quo ante requirement in Rev. Rul.
80-58, involving a sale of property, requires "restoring the parties to the relative positions that they
would have occupied had no contract been made."
Situation 1 of the Revenue Ruling approves the
rescission of the sale of the land, which placed the
buyer and seller "in the same positions as they
were prior to the sale." Ltr. Rul. 200613027, involving an incorporation transaction which the taxpayer
represented constituted a transaction qualifying
under Section 351, contained additional representations (presumably required by IRS to obtain the
favorable rulings), one of which is that the "effect of

(1) The taxpayer would be treated as a partnership at all times during the calendar year
(2005).
(2) A and B would be treated as partners of the
taxpayer during such period.
(3) The conversion of the taxpayer from a corporation into an LLC taxable as a partnership
pursuant to the rescission transaction would not
be treated as a liquidation of Corp for purposes
of determining the taxable income of the taxpayer, A, or B.

9

the Rescission Agreement is to cause the legal and
financial arrangements between the owners and
the Taxpayer to be identical in all material respects,
from the date immediately before the conversion, to
such arrangements as would have existed had the
conversion not occurred." The IRS conditioned its
ruling in Ltr. Rul. 200613027 on, among other
things, "the parties' restoration by December 31,
[2005], of the relative positions they would have
occupied if the Incorporation Transaction had not
occurred" (citing Rev. Rul. 80-58).

ly that such management team members or their
heirs (whose stock was redeemed as a result of the
employees' separation from service or death) would
willingly rescind their transactions, repay any cash
they received in their stock redemptions, and be
returned to the status quo ante.
To the author's knowledge, no prior rescission case
or ruling involved a fact pattern that had intervening
third-party ownership and equity redemptions as
described above.
Intervening (non-equity) transactions inside the
entity also need not affect rescission status.
Although not discussed in the letter ruling, there
undoubtedly also were intervening (non-equity) transactions that occurred inside Corp, affecting its value45
(in addition to the aforementioned issuance and
redemption of management's stock). Nonetheless,
the requirement that there be a restoration of the parties to the status quo ante apparently did not require
the value of the consideration be identical, so long as
the members of the LLC (A and B) were the owners
both before and after the transactions.

The taxpayers' representations in Ltr. Rul.
200613027 are substantially similar to those in Ltr.
Rul. 9829044, the S corporation stock rescission
ruling described above.44 In the latter ruling, IRS
concluded that the two commonly owned corporations in question, as well as their shareholders
(who had transferred all of the stock of one corporation to the other, and then received the same
stock back as a distribution from the transferee corporation) were restored to the relative positions
they would have occupied if the initial capital contribution had never occurred. Those shareholders
represented, among other things, that there "were
no material changes in the legal or financial
arrangements" between the commonly controlled
corporations, or between one or more of the shareholders and the corporations, and that after the
rescissionary transaction (i.e., the distribution of the
contributed stock back to the shareholders), the
"legal and financial arrangements among all of the
parties were identical in all material respects to
such arrangements prior to" the contribution of the
stock. Taken together, Ltr. Ruls. 9829044 and
200613027 indicate that the status quo ante
requirement for a valid rescission that restores
favorable entity tax status turns on re-establishing
the legal and financial aspects of the entities and
their owners in all material respects.

To illustrate, assume A and B have a zero tax basis
in their interests in LLC1, and the FMV of LLC1
was $100 on the date of the incorporation transaction (when the prospects of the IPO were good) and
the FMV of Corp was only $80 on the date of the
rescission transaction (due to the failure of the
IPO). Analyzed at the ownership level, A and B initially owned property (i.e., their interests in LLC1)
worth in the aggregate $100 (for stock presumably
worth $100), and pursuant to the rescission transaction A and B effectively were restored to owning
property (i.e., the LLC2 interests) worth in the
aggregate only $80.46
Contrast this with Ltr. Rul. 200533002, discussed
above, in which it was critical for purposes of the
status quo ante requirement that the amount reconveyed be the same amount ($N) as the original
sale price. Suffice it to say that since A and B were
the sole owners both before and after the incorporation transaction and rescission transaction, there
was nothing more that they could do to meet the
requirement that they be restored to their prior position even if the value of Corp/LLC2 had decreased
(say from $100 to $80).47 Viewed on an entity-level
basis, that certainly was true—A and B presumably
have the same ownership interests in LLC1 and
LLC2, respectively.

Intervening equity transactions need not affect
rescission status. The transactions involving the
management team did not adversely affect the
rescission in Ltr. Rul. 200613027, even though
such transactions (occurring while the entity was a
corporation) apparently were not rescinded. Thus,
there were equity transactions involving corporate
employees who received Corp stock and were
redeemed of such shareholdings during the short
period between Date1 and Date2 (i.e., after the
incorporation transaction but before the rescission
transaction). Such management team members
were not listed as parties to the ruling (in the statement of parties whose names were redacted at the
beginning of the letter ruling), and it is highly unlike-

Does this represent an extension of Rev. Rul. 8058? Is it merely a recognition that the entity-level
analysis should apply to A, B, and LLC1/Corp (the
taxpayer) for purposes of analysis?

10

It is submitted that, in general, any intervening
transactions48 have no bearing on the determination
of whether there has been a valid rescission of A's
and B's ownership in Corp. As noted, the status
quo ante requirement of Rev. Rul. 80-58 is meant
to restore the parties to the same "relative positions
they would have occupied had no contract been
made," i.e., if LLC1 had continued in existence as a
tax partnership throughout the year with A and B as
owners (disregarding for the moment the management team's intervening ownership). As the taxpayers represented in Ltr. Rul. 200613027, the effect of
the rescission transaction and rescission agreement was to cause the legal and financial arrangements between A, B, and LLC2 to be identical in all
material respects to such arrangements as would
have existed had the LLC1-to-Corp conversion
(incorporation transaction) not occurred. Here, if
Corp and LLC2 had never been created and the
incorporation transaction and rescission transaction
never occurred, LLC1 presumably would have suffered the same decrease in value (i.e., from $100
to $80) on failure of the IPO to occur. Therefore,
the difference in value of A's and B's ownership in
LLC1 (at the time of the incorporation transaction)
and in LLC2 (immediately following the rescission
transaction) arising from intervening events49 should
have no bearing on the conclusion that the status
quo ante requirement was met and a valid rescission occurred for federal income tax purposes in
Ltr. Rul. 200613027.

as the owners of the stock each temporarily owned
during the interim.
Thus, the representation in Ltr. Rul. 200613027
enabled the parties to avoid running afoul of Rev.
Rul. 78-119.
The LLC tax distribution payment, while atypical in
a C corporation setting, is commercially reasonable
(given that A and B, LLC1's owners, were liable for
taxes on their allocable shares of the entity's preincorporation income). The payment was made to A
and B after the incorporation transaction; it technically was a corporate distribution. Unlike the result
in Rev. Rul. 77-119, where an unwinding was not
treated as a valid rescission because the dividends
received were not repaid by the shareholders, Ltr.
Rul. 200613027 allows the rescission transaction to
qualify notwithstanding A's and B's failure to repay
the corporate distribution.
Is IRS being overly generous in the letter ruling, or
silently extending Rev. Rul. 80-58? It is doing neither. A and B would have received the same distribution from LLC1 had the incorporation transaction
never occurred. Had A and B remained partners of
the partnership for the entire year, as the ruling so
holds, they would have received and retained the
LLC tax distribution payment. In accordance with
the ruling's stated standard that the legal and financial arrangements between A, B, and LLC1/Corp be
identical in all material respects, it would be wrong
for A and B to regurgitate the tax distribution payment to Corp or LLC2—A's and B's financial
arrangements would then differ from what they had
been immediately before the incorporation transaction, when they were entitled to receive and retain
the LLC tax distribution payment that was to be
made in the next few months.

No distributions to equity owners. The representation in Ltr. Rul. 200613027 that the taxpayer
(Corp) has not made any distributions to its equity
holders (other than the LLC tax distribution payment) since the date of the incorporation transaction
is noteworthy. If Corp had made dividend-type distributions to A and B in 2005 that were not returned by
them in 2005 to Corp prior to the rescission transaction, would IRS have determined that A and B did
not meet the status quo ante requirement?

Unanswered Questions
Ltr. Rul. 200613027 does not address several
questions involving rescissions that affect entity tax
status and the collateral tax consequences to other
equity owners.

In Rev. Rul. 78-119, 1978-1 CB 277, the Service
ruled there was no valid rescission for tax purposes
of a stock transfer agreement which initially qualified as a B reorganization (on 3/13/77) because
dividends that were distributed during the interim
period (3/13/77 to 11/30/77) were retained by the
recipients, and thus the parties were not returned to
their original positions. IRS concluded that the
attempt to unwind (by return of the stock on
11/30/77) constituted a second (separate) transaction that year 1977 for tax purposes, and the taxpayers who received and retained the dividends
during that interim period in 1977 would be treated

1. Which parties must be restored to the status
quo ante in the rescission of a statutory conversion? In Ltr. Rul. 200613027, there are five named
parties involved in the transaction:
• LLC1 (the previously existing LLC taxable as
a partnership).
• A and B (LLC1's owners).
• Corp (the corporation into which LLC1 converts).
• LLC2 (the LLC into which Corp converts back).

11

Which of the named parties must be restored to the
status quo ante in order to meet that requirement of
Rev. Rul. 80-58? Ltr. Rul. 200613027 does not
directly answer this question; its brief rationale for
its favorable rulings is "[b]ased solely on the facts
submitted, the representations made, and the parties' restoration, by December 31 [2005], of the relative position they would have occupied if the
Incorporation Transaction had not occurred...."
(Emphasis added.) It does not explicitly state who
the "parties" are.50 If the incorporation transaction
had not occurred, there would be no Corp, and no
need to create LLC2 (i.e., to replace LLC1)—only
A, B, and LLC1 existed prior to the incorporation
transaction. Since LLC1 has (irrevocably?) dissolved under state law and is effectively replaced
by LLC2 as a matter of state law on Corp's "conversion back," are the parties that must be restored
only A, B, and LLC2? As stated earlier, the letter
ruling defines the "taxpayer" to be LLC1 and Corp
together, and the representations involving the
restoration of legal and financial arrangements
between owners A and B and the taxpayer indicates (without explicitly providing) that A, B, and the
entity (which started out as LLC1, converted into
Corp and converted back into LLC2) all must meet
the status quo ante requirement.

Of course, during the period between the incorporation transaction and the rescission transaction
Corp's assets may have increased, decreased,
been converted, modified physically, sold,
exchanged, liquidated, or reinvested. Thus, on
Corp's reconveyance of the assets, LLC1 (or LLC2)
by definition would not get the exact same assets
that were previously transferred by LLC1 to Corp.
In an assets-over form of incorporation transaction,
does the restoration to the status quo ante requirement apply at the entity level?51 If so, would the
(presumed) changes in assets preclude LLC1 (or
LLC2) from meeting the status quo ante requirement?
To the author's knowledge, no ruling or case has
involved the question of whether a valid rescission
occurred for tax purposes where the transfer of an
ongoing business initially constituted a Section 351
or Section 721 transfer followed by a rescission
transaction returning the assets (and liabilities) to
the transferor. Thus, there is no guidance directly
on point as to the validity or invalidity of an attempted rescission of the transfer of an ongoing business
in an assets-over transaction.
Ltr. Rul. 982904452 involves a Section 351 transfer
by individual shareholders of a single asset (SCo1
stock)—not an ongoing business—and the subsequent distribution of the same asset (the SCo1
stock) by the transferee (SCo2) back to the transferor shareholders; indeed, that ruling supports the
conclusion that an assets-over incorporation transaction can be validly rescinded if the requirements
of Rev. Rul. 80-58 (including the status quo ante
requirement) are met. Moreover, Ltr. Rul. 9829044,
in holding that the legal doctrine of rescission
applies for tax purposes, concludes that under the
applicable facts and representations SCo1, SCo2,
and the shareholders in each corporation were
restored to the relative positions they would have
occupied if SCo1 stock had never been contributed
to SCo2, with the restoration being achieved in the
same tax year. As stated earlier, the same principle—namely, that A, B, and LLC1 (and its successor, LLC2) were restored to the relative positions
they would have occupied if LLC1's statutory conversion (read: assets-over transfer, as described in
the next paragraph) were reversed in the same tax
year—should be sufficient to meet the status quo
ante requirement.

2. What if the incorporation transaction instead
took the form of an "assets-over" transfer?
Would IRS have applied the same analysis and
issued the same favorable rescission rulings if the
incorporation transaction had been implemented by
LLC1 using an assets-over form of transfer, whereby LLC1 actually contributed all its assets (subject
to all liabilities) to newly formed Corp in exchange
for Corp stock, and then LLC1 distributed the stock
to its members (A and B) in liquidation of LLC1? In
that situation, would the rescission transaction
require A and B to reverse their steps in mirror
image fashion to the incorporation transaction, to
obtain the favorable rescission rulings?
If so, the rescission transaction presumably would
require, first, the reconveyance of A's and B's stock
in Corp to LLC1 (if it still were in existence for state
law purposes; if LLC1 had been dissolved for state
law as well as tax purposes, then presumably A
and B would have to resurrect LLC1 under state
law, or alternatively form LLC2, as occurred in Ltr.
Rul. 200613027). Next, LLC1 (or LLC2) would
reconvey Corp's stock back to Corp (or have it cancelled by Corp) in conjunction with Corp's liquidation. In exchange, Corp would reconvey all its
assets to LLC1 (or LLC2), Corp having no other
shareholders.

The preceding assets-over transfer and rescission
analysis may be relevant to rescissions involving
entities that were formed by statutory conversion
(such as occurred in Ltr. Rul. 200613027). In Rev.

12

Rul. 2004-59, 2004-1 CB 1050, IRS ruled that a
formless state law conversion is treated as an
assets-over transaction for purposes of analyzing
the tax consequences of the parties. In the
Revenue Ruling, an unincorporated entity (Q)
organized in state Z was classified as a partnership
for federal tax purposes. Q elected to convert under
a state law formless conversion statute into a state
law corporation. As a result of the conversion, Q
was classified as a corporation for federal tax purposes under Regs. 301.7701-2 and -3.

not deemed to be an assets-over transfer? The
transfer from Corp to LLC2 can be accomplished by
a number of means, including:
(1) Statutory conversion (as in Ltr. Rul.
200613027).
(2) Corp's formation of LLC2 (as a momentary
single-member LLC), transfer of all Corp's
assets (and liabilities) to LLC2, and distribution
of the LLC2 interests to A and B.
(3) Distribution of all of Corp's assets (and liabilities) to A and B, followed by A's and B's capital contribution of the same to LLC2.

Rev. Rul. 2004-59 refers to Rev. Rul. 84-111, 1984-2
CB 88, which describes the tax consequences when
steps are taken as parts of a plan to transfer partnership operations to a corporation organized for
valid business reasons. For each of the three methods of incorporating a partnership,53 Rev. Rul. 84111 gives tax effect (describing the differences in
basis and holding periods) to the form taken provided the steps described are actually undertaken.
Noting that Rev. Rul. 84-111 does not apply to a
partnership that converts into a corporation in accordance with a state law formless conversion statute,
Rev. Rul. 2004-59 holds that a partnership that converts to a corporation under a state law formless
conversion statute will be treated in the same manner as one that makes an election to be treated as
an association taxable as a corporation under Reg.
301.7701-3(c)(1)(i). Therefore, when unincorporated
entity Q converts, under state law, to corporation Q,
for federal tax purposes the following steps are
deemed to occur: unincorporated entity Q contributes all of its assets and liabilities to corporation
Q in exchange for stock in corporation Q, and
immediately thereafter, unincorporated entity Q liquidates, distributing the stock of corporation Q to its
partners. Thus, Rev. Rul. 2004-59 applies an
assets-over analysis to formless conversions, in the
same fashion as alternative 1 in Rev. Rul. 84-111.

Regardless of the form, the analysis in Ltr. Rul.
200613027 that the parties (A, B, LLC1, and LLC2)
will be restored to the relative positions they would
have occupied if the incorporation transaction had
not occurred, should suffice to constitute a valid
rescission, in accordance with Rev. Rul. 80-58. The
letter ruling, being based on its information and representations, does not address any alternative
forms of unwinding.
4. How should the intervening stock redemptions be reflected for tax purposes? The proper
tax reporting of the management team's stock
transactions is not the subject of Ltr. Rul.
200613027, but one might first surmise that they
had been issued the equivalent of options or
unvested ownership interests in LLC1 that vested
on the incorporation transaction or shortly thereafter, and thus the management team members
sprung into being as owners of the taxpayer (Corp)
about that time.54
For tax purposes, how should the redeemed and
non-redeemed management team members report
their status? We assume (1) they were mere
employees of LLC1 prior to the incorporation transaction, (2) they were employee-shareholders during
the period (or, for the redeemed shareholders, a
portion of the time) that Corp was taxable as a C
corporation (but for the forthcoming rescission), and
(3) they remained as employees after the rescission
transaction but no longer owned any equity interest
in LLC2. The 2005 Proposed Regulations on compensatory partnership interests and options for
services55 clearly do not contemplate a rescission
scenario and provide no guidance.

Therefore, it would follow that the incorporation
transaction (via statutory conversion) in Ltr. Rul.
200613027 would be viewed under Rev. Rul. 200459 as an assets-over transfer. In that instance,
should the Service have focused on whether (1) the
owners of the unincorporated entity (i.e., A and B,
the owners of LLC1), (2) the entity itself, LLC1
(later to be LLC2), or (3) both the owners of the
unincorporated entity (A and B) and the deemed
asset transferor (LLC1, later to be LLC2), met the
status quo ante requirement?

As mentioned above, Corp redeemed the stock
owned by management team members who died or
separated from service (during the year of the
rescission, of course). At the time of those redemptions, Corp presumably was taxable as a corpora-

3. If not an assets-over transfer, how can the
parties achieve a valid rescission? Can there be
a valid rescission if the incorporation transaction is

13

tion, and one might speculate that at the time of
their stock redemptions, the redeemed (living)
shareholders and the deceased shareholders' heirs
did not then know or even contemplate that the
rescission transaction would occur and that, for federal income tax purposes, LLC1 and Corp would be
ruled on 12/16/05 to be an LLC taxable as a partnership at all times during the calendar year (2005).
Where did that leave the redeemed shareholders?
Presumably, they would report on their Form 1040
income tax returns for 2005 their transactions as
having been the initial receipt of stock for services
(presumably subject to Section 83) and the
redemption of the stock being treated as a Section
301 dividend-type distribution that likely would qualify for (short-term?) capital (gain or loss) treatment
under Section 302. Ltr. Rul. 200613027 includes a
representation that "[e]ach of [A and B, the owners]
will report the amounts received in the redemptions
described in [the management team redemptions]
consistently with the [t]axpayer's [i.e., Corp/LLC1]
having been an LLC taxable as a partnership during all of taxable year [2005]." Note that "the
amounts received" were received by the management team and not by A and B—unless A and/or B
were also recipients of management team shares,
which seems unlikely (as together they already had
100% ownership). Thus, the representation
appears to be that A and B (who are the sole owners of LLC2 and presumably are the parties who
determine how the tax return(s) for 2005 will be
prepared by the entities) agreed to report the
redemption payments to the management team as
paid by the LLC taxable as a partnership, and
thereby governed by Section 736.

5. How should the issuance of equity compensation to the management team be reflected
for tax purposes? Lacking all the relevant facts,
one nevertheless might speculate that the management team members who (ultimately) received
stock from Corp first received LLC1 compensatory options or uninvested partnership profits or
capital interests, which interests might have
become vested for state law purposes once Corp
was formed and/or issued shares of stock to the
management team. So viewed, the initial receipt
of the compensatory partnership interests might
be treated for income tax purposes quite differently from the treatment of the receipt of stock for tax
purposes.56

Does this mean the LLC1/Corp/LLC2 tax partnership may be sending Schedules K-1 for 2005 to the
redeemed management team members, while the
latter report the transactions as stock redemptions
on their Form 1040 tax returns for 2005? Might the
tax consequences be materially different to the
redeemed shareholders (or their heirs, with respect
to those management team members referred to in
the ruling as having died and being redeemed prior
to the rescission transaction)? The amounts and
terms of the redemption payments are not
described in the ruling. One may speculate, however, that viewed as a stock redemption the payment
would generate a capital gain (or loss) under
Section 302 to the recipient, while if viewed as a
Section 736 payment some portion of the payment
might be characterized as ordinary income under
Section 751 or (less likely, but theoretically possible) ordinary income under Section 736(a)(2).

Assume one or more management team members
take a reporting position inconsistent with that
taken by A and B, the owners of the LLC (who
have represented they will report the redemptions
consistently with LLC1 and Corp having been an
LLC taxable as a partnership for the entire calendar year (2005)). Query whether on the (likely)
audit of the entities or the members for 2005 there
will be the need for filings of notices of inconsistent
position by the "partners." If LLC sends K-1s to the
redeemed shareholders (which the latter disregard), might there be potential penalties applied to
the shareholders? Arguably they have reasonable
cause for believing their stock redemption was just
that for tax purposes. Would the redeemed shareholders' penalty defense position be undermined if
LLC2 sent them a copy of the letter ruling along
with their K-1s, so that the shareholders were on
notice of the valid rescission for tax purposes?

Alternatively, there may have been no LLC1 equity
compensation program. In that event the equity
(stock) awards would then first have arisen after
Corp came into being, in anticipation of (but
before) the IPO. In either scenario, some or all of
the management team members—those redeemed
and those (if any) not redeemed—well might prefer
Corp not to be recognized as a corporation for federal income tax purposes. Instead, the former and
current management team members might prefer
to be treated as K-1 partners for that portion of the
year in which they owned equity interests in Corp.
Analysis of the terms of the Corp stock grants to
the management team members and the relevant
facts and circumstances of each equitized management team member would be necessary to
determine whether each would be better off as a
K-1 partner for 2005 (and thereafter, for those
team members not being redeemed) or as a stockholder.

14

6. Did the ongoing management team members
rescind their receipt of Corp stock? Although not
clear from Ltr. Rul. 200613027, it is quite possible
that the Corp stock issued to the management
team was itself the subject of rescission, or at least
modification. The representations and holding in the
letter ruling state that if the rescission transaction
were effectuated, A and B would be treated as partners of the taxpayer (i.e., LLC1 and Corp) during
such period. Are the management team members
not treated as partners during the year (2005)?
Does the ruling not deal with their equity ownership
status (as partners) because (perhaps) their stock
awards were mutually rescinded? The letter ruling
is silent on this point.

taxes as partners under Section 1402(a) (unless
Section 1402(a)(13) is applicable)? If so, they may
be potentially subject to late payment penalties or
estimated tax penalties because they failed to take
their (formerly W-2, now characterized as K-1)
income into consideration in 2005 for self-employment and income tax withholding purposes! It
seems only appropriate that IRS waive any potential penalties of such management team members,
given they had reasonable cause to believe they
were W-2 employees (not K-1 partners) with proper
withholding taxes being remitted by Corp during the
period they were shareholder-employees—notwithstanding that the subsequent rescission transaction
was given retroactive effect.57

7. What are the payroll and withholding tax consequences of the rescission? Assume that during
the period that Corp was in existence (i.e., from
Date1 to Date2) the management team was paid
cash (in addition to equity) compensation for services. Even though the team members were shareholders, their cash compensation for services
would be subject to FICA, HI tax, and federal (and,
if applicable, state and local) income tax withholdings, with Corp paying its (employer) share of the
FICA and HI taxes.

RESCISSIONS: PARTNERSHIPS INTO
TENANCIES-IN-COMMON
To the author's knowledge, there have been no
Revenue Rulings, letter rulings, or other IRS guidance involving the unwinding of a partnership via
rescission. The case law is sparse.58
In an undated 1992 field service advice (FSA 19991079, 1992 WL 1354785), the Service's National
Office was asked to determine whether the rescission rights exercised by the partners in several cattle-breeding tax-shelter partnerships precluded the
existence of the partnerships, for federal income tax
purposes, from the beginning. The response took
the form of a partially redacted IRS Memorandum
from the Assistant Chief Counsel (Field Service) to
District Counsel.

As a result of the rescission transaction, Corp is no
longer treated as having existed for tax purposes,
and as held in Ltr. Rul. 200613027,
LLC1/Corporation/LLC2 are treated as a partnership for tax purposes for the entire year. Can LLC2
(the surviving legal entity) obtain a refund of its
payroll taxes, as a result of the valid rescission,
because the shareholder-employees are properly
recharacterized as K-1 partners (and whose W-2
salaries arguably are reclassified as being guaranteed payments under Section 707(c), and thus not
subject to payroll tax withholding pursuant to Reg.
1.707-1(c))? Moreover, can the partnership successfully recover all federal, state, and local income
tax withholdings it remitted on behalf of Corp's
putative shareholder-employees (who in light of the
valid rescission logically would be deemed partners
for tax purposes from the moment they owned
equity in Corp)?

In the FSA, the IRS was confronted with limited
partnerships formed under state law in year P.
Subsequently, the promoter of the partnerships was
advised by his counsel that it was not advantageous to operate as partnerships because of potential violations of federal securities laws. In year Q,
the promoter offered the investors the option of
rescinding their agreements to become partners in
the partnership. The purported rescission was
retroactive to an unspecified date.
Forms 1065 for an unspecified number of tax
years of the partnerships were filed, with all relevant lines on the returns being struck through or
containing zeroes. Notes attached to each tax
return stated, among other things, that for tax purposes the partnership was never in existence, and
that "[t]he owners of the business have determined the business was operated as a ‘Tenants
[sic] in Common’ arrangement during [a redacted
time period]."

If Corp/LLC2 is entitled to a refund for paying such
taxes, LLC2 presumably will be legally obligated to
pay the recovery (i.e., the amount wrongly withheld,
in hindsight) to the management team members
who are deemed to be partners for tax purposes.
Conversely, aren't those equity-owing management
team members, thanks to 20-20 hindsight via the
rescission, now liable for their own self-employment

15

To confuse matters further, although the partnerships were rescinded for state law purposes many
of the partners, relying on the K-1s that they had
received from the promoter, took losses for the
(redacted) tax year. IRS asserted that the partners
were not entitled to these losses.

operations nonetheless reportable by the
owners?
• In a tenancy-in-common for tax purposes,
must the losses and income be borne proportionately (i.e., on a "straight up" basis), with
no special allocations being permitted (given
that Section 704(b) by its terms applies only
to the tax partners in a tax partnership, which
by definition this tenancy-in-common is not)?

The facts in FSA 1999-1079 probably would be
somewhat ambiguous and confusing even in their
unredacted form—and they are far more so in the
available version. Nonetheless, the FSA is clear in
its discussion of the issue of whether the state law
partnership was a partnership for the (redacted) tax
year for tax purposes. The FSA's discussion states
in relevant part:

• If the rescission is effective such that no partnership in fact existed under federal income
tax law and if no partnership return is filed, do
the TEFRA audit rules apply? (The FSA indicates it does not.)

"Our impression is that the decision to rescind by
the partners was based on potential securities law
violations. These concerns arose after the partnership had purportedly been formed. We have found
no authority which would allow partners in a partnership to retroactively rescind the existence of a
partnership in a prior taxable year for tax purposes.[Footnote 1 appears here in the original, and is
discussed below.] Thus, the rescission rights would
not preclude formation." (Emphasis added.)

• If a partnership return was filed by a state-law
entity (e.g., a limited partnership) for a tax
year, but it is determined that the entity is not
a partnership (e.g., because of a valid rescission by all the parties), do the TEFRA rules
nonetheless extend to such entity and to persons holding an interest in the entity?
(Apparently they do, according to the FSA,
and authority cited therein.)
These and other aspects of partnership unwindings
and rescissions could clearly benefit from further
IRS guidance.

The Service's refusal in FSA 1999-1079 to allow a
retroactive rescission for a prior tax year is consistent with Rev. Rul. 80-58. The FSA implies, however, that a rescission of the formation of the partnership occurring in the same year of formation could
be respected for tax purposes. In the FSA's footnote 1 to the penultimate sentence in the quote,
above, the IRS National Office notes that amendments (in regards to allocation of partnership items)
to the partnership agreement are allowed before
the partnership return for the year is legally due
and owing (i.e., in the next year), pursuant to
Section 761(c). Moreover, "as a general principal
[sic] of tax law some sales or contract transactions
may be ‘unwound’ in the same tax year. See Rev.
Rul. 80-58...."

Assuming partnership rescissions are otherwise
permissible if in compliance with the two requirements of Rev. Rul. 80-58, will a partnership unwinding that is motivated solely for income tax reasons
be respected by IRS and the courts? Assume that a
family limited partnership is formed for valid personal, non-tax purposes in July 2006. Five months later
the partnership's accountant, in analyzing the
details of the partners' capital contributions, determines the partnership will be classified as an
investment company under Section 721(b), with
gain being recognized by the partners on all appreciated property so contributed. Solely to avoid this
gain the partners agree to rescind the partnership.
In the rescinding transaction the partnership reconveys the assets back to each contributing partner,
while meeting the status quo ante requirement, and
the partners relinquish their interests in the partnership (which dissolves, having neither assets nor
partners). If this is viewed as a valid rescission, the
gain otherwise arising under the investment company rules would be avoided.

Is the National Office hinting (albeit in dictum,
buried in a footnote, wrapped in a nonprecedential
FSA) that a rescission by all (or by all but one) of
the partners of a partnership in the same year as it
is formed could be given effect for tax purposes?
• If so (and perhaps we are reading too much
into the tea leaves), what are the tax consequences to the state-law entity and its statelaw partners—a tenancy-in-common, as the
tax return disclosure claimed? Aren't the taxable losses (as reported in FSA 1999-1079)
or income from the state-law partnership's

The partners' motive for the attempted rescission,
however, is purely tax driven, i.e., to avoid gain
recognition. Would the Service permit a purely tax-

16

motivated rescission from a partnership to individual owners on these facts? The answer is unclear.59

Reinstatement of REIT status pursuant to the
rescission of a transfer of stock that otherwise
would violate the "closely held" rules of Section
856(h) has not yet been the subject of rulings or
cases involving rescissions. Nevertheless, the
analysis and requirements should be very similar to
those described in Ltr. Rul. 200533002 with respect
to rescissions of stock transfers to ineligible shareholders of an S corporation. Rescission of partnerships (and the members' alleged characterization
as mere tenants-in-common) was alleged by the
taxpayer in FSA 1999-1079, but that redacted IRS
document does not give crystalline guidance (and
sheds little light in its redacted form) on the topics
discussed herein.

CONCLUSION
As described above, during the past year IRS has
issued two favorable letter rulings permitting taxpayers to rescind transfers of ownership interests in
S corporations and partnerships, respectively,
resulting in the re-establishment of those entities'
favorable entity-level tax treatment. Ltr. Rul.
200533002 confirms the reinstatement of S corporation status of an entity otherwise taxable as a C
corporation (by recognizing a valid rescission of
stock transfers made to otherwise ineligible shareholders). Ltr. Rul. 200613027 approves a rescission
that permitted an LLC (taxable as a partnership) to
regain its partnership tax status after having been
statutorily converted into a C corporation.

Practice Notes
Two recent letter rulings provide guidance as to the
status quo ante requirement applied by IRS in Rev.
Rul. 80-58 and letter rulings that followed. Care
must be exercised in accomplishing a valid rescission for tax purposes, given the potentially adverse
(if not catastrophic) tax consequences that can
arise if the attempted unwinding is not respected
and both the first and second transactions are
given independent tax effect. In order to effectuate
a valid rescission for tax purposes which changes
the entity's tax status (as described above), IRS
requires the unwinding to cause the legal and financial arrangements between the owners and the
entity involved to be identical in all material
respects, as would have existed if the initial transaction (e.g., the statutory conversion of the LLC in
Ltr. Rul. 200613027; the transfer of SCo1 stock in
Ltr. Rul. 200533002) had never occurred.

Both rulings apply the rescission principles in Rev.
Rul. 80-58 and authority cited therein to permit the
entity to reinstate its favorable status. The rulings
are not remarkable in that regard, but serve as a
useful road map for identifying the conditions IRS
requires to have a rescission respected for federal
income tax purposes.
The rulings do not address the income tax consequences to the owners of the interests in the
respective entities, other than to confirm that the
rescinding transaction does not generate recognition of taxable gain or loss to the entities or their
owners.
The two letter rulings do not provide guidance (and
leave unanswered several questions) with respect
to tangential tax consequences, including the taxation of non-rescinding owners of the equity interests. As discussed above, this might result in certain taxpayers reporting transactions as having
been treated as stock redemptions governed by
Section 302 for federal income tax purposes, while
other owners and/or the entity itself treat those
transactions as partnership redemptions, governed
by Section 736.

1

See, e.g., Penn v. Robertson, 25 AFTR 940, 115
F2d 167 (CA-4, 1940), involving 1930-31 rescission
transactions.

2

See, e.g., Banoff, "Unwinding or Rescinding a
Transaction: Good Tax Planning or Tax Fraud?," 62
Taxes 942 (December 1984).
3
See, e.g., Banoff, "Tax Planning for the
Unexpected," 68 Taxes 1033 (December 1990).

The letter rulings involve valid non-tax reasons for
the rescissions and do not appear subject to
manipulation. Nonetheless, the tax consequences
to the members (including potential Section
302/736 disparities) may not be symmetrical. As
reflected in Rev. Rul. 99-6, 1999-1 CB 432,60 the
parties to a transaction need not be treated consistently, for federal income tax purposes, and that
result has not brought the tax system crashing
down.

4

See Banoff, supra note 2, pages 943 and 947-48.
As to whether intentional "backdating" of documents may successfully constitute a valid rescission for tax purposes or instead constitute fraud,
see id., pages 947-48, 970, and 979-980 (in certain
limited circumstances, backdating a contract or
agreement may be of value in retroactively unwinding or modifying a transaction, but improper backdating, if done to conceal the document or to

17

that "the parties to the transaction must return to
the status quo ante; that is, they must be restored
to ‘the relative positions they would have occupied
had no contract been made’"). There are several
meanings of "rescission" in general parlance. "The
term ‘rescission’ is often used by lawyers, courts
and businessmen in many different senses; for
example, termination of a contract by virtue of an
option to terminate in the agreement, cancellation
for breach and avoidance on the grounds of infancy
or fraud.... [In the Commercial Code] ‘rescission’ is
utilized as a term of art to refer to a mutual agreement to discharge contractual duties...." Calamari
and Perillo, The Law of Contracts, Third Edition
(West, 1987), §21-2, pages 864-65. An earlier edition of Black's Law Dictionary, as quoted in Banoff,
supra note 2, page 957, defined "rescission of contract" as "annulling or abrogation or unmaking of
contract and the placing of the parties to it in status
quo." The more modern definition of "rescission" in
the Seventh Edition of Black's eliminates explicit
reference to "status quo" or "status quo ante" and
defines an "agreement of rescission" as "an agreement by contracting parties to discharge all remaining duties of performance and terminate the contract." Black's defines the verb "rescind" to mean
"1. to abrogate or cancel (a contract) unilaterally or
by agreement, 2. to make void; to repeal or annul."

change the original intent of the parties, is subject
to civil or criminal penalties).
5

See, e.g., Miller, 66 AFTR 2d 90-5337, 907 F2d
994 (CA-10, 1990), fn. 2 (affirming tax attorney's
conviction for making false statements in violation
of 18 U.S.C. section 1001).

6

7

Banoff, supra note 2, pages 944-945.
Id., page 946.

8

See, e.g., Rev. Rul. 74-501, 1974-2 CB 98,
Situation 2.

9

Banoff, supra note 2, page 965. See, e.g., Ltr.
Ruls. 8645047, 9409023, and 199935035.

10

Id., page 960.

11

See, e.g., Ripley Realty Co., 23 BTA 1247
(1931), aff'd per cur. 61 F2d 1038 (CA-2, 1932). Cf.
Hope, 55 TC 1020 (1971), aff'd 31 AFTR 2d 73577, 471 F2d 738 (CA-3, 1973), cert. den., which
also involved a taxpayer contending that a rescission should be given multi-year retroactive effect.
The Tax Court there noted that "[t]his court is not
faced with the situation where the sale is rescinded
in the same year. Compare Penn v. Robertson.... In
fact, it is not necessary to decide what might have
been the result if this sale had been rescinded in
the following year. Compare Penn ... with Ripley
Realty Co...." The Tax Court in Hope thus did not
reject the dictum of Ripley Realty, and one might
speculate that had the facts in Hope presented an
actual rescission, a different result might have followed, i.e., the rescission might have been given
retroactive effect for multiple years for tax purposes. Several commentators have suggested that it is
arguable that a rescission is a nontaxable event on
a retroactive (multi-year) basis, while others are far
less optimistic. See authorities discussed in Banoff,
supra note 2, page 961 and fns. 153-155.

14

In TAM 7802003, which predates Rev. Rul. 8058, IRS stated that "the little authority available
does indicate that there may be a rescission where
a bona fide sale or exchange, otherwise taxable, is
undone and the parties to the transaction are
restored to the status quo, whether the restoration
is complete or less than complete." (Emphasis
added.) The Service cited "the fact that the parties
were returned to substantially the same position as
they were in before the sale ... tends to indicate
that there was an intent to return to the status quo."
(Emphasis added.) The TAM's "less than complete"
phrase is dictum, and in light of Rev. Rul. 80-58, it
would be extremely aggressive for a taxpayer to
rely on TAM 7802003 for the proposition that a
"less than complete" restoration may qualify for
rescission treatment for tax purposes. Indeed, the
TAM no longer constitutes meaningful authority for
purposes of establishing "substantial authority" to
avert the accuracy-related penalty of Section
6662(b)(2). Although the TAM was issued (about
one year) after 10/31/76, so as to constitute
"authority" for purposes of this penalty (see Reg.
1.6662-4(d)(3)(iii)), the fact that it is more than ten
years old (actually, nearly 30) will cause it to be
accorded "very little weight" (see Reg. 1.6662-

12

See, e.g., Branum v. Campbell, 45 AFTR 455,
211 F2d 147 (CA-5, 1954); Reeves, 3 AFTR 2d
1562, 173 F Supp 779 (DC Ala., 1959). See Banoff,
supra note 2, pages 968-69.
13

Black's Law Dictionary, Seventh Edition (West,
1999), defines "status quo ante" as "the situation
that existed before something else (being discussed) occurred." IRS did not use the phrase "status quo ante" in Rev. Rul. 80-58, but has done so in
more recent letter rulings, e.g., Ltr. Ruls. 9829044
and 200533002 (both stating that, according to
Rev. Rul. 80-58, the first of the two conditions that
must be satisfied for the remedy of rescission to
apply to disregard a transaction for tax purposes is

18

20

4(d)(3)(ii)), and the persuasiveness and relevance
of that TAM, in light of subsequent developments
(particularly, the issuance of Rev. Rul. 80-58, which
requires complete restoration of the parties), diminishes the weight of the TAM's dictum to near
weightlessness. (Reg. 1.6662-4(d)(3)(ii) also states
that a Revenue Ruling (e.g., Rev. Rul. 80-58) is
accorded greater weight than a letter ruling
addressing the same issue.)

If A holds the corporation's shares until her
death, even this silver lining is illusory, as A's heirs
would have obtained a basis step-up for her shares
(without having to recognize gain) under Section
1014 at the shares' then-current value.
21

The procedures, conditions, and requirements to
obtain an IRS waiver are beyond the scope of this
article. See generally Eustice and Kuntz, Federal
Income Taxation of S Corporations, Fourth Edition
(Warren, Gorham & Lamont, 2001), ¶5.07.
Alternatively, in rare circumstances S corporation
status may be retained by having the initial transfer
of stock being declared void ab initio by a court of
competent jurisdiction. See, e.g., Ltr. Ruls.
9409023, 9733002, and 199935035 (which in result
are analogous to a valid rescission, i.e., for federal
tax purposes there was no transfer of the stock).

15

See Penn v. Robertson, supra note 1; Banoff,
supra note 2, pages 975-983 and cases cited therein; Letter Rulings, "IRS Recognizes Rescission of
Stock Grant," 74 JTAX 262 (April 1991); Shop Talk,
"IRS Disregards Taxpayer's Attempt to Unwind
Dividend," 95 JTAX 188 (September 2001); Shop
Talk, "Do State Court Nunc Pro Tunc Orders Have
Tax Effect?," 80 JTAX 253 (April 1994); FSA
200124008; Ltr. Rul. 9104039.

22

In some letter rulings involving similar fact patterns (i.e., inadvertent termination; initial transfers by
shareholders to new, ineligible shareholders; transfers effectuated by the same shareholders "rescinding the transaction"), IRS applied relief under
Section 1362(f) rather than applying Rev. Rul. 80-58
to treat the rescission as effective for tax purposes
and restoring S corporation status. See, e.g., Ltr.
Rul. 9304007 (not mentioning Rev. Rul. 80-58).

16

Rev. Rul. 80-58 contains a valid non-tax reason
for its rescission, but does not state that a non-tax
reason is necessary for a rescission to be valid for
tax purposes. Cf. Ltr. Rul. 9829044, where IRS
approved a rescission of a transfer of S corporation
stock undertaken to preserve the S corporation's
election. In the initial transaction, the shareholders
of SCo1 (all of whom also were the shareholders of
SCo2) transferred their SCo1 stock to SCo2 for
valid non-tax reasons. SCo2 planned to make a
qualified Subchapter S subsidiary (QSSS) election,
but the company's accounting firm advised SCo2
that SCo1's suspended loss could disappear if
SCo2 made a QSSS election with respect to SCo1,
and SCo2 followed this advice. Shortly thereafter,
SCo2 distributed the SCo1 stock back to the shareholders in the same proportions as they originally
had contributed the SCo1 stock to SCo2. Applying
Rev. Rul. 80-58, IRS held the legal doctrine of
rescission applied to (1) disregard the transfer of
the SCo1 stock to SCo2, and (2) prevent the termination of SCo1's S corporation status.

23

X failed to meet the eligibility requirements for
two reasons—the issuance of a class of preferred
stock and the purchase of such stock by ineligible
shareholders, i.e., the three limited partnerships.
24

Although not discussed in the ruling, X most likely did not make any dividend-type distributions on
its common stock, either.

25

See note 13, supra.

26

These are standard rulings that are given and
desirable with respect to unwinding or rescinding
intentional or inadvertent terminations of S corporation status.

17

This assumes the shareholder's basis is less
than the amount deemed realized. The shareholder
likely would recognize a capital loss if the opposite
were true.

27

Ltr. Rul. 9829044 indicates that a rescission that
has economic consequences but is solely tax-motivated nonetheless will be respected for tax purposes.

28

Query whether unrelated parties typically will
agree to rescind a transaction at the exact amount
required under Rev. Rul. 80-58, even if the market
indicates the value or income of the company has
increased (or decreased).

18

Conversely, A likely would recognize a capital
loss if her stock basis exceeded the amount she
received from XYZ and she is not subject to loss
limitations (e.g., under Section 267).
19

XYZ also would recognize gain (or loss) to the
extent the amount it receives from A exceeds (or is
less than) XYZ's then-current basis in the C corporation's stock.

29

30

Sections 856(h) and 542(a)(2).

This is understandable. In your author's experience, REITs (whether public or private) generally

19

favorable rulings, but one's self-serving reference to
the unwinding as the "rescission transaction" rather
than, say, the "botched unwinding" is more likely to
find favor with IRS.

are formed by principal shareholders who benefit
from sophisticated advice from their lawyers and
accountants regarding qualification for and maintenance of REIT status. Thus, REIT sponsors generally have familiarity with the REIT's "closely held"
ownership rules. Moreover, REITs use self-operating provisions in their corporate by-laws or other
governing documents to preclude stock transfers
that would jeopardize the REIT's retention of qualification. In contrast, many S corporations are created by shareholders who are less than knowledgeable about the ineligible shareholder rules under
Section 1361. Perhaps more important, many if not
most S corporations' by-laws and other governing
documents do not preclude or treat as void from
the start transfers that would jeopardize the corporation's retention of its S election. Therefore, some
S corporations have resorted to rescissions of stock
transfers, and obtained IRS letter rulings to confirm
the rescissions were effective to reinstate S corporation status as of the initial transfer.

39

The taxpayer does not represent that A and B
are the "transferors" for purposes of Section 351 in
the incorporation transaction.
40

This provides simplicity and may eliminate state
and local transfer tax liability since no deed recording is necessary. Unlike a statutory merger, which
involves two entities coming together, in a statutory
conversion an existing entity is transformed into a
new entity that did not exist before the conversion.
See Banoff, "Mr. Popeil Gets ‘Reel’ About
Conversions of Legal Entities: The Pocket
Fisherman Flycasts for ‘Form’ but Snags on
‘Substance,’" 75 Taxes 887 (December 1997) (the
"Conversions article"), page 889, fn. 12.

41

See, e.g., Del. Code tit. 6, section 18-214(g).

42

31

See, e.g., Rev. Rul. 69-6, 1969-1 CB 104, and
Rev. Rul. 77-321, 1977-2 CB 98; Conversions article, supra note 40, pages 906-07.

Cf. Ltr. Rul. 9829044. See note 16, supra.

32

See Tolles and Arash, "Unwinding the Deal: The
Tax Doctrine of Rescission," 52 Major Tax Planning
(U.S.C. Ann. Inst. on Fed. Tax'n) Ch. 3 (2000).
33

43

For example, on a partnership-to-corporation
conversion, the form is respected, often resulting in
substantially different tax consequences depending
on which form is selected. See Rev. Rul. 84-111,
1984-2 CB 88; Conversions article, supra note 40,
pages 893-896 and 899-901.

See, e.g., Ltr. Ruls. 9627017 and 9719018.

34

Tolles and Arash, supra note 32, observe at
307.2C that operation of the "excess share" provision does not satisfy all the requirements of Rev.
Rul. 80-58. The person from whom the excess
shares are purchased will not be returned to the
same position if the excess shares are not returned
to that person. In addition, the person who purchased the excess shares may not be returned to
the status quo ante since it will bear the risk of loss
associated with any decline in the value of the
excess shares between the time of initial purchase
and the subsequent sale by the trust.

35

44

See note 16, supra.

45

For example, business operations; changes in
cash position; increase or decrease in the value of
assets and amounts of liabilities; and acquisition
and/or disposition of corporate property.
46

This analysis focuses on the aggregate values of
the entities (LLC1 and LLC2) and disregards discounts that ordinarily would be reflected in valuing
A's and B's respective member interests in the
LLCs. Nonetheless, the analysis described in the
text would be the same, i.e., the rescission transaction does not restore A and B to the same values of
the property they owned at the time of the incorporation transaction. This can be proven by assigning
a 40% (or any other) discount for A's and B's
respective ownership interests in LLC1, Corp, and
LLC2. A's and B's interests in LLC1 each would
have been valued at $30 (i.e., 60% of 50% of $100)
at the date of the incorporation transaction and their
interests in LLC2 each would have been valued at
$24 (i.e., 60% of 50% of $80) at the date of the
rescission transaction.

See note 21, supra.

36

The letter ruling states that as a result of the
statutory conversion, A and B, the sole owners of
LLC1, became the sole shareholders of Corp.
Therefore, the management team members must
have become shareholders of Corp thereafter.

37

This presumably relates to taxable income for
the pre-conversion period, as to which the LLC
agreement had provided for cash distributions at a
later date.

38

Nomenclature selected for unwinding transactions should not have substantive effect in obtaining

20

47

56

If in Ltr. Rul. 200613027 A and B were cognizant
that the value of LLC1 was $100 at the date of the
incorporation transaction and that (on the date of
the rescission transaction) Corp/LLC2 was only
worth $80, A and B could first contribute $20
(increasing Corp/LLC2's value to $100 at the date of
the rescission transaction) so that the values of
LLC1 and Corp/LLC2 were equal. This seems to be
a formalistic, needless approach to meeting the status quo ante requirement. Moreover, A and B would
not personally be in the same relative positions they
would have occupied had no incorporation transaction occurred, as they personally would have
reduced their net worth by the $20 cash they would
contribute to Corp/LLC2 under this alternative.

48

See, e.g., Rev. Proc. 93-27, 1993-2 CB 343;
Rev. Proc. 2001-43, 2001-2 CB 191; REG-10534603, 5/24/05; Mincey, Sloan, and Banoff, "Rev. Proc.
2001-43, Section 83(b) and Unvested Profits
Interests—The Final Facet of Diamond?," 95 JTAX
205 (October 2001); Banoff, Carman, and Maxfield,
id.
57

We have pointed out analogous conundrums for
unincorporated entities taxable as partnerships
which, within 75 days of the beginning of the tax
year, elect under the check-the-box Regulations to
be taxable as corporations. Under Reg. 301.77013(c)(1)(iii), the 75-day "look back" provides certain
advantages to the entity and its owners but also
can wreak havoc with payments to service
providers who own equity in the unincorporated
entity. Initially viewed as compensation to K-1 partners, such payments for services would constitute
guaranteed payments under Section 707(c), not
subject to employer withholding or payroll taxes. If
the LLC later made a retroactive election to be
taxed as a corporation, the compensation payments could no longer be characterized as Section
707(c) guaranteed payments since the entity would
not at any time be treated as a partnership for tax
purposes. The payments instead presumably
would be wages to an employee of the corporation,
raising many questions with respect to payroll tax
liability, penalties and interest, particularly as to
service "partners" who withdraw from the unincorporated entity prior to its election to be taxable as
a corporation. See Shop Talk, "LLCs Electing to Be
Taxable as Corporations: Tangential Problems," 96
JTAX 127 (February 2002).

Such as those described in note 45, supra.

49

Again, this assumes all other requirements for a
valid rescission have been maintained, e.g., Corp
and LLC2 made no distributions to the equity holders except as represented in the ruling.

50

Most likely IRS does not mean to include as
"parties" those "certain members of the [t]axpayer's
management team" whose stock in Corp was
redeemed. Moreover, unless all of those redeemed
shareholders voluntarily returned (to Corp or LLC2)
the redemption proceeds they would not have
been restored to "the relative position they would
have occupied if the Incorporation Transaction had
not occurred," which, as emphasized above in the
text, is the Service's rationale for its favorable rulings.
51

That is, either solely at the entity level, or at both
the entity level and the member/shareholder level.

58
52

See Branum v. Campbell, supra note 12, involving the tax consequences resulting from the formation and purported rescission of a partnership in
the same tax year. See generally Robb and
McNulty, "The Tax Consequences of Rescinding a
Partnership or One Partner's Investment," 12 J.
Partnership Tax'n 18 (1995).

See note 16, supra.

53

These are (1) the partnership contributes its
assets to the corporation in exchange for stock of
the corporation, and then distributes the stock to its
partners in liquidation ("alternative 1"); (2) the partnership liquidates and distributes undivided interests in its assets and liabilities to its partners, who
then contribute their undivided interests to the corporation for stock ("alternative 2"); and (3) the partners contribute the partnership interests to the corporation in exchange for stock ("alternative 3").

54

59

One author concludes on these facts that it is
unlikely that the Service would permit a purely taxmotivated rescission (at least in this context).
Shenkman, "Avoiding the Investment Company
Trap When Forming FLPs and LLCs," 26 Estate
Planning 484 (December 1999). Cf. Ltr. Rul.
9829044, discussed in note 16, supra, where IRS
approved a rescission of a transfer of S corporation stock that was done to preserve the S corporation's election (indicating a non-tax reason is not
required for a rescission to be valid for tax purposes).

See note 36, supra.

55

REG-105346-03, 5/24/05. See generally Banoff,
Carman, and Maxfield, "Prop. Regs. on
Partnership Equity for Services: The Collision of
Section 83 and Subchapter K," 103 JTAX 69
(August 2005).

21

60

There, IRS ruled that the sellers of all of a partnership's interests were each deemed to have sold partnership interests for federal income tax purposes, while the sole buyer was deemed to have purchased the partnership's assets (subject to its liabilities).

© Copyright 2006 RIA. All rights reserved.
This article appeared in the July 2006, Volume 105, Number 01 issue of The Journal of Taxation.

Sheldon I. Banoff, P.C.
Partner
Chicago, Illinois
p_ 312.902.5256
f_ 312.577.8817
sheldon.banoff@kattenlaw.com
Sheldon I. Banoff has concentrated in the area of federal income taxation for over 30 years, with particular concentration in investment, real estate, partnership and limited liability company taxation matters.
His practice includes the representation of major real estate developers, syndicators, lenders and
investors, including both taxable and tax-exempt investors and professional service (including law and
accounting) firms.
In addition to his work on behalf of the Firm’s clients, Mr. Banoff is also a nationally and internationally
known author and lecturer. Editor of the Journal of Taxation’s monthly "Shop Talk" column since 1985,
he has also written over 200 leading articles in the tax area. He is co-author of two books: "Illinois
Limited Liability Company - Forms and Practice Manual" (Data Trace Legal Publishing Inc. 2002) and
"Limited Liability Companies and S Corporations" (Illinois Institute of Continuing Legal Education 2005).
Also, Mr. Banoff has been a Lecturer in Law at the University of Chicago Law School, where he taught
an Advanced Seminar on Real Estate Transactions with emphasis on choice of form of entity, fiduciary
duties, economic analysis of investments and taxation matters. He also serves on the Law School's
Annual Tax Conference Planning Committee (which he chaired in 1993 and 1994).
A past chairman of the Chicago Bar Association’s Federal Taxation Committee, he now serves on its
Executive Council. He is actively involved in the American Bar Association Section of Taxation, and is a
frequent program speaker on partnership, limited liability company and tax planning matters. Actively
involved in executive compensation and professional firm organization and management matters, Mr.
Banoff is past Chairman of the Chicago Bar Association's Large Law Firm Committee and counsels law
and accounting firms on various tax and non-tax matters.
Mr. Banoff, a frequent spokesperson on taxation matters, has been interviewed on television and radio, and
in magazines and newspapers. At the request of the Committee on Ways and Means of the U.S. House of
Representatives, he has testified on partnerships and other pass-through entities. Mr. Banoff has annually
been selected by a national poll of lawyers as one of the "The Best Lawyers in America" and is profiled in
"Leading Illinois Attorneys," "Who’s Who in American Law," Euromoney's "Guide to the World's Leading Tax
Attorneys," "The International Who's Who of Business Lawyers-Corporate Tax," Chambers Global's
Directory, "The World's Leading Lawyers" and Chambers USA's Directory "America's Leading Lawyers for
Business." He is a member of the Chicago Federal Tax Forum and elected as a Fellow of the American
College of Tax Counsel.
Mr. Banoff graduated with high honors from the University of Illinois at Chicago with a Bachelor of
Science degree in Accounting and received his law degree in 1974 from the University of Chicago Law
School, where he was Associate Editor of the Law Review.

22

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