Fixing a terminated S Corporation election through rescission

According to the IRS’s 2018 Data Book, S corporation filings were up almost 6% during fiscal-year 2018 (October 1, 2017 through September 30, 2018). As S corporations become more popular, you should be on the lookout for transactions that could jeopardize your client’s S corporation status.

For example, the company could transfer stock to an ineligible shareholder or create a second class of stock. Regardless of the scenario, proactively advising clients before a transaction occurs can prevent a lot of headaches down the road.

However, despite our warnings, clients still surprise us. What should you do if a client informs you of a transaction that inadvertently terminated its S corporation election? You could always request a letter ruling to waive the effect of the terminating event, but this process is expensive and time consuming. A better option would be to rescind the transaction, assuming the client meets certain requirements.

What is rescission?

Rescission allows parties to a contract to undo a transaction if they’re returned to their original positions. The concept was addressed by the IRS in Rev. Rul. 80-58. In that ruling, A sells a tract of land to B for cash. According to the agreement, at B’s request, A is obligated to take the land back if it can’t be rezoned within nine months to accommodate B’s business. The ruling emphasizes that if such a request is made, both A and B would be restored to the positions they had before the sale.

In Situation 1 of the ruling, B determines that rezoning is impossible and exercises its option to reconvey the land. Therefore, in the same tax year as the initial sale, B returns the land to A in exchange for the original purchase price. The IRS concludes that the rescission would be respected for federal income tax purposes. In other words, the initial sale would be ignored, and A wouldn’t recognize any gain or loss. The rescission also protects B from any gain realized on the reconveyance transaction.

Situation 2 of the ruling slightly changes the facts. Instead of exercising its option in the same tax year as the initial sale, B returns the land to A the next year. In this case, the IRS concludes that the rescission is disregarded in determining the tax consequences of the transactions. Therefore, A would recognize gain or loss on the initial sale, and B could possibly recognize gain on the reconveyance transaction. A’s basis in the reconveyed property equals the price paid to B for the reconveyance.

As illustrated by these two situations, a rescission will be respected for tax purposes if the following requirements are met: (1) the original transaction and the rescission take place in the same tax year, (2) the rescission is carried out by the original parties to the transaction, and (3) the parties are returned to the positions they had before executing the agreement within the same tax year as the original transaction.

How do you rescind a transaction?

A rescission may be accomplished 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 a court for a decree of rescission. If the parties mutually agree on rescission, they should document their intentions by executing a written rescission agreement that addresses each of the requirements in Rev. Rul. 80-58. The agreement should adequately describe the transaction to be rescinded, when rescission will occur, and how the parties will be restored to their pre-transaction conditions.

Example: Hummingbird, Inc., an S corporation, has an employee stock purchase program. Linda wants to take advantage of the program (and its matching feature) by having her IRA buy company stock. Therefore, Hummingbird, Linda, and her IRA enter into a subscription agreement under which the IRA purchases shares. Later that year, legal counsel notifies Hummingbird that the transaction terminated its S corporation election because IRAs are generally ineligible shareholders. To remedy the situation, Hummingbird, Linda, and her IRA execute a rescission agreement under which the company voids the stock certificate issued to the IRA and returns the purchase price. The rescission will be respected for federal income tax purposes because (1) the parties were restored to their original positions and (2) the initial stock transfer and the rescission occurred within the same tax year. Therefore, Hummingbird’s S corporation election remains intact.

The IRS doesn’t issue private letter rulings on rescission

As you can imagine, a rescission analysis is highly fact intensive. As such, S corporations have historically relied on the private letter ruling process to confirm the effectiveness of rescission transactions. However, the IRS no longer issues private letter rulings on rescissions. Nevertheless, Rev. Rul. 80-58 is still good law and is binding on the IRS.

Conclusion

The next time an S corporation client surprises you with an unexpected transaction, ask yourself whether rescission is a viable option to fix a terminated S corporation election. Although the IRS no longer issues private letter rulings on the topic, Rev. Rul. 80-58 still provides a way to undo undesirable transactions. Just make sure the initial transaction and the rescission take place in the same tax year and that the parties are restored to their original positions. Clients should consult their legal counsel for additional guidance.