Court Finds Rescission Doctrine Inapplicable on Complex ESOP Arrangement

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Court Finds Rescission Doctrine Inapplicable on Complex ESOP Arrangement

The so-called “rescission doctrine” has long been utilized by tax professionals to correct erroneous transactions that occur in the same tax year.  Under that doctrine, if the parties to a transaction can effectively be placed in the same position as they were prior to the transaction and in the same year, federal tax law will look the other way and consider the transaction a nullity.

But, how far does the rescission doctrine go and does it apply to all transactions?  In a recent decision by the Fourth Circuit, Estate of Kechijian v. Comm’r (4th Cir. June 23, 2020), the Court explores the contours of the rescission doctrine in addition to other areas of federal tax law.  The decision in Estate of Kechijian is discussed in this Insight.

Facts.

The taxpayers were partners in a distressed debt loan portfolio business.  In 1998, the taxpayers reorganized their business.   Prior to the reorganization, the taxpayers had been owners and operators of a group of corporations and limited liability companies known as “UMLIC entities.”  However, as part of the reorganization, the taxpayers chose to consolidate all of these entities into a single holding company, UMLIC Consolidated, Inc., which was treated as an S corporation for federal tax purposes.

To effectuate the reorganization, the taxpayers executed a series of documents.  First, they each transferred the entirety of their ownership in the UMLIC entities, each valued at $142,566, to UMLIC Consolidated, Inc., in return for 47,500 of its shares.  At the same time, the taxpayers executed two collateral agreements – the Restricted Stock Agreement (RSA) and the Employment Agreement (EA).  Together, these documents provided that if either taxpayer voluntarily terminated his employment with the company before January 1, 2004, he would lose at least 50% of the value of UMLIC Consolidated, Inc. This 5-year “earnout” period was designed to incentivize the taxpayers to continue working for UMLIC Consolidated, Inc. so that the new company would benefit from their skills.

Thereafter, the taxpayers also created an employee stock ownership plan (ESOP) for UMLIC Consolidated, Inc.  The ESOP purchased 5,000 shares of UMLIC Consolidated, Inc. common stock at a price of $500,000.  Later, the taxpayers transferred 24,500 shares of their UMLIC Consolidated, Inc. stock to irrevocable trusts established for the benefit of their families.  As of August 1999, the taxpayers, their trusts, and the ESOP were the only shareholders of UMLIC Consolidated, Inc.

The Tax Deferral Scheme.

The taxpayers’ actions were designed to limit their tax liabilities and depended on several provisions of the Internal Revenue Code and a Regulation.  First, Section 83 applies where property (including stock) is transferred to a taxpayer “in connection with the performance of services.”  Unless a specific election is made under Section 83(b), the taxpayer may defer the inclusion of gross income related to the transfer of stock until the tax year in which his rights in the stock “are not subject to a substantial risk of forfeiture.”  Here, because the taxpayers’ rights were subject to the conditional performance of future services, the stock was subject to a substantial risk of forfeiture under Section 83(a) and not includible in income until that risk was gone (i.e., 2004).

Second, the Internal Revenue Code provides that an S corporation does not separately pay income taxes.  Instead, it passes (or flows through) that income to its shareholder.  Third, restricted stock in an S corporation that is issued in connection with the performance of services and that is substantially non-vested (e.g., subject to a substantial risk of forfeiture) is not treated as outstanding stock of the corporation for tax purposes.  See Treas. Reg. § 1.1361-1(b)(3).  Under this rule, profits from the S corporation do not flow through to the holder of a non-vested stock and therefore is not included on the holder’s tax return.  Fourth, an ESOP is a tax-exempt entity.

Taken together, the taxpayers took the position on their returns that they did not need to report income from UMLIC Consolidated, Inc. because their shares (and the shares held in trust) were subject to substantial risks of forfeiture.  In addition, the taxpayers took the position that the ESOP, which was a tax-exempt entity, was the only entity required to include income from UMLIC Consolidated, Inc. for 2000 through 2003.

The Second Reorganization.

In late 2003, the taxpayers sought again to reorganize their business operations.  They did so for two reasons.  First, they hoped to attract greater outside investment from hedge funds and private equity firms, which they felt would be difficult with the business continuing to operate as an S corporation.  Second, Congress had amended the tax laws to close the loophole by which the taxpayers had avoided reporting taxable income on the earnings of UMLIC Consolidated, Inc.

Thus, to effectuate the second restructuring, the taxpayers formed UMLIC Holdings, LLC.  After the restructuring, the taxpayers each owned 50% of the new entity.  In November 2003, UMLIC Holdings, LLC purchased all of UMLIC Consolidated, Inc.’s assets in exchange for a $190 million interest-bearing promissory note and the assumption of various liabilities.  UMLIC Consolidated, Inc. recognized $174.6 million of capital gain but allocated the entirety of this gain to the ESOP, the tax-exempt entity.

Vesting of the S-Corp Shares.

On January 1, 2004, the restrictions imposed by the RSA and EA on the taxpayers’ UMLIC Consolidated, Inc. shares lapsed and their shares became fully vested.  When those shares vested, they had a fair market value of approximately $45.9 million.  However, on March 30, 2004, the taxpayers entered into “surrender” and “subscription” agreements with UMLIC Consolidated, Inc. in which they returned the entirety of their newly vested shares to UMLIC Consolidated, Inc. and simultaneously repurchased 47,500 identical shares of UMLIC Consolidated, Inc. in exchange for a $41.5 million promissory note.  In accordance with these transactions, the taxpayers reported $4.5 million in compensation income on their 2004 income tax returns.

The IRS Audit.

The IRS examined the taxpayers’ tax returns for the years 2000-2004.  On January 15, 2010, the IRS issued notices of deficiency to the taxpayers.  In the notices of deficiency, the IRS took the following alternative positions:  (1) the taxpayers’ stock in UMLIC Consolidated, Inc. was substantially vested upon receipt in 1998, and (2) even if the stock did not substantially vest until the RSA restrictions lapsed in January 2004, the taxpayers should have reported the fair market value of the stock as taxable income in 2004.  The IRS also assessed accuracy-related penalties under Section 6662.

The taxpayers timely filed Tax Court petition.  At the Tax Court, the taxpayers contended that the rescission doctrine applied to negate any tax liabilities that may have resulted from the vesting of their UMLIC Consolidated, Inc. stock in 2004.  Moreover, after the Tax Court issued its Opinion, the taxpayers raised for the first time that they should be entitled to an NOL carryback.  The taxpayers lost on all of those issues and appealed the decision to the Fourth Circuit Court of Appeals.

The Fourth Circuit’s Decision.

During the Tax Court and Fourth Circuit proceedings, the taxpayers argued that they were not required to report the approximately $45 million in gain that they realized when their shares in UMLIC Consolidated, Inc. vested.  Although the taxpayers seemingly acknowledged that those shares had vested in 2004, they contended that the surrender and subscription arrangements they entered into resulted in no taxable gain.  In so arguing, the taxpayers contended that the rescission doctrine should apply.  In addition, the taxpayers argued that they should be entitled to an NOL carryback, which was raised at the first time during post-trial proceedings.

Rescission Doctrine and Economic Substance Doctrine.

In the words of the Fourth Circuit, they did “not see it.”  Specifically, under the rescission doctrine, the transactions at issue are required to restore the taxpayers “to the relative positions that they would have occupied had no contract been made.”  See Rev. Rul. 80-58; Hutcheson v. Comm’r, T.C. Memo. 1996-127 (“For the rescission to be effective, both buyer and seller must be put back in their original positions.”).  Thus, according to the Fourth Circuit, “if you can’t restore, you can’t rescind.”  In this regard, the Fourth Circuit reasoned:

The contracts at issue here were for personal services, namely the five years of services performed by petitioners on behalf of UMLIC S-Corp.  When a personal services contract has actually been performed, it is essentially impossible for the individual who rendered the services to be ‘returned’ to his position ex ante.  See Jasper L. Cummings, Circular Cash Flows and the Federal Income Tax, 64 Tax Law. 535, 602 (2011) (noting that ‘compensation arrangements are not well suited’ to analysis under the tax rescission doctrine ‘because the employee cannot usually give back his or her performance’).  What is more, as part of the underlying contracts, petitioners transferred the entirety of their interests in the UMLIC entities to UMLIC S-Corp, but they did not receive those assets back in the Surrender Transactions.  As such, the Surrender Transactions are completely unlike the prototypical instance of rescission, in which all property that changes hands is returned to its original owner.  See Rev. Rul. 80-58.

Stated differently and summarily, the taxpayers lost on their rescission argument.  But, the Fourth Circuit went further, alternatively deciding that even if the rescission doctrine applied, the transactions the taxpayers entered into lacked economic substance and should be disregarded for federal income tax purposes.  See Frank Lyon Co. v. U.S., 435 U.S. 561 (1978) (“the objective economic realities of the transaction rather than the particular form the parties employed” determine the tax effect of a transaction).

In addition, the Fourth Circuit held that the taxpayers were liable for the accuracy-related penalties.  Significantly, the Fourth Circuit noted that the taxpayers were unable to show reasonable cause for, among other reasons, because “[t]hey did not obtain or rely on the opinion of a tax professional in adopting their position regarding the tax effect of the Surrender Transactions.”  Another unhelpful fact was that the Fourth Circuit specially found that the taxpayers had “structured the Transactions with the specific purpose of evading tax liability on the compensation income that even petitions admit they realized at the moment their shares substantially vested.”

NOL Carryback.

After the Tax Court’s opinion, the taxpayers contended that the tax liabilities for 2004 should be reduced due to an NOL carryback.   However, the Tax Court’s rules for addressing issues after an opinion has been issued are under Rule 155.  Under that rule, the Tax Court may conduct further proceedings after it “has filed or stated its opinion or issued a dispositive order determining the issues in a case,” for the limited purpose of calculating a taxpayer’s tax liability.  However, during these Rule 155 proceedings, parties are not permitted to raise “new issues” that go beyond “computation of the amount to be included in the decision resulting from the findings and conclusions made by the Court.”  Vessio v. Comm’r, T.C. Memo. 1990-565; Vento v. Comm’r, 152 T.C. 1, 9 (2019).   For purposes of Rule 155, a new issue is one that “was neither placed in issue by the pleadings, addressed as an issue at trial, nor discussed by [the Tax] Court in its prior opinion,” or one that “would necessitate retrial or reconsideration.”  Vento, 152 T.C. at 8.  Under these rules and procedures, the Fourth Circuit found that the taxpayers’ NOL carryback claim was “clearly a new issue within the meaning of Rule 155.”  Thus, the taxpayers could not raise it.

Take-Away.

The decision in Kechijian is not surprising.  Although the rescission doctrine can apply in a multitude of different circumstances, it is hard to see its application in the context of restricted stock and compensation arrangements.  Moreover, the decision in Kechijian serves as a cautionary warning that taxpayers should raise all relevant issues during the Tax Court proceeding or risk having those issues waived.