Occasionally, parties to a transaction may determine after closing that they would have been better off not completing the transaction. This may result from a misunderstanding of the facts or the law, the failure of anticipated events to occur, or the occurrence of unanticipated events.

Under what has come to be known as the “rescission doctrine,“ parties to a completed transaction may be able to unwind that transaction and have it be disregarded for tax purposes. This principle was originally adopted in case law in 1940 and ultimately accepted by the IRS in 1980. Pursuant to IRS guidance (Rev. Rul. 80-58), the IRS will disregard the tax consequences of a transaction that has been rescinded where the following two prerequisites are met:

(1) the parties have each been returned to the positions they were in prior to the transaction; and

(2) the rescission is completed within the same tax year as the original transaction.

In Rev. Rul. 80-58, the IRS approved rescission where a real estate sale that had closed was unwound during the same year pursuant to the terms of the original sale agreement. The IRS has demonstrated flexibility in subsequent private letter rulings and approved rescissions that were not authorized in the original agreement between the parties. It has also authorized rescission where the parties are related. The IRS has even approved rescission of only portions of a transaction. The rulings suggest that at least in the context of a private letter ruling request, the IRS may permit the rescission and reformation remedy not only in those situations where it is applied to correct a problem in the original transaction, but also to achieve more favorable tax consequences or to reengineer the underlying transaction using the benefit of hindsight.

While the IRS adopted a no ruling policy with respect to rescission transactions in 2014, this appears to be more a function of budgetary considerations than opposition to the doctrine of rescission.

Bottom Line: When parties discover that a transaction did not have the tax or business consequences that they were trying to achieve, the doctrine of rescission may give them the opportunity to turn back the clock and unwind the transaction, and perhaps even to modify it to some degree as long as it is within the same year.

“All you need in this life is ignorance and confidence; then success is sure.” ― Mark Twain