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.

For various non-tax reasons (including IPOs), owners of pass-through entities might consider con-

verting 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.

Arecurring issue is whether taxpayers can

unwind or rescind transfers of ownership

interests that effectively change the tax sta-

tus of the entities themselves (e.g., from C corpora-

tion 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?

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 retain-

ing pass-through entity status or avoiding C corpo-

ration (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 altogeth-

er, i.e., rescissions of partnerships into tenancies-

in-common.

Two letter rulings issued in the past year, Ltr. Ruls.

200533002 and 200613027, provide the focal

points for this analysis. These favorable letter rul-

ings 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 re-

establish 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-

nouncement) provide limited but helpful guidance

as to rescission transactions that change the tax

status of the entities involved. Nevertheless, tan-

gential tax consequences involving such rescis-

sions remain unclear.

UNWINDINGS AND RESCISSIONS:

COLLIDING POLICIES

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.1Neither 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 unwind-

ings, (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

Taxpayers may wish to unwind, rescind, or substan-

tially modify a transaction for non-tax and/or tax-

related reasons. Non-tax motivations may include a

mistake of law or of fact, including the failure of cer-

tain anticipated events to materialize, and, con-

versely, 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

events to materialize, the promulgation of retroac-

tively effective legislation, Regulations or Rulings,

and the failure to properly anticipate the taxpayer's

tax profile prior to the occurrence of the transaction.

Because of the many types of transactions that

arise in today's sophisticated business and invest-

ment world, it is often difficult to predict which types

of unwinding events will be given effect for tax pur-

poses, and under what conditions or situations.

Indeed, the devices that may cause an unwinding

to occur include:

•Rescission agreements.

•Reformation or reconveyance actions.

•Savings clauses.

•Escrows.

•Warranties.

•Conditional sales.

•Options.

•Put rights.3

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 permit-

ting 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):

(1) The substance over form doctrine requires

the tax law to determine "what really hap-

pened?" Retroactivity brings a different result

from what really happened.

(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"

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):

(1) The tax law should be interpreted reason-

ably and mirror commercial reasonableness. It

is commercially reasonable for people in busi-

ness to have a transaction remain "open" for

economic purposes. Thus, the tax law should

reflect flexibility to recognize unwindings as of

the original transaction.

(2) If tax-motivated unwindings are of concern,

arguably a transaction that has some valid non-

tax 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 govern-

ment should defer to state law as to recognition

of property and legal rights, and then apply fed-

eral 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 ger-

mane to the unwinding.

(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 cer-

tain situations, anyway?

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 rev-

enue ascertainable, and payable to the government,

at regular intervals. Only by such a system is it prac-

ticable 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

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 uncer-

tainty (in audits, rulings and litigation) as to when

unwinding is acceptable.7

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.8Taxpayers, however, often seek

to characterize their unwindings as rescissions

because of real or perceived tax benefits pertaining

thereto.9As 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 effec-

tive 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 ini-

tial 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 rescis-

sion. 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.

Thus, the 1931 rescission was disregarded for pur-

poses 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 other-

wise 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 gener-

ally 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 guar-

antee that tax consequences will not arise from the

initial transaction.12

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 par-

ties 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 pos-

sible 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.

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 obli-

gations to each other and restoring the parties to

the relative positions that they would have occu-

pied 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 suffi-

cient grounds exist, or by applying to the court for

a decree of rescission.

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 origi-

nal 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.

In situation 2, as in situation 1, there was a com-

pleted 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 subse-

quent events.

RESCISSIONS AFFECTING ENTITY TAX

CLASSIFICATION

Although Rev. Rul. 80-58 and other rulings and

cases generally involve successful or failed rescis-

sions or unwindings of sales of property, the issue

of the tax treatment of (attempted) unwindings or

rescissions can arise in many other types of trans-

actions, including unilateral awards of employer

stock or stock benefit fund credits to employees,

gifts by a donor to donees, transfers in divorce pur-

suant to nunc pro tunc orders (i.e., retroactive prop-

erty 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.

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 (sub-

stantial) 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

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 recon-

veyance 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.

The question has recently arisen in two very differ-

ent 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 revoca-

tion 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 limit-

ed partnerships that wished to invest in the corpora-

tion. In Ltr. Rul. 200613027, at issue was whether a

corporation (formed through a statutory conversion

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 corpora-

tion's subsequent conversion back into an LLC

(taxable as a partnership) would not be treated as a

taxable liquidation. While the IRS reached favor-

able conclusions in both, the rulings do not discuss

the tangential but potentially significant tax conse-

quences that may flow from the approved rescis-

sions.

THE CONSEQUENCES OF FAILURE:

INEFFECTIVE ‘RESCISSIONS’

In analyzing the two letter rulings, we should keep

the stakes in mind. What are the potential adverse

tax consequences if the rescission under consider-

ation 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 partner-

ship (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 capi-

tal 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 part-

nership 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.)

If the second transaction involves the shareholders

of a C corporation attempting to rescind a stock

transfer (to an ineligible shareholder) that had ter-

minated the corporation's S election, what are the

adverse tax consequences if the attempted rescis-

sion is not respected for tax purposes, such that

the second transfer is treated as a separate trans-

action? 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 (typi-

cally illiquid) stock but will have recognized taxable

gain (without cash proceeds to pay the tax, A hav-

ing 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-elec-

tion. 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

What are the potentially adverse consequences if

an S corporation issues a second class of stock

(e.g., convertible preferred) for cash to a sharehold-

er (as occurred in Ltr. Rul. 200533002), and the

corporation reacquires the stock for cash in a sec-

ond transaction that does not constitute a valid

rescission for tax purposes? First, loss of the S cor-

poration's status will result (absent other qualifica-

tion 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 dividend-

type distribution (unless the payment qualifies as a

redemption under Section 302).

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 corpora-

tion 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).

An S corporation's status can be terminated inten-

tionally 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

In some situations, an S corporation's shareholders

may prefer another alternative if the inadvertent ter-

mination 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 pat-

tern (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

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 trans-

ferors in 1980 expected to return to S corporation

status, given the ineligible corporate shareholder.

The requirements of Rev. Rul. 80-58 are incorporat-

ed into Ltr. Rul. 8304134, but curiously the letter

ruling makes no reference to the Revenue Ruling.

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 pur-

chase 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 nshares of X

stock to the fund. On a date believed to be in 2004

("Date1"), X sold nshares of newly issued convert-

ible 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 cor-

poration in Section 1361(b)(1).23

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

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 agree-

ment, with the exception that the indemnification

clauses for the partnerships and their representa-

tive 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 pre-

ferred stock dividends).24

In Ltr. Rul. 200533002 the IRS ruled favorably for X

and its original shareholders. The letter ruling quot-

ed from Rev. Rul. 80-58, which provides the afore-

mentioned 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:

(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 origi-

nal shareholders, and the three limited partner-

ships 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 convert-

ible preferred stock and X's issuance of that stock

to the partnerships, and (2) prevent the termination

of X's S corporation status.

Based on the above, in Ltr. Rul. 200533002 the IRS

ruled as follows:

•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 ter-

minated 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 pro-

vided in Section 1368.26

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 specula-

tion is correct, it was only the falling out of X's origi-

nal shareholders and the new shareholders that led

to the reconveyance of the stock.

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 par-

ties in the same positions as they were in prior to

the initial transaction.28

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?

No dividends or other distributions were made on

the preferred stock during the interim. The letter rul-

ing does not state whether the convertible preferred

stock had a cumulative dividend to which the pre-

ferred 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 compo-

nent, yield factor, or other pricing adjustment, to

meet the status quo ante requirement.

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 trans-

fer of an excessive amount of shares to one individ-

ual can thus jeopardize REIT status, in the same

fashion that a transfer to an ineligible shareholder

as defined under Section 1361 can terminate S cor-

poration status.

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 sta-

tus. 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 let-

ter ruling should be obtainable even if the sole pur-

pose of the rescission is to reinstate the favorable

tax treatment afforded REITs.31

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 divi-

dends on such shares and is not entitled to any

portion of the gain realized on the disposition of

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 trans-

fers 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 restric-

tion—as void to begin with—is not a true rescis-

sion.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 objec-

tive 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 domes-

tic LLC (treated for federal tax purposes as a part-

nership) 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 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 outstand-

ing 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 corpora-

tion 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 distribu-

tion 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

The ruling states that the incorporation transaction

was effected in anticipation of making an initial pub-

lic 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 anoth-

er IPO "in the near future."

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 includ-

ed the original conversion, so that it and A and B

again would be subject to only a single level of fed-

eral income taxation. The proposed reversion of

Corp into an LLC was referred to as the "rescission

transaction" in the letter ruling38 and would be con-

ducted 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.

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 incorpo-

ration transaction.

(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 part-

nership 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 rela-

tionship among A, B, and LLC1.

(4) If the rescission transaction became effec-

tive, the taxpayer would file its federal income

tax return as if it was a partnership during all of

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 tax-

payer's having been an LLC taxable as a part-

nership during all of that tax year (2005).

(5) On the rescission transaction's becoming

effective, the relationship among A, B, and

LLC2 would be governed by the same operat-

ing 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 con-

verted 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 tax-

payer to be identical in all material respects,

from the date immediately before the conver-

sion, to such arrangements as would have

existed had the conversion not occurred.

(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 representa-

tions and the parties' restoration by December 31

(2005) of the relative positions they would have occu-

pied if the incorporation transaction had not occurred,

IRS (citing Rev. Rul. 80-58) ruled in Ltr. Rul.

200613027 that, for federal income tax purposes:

(1) The taxpayer would be treated as a partner-

ship 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 cor-

poration 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 tax-

payer, A, or B.

Ltr. Rul. 200613027 is of interest for several rea-

sons, 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 pro-

vides that on the conversion, title to any real or per-

sonal property, and all liabilities, are deemed trans-

ferred 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 "conver-

sion back" is also by statutory conversion, if state Z

(like a majority of other states41) also permits "oppo-

site direction" statutory conversions, i.e., from cor-

porations to LLCs, just as it permits such conver-

sions of LLCs into corporations.

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 corpo-

ration terminates and its shareholders become part-

ners42 supports this conclusion in the corporation-to-

LLC 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.

The status quo ante requirement. As stated

above, the status quo ante requirement in Rev. Rul.

80-58, involving a sale of property, requires "restor-

ing 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, involv-

ing an incorporation transaction which the taxpayer

represented constituted a transaction qualifying

under Section 351, contained additional representa-

tions (presumably required by IRS to obtain the

favorable rulings), one of which is that the "effect of

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).

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 corpora-

tions in question, as well as their shareholders

(who had transferred all of the stock of one corpo-

ration to the other, and then received the same

stock back as a distribution from the transferee cor-

poration) were restored to the relative positions

they would have occupied if the initial capital contri-

bution 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 share-

holders 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.

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 state-

ment of parties whose names were redacted at the

beginning of the letter ruling), and it is highly unlike-

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) trans-

actions 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 par-

ties 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.

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 transac-

tion (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 ini-

tially owned property (i.e., their interests in LLC1)

worth in the aggregate $100 (for stock presumably

worth $100), and pursuant to the rescission trans-

action 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 recon-

veyed 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 incorpo-

ration transaction and rescission transaction, there

was nothing more that they could do to meet the

requirement that they be restored to their prior posi-

tion 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.

Does this represent an extension of Rev. Rul. 80-

58? Is it merely a recognition that the entity-level

analysis should apply to A, B, and LLC1/Corp (the

taxpayer) for purposes of analysis?

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 manage-

ment team's intervening ownership). As the taxpay-

ers represented in Ltr. Rul. 200613027, the effect of

the rescission transaction and rescission agree-

ment was to cause the legal and financial arrange-

ments 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 suf-

fered 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 rescis-

sion occurred for federal income tax purposes in

Ltr. Rul. 200613027.

No distributions to equity owners. The represen-

tation in Ltr. Rul. 200613027 that the taxpayer

(Corp) has not made any distributions to its equity

holders (other than the LLC tax distribution pay-

ment) since the date of the incorporation transaction

is noteworthy. If Corp had made dividend-type distri-

butions to A and B in 2005 that were not returned by

them in 2005 to Corp prior to the rescission transac-

tion, would IRS have determined that A and B did

not meet the status quo ante requirement?

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 quali-

fied 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) transac-

tion that year 1977 for tax purposes, and the tax-

payers who received and retained the dividends

during that interim period in 1977 would be treated

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 pre-

incorporation income). The payment was made to A

and B after the incorporation transaction; it techni-

cally 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 nei-

ther. A and B would have received the same distri-

bution 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 finan-

cial 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 pay-

ment to Corp or LLC2—A's and B's financial

arrangements would then differ from what they had

been immediately before the incorporation transac-

tion, when they were entitled to receive and retain

the LLC tax distribution payment that was to be

made in the next few months.

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.

1. Which parties must be restored to the status

quo ante in the rescission of a statutory conver-

sion? 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).

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 par-

ties' restoration, by December 31 [2005], of the rel-

ative 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?) dis-

solved under state law and is effectively replaced

by LLC2 as a matter of state law on Corp's "conver-

sion 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 indi-

cates (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.

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, where-

by 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 can-

celled by Corp) in conjunction with Corp's liquida-

tion. In exchange, Corp would reconvey all its

assets to LLC1 (or LLC2), Corp having no other

shareholders.

Of course, during the period between the incorpora-

tion 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 require-

ment apply at the entity level?51 If so, would the

(presumed) changes in assets preclude LLC1 (or

LLC2) from meeting the status quo ante require-

ment?

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 attempt-

ed 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 subse-

quent distribution of the same asset (the SCo1

stock) by the transferee (SCo2) back to the trans-

feror shareholders; indeed, that ruling supports the

conclusion that an assets-over incorporation trans-

action 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 princi-

ple—namely, that A, B, and LLC1 (and its succes-

sor, LLC2) were restored to the relative positions

they would have occupied if LLC1's statutory con-

version (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.

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.

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 pur-

poses under Regs. 301.7701-2 and -3.

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 part-

nership operations to a corporation organized for

valid business reasons. For each of the three meth-

ods of incorporating a partnership,53 Rev. Rul. 84-

111 gives tax effect (describing the differences in

basis and holding periods) to the form taken provid-

ed the steps described are actually undertaken.

Noting that Rev. Rul. 84-111 does not apply to a

partnership that converts into a corporation in accor-

dance with a state law formless conversion statute,

Rev. Rul. 2004-59 holds that a partnership that con-

verts to a corporation under a state law formless

conversion statute will be treated in the same man-

ner 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 con-

tributes all of its assets and liabilities to corporation

Q in exchange for stock in corporation Q, and

immediately thereafter, unincorporated entity Q liqui-

dates, 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.

Therefore, it would follow that the incorporation

transaction (via statutory conversion) in Ltr. Rul.

200613027 would be viewed under Rev. Rul. 2004-

59 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?

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

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 lia-

bilities) to A and B, followed by A's and B's cap-

ital contribution of the same to LLC2.

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 rep-

resentations, does not address any alternative

forms of unwinding.

4. How should the intervening stock redemp-

tions 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 there-

after, 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 trans-

action, (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 com-

pensatory partnership interests and options for

services55 clearly do not contemplate a rescission

scenario and provide no guidance.

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 redemp-

tions, Corp presumably was taxable as a corpora-

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 fed-

eral income tax purposes, LLC1 and Corp would be

ruled on 12/16/05 to be an LLC taxable as a part-

nership 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 qual-

ify 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 dur-

ing all of taxable year [2005]." Note that "the

amounts received" were received by the manage-

ment 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 own-

ers 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.

Does this mean the LLC1/Corp/LLC2 tax partner-

ship 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, howev-

er, 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 possi-

ble) ordinary income under Section 736(a)(2).

5. How should the issuance of equity compen-

sation to the management team be reflected

for tax purposes? Lacking all the relevant facts,

one nevertheless might speculate that the man-

agement team members who (ultimately) received

stock from Corp first received LLC1 compensa-

tory 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 different-

ly from the treatment of the receipt of stock for tax

purposes.56

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 fed-

eral 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 man-

agement 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 stock-

holder.

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 calen-

dar 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 disre-

gard), 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 share-

holders' 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?

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 part-

ners 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.

7. What are the payroll and withholding tax con-

sequences 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 servic-

es. Even though the team members were share-

holders, their cash compensation for services

would be subject to FICA, HI tax, and federal (and,

if applicable, state and local) income tax withhold-

ings, with Corp paying its (employer) share of the

FICA and HI taxes.

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 partner-

ship 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 guaran-

teed payments under Section 707(c), and thus not

subject to payroll tax withholding pursuant to Reg.

1.707-1(c))? Moreover, can the partnership suc-

cessfully 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)?

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

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-employ-

ment and income tax withholding purposes! It

seems only appropriate that IRS waive any poten-

tial 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—notwith-

standing that the subsequent rescission transaction

was given retroactive effect.57

RESCISSIONS: PARTNERSHIPS INTO

TENANCIES-IN-COMMON

To the author's knowledge, there have been no

Revenue Rulings, letter rulings, or other IRS guid-

ance involving the unwinding of a partnership via

rescission. The case law is sparse.58

In an undated 1992 field service advice (FSA 1999-

1079, 1992 WL 1354785), the Service's National

Office was asked to determine whether the rescis-

sion rights exercised by the partners in several cat-

tle-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.

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 advanta-

geous to operate as partnerships because of poten-

tial 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 rele-

vant lines on the returns being struck through or

containing zeroes. Notes attached to each tax

return stated, among other things, that for tax pur-

poses the partnership was never in existence, and

that "[t]he owners of the business have deter-

mined the business was operated as a ‘Tenants

[sic] in Common’ arrangement during [a redacted

time period]."

To confuse matters further, although the partner-

ships 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.

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:

"Our impression is that the decision to rescind by

the partners was based on potential securities law

violations. These concerns arose after the partner-

ship had purportedly been formed. We have found

no authority which would allow partners in a part-

nership to retroactively rescind the existence of a

partnership in a prior taxable year for tax purpos-

es.[Footnote 1 appears here in the original, and is

discussed below.] Thus, the rescission rights would

not preclude formation." (Emphasis added.)

The Service's refusal in FSA 1999-1079 to allow a

retroactive rescission for a prior tax year is consis-

tent with Rev. Rul. 80-58. The FSA implies, howev-

er, that a rescission of the formation of the partner-

ship occurring in the same year of formation could

be respected for tax purposes. In the FSA's foot-

note 1 to the penultimate sentence in the quote,

above, the IRS National Office notes that amend-

ments (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...."

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 conse-

quences to the state-law entity and its state-

law partners—a tenancy-in-common, as the

tax return disclosure claimed? Aren't the tax-

able losses (as reported in FSA 1999-1079)

or income from the state-law partnership's

operations nonetheless reportable by the

owners?

•In a tenancy-in-common for tax purposes,

must the losses and income be borne propor-

tionately (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)?

•If the rescission is effective such that no part-

nership in fact existed under federal income

tax law and if no partnership return is filed, do

the TEFRA audit rules apply? (The FSA indi-

cates it does not.)

•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 rescis-

sion by all the parties), do the TEFRA rules

nonetheless extend to such entity and to per-

sons 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.

Assuming partnership rescissions are otherwise

permissible if in compliance with the two require-

ments of Rev. Rul. 80-58, will a partnership unwind-

ing 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 person-

al, non-tax purposes in July 2006. Five months later

the partnership's accountant, in analyzing the

details of the partners' capital contributions, deter-

mines the partnership will be classified as an

investment company under Section 721(b), with

gain being recognized by the partners on all appre-

ciated property so contributed. Solely to avoid this

gain the partners agree to rescind the partnership.

In the rescinding transaction the partnership recon-

veys the assets back to each contributing partner,

while meeting the status quo ante requirement, and

the partners relinquish their interests in the partner-

ship (which dissolves, having neither assets nor

partners). If this is viewed as a valid rescission, the

gain otherwise arising under the investment compa-

ny rules would be avoided.

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-

motivated rescission from a partnership to individ-

ual owners on these facts? The answer is unclear.59

CONCLUSION

As described above, during the past year IRS has

issued two favorable letter rulings permitting tax-

payers 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 corpo-

ration status of an entity otherwise taxable as a C

corporation (by recognizing a valid rescission of

stock transfers made to otherwise ineligible share-

holders). 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.

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 conse-

quences to the owners of the interests in the

respective entities, other than to confirm that the

rescinding transaction does not generate recogni-

tion 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 taxa-

tion of non-rescinding owners of the equity inter-

ests. As discussed above, this might result in cer-

tain 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.

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 consis-

tently, for federal income tax purposes, and that

result has not brought the tax system crashing

down.

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 share-

holders of an S corporation. Rescission of partner-

ships (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.

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 rescis-

sion 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 finan-

cial arrangements between the owners and the

entity involved to be identical in all material

respects, as would have existed if the initial trans-

action (e.g., the statutory conversion of the LLC in

Ltr. Rul. 200613027; the transfer of SCo1 stock in

Ltr. Rul. 200533002) had never occurred.

1See, e.g., Penn v. Robertson, 25 AFTR 940, 115

F2d 167 (CA-4, 1940), involving 1930-31 rescission

transactions.

2See, e.g., Banoff, "Unwinding or Rescinding a

Transaction: Good Tax Planning or Tax Fraud?," 62

Taxes 942 (December 1984).

3See, e.g., Banoff, "Tax Planning for the

Unexpected," 68 Taxes 1033 (December 1990).

4See Banoff, supra note 2, pages 943 and 947-48.

As to whether intentional "backdating" of docu-

ments may successfully constitute a valid rescis-

sion 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 unwind-

ing or modifying a transaction, but improper back-

dating, if done to conceal the document or to

change the original intent of the parties, is subject

to civil or criminal penalties).

5See, 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 Banoff, supra note 2, pages 944-945.

7Id., page 946.

8See, e.g., Rev. Rul. 74-501, 1974-2 CB 98,

Situation 2.

9Banoff, 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 73-

577, 471 F2d 738 (CA-3, 1973), cert. den., which

also involved a taxpayer contending that a rescis-

sion 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 fol-

lowed, i.e., the rescission might have been given

retroactive effect for multiple years for tax purpos-

es. 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.

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 dis-

cussed) occurred." IRS did not use the phrase "sta-

tus 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

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 agree-

ment to discharge contractual duties...." Calamari

and Perillo, The Law of Contracts, Third Edition

(West, 1987), §21-2, pages 864-65. An earlier edi-

tion of Black's Law Dictionary, as quoted in Banoff,

supra note 2, page 957, defined "rescission of con-

tract" 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 agree-

ment by contracting parties to discharge all remain-

ing duties of performance and terminate the con-

tract." 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."

14 In TAM 7802003, which predates Rev. Rul. 80-

58, 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-

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), dimin-

ishes 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.)

15 See Penn v. Robertson, supra note 1; Banoff,

supra note 2, pages 975-983 and cases cited there-

in; 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.

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 share-

holders 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 termi-

nation of SCo1's 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.

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 corpo-

ration's stock.

20 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).

22 In some letter rulings involving similar fact pat-

terns (i.e., inadvertent termination; initial transfers by

shareholders to new, ineligible shareholders; trans-

fers effectuated by the same shareholders "rescind-

ing 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).

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 like-

ly 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 corpora-

tion status.

27 Ltr. Rul. 9829044 indicates that a rescission that

has economic consequences but is solely tax-moti-

vated 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).

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

30 This is understandable. In your author's experi-

ence, REITs (whether public or private) generally

are formed by principal shareholders who benefit

from sophisticated advice from their lawyers and

accountants regarding qualification for and mainte-

nance of REIT status. Thus, REIT sponsors gener-

ally have familiarity with the REIT's "closely held"

ownership rules. Moreover, REITs use self-operat-

ing provisions in their corporate by-laws or other

governing documents to preclude stock transfers

that would jeopardize the REIT's retention of qualifi-

cation. In contrast, many S corporations are creat-

ed by shareholders who are less than knowledge-

able 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 corpo-

ration'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 corpo-

ration status as of the initial transfer.

31 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 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" provi-

sion 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 pur-

chased 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 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 transac-

tions should not have substantive effect in obtaining

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.

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 record-

ing 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 See, e.g., Rev. Rul. 69-6, 1969-1 CB 104, and

Rev. Rul. 77-321, 1977-2 CB 98; Conversions arti-

cle, supra note 40, pages 906-07.

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.

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 dis-

counts 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 transac-

tion does not restore A and B to the same values of

the property they owned at the time of the incorpo-

ration 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.

47 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 sta-

tus quo ante requirement. Moreover, A and B would

not personally be in the same relative positions they

would have occupied had no incorporation transac-

tion occurred, as they personally would have

reduced their net worth by the $20 cash they would

contribute to Corp/LLC2 under this alternative.

48 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 hold-

ers 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 rul-

ings.

51 That is, either solely at the entity level, or at both

the entity level and the member/shareholder level.

52 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 part-

nership liquidates and distributes undivided inter-

ests in its assets and liabilities to its partners, who

then contribute their undivided interests to the cor-

poration for stock ("alternative 2"); and (3) the part-

ners contribute the partnership interests to the cor-

poration in exchange for stock ("alternative 3").

54 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).

56 See, e.g., Rev. Proc. 93-27, 1993-2 CB 343;

Rev. Proc. 2001-43, 2001-2 CB 191; REG-105346-

03, 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. 301.7701-

3(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 part-

ners, 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 pay-

ments 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 unincor-

porated 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).

58 See Branum v. Campbell, supra note 12, involv-

ing the tax consequences resulting from the forma-

tion 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).

59 One author concludes on these facts that it is

unlikely that the Service would permit a purely tax-

motivated 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 corpora-

tion stock that was done to preserve the S corpora-

tion's election (indicating a non-tax reason is not

required for a rescission to be valid for tax purpos-

es).

60 There, IRS ruled that the sellers of all of a partnership's interests were each deemed to have sold partner-

ship interests for federal income tax purposes, while the sole buyer was deemed to have purchased the part-

nership's assets (subject to its liabilities).

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 particu-

lar 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.

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