Abstract
In a variety of contexts, taxpayers can file tax elections that dictate their tax treatment. After filing or not filing a given tax election, a taxpayer might later feel regret. Perhaps the taxpayer lacks adequate information about the election’s existence or tax effects at the time the taxpayer makes (or fails to make) the election. Later, the taxpayer acquires additional tax law information revealing that an alternative election would have produced more favorable tax results. Alternatively, the taxpayer may make an election because it will produce favorable tax consequences if the taxpayer’s transactions or behavior play out the way the taxpayer predicts. When the taxpayer’s predictions prove to be inaccurate, the taxpayer wishes she had made a different election. A taxpayer who learns that an earlier election was, in retrospect, ill-advised might attempt to benefit from her newly acquired knowledge by retroactively filing a new election. Tax law’s limitations on the use of hindsight determine whether the taxpayer will succeed.
Existing literature lacks an analysis focused on the questions of when taxpayers can and should be able to act on their regrets by using hindsight. The first aim of this Article is to undertake a thorough examination of restrictions on (and allowed uses of) hindsight when making tax elections. By focusing on the use of hindsight and analyzing the relevant rules collectively, this Article demonstrates that the tax law’s approach to the use of hindsight is far from consistent. The second aim of this Article is to suggest and analyze underlying policy goals that motivate restrictions on the use of hindsight. An examination of the underlying policy goals brings to light some features of existing law that are useful and others that merit revision.
The use of hindsight affects tax revenue collection and the fairness of the tax system and thus is a topic of significance at any time. In addition, certain recent legislative changes relate to restrictions on the use of hindsight when making tax elections.
I. Introduction
Tax elections allow taxpayers to obtain different tax outcomes by simply filing tax forms or indicating given choices on their tax returns or other tax forms. Tax elections pervade the Code and Treasury Regulations and affect the tax treatment of individuals, business entities, and other taxpayers.
Often, taxpayers regret elections that they made or did not make upon learning that some alternative course of action would have yielded a more favorable tax outcome. When allowed, such a taxpayer might make use of their newly acquired knowledge and revise their previous decision. Stated differently, if permitted, the taxpayer would like to modify an earlier election with the benefit of hindsight. Depending on the context, the tax law’s approach to the use of hindsight can be very permissive, very restrictive, or somewhere in between.
To illustrate a permissive approach to the use of hindsight, consider the choice that an individual taxpayer faces each year to either claim the standard deduction or itemize deductions. If a taxpayer claims the standard deduction, then the taxpayer, when computing taxable income, deducts a set dollar amount, adjusted annually for inflation. For 2023, for instance, the standard deduction is $13,850 for single taxpayers and $27,700 for married taxpayers filing a joint return. If, instead, the taxpayer opts to itemize deductions, the taxpayer will deduct an amount equal to certain actual expenses incurred by the taxpayer, subject to various limitations. Generally, taking the standard deduction is advisable when the amount of the standard deduction exceeds the taxpayer’s allowable itemized deductions, while claiming itemized deductions is advisable when the reverse is true.
As a threshold matter, this election exemplifies a permissive approach to the use of hindsight because it is a backward-looking tax election. In other words, oftentimes all information necessary to determine the taxpayer’s allowable itemized deductions (and, therefore, all information needed to evaluate the wisdom of making the election) is knowable as of the deadline for filing the election. In particular, the taxpayer must make the election with the taxpayer’s tax return for a given year and is free to make a different election each year. Thus, as of the election’s due date, the taxpayer is often able to determine allowable itemized deductions for the taxable year affected by the election given that the election’s due date falls after the affected year has come to a close.
In addition, this election illustrates a permissive approach to the use of hindsight because the taxpayer can change the election on an amended tax return. Perhaps, at the time of filing an initial tax return, a taxpayer opts to claim the standard deduction, believing that it is greater than the taxpayer’s total allowable itemized deductions. The next year, the taxpayer discovers that she was wrong. The taxpayer learns that a given expense for the previous year was higher than she thought at the time she filed the initial return, and, taking into account the new information, the taxpayer’s allowable itemized deductions for the previous year exceed the standard deduction. Alternatively, the taxpayer, at the time she filed the initial return, may have been unaware that a given expense was deductible if she had itemized deductions, and she later realizes that this is the case. In either instance, the taxpayer may amend her tax return for the previous year and make a different election that is, in retrospect, more favorable.
The tax law takes a restrictive approach to the use of hindsight in the context of dependent care Flexible Spending Accounts (“FSAs”). If a taxpayer’s employer provides the option to participate in a dependent care FSA, before the beginning of each tax year the taxpayer can elect to participate and can, subject to certain limits, specify a dollar amount of her compensation that will be contributed to the FSA for the upcoming year. Amounts contributed to the FSA are not subject to income taxation but can only be used for certain purposes. In particular, funds in a dependent care FSA may be used for certain expenses incurred to pay for care of the taxpayer’s dependents so that the taxpayer is able to work and earn income. Dependent care FSAs are subject to a “use it or lose it” rule, meaning the taxpayer forfeits any amounts not spent on eligible expenses that remain in the account after a specified time.
Dependent care FSAs demonstrate a restrictive approach to the use of hindsight because the election to participate and the decision about the amount to contribute are forward-looking elections, meaning that the wisdom of making the elections depends on future events (including the dollar amount of eligible expenses the taxpayer incurs in the upcoming year). Moreover, the taxpayer has limited ability to revisit a previously made election. In particular, during the year, in some circumstances the taxpayer might opt to adjust the amount of future contributions to an FSA but cannot revoke the decision to contribute amounts already put into the account. Thus, if a taxpayer contributes money to a dependent care FSA based on predictions about future expenses that prove to overestimate actual expenses, the taxpayer cannot revise earlier contribution decisions to benefit from hindsight. Likewise, the taxpayer will be unable to revisit an earlier election that she made based upon a mistaken understanding of the rules governing FSAs—she cannot obtain relief based upon the fact that she was unaware of the “use it or lose it” rules for instance. Similarly, a taxpayer might regret opting to participate in a dependent care FSA if she later learns that she would have benefited more from taking a tax credit for child and dependent care expenses and loses eligibility for the credit as a result of funding expenses through a dependent care FSA. Such a taxpayer is unable to benefit from hindsight by revoking her earlier election.
Recently, lawmakers enacted a temporary relief provision granting taxpayers more time to spend amounts contributed in 2020 and 2021 and allowing taxpayers to carry over unused funds contributed in 2020 or 2021 to the subsequent year. Presumably, this relief provision could mitigate the harsh consequences that might otherwise befall taxpayers who contributed money to a dependent care FSA that, unexpectedly, could not be used for eligible expenses because of dependent care disruptions caused by the COVID pandemic. Thus, to a limited degree and in response to extraordinary circumstances that affected many taxpayers, lawmakers allowed taxpayers to, in a sense, benefit from hindsight. In particular, the relief measures softened the otherwise harsher consequences that typically follow from eligible expenses being, in retrospect, lower than the taxpayer anticipated.
The election available under section 754 offers an example of an election that falls in between the very permissive and very restrictive ends of the tax election spectrum. In some circumstances, whether a section 754 election is in place determines whether the sale of a partnership interest affects the amount of gain or loss recognized when the partnership subsequently sells partnership assets. While not invariably the case, making the election can ensure more favorable tax consequences if partnership assets have appreciated in value at the time of the sale of a partnership interest, but refraining from making the election can bring about more favorable tax consequences if partnership assets have fallen in value at the time of the transfer. A partnership must make the election with its tax return for the year the election takes effect. Once the partnership makes the election, it stays in place for future years unless and until it is revoked, and the Internal Revenue Service (the “Service”) must consent to revocation.
With respect to the use of hindsight, the section 754 election is, in a sense, less restrictive than the dependent care FSA election because it is partly backward-looking. The dependent care FSA election is forward-looking. At the time a taxpayer makes the dependent care FSA election, the taxpayer will not know, with certainty, the amount of the taxpayer’s eligible expenses for the year affected by the election. By contrast, when a taxpayer initially makes a section 754 election, the taxpayer will know whether partnership assets have appreciated in value as of the time of any partnership interest transfers that occurred during the first year affected by the election, given that the year will have already come to a close.
The section 754 election is, however, more restrictive than the election between claiming the standard deduction or itemizing deductions because, unlike that election, the section 754 election is partly forward-looking. The election between claiming the standard deduction and itemizing deductions is made after the close of the affected year, and the taxpayer can freely make a different election each year. Thus, the taxpayer need not make any predictions about the future to evaluate the wisdom of making the election. By contrast, once made, the section 754 election affects not only the first year that it is in place, which has already come to a close, but all future years, unless and until the Service permits the taxpayer to revoke the election. Thus, at the time the taxpayer makes the election, the taxpayer will not know the value of the partnership’s assets at the time of partnership interest transfers that occur in future years affected by the election. Moreover, when providing guidance on the ability to revoke the election, the Treasury Regulations make clear that a taxpayer who regrets the election in a year when it produces unfavorable results due to a decline in the value of the partnership’s assets is unlikely to be able to use hindsight to revoke the election.
Prior to the enactment of 2017 tax legislation, some taxpayers engaged in self-help to benefit from hindsight by effectively terminating various partnership elections (like the section 754 election) that they came to regret. In particular, under prior law, the transfer of a 50% or greater interest in a partnership would cause a “technical termination” of the partnership. A technical termination wiped the partnership’s slate clean as far as many tax elections go. For instance, after a technical termination, a previously made section 754 election would no longer be in effect. Tax legislation enacted in 2017 eliminated the technical termination rules. Legislative history accompanying the change in law indicated that lawmakers intended for the change to bring an end to taxpayers using technical terminations to circumvent restrictions on changes to partnership tax elections. As a result of new law, the ability to use hindsight in the context of section 754 elections is more limited—taxpayers must seek Service consent to revoke an election, consistent with the explicit rules governing the section 754 election.
The examples above are, by no means, exhaustive. In a wide variety of contexts, taxpayers might later regret making or not making an election, and the ability of taxpayers to use hindsight can vary from context to context. In general terms, the ability to use hindsight is governed by statutory and regulatory rules that set deadlines for filing elections and specify when taxpayers can file late elections or revoke elections already made. Some tax elections strictly limit the use of hindsight—the “use it or lose it” rules associated with FSAs offer one example. Other tax elections are accompanied by very generous rules that allow taxpayers to freely benefit from hindsight–the choice between the standard deduction and itemizing deductions represents one example. Some tax elections—like the section 754 election—fall into an intermediate category.
Taxpayer’s regrets about tax elections can stem from a variety of different causes. As one example, a taxpayer might fail to make a favorable tax election simply because the taxpayer was unaware of the applicable tax rules. If the taxpayer had been adequately informed, the taxpayer would have known that a different election ought to be made. If this taxpayer attempts to make the favorable election later, she will seek to benefit from what this Article will label “Mistake of Tax Law Hindsight.” To take a different example, a taxpayer might make an election that appeared beneficial at the time based on the taxpayer’s predictions about future events. Later, when the taxpayer’s predictions prove to be inaccurate, it becomes clear that a different election would have been more favorable. For example, a taxpayer might make an election that would be favorable if a transaction is profitable, as the taxpayer predicts, but the election proves to be unfavorable when the transaction, in fact, produces a loss. If this taxpayer attempts to revise their earlier tax election, she will seek to utilize what this Article will label “Misprediction of Fact Hindsight.”
As this Article will describe, restrictions on the use of hindsight may serve a variety of policy goals. First, the ability to use hindsight would diminish tax revenue by allowing taxpayers to make elections that more effectively reduced their tax burdens. Second, if taxpayers with access to sophisticated advice can make tax elections with the benefit of all relevant information about a transaction’s outcome, they may make even more effective use of tax minimizing strategies that are unavailable to taxpayers without access to sophisticated advice, at the expense of fairness.
Third, the ability to use some types of hindsight could create problematic incentives for taxpayers. To take one example, if any credible showing of Mistake of Tax Law Hindsight opened the door to revising earlier tax elections, taxpayers with access to sophisticated advice might attempt to manufacturer credible evidence of Mistake of Tax Law Hindsight as a strategy to use Misprediction of Fact Hindsight. To illustrate, imagine that making a given election produces favorable tax results if a transaction is profitable but unfavorable results if the transaction produces a loss. Imagine a taxpayer must file the election before discovering whether the transaction is profitable. Suppose the taxpayer, at the time the election must be made, predicts the transaction will be profitable and creates contemporaneous evidence of this prediction. While the taxpayer predicts the transaction will be profitable, the taxpayer is also aware of a risk that the transaction will produce a loss. If any credible showing of Mistake of Tax Law Hindsight permitted a taxpayer to revisit an earlier tax election, this taxpayer might intentionally refrain from making the election, with the plan to do the following. First, if the transaction does, indeed, prove to be profitable, so that filing the election would have been beneficial, the taxpayer plans to seek relief to file late and claim that the failure to file was attributable to Mistake of Tax Law Hindsight. To support this claim, the taxpayer plans to offer proof that, at the time of the election’s deadline, the taxpayer predicted the transaction would be profitable. From this, the taxpayer argues that the Service ought to infer that the failure to file was attributable to a mistaken understanding of tax law given that the election produces favorable results for profitable transactions so someone who predicted a transaction would be profitable would have filed the election if they understood its tax consequences. Second, if, instead, the transaction produces a loss, the taxpayer plans to simply not seek relief and benefit from the fact that the election was not in place. If this strategy succeeds, the taxpayer creates the ability to benefit from Misprediction of Fact Hindsight by seeking relief or not, depending on whether the taxpayer’s prediction about the transaction’s profitability proves to be accurate.
Fourth, the ability to use hindsight could, in some cases, create tax reporting inconsistencies among multiple parties to a transaction. This could arise if a tax election affects multiple parties, and some report tax consequences based upon the originally filed election while others report tax consequences stemming from a later modified election. Similarly, if a tax election affects multiple years, sometimes changing the election could result in tax reporting inconsistencies by one taxpayer over time. Finally, the ability to use hindsight could make tax administration more difficult by allowing taxpayers to later take tax positions that differed from what they had reported on already filed returns.
An examination of underlying policy goals reveals that not all uses of hindsight are equally problematic. For instance, allowing taxpayers to benefit from Mistake of Tax Law Hindsight does not offend underlying policy objectives to the same degree as allowing resort to Misprediction of Fact Hindsight, as long as the taxpayer is not using Mistake of Tax Law Hindsight as a cover for Misprediction of Fact Hindsight. Moreover, prohibiting the use of Mistake of Tax Law Hindsight could undermine fairness by increasing the likelihood that tax elections will trap unwary taxpayers.
When evaluated against underlying policy goals, some features of current law seem sensible. For instance, in some contexts, the rules governing use of hindsight are sensitive to the type of hindsight used by the taxpayer. With respect to some tax elections, a taxpayer who is seeking to use only Mistake of Tax Law Hindsight is more likely to obtain relief to file a late tax election than a taxpayer who is also or instead attempting to use Misprediction of Fact Hindsight. Also sensible is the fact that some tax elections that tend to affect taxpayers without access to sophisticated advice take a generous approach to the use of hindsight.
Other aspects of current law merit revision. For instance, some tax elections that affect taxpayers who lack access to sophisticated advice take a restrictive approach to hindsight, at the risk of trapping unwary taxpayers. Also, in some contexts, the Service’s approach to determining the type of hindsight used by a taxpayer may open the door to taxpayers disguising Misprediction of Fact Hindsight as something more benign.
Existing literature discusses various features of tax elections that affect taxpayers’ ability to use hindsight. For instance, existing scholarship notes how the deadline for filing particular tax elections can sometimes require that taxpayers make difficult predictions to assess the benefits of making a given election. Scholars have also discussed how the revocability of certain tax elections affects the ability of taxpayers to use hindsight. This Article contributes to the existing literature by focusing on hindsight and examining how all of the various features of tax elections—not just their revocability—interact to allow or limit the use of hindsight. Looking at the features collectively across a variety of tax elections paints a more complete picture of the use of hindsight in tax law. While tax law often disfavors the use of hindsight by taxpayers making or revising tax elections, it is by no means universally true that taxpayers cannot benefit from hindsight. In addition to describing the existing state of the law, this Article suggests and analyzes underlying policy goals that may justify restrictions on the use of hindsight. This analysis helps to address the question of when taxpayers ought to be able to benefit from hindsight. Based on this analysis, this Article offers recommendations that could bring more coherence to tax law’s approach and better align its approach with underlying policy goals.
This Article will proceed as follows. Part II clarifies what, precisely, constitutes use of hindsight. Part III describes the existing rules that govern the use of hindsight in the context of tax elections. Part IV suggests and analyzes underlying policy goals that might justify restrictions on the use of hindsight. Part V offers recommendations for changes that would better align tax law’s approach with underlying policy goals. Finally, Part VI concludes the Article.
II. Uses of Hindsight
As a threshold matter, some clarification about what constitutes use of hindsight is in order. The instances when taxpayers might wish to use hindsight are varied, and not all uses of hindsight are equally problematic. Because of this, it is useful to lay out the range of different ways that hindsight might be employed.
Taxpayers might attempt to benefit from hindsight in four different sets of circumstances: (1) when the taxpayer obtains new information about the tax law; (2) when the taxpayer obtains new information about some non-tax aspect of a transaction that was knowable at the time the taxpayer made an earlier election but was not known by the taxpayer; (3) when the taxpayer obtains new information about the non-tax aspects of a transaction that come to light after the taxpayer makes an election; and (4) when the taxpayer learns that the Service has challenged or likely could challenge a transaction’s reported tax consequences.
In the first set of circumstances, a taxpayer may simply fail to obtain adequate tax advice ahead of time and later learn that some alternative course of action would have been preferrable. Upon acquiring that new information about the tax law, the taxpayer may seek to revoke an election, file an election late, or file a new election to benefit from what this Article will label “Mistake of Tax Law Hindsight.”
In the second set of circumstances, a taxpayer makes an election that produces less favorable tax consequences than what would have followed from an alternative election. The taxpayer failed to make the more favorable choice because of a misconception about a particular fact or a non-tax legal aspect of the transaction. The fact or non-tax legal information was available at the time the taxpayer made an earlier election but was unknown to the taxpayer. Upon discovering the misconception, if the taxpayer attempts to take steps to allow her to claim the more favorable tax consequences that would have resulted from the alternative election, then she is attempting to benefit from what this Article will label “Mistake of Knowable Fact Hindsight”.
In the third set of circumstances, a taxpayer makes an election that produces a favorable tax result if a transaction’s future non-tax aspects are what the taxpayer anticipates. The taxpayer regrets making that election when the transaction’s non-tax aspects turn out to be different from what the taxpayer anticipated. For instance, the taxpayer makes an election based on the assumption that a transaction will produce a gain and discovers, to the taxpayer’s surprise and disappointment, that the transaction produces a loss. The loss is particularly discouraging because the taxpayer regrets not having filed an alternative election that would have produced a more favorable tax outcome given the loss. If the taxpayer engages in efforts to allow her to claim the tax consequences that would have resulted from that alternative election, then she is attempting to leverage the advantages of what this Article will label “Misprediction of Fact Hindsight.”
In the fourth set of circumstances, a taxpayer might undertake a transaction and report her hoped-for tax consequences to later discover that the Service challenges (or likely will challenge) the claimed tax consequences. Had the taxpayer known the Service would challenge the claimed tax consequences, the taxpayer may have made a different election that would have led to more favorable tax consequences than those that the Service seeks (or likely will seek) to impose. If the taxpayer takes steps to try to report the tax consequences that would have followed from that alternative election, she is attempting to exploit the advantages of what this Article will label “Misprediction of Service Challenge Hindsight.”
III. Current Law: Restrictions on and Allowed Uses of Hindsight
Taxpayers who attempt to use hindsight when making or revising a tax election sometimes succeed and sometimes face obstacles in the form of statutory or regulatory rules. The ability of a taxpayer to use hindsight when making a tax election is determined, as a threshold matter, by the deadline for filing the election. If the deadline falls after the taxpayer is in a position to acquire more relevant information, the taxpayer will be in a better position to use hindsight. In some cases, if a taxpayer misses the deadline for filing an election, relief may be available to file the election late. Various requirements that must be met to obtain such relief, therefore, also affect the taxpayer’s ability to use hindsight. Similarly, in some cases, a taxpayer may be able to revoke an election. This, too, affects the taxpayer’s ability to use hindsight. Finally, in some contexts, taxpayers are able to file so-called protective tax elections, which, in a sense, can allow taxpayers to benefit from the same informational advantages that stem from using hindsight. Each of these features of tax elections and their implications for the use of hindsight are discussed below.
A. Deadline for Filing
A range of possible filing deadlines exist with different implications for the ability of taxpayers to use hindsight. Deadlines that allow for the least ability to use hindsight are those that arise prior to the time when even a well-informed taxpayer possesses most of the information needed to determine whether the election is beneficial. Tax elections in this category will be labeled “forward-looking tax elections.” Deadlines that allow for the greatest ability to use hindsight coincide with the filing of a tax return (including an amended tax return) and are associated with elections that are backward-looking. They are backward-looking because all information that determines whether the election is beneficial is knowable at the time the election must be filed. In between the extremes lie various elections that are, in part, forward-looking, and, in part, backward-looking. Examples that fall in each category are discussed below.
1. Forward-Looking Elections
At one extreme, some tax elections are forward-looking. They are forward-looking because the wisdom of filing the election depends on facts that are mostly not knowable as of the time the election must be filed. This type of deadline is the least generous in terms of affording taxpayers the opportunity to benefit from hindsight.
The election to contribute to a dependent care FSA offers one example of a forward-looking election, as discussed above. Evaluating whether making a contribution is advisable (and deciding how much to contribute) requires making predictions about future events—such as the amount of the taxpayer’s future eligible expenses. Health care FSAs offer another example, and, in that context, predicting the amount of eligible expenses may be even more difficult.
The section 83(b) election offers another example of a forward-looking election. To illustrate the role played by the section 83(b) election, imagine an employee of a corporation receives shares of corporate stock as compensation, subject to the condition that the employee cannot transfer the stock for three years and will forfeit the stock if their employment is terminated during the next three years. After three years, the employee’s interest in the stock vests. The employee’s tax treatment will depend on whether the employee files a section 83(b) election, and, if the employee opts to file the election, it must be made no later than 30 days after the stock is transferred to the employee. If the employee does not file the election and if employment continues so that the employee’s interest in the stock vests in year three, the employee will include in income in year three, as ordinary income, the value of the stock at that time. If the employee does file the election, the employee will include in income in the year the stock is received, as ordinary income, the value of the stock at that time. In general, the potential disadvantage of filing the election is that the employee includes the value of the stock in income sooner (and takes on the additional risk that a later decrease in the value of the stock may leave the taxpayer worse off), while the potential advantage of filing the election is that the subsequent vesting of the employee’s interest in the stock does not, at that time, trigger any income inclusion. Moreover, if the employee makes a section 83(b) election, if and when the employee later sells the stock, any increase in value of the stock between the time of initial receipt and sale will likely be treated as capital gain rather than ordinary income and thus, generally, will be subject to taxation at a lower rate. As a result, if the employee predicts that the stock will increase in value and predicts that they will continue to hold the stock until it vests, the employee is likely well-advised to file the election. If it later turns out that the stock does not increase in value or that the employee forfeits the stock, the employee may come to regret having made the election. At the time the election must be filed (within 30 days of receipt of the stock), these relevant facts about the future are not knowable. Thus, the employee must decide what to elect based upon predictions about the future.
The election available under section 475(f) to taxpayers who are traders in stock and securities offers another example of a forward-looking election. By making such an election, a taxpayer will be taxed on a mark-to-market basis. In other words, each year the taxpayer will take into account, for tax purposes, increases and decreases in the value of certain stocks and securities owned by the taxpayer instead of only taking into account gains and losses upon sale or other disposition of the assets. Furthermore, any gains and losses recognized will be treated as ordinary rather than capital. Generally, a taxpayer must make such an election no later than the tax return due date for the year prior to the effective date of the election. If an individual calendar year taxpayer wishes for the election to be effective for the year 2024, for instance, the taxpayer must make the election no later than April 15, 2024. If the taxpayer makes the election for any given year, it will be effective for that year and all future years and cannot be revoked without obtaining Service consent. The strict deadline that accompanies this election appears to be motivated, at least in part, by the concern that taxpayers who stand to benefit more from the election when they accrue losses rather than gains would use hindsight and make the election only if and when they accrue losses.
Another example of an election deadline that is similar but slightly more generous is the entity classification election. Some business entities can file a form that dictates their tax classification. For instance, some multi-owner business entities can elect between classification for tax purposes as a partnership and classification for tax purposes as a corporation.
The entity classification election must be filed no later than 75 days after the chosen effective date for the election. Because a change in tax classification can trigger undesirable tax consequences, often the chosen effective date is the date the entity is formed. Thus, in many cases, filing within 75 days of the date of entity formation is necessary to obtain a preferred tax outcome. The election is also forward-looking. An entity’s tax classification will significantly affect the tax treatment of the entity and its owners from the effective date of the election onward. In some cases, the treatment that is most favorable depends on events that occur after the election is filed, such as the profitability of the entity. Furthermore, while taxpayers have some ability to later change the tax classification of an entity, as noted above, a change in tax classification can trigger undesirable tax consequences, so that it is not always a viable solution for a taxpayer who regrets an earlier decision about entity classification.
While the entity classification election limits taxpayers’ use of hindsight in ways that are somewhat similar to the section 83(b) election or the section 475(f) election in that all are forward-looking elections, the entity classification election’s parameters are more generous in a couple of respects. First, in the case of an entity classification election, the taxpayer is given 75 days after entity formation to make a decision instead of merely 30 days after the receipt of property in the case of a section 83(b) election. Second, as will be discussed below, late filing relief may rescue taxpayers from failing to timely file desired entity classification elections but is unavailable in the case of section 83(b) elections and rarely obtained in the case of section 475(f) elections.
2. Backward-Looking Elections
At one extreme, forward-looking tax elections afford taxpayers little recourse to hindsight. At the other extreme, backward-looking tax elections that are filed with a tax return (including an amended tax return) allow for significant use of hindsight. A tax election is backward-looking if all information needed to evaluate the consequences of filing the election is knowable as of the time the election must be filed.
The election between claiming the standard deduction or itemizing deductions, discussed above, offers one example. Whether choosing to claim the standard deduction is more favorable to the taxpayer than opting to itemize deductions depends on expenses incurred by the taxpayer and income earned by the taxpayer in the year for which the taxpayer makes the election – all information that is generally available as of the time the election must be filed. Furthermore, a taxpayer is able to change the election on an amended return which can be filed within the statute of limitations for claiming a tax refund, giving the taxpayer additional time to discover information bearing on the wisdom of making the election.
Another example of a backward-looking election is the election available under section 121(f). Section 121 of the Code allows a taxpayer to exclude from gross income up to a specified amount of gain from the sale of a principal residence, as long as the taxpayer meets certain requirements. Typically, a taxpayer can make use of the ability to exclude gain on only one sale within any two-year period of time. If a taxpayer sells two homes within a two-year period and each would qualify for exclusion but for this limitation, under section 121(f), the taxpayer can elect to include in income the gain from one sale in order to preserve the use of the exclusion for the other sale.
A taxpayer makes the election by filing a tax return for the year of the sale that includes in income the gain from sale of the home. Moreover, a taxpayer can make the election (or revoke the election after having made it) at any time within a three-year period beginning on the due date for filing the tax return for the year in which the sale occurs. Because the Treasury Regulations grant the taxpayer three years to make the election and because the restriction affects the ability to use the section 121 exclusion if the taxpayer used it already within two years, at the time the taxpayer must make the election, the taxpayer will be in a position to determine whether another sale within the two-year period would benefit more from the exclusion. In other words, if two sales occur within a two- year period, the taxpayer does not have to predict, at the time of the first sale, that a second sale will occur that would more benefit from the exclusion. When filing an initial return for the year of the first sale, the taxpayer could exclude the gain from income. Later within the two-year period, if a second sale occurs and the taxpayer would prefer to use the exclusion for that second sale (because it would generate greater tax liability than the first sale), the taxpayer can amend the earlier return to elect to include the gain from the first sale in income so that the taxpayer can, then, use the exclusion for the second sale.
3. Partly Backward-Looking and Partly Forward-Looking Tax Elections
An intermediate type of election that allows taxpayers to use hindsight to some degree is an election that is partly backward-looking and partly forward-looking. The section 754 election offers an example.
When one partner sells her interest in a partnership to another person, if a section 754 election is not in effect gain attributable to an increase in the value of a partnership’s assets potentially will be recognized twice for tax purposes—first on sale of an interest in the partnership and second on sale by the partnership of its assets. By making a section 754 election, the partnership effectively eliminates the second, duplicative tax gain. Special rules apply in the case of partnerships that hold assets that have declined in value.
To further illustrate the effects of a section 754 election, imagine that two individuals, Charles and Oliver, each contribute $100 in exchange for a 50% interest in a newly formed entity treated as a partnership for tax purposes. The partnership uses the $200 contributed by the partners to acquire land. Two years later, when the value of the land is $300, Charles sells his interest in the partnership to Mabel for $150. A year after the sale of the partnership interest, the partnership sells the land for $300.
At the time that he sells his partnership interest, Charles will recognize $50 of gain for tax purposes. If the partnership does not have a section 754 election in effect for the year in which the transfer of the partnership interest occurs, the partnership will recognize $100 of tax gain on sale of the land which will be allocated $50 to Oliver and $50 to Mabel. The $50 of tax gain that is allocated to Mabel is effectively a duplication of the tax gain recognized by Charles on sale of his interest in the partnership to Mabel because both $50 tax gains are attributable to Charles’s share of the increase in value of the land that occurred prior to sale of the partnership interest by Charles to Mabel.
By contrast, assume the partnership does have a section 754 election in effect for the year in which Charles transfers his partnership interest to Mabel. With the election, when the partnership later sells the land for $300, $50 of tax gain will be allocated to Oliver (the same amount that would have been allocated to him absent the election), but $0 of tax gain will be allocated to Mabel. Thus, unlike what occurs in the absence of a section 754 election, the $50 of tax gain attributable to Charles’s share of the increase in the value of the land that occurred prior to Charles’s sale of his partnership interest to Mabel is recognized only once—by Charles on sale of his interest to Mabel—and not a second, duplicative time by Mabel upon the partnership’s sale of the land.
If a partnership’s assets have a “substantial built-in loss” immediately after the transfer of an interest in the partnership, then the results that would follow from making a section 754 election are mandatory regardless of whether the partnership has made such an election. In other words, in such a case, the partnership is required to take steps to avoid the recognition of the same tax loss a second time. A “substantial built-in loss” exists if a partnership’s total basis in its assets, in aggregate, exceeds the total value of the partnership’s assets by more than $250,000. In effect, if the loss involved is large, this rule prevents taxpayers from avoiding making a section 754 election in order to duplicate a tax loss. However, duplication of losses can still occur in the absence of a section 754 election if the loss is not sufficiently large to constitute a “substantial built-in loss.”
Partnerships file the section 754 election with the tax return for the year in which the partnership interest transfer occurs. The election is partly backward-looking in the sense that, at the time of filing, the taxpayer has information about transfers made in the year for which the election is filed. The taxpayer could know, for instance, whether the partnership’s assets had a built-in gain at the time of any transfer during the year for which the election is filed (which could generally make the election advantageous) or instead had a built-in loss that was not large enough to constitute a “substantial built-in loss” (making the election potentially disadvantageous).
The election is also partly forward-looking. Once made, the election applies to all subsequent taxable years in addition to the year for which it is made unless and until it is revoked. The election can only be revoked with Service approval. The Treasury Regulations provide examples of situations when taxpayers will be granted permission to revoke the election. The examples are all instances when it becomes administratively more difficult for the taxpayer to make the adjustments required if the election is in place because, for instance, the partnership holds more assets or partnership interest transfers occur more frequently. The Treasury Regulations guard against the possibility that a taxpayer would use Misprediction of Fact Hindsight by trying to revoke the election upon discovering that it would prevent the taxpayer from duplicating a loss. In particular, the Regulations provide that permission to revoke the election will not be granted if the taxpayer’s primary purpose is, for example, to increase the loss recognized upon a sale of partnership assets. Furthermore, as discussed above, 2017 tax legislation closed off an avenue that taxpayers had used in the past to effectively revoke section 754 elections by triggering the technical termination of a partnership.
Thus, the election is partly forward-looking because, at the time the election is made, the taxpayer will not be in a position to have full information about the advantages and disadvantages of filing. In particular, the taxpayer will lack information about whether the partnership’s assets will have built-in gains or losses at the time of partnership interest transfers in future years when the election could remain binding.
B. Ability to File Late
Taxpayers may be able to obtain relief to file an election after its deadline, which could allow taxpayers greater ability to benefit from at least some types of hindsight. For some tax elections, late filing relief is never available. For instance, no late filing relief is available for the section 83(b) election. It does not benefit from the automatic extension of time rules that apply to some elections. In addition, the Service takes the position that it lacks authority to grant relief to file a late section 83(b) election. Moreover, on at least one occasion, a taxpayer attempted to engage in self-help to effectively obtain an extension of time to file a section 83(b) election by reissuing stock to replace earlier issued stock more than 30 days after its initial issuance. The taxpayer wished to file a section 83(b) election within 30 days of receipt of the new stock. The Service concluded that the new stock was, in substance, the same as the old stock so that the taxpayer’s attempt to file an election came too late.
For many other elections—including, for instance, the entity classification election and the section 754 election—a taxpayer may obtain relief to file the election late. In certain circumstances, the taxpayer can obtain an automatic extension of some amount of time to file late. If a taxpayer is not eligible for an automatic extension, the taxpayer can request a letter ruling from the Service to obtain relief to file the election late. At least based on the requirements contained in the Treasury Regulations, it appears that late filing relief may provide taxpayers with the ability to use Mistake of Tax Law Hindsight and Mistake of Knowable Fact Hindsight but not Misprediction of Fact Hindsight or Misprediction of Service Challenge Hindsight. Moreover, when the taxpayer is attempting to benefit from Mistake of Tax Law Hindsight but also in a position to benefit from Misprediction of Fact Hindsight, the taxpayer will generally be unable to file the election late. For instance, imagine the taxpayer failed to file the election by its deadline because the taxpayer was unaware of the election’s existence. The taxpayer later learns of the election and seeks relief to file it after the deadline. If new information about a relevant transaction became available between the election’s deadline and the time the taxpayer wishes to file and the new information makes clearer that the election is beneficial, the taxpayer will likely obtain no relief to file the election late.
To obtain a letter ruling granting relief to file late, the taxpayer must submit a request to the Service for a letter ruling and pay the associated user fee. To obtain relief, a taxpayer must establish that they acted “reasonably and in good faith” in addition to complying with other requirements. The Regulations specify that a taxpayer has not acted reasonably and in good faith if the taxpayer has filed a tax return that has been or could be subject to an accuracy-related penalty and the taxpayer wants to alter what they have claimed on the return and wants to file an election late in connection with the new outcome they intend to claim. In addition, the Regulations disallow relief for late filing if the taxpayer “was informed in all material respects of the required election and related tax consequences, but chose not to file the election.” The Treasury Regulations also provide that a taxpayer will not be entitled to file a late election if the taxpayer “uses hindsight.” Providing some more detail, the Regulations state: “if specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer, the Service will not ordinarily grant relief. In such a case, the Service will grant relief only when the taxpayer provides strong proof that the taxpayer’s decision to seek relief did not involve hindsight.”
Relief to file late is also disallowed if late filing would prejudice the interests of the government. This limitation appears to be concerned about the possibility of inconsistent reporting by the taxpayer over time or inconsistent reporting by the taxpayer and others that could result in less total tax revenue collection than what would have occurred if the election had been timely filed. Relatedly, the Regulations provide that the interests of the government ordinarily will be prejudiced if any taxable years affected by the election are closed by the statute of limitations. In addition, the Regulations list instances when the interests of the government are deemed to be prejudiced except in “unusual and compelling circumstances.” This applies, for example, if the election affects the taxpayer’s accounting method and late filing would require an adjustment to ensure that no item is improperly deducted in multiple years or omitted from income as a result of year-to-year inconsistency in the taxpayer’s method of accounting. A request to file a late mark-to-market election under section 475(f), at least if the taxpayer has reported results without using the mark-to-market method in previous years, is subject to this restriction.
Taken together, these requirements for non-automatic extensions of time appear to disallow obtaining late filing relief to benefit from Misprediction of Fact Hindsight or Misprediction of Service Challenge Hindsight. On the other hand, they generally allow obtaining late filing relief to benefit from Mistake of Tax Law Hindsight alone, subject to the caveat that the relief will not prejudice the interests of the government by, for instance, leading to a taxpayer-favorable inconsistency with reporting in a year that is closed by the statute of limitations. Indeed, the Treasury Regulations contain an example indicating that a taxpayer would be entitled to late filing relief if she originally was unaware of a regulatory election and learned about it two years later when using the services of a tax professional to prepare a return for a later year. Furthermore, while the Treasury Regulations do not contain an example specifically on point, nothing about the requirements would preclude obtaining late filing relief to benefit from Mistake of Knowable Fact Hindsight, subject again to the caveat that relief will not prejudice the interests of the government.
C. Application of the Late Filing Rules—Insights from Letter Rulings
An examination of letter rulings issued in response to taxpayer requests for late filing relief offers examples that may be instructive as to the potential to use different types of hindsight. Some issued letter rulings granting late filing relief contain too little factual description to discern the basis for the Service’s conclusion.
Many letter rulings that grant relief for late filing involve taxpayers who failed to properly make an election that the taxpayer, all along, intended to make. All along, they understood the effect of the election and wanted to make the election based on the information available as of the filing deadline. However, they simply failed to make the election because they forgot to submit the necessary paperwork or did not fully comply with the procedural requirements for filing the election. Such taxpayers are not, in any significant way, using hindsight of any of the types described above in Part II. If they are attempting to benefit from any new information, it is merely information about procedural requirements for filing the election.
Many letter rulings of this sort specifically mention facts that might be seen as evidence that the taxpayer intended to make the election all along. For instance, the rulings point to the fact that the taxpayer has a history of filing returns consistent with the election being in place. Along similar lines, some letter rulings granting relief to a partnership for late filing of a section 754 election note that the partners had contractually agreed to make the election. Arguably, prior tax returns are more convincing evidence than contractual language given that the latter is something the taxpayer might disclose to the Service only if the taxpayer does later decide the election would be beneficial. Some rulings involving taxpayers who failed to make an election they always intended to make do not specifically mention any evidence of the taxpayer’s long-standing intent to file the election. It is, however, possible that the taxpayer noted such facts in the taxpayer’s request, and the facts were simply omitted from the ruling.
Many letter rulings that grant late filing relief specify that the relief is contingent on the taxpayer reporting tax consequences consistently with the election having been in effect including by amending earlier returns to ensure consistency with the election. In some cases, the language requiring tax return amendment may simply be boilerplate letter ruling language. If any taxpayers did already file returns that were inconsistent with the election, presumably such taxpayers did not, in fact, intend to file the election all along. Such taxpayers might be using Mistake of Tax Law Hindsight, for instance, if they were not aware of the election’s existence or effects in time to file by the regular deadline. Presumably, the Service did not think the taxpayers were using Misprediction of Fact Hindsight or Misprediction of Service Challenge Hindsight because then granting relief likely would be inconsistent with the Treasury Regulations.
Some letter rulings that grant late filing relief contain more complete factual descriptions that reveal the taxpayer was, indeed, using Mistake of Tax Law Hindsight. For example, in a 2021 letter ruling, a taxpayer was granted an extension of time to file a section 754 election when the taxpayer failed to make a timely election because the taxpayer’s advisor failed to inform the taxpayer of the availability of the election. In another 2021 letter ruling, a taxpayer obtained an extension of time to file an entity classification election for a non-U.S. entity. A timely election was not made because the taxpayer’s advisors had not informed the taxpayer about the possibility that new Regulations could cause the taxpayer’s tax classification to produce unfavorable tax consequences.
Some letter rulings allowing for late filing involve taxpayers making use of Mistake of Knowable Fact Hindsight. For example, in a 2021 letter ruling, the Service provided an extension of time for filing a section 754 election. The partnership that obtained the ruling had not filed the election in a timely manner because it did not know that a partner had died, a fact that made the election beneficial.
Some publicly available letter rulings deny taxpayers’ requests for late filing relief. While some letter rulings lack facts necessary to discern the reasons for the Service’s refusal to grant relief, in numerous rulings, the Service appears to be concerned that the taxpayer is attempting to use Misprediction of Fact Hindsight.
Consider, for instance, letter rulings involving requests to make late section 475(f) mark-to-market elections. There are a total of 22 publicly available letter rulings issued in response to such requests, and, of these 22, 3 grant relief to file late elections while 19 deny relief. In 14 of the 19 rulings denying relief, the Service indicated that its decision was motivated, at least in part, by a concern that the taxpayer may have been attempting to benefit from hindsight, seemingly Misprediction of Fact Hindsight. In most or all instances, the taxpayer at least claimed to be attempting to use Mistake of Tax Law Hindsight, but relief was denied because, given the passage of time and additional information the taxpayer would have about trading activities, the taxpayer could also have been attempting to benefit from Misprediction of Fact Hindsight.
For example, in PLR 202037007, the taxpayer failed to file a timely section 475(f) election because the taxpayer’s accountant, being unaware of the extent of the taxpayer’s trading activities, did not inform the taxpayer about the existence of the election in time to file. The taxpayer’s request to file a late election was denied because, after the tax election’s deadline, the taxpayer had engaged in substantial sales producing tax losses which made the election more beneficial. This fact pattern triggered the Treasury Regulations’ rebuttable presumption that the taxpayer was attempting to benefit from hindsight. In particular, under the Regulations, if “specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer,” the taxpayer is denied relief unless the taxpayer provides “strong proof that the taxpayer’s decision to seek relief did not involve hindsight.” A similar example is offered by PLR 201048029.
As another illustration consider PLR 202009013. In this ruling, the taxpayer—an attorney and an accountant—was aware of the existence of the election and represented that he always intended to file it but failed to file it because he operated under the mistaken assumption that its due date was a year later than the actual deadline. The taxpayer’s request for relief to file a late election was denied because additional losses incurred by the taxpayer after the election’s deadline made the benefits of filing the election clearer. As a result, the same rebuttable presumption that the taxpayer was motivated by hindsight came into play.
PLR 200953006 provides another example. In that ruling, the taxpayer utilized the services of an accountant but did not learn about the availability of the section 475(f) election from the accountant. In fact, the taxpayer first learned about the election when he called the Service to seek guidance and was asked if he had filed the election. After his conversation with the Service, the taxpayer asked his accountant about the election and his accountant “acknowledged that he had heard of the election but was not quite sure how it worked.” The taxpayer’s request for relief to file a late election was denied because the taxpayer continued to engage in trading activity and accrued losses after the election’s due date. Thus, once again, the facts triggered the rebuttable presumption that the taxpayer was motivated by hindsight.
Along similar lines, in PLR 200736018 the taxpayer sought and was denied relief to file a late election under section 475(f). The taxpayer utilized the services of an accountant who did not inform the taxpayer of the availability of the election in time to file it. Indeed, the taxpayer brought a malpractice claim against the accountant and the claim was settled. The Service denied the taxpayer’s request to file a late election because substantial time elapsed between the election’s due date and the time the taxpayer requested relief, and during that time the taxpayer continued to engage in trading activities giving the taxpayer the benefit of hindsight.
A 2006 Tax Court case, Vines v. Commissioner, offers an example of a taxpayer who was able to obtain relief to file a late section 475(f) election after challenging the Service’s denial of relief. In Vines, a retired personal injury lawyer began a new career as a securities trader. On April 14, 2000, the taxpayer’s securities portfolio was liquidated, producing a significant loss, after which the taxpayer held no additional securities. An accountant with over 30 years of experience who had advised the taxpayer on tax matters and assisted with tax return preparation for over 13 years was well aware of the taxpayer’s trading activities. However, being unaware of the existence of the election, the accountant did not advise the taxpayer to file it by the deadline. The taxpayer later learned about the election from a friend and used the assistance of tax counsel to request relief to file a late election. Between the deadline for filing the election and the date the taxpayer requested relief, the taxpayer did not purchase or sell any publicly traded stock. Thus, as of the date the taxpayer requested relief, his tax losses were exactly the same as they were as of the deadline for filing the election.
Following a letter ruling conference, the Service issued a conference report noting its view that the drafters of the revenue procedure providing guidelines for filing the section 475(f) election did not intend late filing relief to be available for this election. In addition, the report stated, “For basically administrative reasons, we were forced to allow 3 ½ months of hindsight [by giving taxpayers until the previous year’s tax return due date to file the election], but if we had the choice, we would not have allowed one day of hindsight.”
Before the Tax Court, the Service argued that late filing relief would allow the taxpayer to benefit from hindsight. The Tax Court ruled in favor of the taxpayer, granting relief to file the late election. When addressing the question of whether the taxpayer was benefiting from hindsight, the court stated:
“the relevant inquiry is whether allowing a late election gives the taxpayer some advantage that was not available on the due date. In the instant case, the only fact that changed after the due date for making the election was the discovery of the availability of the election itself. . . .If a late election is allowed, petitioner will not be entitled to anything more than that to which he would have been entitled had he timely made the election.”
In other words, the facts made clear that the taxpayer was attempting to benefit from Mistake of Tax Law Hindsight only and not Misprediction of Fact Hindsight.
The fact that the taxpayer engaged in no trading activities after the election’s due date and before requesting relief was decidedly key to the outcome of Vines. In contrast to the Vines case, when taxpayers have continued to engage in trading activities after the deadline for filing the election and before requesting relief for late filing, the Tax Court has agreed with the Service’s view that the taxpayer is attempting to benefit from hindsight.
As was true for the section 475(f) election, letter rulings have denied relief to file late entity classification elections when a taxpayer could be attempting to benefit from Misprediction of Fact Hindsight. For instance, in a 2008 letter ruling, the Service denied relief and noted that the taxpayer did not exercise due diligence to become informed about the benefits of the election despite typically seeking tax planning advice. Moreover, the ruling noted that facts had changed between the due date for filing the election and the time the taxpayer sought relief to file late that made the advantages of the election clearer. This triggered the rebuttable presumption that the taxpayer was attempting to benefit from Misprediction of Fact Hindsight.
Some letter rulings that deny late filing relief effectuate the regulatory provision that withholds relief from a taxpayer who “was informed in all material respects of the required election and related tax consequences, but chose not to file the election.” If a taxpayer is fully informed about the effects of the election and truly makes a conscious decision to not file, there may be a heightened risk that the taxpayer is attempting to benefit from Misprediction of Fact Hindsight. By way of example, consider PLR 200830010. In that ruling, the taxpayer’s advisors informed the taxpayer, all along, that an election ought to be filed, but the taxpayer did not file the election. It is possible that the taxpayer simply failed to file inadvertently. However, perhaps the Service’s unarticulated concern was that the taxpayer would only raise the fact that advisors had recommended making the election if, in hindsight with more complete information about the relevant facts, the election does, indeed, prove to be beneficial. In other words, the taxpayer may have planned to wait and see and request relief to file late only if making the election, in hindsight, did indeed prove to be advantageous, and the taxpayer raised the advisors’ recommendations to try to bolster a claim that the taxpayer intended to make the election all along. Arguably, the same concern might be raised about contractual provisions committing partnerships to make section 754 elections that seemingly have been relied on as evidence of the fact that the taxpayer, all along, intended to make the election, as discussed above.
Some letter rulings deny relief to file late elections because the taxpayer neglected to take prompt action to request relief upon discovering the failure to file a timely election. While the rulings do not, specifically, articulate this concern, the resistance to granting relief justifiably may be motivated by the concern that the taxpayer is attempting to benefit from Misprediction of Fact Hindsight. In other words, the taxpayer may have intentionally delayed submitting a request for late filing relief to acquire more information bearing on whether the election would be beneficial (in which case the taxpayer requests relief) or disadvantageous (in which case the taxpayer stays silent).
Finally, at least one denial of a request to file a late election involves a taxpayer who appeared to be attempting to use something akin to Misprediction of Service Challenge Hindsight. In particular, in PLR 200607016, a taxpayer held assets that had appreciated in value, formed a non-U.S. entity treated as a corporation for U.S. tax purposes, and contributed the assets to the entity. The taxpayer did so in hopes of avoiding U.S. tax liability upon later sale of the assets. After being informed by accountants that the plan was ill-conceived because gain would be subject to U.S. tax upon transfer of assets to the entity, the taxpayer requested an extension of time to elect to treat the entity as a disregarded entity for U.S. tax purposes to prevent recognition of gain upon contribution of the assets. Thus, the taxpayer attempted to benefit from hindsight—in particular from new knowledge that the taxpayer’s tax avoidance plan would not succeed. The Service denied the taxpayer’s request for late filing relief, stating that the taxpayer was “deemed to have not acted reasonably and in good faith.”
D. Ability to Revoke
Just as late filing might potentially open the door to use of various types of hindsight, so can the ability to revoke an election. In particular, a taxpayer who initially makes an election might later revoke the election upon acquiring additional information showing the election was disadvantageous.
For some elections, taxpayers are given wide latitude to revoke. Consider, for instance, the section 121(f) election described above. Imagine a taxpayer initially opts to include in income gain from sale of a principal residence because the taxpayer anticipates another sale within two years and wants to preserve the exclusion for that sale. If the taxpayer later learns that the second sale will not occur or that the earlier sale will benefit more from the exclusion, the taxpayer can revoke the election and exclude from income gain from the earlier sale.
In some contexts, tax law affords leniency to revoke elections in an asymmetric fashion. As one example, Professor Oren-Kolbinger has noted that married taxpayers who elect to file separate returns are granted leeway to revoke that election and file jointly, while married taxpayers who file jointly are not given the same latitude to revisit that decision and file separately.
In the case of some elections, rules governing the ability to revoke are designed to disallow the use of Misprediction of Fact Hindsight. The section 754 election described above offers an example. Here, the Regulations make clear that attempts to revoke that are motivated by Misprediction of Fact Hindsight will not succeed. Furthermore, as discussed above, 2017 legislative changes ended the ability of taxpayers to use self-help to circumvent the restrictions on revocation by triggering technical partnership terminations.
In other instances, the ability to revoke is even more limited. This is true of the section 83(b) election described above. Once made, a section 83(b) election cannot be revoked without Service consent. Given that late filing relief for a section 83(b) election is unavailable, it may, at first, seem curious that revocations of section 83(b) elections are allowed at all. Both late filing and the ability to revoke raise the risk of allowing for Misprediction of Fact Hindsight. In other words, just as a taxpayer who failed to make a section 83(b) election because of an inaccurate prediction that stock would decline in value might want to make the election late upon discovering that it increased in value, so too might a taxpayer want to revoke an earlier election upon discovering that stock declined in value contrary to the taxpayer’s prediction that its value would increase. Furthermore, as discussed below, in general, tax law ought to be the most lenient when a taxpayer is attempting to benefit from only Mistake of Tax Law Hindsight. In many cases, late filing—but not the ability to revoke—may be the only useful tool for a taxpayer who operated under a mistaken understanding about the tax law. For instance, if a taxpayer was not aware of an election at all before its deadline, the taxpayer will simply not make the election. While late filing relief may offer the taxpayer some assistance, the ability to revoke an election offers no aid.
However, the ability to revoke section 83(b) elections becomes somewhat less of a mystery when one considers that revocation is allowed in quite limited circumstances. Under the Regulations, revocation is allowed only if the recipient of the property was operating “under a mistake of fact as to the underlying transaction.” The Regulations grant the taxpayer 60 days after discovering the mistake of fact to request relief, presumably to thwart attempts by taxpayers to intentionally delay more than 60 days to acquire information about the property’s value before deciding whether to request relief. To guard against the use of Misprediction of Fact Hindsight, the Regulations note that “a mistake as to the value, or decline in the value of the property with respect to which an election under section 83(b) has been made” does not constitute a mistake of fact. In addition, Service guidance makes clear that a mistake of law—such as a failure to understand the tax consequences of making a section 83(b) election—does not constitute a mistake of fact. Thus, the rules allow for some limited use of Mistake of Knowable Fact Hindsight but no other type, including Mistake of Tax Law Hindsight.
The Service is quite lenient about granting relief to revoke a section 83(b) election if the taxpayer requests relief before the initial deadline for filing the election. Given that a taxpayer who has not yet made the election is granted until the deadline to acquire all available information before deciding whether to file, there is no reason to bar a taxpayer who has already made the election from changing her mind for any reason prior to the initial deadline.
To revoke a section 83(b) election, the taxpayer must request a letter ruling. Twenty-nine publicly available letter rulings respond to taxpayer requests to revoke section 83(b) elections. Sixteen of these involve taxpayer requests to revoke elections within the period allowed for initially filing the election, and all of these requests were granted.
Thirteen rulings respond to requests made after the initial filing deadline. Of these, four grant the taxpayer’s request to revoke, and nine deny the request. All four taxpayers who obtained relief discovered that a grant had not been authorized by the corporation’s board of directors so that the taxpayers had to return the stock to their employers. The taxpayers who failed to obtain relief include, among others: (1) a taxpayer who forfeited shares when they resigned to take a position with another company because of “turmoil and uncertainty” at the taxpayer’s previous employer, (2) a taxpayer who made the election after receiving inaccurate advice about its tax consequences from the in-house counsel of the taxpayer’s employer, (3) a taxpayer who received a packet of paperwork at the time of the initial grant with “sign here” stickers affixed at various spots, including on a section 83(b) election form so that the taxpayer signed the form without considering its consequences and based on the assumption that signing was necessary to receive the grant, (4) a taxpayer who received multiple blocks of stock, intended to make the election with respect to some of the blocks but not all—a strategy previously discussed with the taxpayer’s accountant—but inadvertently signed a document making the election for all of the blocks of stock, (5) a taxpayer who initially made the election because corporate officers allegedly assured the taxpayer of continued employment and misleadingly advised the taxpayer that the election was easily revocable if the taxpayer’s employment ended, (6) a taxpayer whose judgments about the value of stock were skewed by misleading assurances by the taxpayer’s employer about its financial strength, and (7) a taxpayer who made the election under the mistaken belief that the taxpayer would have sufficient funds to pay the resulting tax owed upon receipt of the shares but later was unable to pay the resulting tax liability without “experiencing extreme financial hardship.”
The ability to revoke a section 83(b) election is not unique in terms of granting more leeway to taxpayers for mistakes of fact than mistakes of law. Courts have thwarted taxpayers’ attempts to revoke other tax elections upon discovering a mistake about the tax law. Whether this result makes sense as a policy matter has been questioned by courts and commentators.
In summary, the ability to revoke tax elections varies from context to context. At one extreme, for some tax elections like section 121(f), revocation is allowed for any reason. At the other extreme, for tax elections like section 83(b), revocation is allowed in only limited circumstances so that, in effect, it might be used to benefit from Mistake of Knowable Fact Hindsight but no other types of hindsight, including Mistake of Tax Law Hindsight.
E. Ability to File Protectively
In some cases, if a taxpayer anticipates, in advance of an election’s due date, that they might be acting under a mistaken belief about tax law, non-tax law, or a fact related to a transaction, the taxpayer may be able to file an election on a protective basis to secure favorable tax treatment in case the taxpayer is, indeed, mistaken. The ability to make a protective filing offers no assistance to taxpayers who are entirely unaware of an election or its effects by the time of the deadline for filing. However, protective filings can be used by taxpayers who are aware of the potential risk for certain mistakes by the time for filing. While such taxpayers are not using hindsight in the sense of changing their elections after the deadline, they are preemptively electing into the ability to benefit from information that they might later acquire.
To demonstrate how a protective tax election could allow a taxpayer to obtain the same benefits as a taxpayer who uses Mistake of Knowable Fact Hindsight, consider a group of taxpayers who form a business entity outside of the United States and who want to treat the entity as a corporation for U.S. tax purposes. Assume it is not a type of business entity that is required to be treated as a corporation for U.S. tax purposes. Imagine they believe that all owners of the entity have limited liability under non-U.S. law, but they are aware of some possibility that they may be mistaken. To guard against that possibility, they might opt to file a protective tax election to treat the entity as a corporation for U.S. tax purposes. The election is protective because it is possible that it is not necessary. In particular, if all owners have limited liability, then the entity is, by default, treated as a corporation for U.S. tax purposes so that filing is unnecessary. If it turns out to not be the case that all owners have limited liability, the protectively filed election secures their desired tax classification.
In other contexts, protective tax elections could allow a taxpayer to obtain the same informational benefits as a taxpayer who uses Mistake of Tax Law Hindsight or Misprediction of Service Challenge Hindsight. In particular, in some contexts, taxpayers can, essentially, claim a desired tax result but file a protective tax election that would produce more favorable alternative tax treatment in case the taxpayer’s claimed tax outcome is unavailable. As one example, a taxpayer might sell appreciated real estate and take the position that the real estate is a capital asset so that the resulting gain is capital gain, subject to tax at a lower rate than ordinary income. If the taxpayer fears that the Service might challenge the taxpayer’s position that the real estate is a capital asset, in some cases the taxpayer can file a protective tax election to secure more favorable alternative tax treatment than what would result from successful Service challenge in the absence of the protective filing.
F. Summary
Taxpayers’ ability to make tax elections with the benefit of hindsight varies greatly from election to election. At one extreme, backward-looking tax elections with generous filing deadlines offer taxpayers the ability to benefit from hindsight of all types. In order to demonstrate, consider the following examples.
Example 1. Mistake of Tax Law Hindsight
Imagine a taxpayer claims the standard deduction because she is unaware that an expense she incurred is deductible if she itemizes deductions. The taxpayer knows she incurred the expense but does not know it is deductible. The next year, she learns that the expense is deductible and would result in total itemized deductions that exceed the standard deduction. By amending the earlier return, she can use Mistake of Tax Law Hindsight to change her election and itemize deductions.
Example 2. Mistake of Knowable Fact Hindsight
Imagine the same taxpayer from Example 1 except that the reason she failed to itemize deductions is that she was unaware that she had incurred the expense. If she later learns about the expense in time to amend her earlier return, she can do so to benefit from Mistake of Knowable Fact Hindsight.
Example 3. Misprediction of Fact Hindsight
Imagine a taxpayer initially opts to include in income gain from sale of a principal residence because she anticipates another sale within two years and wants to preserve the section 121 exclusion for that sale. If the taxpayer later learns that the second sale will not occur or that the earlier sale will benefit more from the exclusion, the taxpayer can revoke the election and exclude from income gain from the earlier sale. This taxpayer benefits from Misprediction of Fact Hindsight.
Example 4. Misprediction of Service Challenge Hindsight
Imagine a taxpayer itemizes deductions, including deducting a given amount as an uninsured medical expense. The Service subsequently successfully challenges the taxpayer’s position that the expense was incurred for medical care. With that item, the taxpayer’s total itemized deductions were $15,000, while without that item the taxpayer’s total itemized deductions were $10,000, and the standard deduction is $13,850. In recomputing the taxpayer’s correct taxable income, the taxpayer will get the benefit of the $13,850 standard deduction rather than being limited to claiming $10,000 in itemized deductions. In some cases, the taxpayer might be subject to an explicit tax penalty for incorrect reporting, but the taxpayer will not be subject to an implicit penalty of foregoing the opportunity to elect the standard deduction that was, with the benefit of Misprediction of Service Challenge Hindsight, more beneficial.
While backward-looking elections with late deadlines offer a multitude of opportunities to benefit from hindsight, forward-looking elections offer taxpayers little ability to benefit from hindsight. In addition, if an election is not associated with a tax return, there may be a greater risk that some taxpayers are unaware of the existence of the election by the deadline for filing it.
Across different forward-looking elections, the tax law’s approach to Mistake of Tax Law Hindsight is not entirely consistent. For example, taxpayers cannot revoke section 83(b) elections to benefit from Mistake of Tax Law Hindsight. In some cases, taxpayers can obtain relief to file section 475(f) elections late to benefit from Mistake of Tax Law Hindsight but only when the taxpayer is clearly not also attempting to benefit from Misprediction of Fact Hindsight (because the taxpayer engaged in no trading activities between the filing deadline and the time the taxpayer requests relief). If the taxpayer could, potentially, benefit from both Mistake of Tax Law Hindsight (learning about the elections’ existence) and Misprediction of Fact Hindsight (because the taxpayer continued to engage in trading activities after the filing deadline and is in possession of new information about the outcome of the activities that makes the benefits of filing clearer), the taxpayer’s efforts to file late are likely doomed. Taxpayers who failed to make other beneficial elections—such as a section 754 election or an entity classification election—because of a lack of awareness of the relevant tax consequences have obtained relief to file late elections after discovering their errors.
Across a variety of forward-looking tax elections, the tax law is generally forgiving of taxpayers who seek to use Mistake of Knowable Fact Hindsight. Even in the section 83(b) election context in which tax law is quite wary of attempts to use hindsight, taxpayers are granted the ability to revoke section 83(b) elections if the taxpayer made the election based on a mistake of fact about the transaction. For instance, taxpayers who were required to return stock to their employers have obtained permission to revoke section 83(b) elections that they made without knowledge that the corporate board had not approved the stock grant. Curiously, the approach to Mistake of Knowable Fact Hindsight is asymmetric in the section 83(b) context – upon discovering a mistake of fact, taxpayers may be allowed to revoke elections but not file them late.
Taxpayers can file other late elections to benefit from Mistake of Knowable Fact Hindsight, such as the section 754 election. As another example, consider a taxpayer who desires to treat a non-U.S. entity as a corporation for U.S. tax purposes but mistakenly believes that all owners have limited liability under the jurisdiction in which the entity is formed so that it is a corporation by default. If the taxpayer discovers the mistake later, they may be able to file the election late to make use of Mistake of Knowable Fact Hindsight. In some cases, relief may be available automatically. In other cases, obtaining relief may require requesting a letter ruling and paying associated user fees. If the same taxpayer has enough foresight as of the initial filing deadline to appreciate that there is uncertainty about whether all owners have limited liability, the taxpayer could file an election to be treated as a corporation on a protective basis, obviating the need to obtain late filing relief if the taxpayer later discovers that the owners do not all have limited liability. Thus, sometimes having filed a protective tax election could spare the taxpayer the costs of submitting a ruling request and paying a user fee.
Across a variety of forward-looking tax elections, the tax law is hostile to attempts to use Misprediction of Fact Hindsight. The Regulations preclude relief for late filing when facts have changed since an election’s due date that make the election advantageous unless the taxpayer provides “strong proof that the taxpayer’s decision to seek relief did not involve hindsight.” This rebuttable presumption has prevented taxpayers from obtaining late filing relief for a variety of elections, including the section 475(f) election and the entity classification election. In a parallel fashion, the rules governing the ability to revoke a section 83(b) election specifically provide that “a mistake as to the value, or decline in the value of the property with respect to which an election under section 83(b) has been made” cannot serve as the basis for revoking the election. Likewise, section 754 elections cannot be revoked if the primary purpose of the revocation is to allow the partnership to recognize more tax loss upon sale of partnership assets.
Tax law is also hostile to attempts to file forward-looking elections late or revoke forward-looking elections to benefit from Misprediction of Service Challenge Hindsight. Consider for instance PLR 200607016, discussed above. In that ruling, a taxpayer held assets that had appreciated in value, formed a non-U.S. entity treated as a corporation for U.S. tax purposes, and contributed the assets to the entity. The taxpayer did so in hopes of avoiding U.S. tax liability upon later sale of the assets. After being informed by accountants that gain would be subject to U.S. tax upon transfer of assets to the entity, the taxpayer requested an extension of time to elect to treat the entity as a disregarded entity for U.S. tax purposes to prevent recognition of gain upon contribution of the assets. The Service denied the taxpayer’s request for late filing relief. If the taxpayer had, in fact, reported results indicating that no gain was recognized upon contribution of assets to the entity and attempted to file the election late after the Service challenged the reported results, the Service presumably would have had all the more reason to deny late filing relief. The Treasury Regulations governing late filing relief specifically provide that relief will be denied if a taxpayer has filed a tax return that has been or could be subject to an accuracy-related penalty and the taxpayer wants to alter what they have claimed on the return and wants to file an election late in connection with the new outcome they intend to claim. This could be true of the taxpayer in this example.
Just as attempts to file late to benefit from Misprediction of Service Challenge Hindsight are met with hostility, so too are attempts to revoke elections under similar circumstances. As Professor Yorio notes, “courts have generally been antagonistic to taxpayer revocations in response to tax audits.”