Avoid Tax by Returning Pay

There are times when a business structure or transaction no longer makes sense.

This may be due to a change in the business environment, such as swings in the economy or unexpected gains or losses. It can also arise due to a change in the owners’ personal circumstances, such as a divorce or death of a family member. It can also arise due to the tax benefits of the structure no longer being available due to tax law changes.

The rescission doctrine provides one way to unwind a business structure or transaction. The doctrine allows a do-over. But to qualify, the parties have to be put back in the same position as they would have been if the transaction had not been entered into.

This begs the question as to whether the rescission doctrine can apply to services rendered and compensation for those services. The party providing the services cannot turn back time and unperform the services–or can they? The Estate of Kechijian, No. 18-2277 (4th Cir. 2020), provides the answer.

Facts & Procedural History

The taxpayers owned a distressed debt portfolio business. They entered into transactions to convert the business to an S corporation and having it owned by an employee stock ownership plan (“ESOP”). The ESOP S corporation combo presents a number of tax planning opportunities.

The version, in this case, involved restricted S corporation stock. Essentially the shares owned by the individuals were not vested and, as such, the income from the S corporation business flowed to the non-taxable ESOP for several years. The tax saving from this part of the transaction was approved by the U.S. Tax Court–allowing the business profits to avoid income tax for three years. So far so good.

The ESOP S corporation rules were changed and the structure no longer provided the tax savings it did in the past. And for private equity types like those in this case, S corporations make it more difficult to raise funds. That is a problem. That leads to the problem in this case. How do you unwind the ESOP S corporation transaction?

The transaction to unwind the ESOP S corporation did not fare as well in the tax court litigation. The S corporation shares vested in the individual shareholders in 2003. The plan to unwind the ESOP S corporation was to have the individual shareholders surrender their S corporation stock in 2003. They then executed a subscription agreement to purchase the shares from the ESOP in exchange for a promise to pay the ESOP over time.

This resulted in the taxable gain being reported to the ESOP, which again, was not subject to tax. According to the individual shareholders, they surrendered the S corporation stock in the year it was received and, as such, they should be treated as not having received it. The U.S. Tax Court did not agree. This is the issue that the appeals court considered.

The Rescission Doctrine

The rescission doctrine is found in court cases and in IRS guidance. This includes Revenue Ruling 80-58, 1980-1 C.B. 181. The recession doctrine generally says that you can unwind a transaction if:

  1. The parties are returned to the status quo as if the transaction had not been entered into and
  2. The restoration is done in the same tax year as the original transaction.

If these requirements are met, then the parties can file tax returns as if the transaction did not happen.

In this case, the shareholders raised the recission doctrine on appeal. They argued that the rescission doctrine applied and, as a result, the shareholders did not have any taxable income:

they maintain that the Surrender Transactions effectuated a complete rescission of their contractual agreements with UMLIC S-Corp., and because that rescission occurred in the same year as petitioners’ receipt of compensation income under those agreements, that income should be disregarded for federal income tax purposes.

The appeals court noted that in this case, the restriction on the shares was in exchange for providing services to the corporation. Thus, the shareholders would be rescinding the services they provided to the corporation for the past five years.

According to the appeals court, taxpayers cannot rescind services that they previously provided. Put another way, the shareholders could not be put in the position they were before the transaction as they cannot undo their labor. Based on this, the appeals court held that the recession doctrine did not shelter the income.

Returning Compensation

The shareholders also argued that compensation can be returned to the employer and not subject to tax:

In attempting to fit the square peg of the Surrender Transactions into the round hole of the rescission doctrine, petitioners point to a line of authorities suggesting that compensation is not taxable to an employee if returned to his employer in the year it was received. See, e.g., Russel v. Comm’r, 35 B.T.A. 602 (1937).

The appeals court did not agree. It concluded that the prior cases did not apply given the current facts. The restricted stock agreements did not provide that they could be modified. They were absolute.

It also upheld the U.S. Tax Court’s application of the economic substance doctrine.

The Takeaway

The Estate of Kechijian case answers the question as to whether the rescission doctrine can be applied to stock compensation. The case suggests that it is possible to return compensation for services rendered as long as the terms of the agreements that provided the restriction say that the agreements were able to be modified.

It should also be noted that this court case does not impact the prior body of case law that applies the recession doctrine to other types of income. The prior court cases apply the recission doctrine to corporate dividends, for example. Had the facts been different, such as if the stock restriction was not based on future services, the plan to unwind the ESOP S corporation may have worked fine.

The rescission doctrine remains a valuable tax planning tool. It should be considered when the economics of business structures or transactions no longer makes sense. Those looking to unwind business structures transactions should consult with their tax attorneys to void potential foot faults in the process.

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