If Only
Have you ever wondered what trajectory your career or business would have taken had you done something differently? Have you ever wished you could turn back the clock to correct a mistake, to complete an unfinished task, to approach an old project from another perspective?
Each of us has experienced such “what if?” moments in our professional or business lives.[i]
Query whether institutions, like Congress, are capable of recognizing a lost opportunity that may have produced a different outcome; for example, “what if” Senators Manchin[ii] and Sinema[iii] had made their objections to the Administration’s “build back better” bill[iv] known before voting for the reconciliation budget resolution back in August instead of leaving everyone in limbo for as long as they have?
Eventually, most individuals and organizations recognize the futility of such thinking. After all, “what’s done is done.” Or is it?[v]
In most cases, yes.
That’s Not Fair
However, there are circumstances in which one may avoid the adverse consequences of a past act by “pretending,” usually only with the consent of others, that it never occurred. I understand, for example, that it is not uncommon in the pseudo-sport known as golf for a player to take a so-called “mulligan” – the equivalent of a “do over” in a child’s game – where the others with whom they are golfing deem it “fair” to do so.[vi]
Variations of this principle have long been a part of income tax jurisprudence, where its application seeks to balance what is concededly a question of fairness to a taxpayer against the government’s interest in the uniform administration of the tax laws and the timely collection of the income tax. The fact that this principle has been applied only in limited situations is a manifestation of the challenge faced in trying to reconcile these goals.
Before considering one taxpayer’s[vii] recent attempt to employ the “claim of right” doctrine to avoid the recognition of income in circumstances that, on some visceral level, seemed unfair (at least from the perspective of the taxpayer), it would behoove us to review the legal or “accounting” framework within which a taxpayer’s income tax liability is determined.
The Annual Tax Period
In general, the tax law treats each taxable year of a taxpayer as a “separate unit” for tax accounting purposes and requires that one look at a particular transaction on an “annual basis,” using the facts as they existed at the end of the taxable year to determine the income tax liability arising therefrom; in other words, one determines the tax consequences of the transaction at the end of the taxable year in which the transaction closed, without regard to events in subsequent years.[viii]
Rescission
From this basic principle – i.e., the annual tax period – is derived a key element of an important exception to “closed transaction” treatment: the rescission doctrine, pursuant to which a taxpayer may treat a transaction from earlier in the taxable year as never having occurred. In order for the doctrine to apply, the transaction must be rescinded before the end of the taxable year (the annual tax period) in which the transaction took place.[ix]
According to the IRS, the legal concept of “rescission” (i) refers to the canceling or voiding of a contract or transaction, that (ii) has the effect of releasing the parties from further obligations to each other, and (iii) restores them to the relative positions they would have occupied had no contract been made or transaction completed.[x]
A rescission may be effectuated by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other (if sufficient grounds exist), or by applying to the appropriate court for a decree of rescission.
It is imperative, based on the annual accounting concept, that the rescission occur before the end of the taxable year in which the transaction took place.
If these requirements are satisfied, then the rescinded transaction is ignored for tax purposes – it is treated as though it never occurred.
Thus, a sale may be disregarded for federal income tax purposes where the sale is rescinded within the same taxable year that it occurred, and the parties are placed in the same positions as they were prior to the sale.[xi]
If the foregoing requirements are not satisfied, the rescission of the original transaction will not be respected, the tax consequences of such transaction will have to be reported on the return filed for the taxable year in which the transaction took place, and the “unwinding” of the original transaction will be analyzed as a separate event that generated its own income tax consequences.
That said, there may be another alternative available to a taxpayer to mitigate the tax consequences of an unintended or unwanted transaction: the statutory version of the “claim of right” doctrine on which Taxpayer relied, without success, in the case described below.
Unauthorized Sale
Taxpayer created a revocable trust[xii] that was administered by Trustee. Under the terms of the trust, Trustee had broad authority as to the investment of the trust assets in general, but that power was limited with respect to certain publicly traded equities (the “Restricted Stock”) held by the trust; specifically, Trustee was prohibited from disposing of such Restricted Stock without Taxpayer’s express authorization.
Despite that restriction, Trustee sold the Restricted Stock and recognized a taxable gain on the sale in excess of $5.6 million. In compliance with the grantor trust rules, Taxpayer included that gain in their gross income on their personal tax return for the year of the sale, and paid income taxes thereon.
Trustee subsequently realized that the sale of the Restricted Stock was prohibited by the trust agreement and, at the beginning of the immediately succeeding taxable year, Trustee purchased the same number of shares of Restricted Stock with the sale proceeds from the earlier transaction.
Following the purchase of shares of the Restricted Stock in the year after the sale, Taxpayer sought to invoke the “claim of right doctrine” as codified in the Code to claim a deduction on their income tax return for the year of the purchase.
Claim of Right
Under the original claim of right doctrine, a taxpayer had to report income in the year in which it was received, even if the taxpayer could have been required to return the income in a later year. To “compensate” the taxpayer for having reported and paid tax on income to which they ultimately were not entitled and had to repay, the claim of right doctrine allowed the taxpayer a deduction in the year of that repayment.[xiii]
To alleviate the inequity arising from the application of the doctrine – the mismatching arising from the inclusion of income in one taxable year and the deduction of its repayment in a different taxable year,[xiv] plus the possibility that the deduction in the later year may not reduce the taxpayer’s liability as much as it was increased by the inclusion in the earlier year – Congress enacted a provision which gives taxpayers the option of reducing their tax liability for the year of repayment by the amount of tax attributable to the earlier inclusion as an alternative to claiming a deduction in the repayment year.[xv]
In order to qualify for relief under this provision , a taxpayer must plead that: “(1) an item was included in gross income for a prior taxable year because it appeared that the taxpayer had an unrestricted right to such item”; and “(2) a deduction is allowable for the current taxable year because it was established after the close of the prior taxable year that the taxpayer did not have an unrestricted right to such item, which it repaid.”
If these criteria are met, then the tax imposed for the taxable year of the repayment is the lesser of (1) “the tax for such taxable year computed with such deduction,” or (2) “the tax for such taxable year computed without such deduction, minus … the decrease in tax … for the prior taxable year” which would result solely from the exclusion of such item from gross income for such prior taxable year.
The Parties’ Positions
Following the district court’s dismissal of Taxpayer’s claim for relief, Taxpayer appealed to the federal Court of Appeals, where the government argued that Taxpayer failed to allege (1) that, after the close of the year of sale, they did not have an unrestricted right to the income from the sale of the Restricted Stock held in the trust and (2) that they were under a legal obligation to restore that income to its actual owner, as required under the Code.
The government asserted that Trustee simply bought some stock in the same company in the following year in an attempt to reverse the effect of the earlier transaction, but that Taxpayers’ right to the income from such earlier transaction was never in question.
Finally, the government argued that Taxpayer did not, and could not, plead that their “restoration” of income (the “repurchase” of shares of stock in the following year) was a deductible expense to them.
Taxpayer contended that because the issue concerned the tax obligations of the trust, not of Taxpayer individually, the proper focus had to be on whether the trust had an unrestricted right to the income in the initial and subsequent tax years.
Accordingly, Taxpayer challenged the government’s argument that there was no legal obligation to restore the item of income because Taxpayer had the ability to approve of the sale of the Restricted Stock and, therefore, authorized the sale and the retention of the proceeds after-the-fact.
The Court
The Court found that Taxpayer, as the sole beneficiary of the trust, had an unrestricted right to the funds, because Taxpayer had the absolute authority to choose to accept the funds and authorize the trust’s actions.
Taxpayer argued that the Trustee’s sale and subsequent repurchase of the Restricted Stock fell within the language of the Code as a taxable transaction that was “reversed” in the year after the sale by a trustee that was legally obligated to do so.
As an initial matter, the Court observed, the characterization of the purchase of stock in the later year as a “reversal” of the original sale of Restricted Stock in the earlier year “implied that the purchase was a retraction of the first, undoing it cleanly and putting the parties to the transaction in the same place as before it”; i.e., a rescission. However, the different timing of the two transactions (in separate taxable years) rendered that characterization inaccurate.
Moreover, the Court continued, the number of shares of Restricted Stock that the trust sold in the earlier year was repurchased for a lower price in the subsequent year. The Court concluded that a sale of stock in one time period cannot be simply “reversed” by purchasing the stock back at a different time, because the fluctuation in market prices often resulted in a greater loss or gain over that time.
No Legal Obligation
Regardless of the foregoing issues, the Court explained that the truly “insurmountable problem” for Taxpayer was not that the transactions were unequal in nature, but that Taxpayer did not allege that the trust had a legal obligation to restore the Restricted Stock.
According to the Court, Taxpayer had to show that the repayment in the later year occurred because “it was established after the close of such prior taxable year” that Taxpayer “did not have an unrestricted right to such item.” The statutory language requiring that “it was established” a taxpayer did not have an unrestricted right to the item has been interpreted, the Court stated, “as requiring a legal obligation to restore the item of income; a voluntary choice to repay is not enough.” To meet that requirement, Taxpayer had to demonstrate they did not have an unrestricted right to the income, that they “involuntarily gave away the income because of some obligation, and the obligation had a substantive nexus to the original receipt of the income.”
The Court found no allegation that the trust did not have an unrestricted right to the item of income from the sale. Taxpayer made no allegations that they, as the sole beneficiary of the trust, demanded the restoration of the stock sold, or challenged the purchase of stock, or otherwise communicated an intent to pursue any of their rights for the breach of the trust agreement. Taxpayer never sought any relief at all from Trustee. The Court concluded that the existence of a potential claim was not enough to “establish” that the trust lacked an unrestricted right to the income.
Finally, the Court noted that the only authority relied upon by Taxpayer as establishing a legal obligation to reverse the sale – state law – did not support that interpretation. In fact, the statute did not mandate as a remedy the action taken by Trustee – the repurchase of the stock.[xvi] The Court stated that, given the range of potential remedies, including merely seeking damages from the Trustee or suspending or removing the Trustee, the statutory authority did not establish an obligation for the Trustee to repurchase the stock.
Wrap Up
It bears repeating – as a general rule, with respect to any taxpayer, every taxable year stands on its own for purposes of determining the taxpayer’s income tax liability for such year. If an item is included in income in one year, its repayment in a subsequent year will not generate a deduction in the earlier year.
In determining the tax consequences of a transaction undertaken by a taxpayer during a taxable year, the concept of the annual accounting requires that one consider the relevant facts as they existed at the end of the taxable year.
If a taxpayer decides to unwind a transaction, they may do so without tax consequences – i.e., the transaction and its unwinding will be disregarded for federal income tax purposes – if the following conditions are satisfied: first, the parties to the transaction are returned or restored to the relative positions they would have occupied had the transaction not occurred; and second, this restoration must be achieved within the taxable year of the transaction.
This may be easier said than done. For example, in a case somewhat like the one discussed above, a taxpayer instructed their broker to sell $100,000 worth of a particular stock; the broker misunderstood and, instead, sold 100,000 shares of that stock, with a value of approximately $3 million.[xvii] When the broker realized the error, they repurchased the same number of shares of stock in the corporation as they had sold in error. The sale and purchase occurred within a single taxable year. The taxpayer claimed that the rescission doctrine should be applied to disregard the sale for tax purposes. The Tax Court disagreed. The persons from whom the broker (acting as the taxpayer’s agent) purchased shares were not the same persons to whom the broker previously had sold shares. In other words, the parties to the sale transaction were not returned to their pre-sale positions, the rescission doctrine did not apply, and the taxpayer had to recognize the gain from the sale.
If the taxpayer is compelled to unwind a transaction – because it turns out they did not have an unrestricted right to the property or proceeds acquired or received and were legally obligated to return them – they should consider whether the claim of right doctrine provides any relief.
If all else fails, try taking a mulligan.
[i] Wasted time, all of it. To quote that well-regarded philosopher from the African savannah, Pumba – like Socrates and Confucius, he is known by only one name – “You got to put your behind in your past.”
[ii] Last week he quashed rumors that he was going to join the Republican Party.
[iii] Last week she finally shared that she does not favor corporate or individual rate hikes. At the same time, she agreed that tax revenues should be raised from businesses and the wealthy. How does one achieve the latter without the former? It isn’t easy.
[iv] Too much alliteration?
[v] The Terminator movies, for example, are based upon the premise that a “flesh”-covered robot can travel back in time – some version of Einstein’s general relativity and the 4th dimension known as space-time – to kill the mother of the yet-to-be conceived individual who will some day – in fact, in the future from which the robot traveled back in time – lead a revolt against Skynet.
[vi] Anyone who feels as I do about golf should read this article: https://www.chicagotribune.com/news/ct-xpm-2002-04-19-0204190149-story.html .
[vii] Heiting v. U.S. (7th Cir. 2021).
[viii] Stated differently, taxpayers generally cannot take a “wait-and-see” approach before they report a transaction on their tax return.
Of course, subsequent events (like a sale or an earnout) may shed some light on the true nature of an earlier transaction or on the true value of property that was the subject of the transaction.
There are also limited exceptions to “closed transaction” treatment, among the most common being the grant of an option to buy property. In that case, the amount paid by the holder for the grant of the option is not taxable to the property owner until the option is exercised or expires – the tax treatment is said to remain “open.”
[ix] The rescission of a transaction allows the taxpayer to view the transaction using the facts as they exist at the end of the taxable year – i.e., as though the transaction never occurred.
[x] Rev. Rul. 80-58.
[xi] Oversimplified: the property is returned to the seller and the cash is returned to the buyer.
[xii] Because Taxpayer could revoke the trust agreement at any time, the trust was considered a “grantor trust” for income tax purposes. IRC Sec. 671 and Sec. 676. As such, the trust itself was not taxable; rather, Taxpayer reported trust’s gains and losses on their own returns.
[xiii] The tax character of the income determines the character of the deduction. Think Arrowsmith – not Aerosmith – 344 U.S. 6 (1952).
[xiv] Compare to a rescission in which both events occur in the same taxable year.
[xv] IRC Sec. 1341.
[xvi] The state statute cited by Taxpayer provided a list of potential remedies for a breach of trust including, among others: compelling a trustee to redress a breach of trust by paying money, restoring property, or other means; ordering a trustee to account; suspending or removing the trustee; reducing the compensation or denying the compensation to the trustee; and voiding an act of a trustee, or tracing trust property and ordering recovery of the property or its proceeds.
[xvii] Hutcheson, TC Memo. 1996-127 (1996).
