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The Tax Lawyer

The Tax Lawyer: Fall 2023

Taxpayers' Tax Election Regrets

Emily Cauble

Summary

  • This article examines the restrictions on (and allowed uses of) hindsight when making tax elections and the when a taxpayer can benefit by retroactively filing a new election.
  • The article also surveys the existing policy on the use of hindsight when making tax elections.
  • Shortfalls in existing policy merit changes to existing law, including recent legislative changes restricting the use of hindsight. This article proposes several revisions.
Taxpayers' Tax Election Regrets
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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.”

IV. Policy Considerations

Several policy considerations may underlie the tax law’s resistance to taxpayers’ attempts to use hindsight. First, as is true of tax elections generally but even more so when taxpayers can make elections with full information, the ability to make tax elections with the benefit of hindsight would diminish tax revenue. Second, if taxpayers with access to sophisticated advice can make tax elections with full 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 hindsight could create problematic incentives for taxpayers. For instance, if taxpayers were able to make use of Misprediction of Service Challenge Hindsight, they may be more likely to take questionable reporting positions that carry with them a greater risk of Service challenge. Also, in some cases, the ability to use Mistake of Tax Law Hindsight might prompt taxpayers to fabricate claims that they failed to understand an election’s tax consequences.

Fourth, the ability to use hindsight could, in some cases, create tax-revenue-reducing inconsistencies among multiple parties to a transaction. If a tax election affects more than one taxpayer, for instance, a retroactive change to the election could result in inconsistent reporting if one party reports based upon the original tax election while the other party reports based upon the revised election. Similarly, the ability to use hindsight could create tax-revenue-reducing inconsistent reporting by a taxpayer over time if a taxpayer reports in some years as if one election was in place but in other years as if a different election was in place. 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.

While preventing the use of hindsight may guard against numerous potentially undesirable effects, some of these effects only arise in some cases when taxpayers attempt to use hindsight, and, thus, do not necessarily justify a blanket prohibition against the use of hindsight. Moreover, preventing the use of hindsight in some cases creates its own undesirable effects. For instance, not allowing taxpayers to benefit from Mistake of Tax Law Hindsight can exacerbate the extent to which effective tax planning strategies are only available to well-advised taxpayers. This Part will proceed by discussing the policy implications of restricting or allowing the use of hindsight.

A. Tax Revenue

The availability of tax elections, generally, sacrifices tax revenue. If taxpayers are allowed to make tax elections with the benefit of hindsight, even more tax revenue will be foregone. The extent to which this ought to concern lawmakers varies based on the type of hindsight taxpayers employ and the particular election involved.

Regarding the type of hindsight, tax revenue loss is of most concern when taxpayers use Misprediction of Fact Hindsight or Misprediction of Service Challenge Hindsight and of least concern when taxpayers use Mistake of Tax Law Hindsight or Mistake of Knowable Fact Hindsight. If a taxpayer uses only Mistake of Tax Law Hindsight or Mistake of Knowable Fact Hindsight when making an election, the taxpayer merely obtains the same beneficial tax treatment that a well-advised taxpayer could have obtained without the use of hindsight. As a result, these uses of hindsight are not particularly objectionable on the grounds of loss of tax revenue for two reasons. First, one could argue that the lost tax revenue is no more than what lawmakers intended when they afforded to taxpayers the opportunity to choose their tax treatment.

Second, one could argue that any tax revenue lost as a product of allowing taxpayers to use Mistake of Tax Law Hindsight or Mistake of Knowable Fact Hindsight ought to be recouped in fairer ways. If a taxpayer reduces her tax liability by using hindsight of these types, she is simply obtaining the same tax outcome available to well-advised taxpayers without resort to hindsight. Foreclosing the opportunity for taxpayers to avail themselves of these types of hindsight, therefore, raises tax revenue solely as an artifact of setting traps for unwary taxpayers. If the lost tax revenue is objectionable, then broader change that makes the tax outcome no longer elective for all taxpayers is preferrable to limiting tax revenue loss by counting on some taxpayers making ill-informed decisions.

By contrast, if a taxpayer who obtains late filing relief is able to benefit from Misprediction of Fact Hindsight in addition to (or instead of) Mistake of Tax Law Hindsight to make a better-informed decision than a taxpayer who filed by the deadline, then granting late filing relief sacrifices more tax revenue than what would result from all taxpayers making well-informed, timely elections. It is easiest to conclude that late filing might allow a taxpayer to benefit from Misprediction of Fact Hindsight if an election would have appeared disadvantageous as of the original filing deadline but, as of the time the taxpayer seeks to file late, the election appears advantageous. To demonstrate, imagine a taxpayer failed to make a section 83(b) election because she was unaware of the election’s existence, and even a well-informed taxpayer in her position would not have made the election based upon the taxpayer’s predictions, as of the filing deadline, for the future trajectory of the property’s value. Imagine, by the time the taxpayer learns of the election, the actual trajectory of the property’s value differs from what was expected in a way that makes clear that filing the election is beneficial. Allowing such a taxpayer to file a late election as a remedy for their mistake as to tax law would do more than put them in the same position as a well-informed taxpayer. It would lead to more tax revenue loss than what lawmakers bargained for when making the election available. Furthermore, as discussed below, it could create problematic incentives for taxpayers to stay willfully ignorant about tax law (or at least to try to feign ignorance) to buy more time to make tax elections.

A case in which it may be more difficult to determine whether a taxpayer seeks to benefit from Misprediction of Fact Hindsight arises when no facts have changed since an election’s deadline but there was potential for the facts to change in a way that would affect whether the election was advantageous. It is possible a taxpayer may have deliberately failed to make a seemingly beneficial election to preserve the option to either request late filing relief if the election turns out to be advantageous, as predicted, or not request relief if facts change in a way that makes the election disadvantageous. To demonstrate, imagine that, as of the deadline for filing a section 83(b) election, filing the election would be beneficial based upon the taxpayer’s predictions for the future trajectory of the property’s value, while if the property’s future value turns out to be different than predicted filing the election could prove to be disadvantageous. If late filing relief were available as a remedy for mistakes about tax law, a scheming taxpayer who was aware of the resulting tax consequences might deliberately choose to not file the election. The taxpayer might do so planning to seek relief to file late if the election turns out to be advantageous (and assert that failing to file the election was attributable to a mistake about tax law given that filing would have been the wiser course of action in light of the taxpayer’s predictions for the property’s value). If the election turns out to be disadvantageous, the taxpayer plans to not seek relief and to instead benefit from the fact that an election is not in place. In this way, the taxpayer plans to use Misprediction of Fact Hindsight but disguise it as Mistake of Tax Law Hindsight.

In general terms, as this second example demonstrates, allowing relief for Mistake of Tax Law Hindsight and being too easily convinced that a taxpayer’s decision was based upon a mistake about tax law could sacrifice tax revenue if well-advised taxpayers game the rules. They might do so by intentionally making seemingly ill-advised choices to have the option later of deciding whether or not to “discover” the error and seek relief once more complete information becomes available. The risk of this occurring would be minimized if lawmakers granted relief for seemingly ill-advised choices only when credible evidence showed that the taxpayer was not gaming the system in this way. This could include showing clearly that the taxpayer was not aware of applicable tax rules at the time the taxpayer made the seemingly ill-advised choice. In addition, if the odds that the seemingly ill-advised choice would later turn out to be beneficial are very low or the potential benefit that it would afford is very slight, it is unlikely that the taxpayer was intentionally gaming the system to preserve the option to claim the results that would follow from the seemingly ill-advised choice.

Just as the potential for tax revenue loss is more or less concerning depending on the type of hindsight utilized by the taxpayer, concerns about tax revenue loss can also vary depending on the particular tax election involved. In particular, tax revenue loss stemming from use of hindsight may be less objectionable in the case of some elections that have a built-in cap on the maximum potential tax revenue loss. Consider, for instance, the section 121(f) election. As discussed above, if certain requirements are met, a taxpayer can exclude from income gain from sale of a principal residence. Generally, the taxpayer can use the exclusion for only one sale in any given two-year period, and if the taxpayer engages in multiple qualifying sales within any given two-year period, the taxpayer uses the section 121(f) election to choose which of those sales benefits from the exclusion. Taxpayers are granted wide latitude to use hindsight—including Misprediction of Fact Hindsight—when making this election. The potential tax benefit that a taxpayer achieves under the provision is capped. In particular, for single taxpayers, for instance, the maximum amount of gain that can be excluded as a result of a sale is $250,000. Thus, even if taxpayers can, with the benefit of hindsight, use the exclusion in the most beneficial way possible, a built-in cap limits the potential loss of tax revenue. By contrast, other tax elections, like the section 83(b) election or the section 475(f) mark-to-market election have no such built-in cap on tax revenue loss. This may, in part, explain why the law generously allows use of hindsight for the section 121(f) election but strictly guards against the use of hindsight in the case of the section 83(b) election or the section 475(f) election.

B. Fairness

The ability to elect into more favorable tax treatment, generally, undermines fairness. Allowing the use of hindsight could either exacerbate or ameliorate this tendency depending on the type of hindsight involved. Allowing taxpayers to benefit from Misprediction of Fact Hindsight or Misprediction of Service Challenge Hindsight would exacerbate the problem. Well-advised taxpayers could even more effectively reduce their tax burdens if they could make elections with full information about a transaction’s outcome. In addition, if they were able to revise their elections in response to a successful Service challenge, as discussed below, they might take more aggressive initial reporting positions, which would result in lower tax liability for taxpayers whose positions go unchallenged.

By contrast, allowing taxpayers to benefit from Mistake of Tax Law Hindsight or Mistake of Knowable Fact Hindsight could ameliorate the unfairness stemming from the availability of tax elections. Giving taxpayers who, initially, do not obtain adequate advice another opportunity to obtain favorable tax treatment will assist some taxpayers. One might argue that taxpayers who make ill-advised elections due to a lack of access to sophisticated advice are also unlikely to obtain guidance that would allow them to benefit from relief to make or revoke elections later. While this is no doubt true in some instances, there may also be some taxpayers who seek tax advice only in the context of obtaining tax return preparation advice. Such taxpayers might obtain guidance that would allow for them to take advantage of the ability to make (or revoke) elections late. Yet, likely they lacked advice when navigating the process of becoming aware of and deciding whether to file an election that was due during the year rather than with a tax return. Even for an election that is due with a tax return, a taxpayer who seeks advice in some years but not in other years might benefit from the opportunity to correct tax election mistakes that she discovers later.

C. Taxpayer Incentives

Lawmakers might object to the use of hindsight on the grounds that the ability to use it would create problematic incentives for taxpayers. The potential problematic incentives that arise vary depending on the type of hindsight used.

Allowing taxpayers to benefit from Misprediction of Service Challenge Hindsight could create problematic taxpayer incentives. If a taxpayer could revisit the decisions that they made in response to a Service challenge in an effort to achieve more favorable tax consequences than what the Service seeks to impose, taxpayers might be more inclined to play the audit lottery by taking unduly favorable reporting positions that have a low likelihood of being upheld if the Service, in fact, challenges them. To demonstrate, consider the example above in which a taxpayer holds assets that have appreciated in value, forms a non-U.S. entity treated as a corporation for U.S. tax purposes, and contributes the assets to the entity. The taxpayer does so in hopes of avoiding U.S. tax liability upon later sale of the assets. Despite the fact that the taxpayer ought to recognize gain upon contribution of the assets to the entity, the taxpayer does not report gain recognized. If the taxpayer is not audited, the taxpayer could achieve the goal of not including gain in income at the time of the contribution or upon later sale. If the taxpayer is audited, the taxpayer might attempt to resort to Misprediction of Service Challenge Hindsight by making a late election to treat the entity as a disregarded entity. The taxpayer would give up their hoped-for outcome of never including gain in income by conceding that gain would be included in income upon later sale, but the taxpayer would achieve an outcome that is better than what the Service seeks to impose (in particular, gain would be included in income upon later sale rather than at the time of the contribution). Rules governing late election filing prevent the taxpayer from using hindsight in this manner. As a result, the taxpayer, if audited, would be stuck with the least favorable possibility of including gain in income at the time of contribution. The inability to use hindsight in this way may deter some taxpayers from engaging in the transaction and reporting the unduly favorable results. Perhaps in an effort to do precisely that, in general, the tax law is hostile to attempts to use Misprediction of Service Challenge Hindsight when making tax elections.

Problematic incentives would also arise if a taxpayer could revise elections when the taxpayer stands to benefit not only from Mistake of Tax Law Hindsight but also from Misprediction of Fact Hindsight. For example, assume a taxpayer who was unaware of the existence of a section 83(b) election in time to file could obtain relief to file late. By the time the taxpayer learns of the election, she would also be in the possession of useful information about the value of property received. If such a taxpayer was able to file late as a remedy to correct for her mistake about tax law, she would also benefit from the ability to make a more informed decision. This might create an incentive for taxpayers to stay deliberately uninformed (or at least to try to create a credible story that they were uninformed) to file late elections.

Allowing hindsight when a taxpayer is clearly only using Mistake of Tax Law Hindsight, on the other hand, is fairly benign from the standpoint of taxpayer incentives. If a taxpayer is unaware of the existence of an election in time to file it, for instance, the taxpayer is also, at the time that filing would be required, presumably unaware of the ability to obtain late filing relief. Therefore, allowing late filing relief is unlikely to affect the taxpayer’s initial decision about whether to file. One might raise the concern that allowing taxpayers to correct for mistakes of tax law will incentivize taxpayers to remain uninformed about the law. However, this seems unlikely to be the case if relief is only granted in situations where it is clear that a taxpayer is using only Mistake of Tax Law Hindsight. Because such relief would not save taxpayers from all mistakes, and because such relief is only of assistance to taxpayers who, ultimately, become aware of a mistake, ample incentives to acquire information about tax law would remain.

Similarly, granting relief when a taxpayer is clearly only using Mistake of Knowable Fact Hindsight is unlikely to improperly incentivize taxpayers. A taxpayer gains nothing by making a tax election late instead of on time, at least if relief to do so is only granted when it is clear that the taxpayer’s failure to make the beneficial choice initially resulted solely from a mistake of knowable fact—in other words, it is clear that, absent the mistake, the taxpayer would have made the same election on time. Because there is no advantage to be gained by making and correcting a mistake, and because there may be a variety of non-tax disadvantages to operating under a mistake of fact about a transaction, providing tax relief is unlikely to affect taxpayers’ incentives to acquire accurate factual information.

D. Consistency

The ability to use hindsight could, in some cases, create tax-revenue-reducing inconsistencies among multiple parties to a transaction. Similarly, the ability to use hindsight could create tax-revenue-reducing inconsistent reporting by a taxpayer over time. While inconsistency is a risk, it will not arise in all cases. As a result, it arguably does not justify a blanket prohibition against all use of hindsight.

In the context of relief for filing late regulatory elections, lawmakers recognize that inconsistency is a risk but not a reason to prohibit all late filings. In particular, automatic extension of time rules allow late filing only if the taxpayer requesting relief and all taxpayers affected by the election file tax returns consistent with the election in all affected years. In addition, the Regulations governing requests for non-automatic extensions of time disallow late filing relief if it would result in tax-revenue-reducing inconsistent reporting by the taxpayer over time or inconsistent reporting by the taxpayer and other taxpayers.

Arguably, to address concerns about consistency when taxpayers use hindsight, lawmakers could borrow the late filing rules’ approach to the consistency concern in the context of some tax elections and apply it more broadly, recognizing that the concern is addressed as long as all affected taxpayers agree to report the results consistent with a given election in all affected years.

E. Administrative Efficiency

The Service and courts frequently point to the concern that allowing the use of hindsight would make tax administration more difficult by permitting taxpayers to later take tax positions that differed from what they had reported on already filed returns. While this concern may arise if the taxpayer has already reported results that are inconsistent with a choice a taxpayer later seeks to make, it does not inevitably arise every time a taxpayer seeks to use hindsight. Sometimes a taxpayer will discover her error before reporting results at all. Even if a taxpayer has already reported results of an ill-conceived choice made as a result of a mistaken understanding of tax law, giving the taxpayer some time to make a new choice and revise the reported results may more effectively balance concerns about tax administration and countervailing concerns about trapping unwary taxpayers. Lawmakers appear to recognize this in the context of some tax elections. Relief to file late elections has sometimes been granted even when doing so appears to require amendments to previously filed tax returns. Furthermore, the preamble to the Regulations granting late filing relief for some tax elections acknowledges the need to balance the consideration of tax administration with a concern for fairness. Arguably, similar thinking ought to inform the tax law’s approach to the use of hindsight more generally.

V. Recommendations

Part IV’s examination of underlying policy concerns sheds some light on the tax law’s current approaches to making tax elections with the benefit of hindsight. It reveals that some features of current law are well-justified and some warrant revisiting. To take, first, an example of a feature that may be well-justified, tax revenue considerations may explain the fact that taxpayers can resort to hindsight more readily in the context of some tax elections. In particular, some tax elections that allow for greater use of hindsight include a built-in cap on the amount of potentially foregone tax revenue.

The greater generosity of some tax elections might also be explained by fairness considerations. For instance, taxpayers are given leeway to use hindsight when deciding whether to claim the standard deduction or itemize deductions, perhaps because this choice faces all taxpayers including those who lack access to sophisticated advice. As a result, it is an election that could potentially trap many unwary taxpayers if it took a less generous approach to the use of hindsight. Conversely, limiting hindsight in the context of tax elections that tend to affect taxpayers with access to sophisticated advice might also be justified on fairness grounds because such elections are less likely to trap unwary taxpayers. Perhaps the section 83(b) election could fall in this category in that, even if the employee might lack tax knowledge, at least the employer who transfers the stock or other property may be in a position to alert the employee to the need to seek tax advice before the filing deadline. That said, some issued letter rulings paint a less optimistic picture, showing that employers do not always provide the necessary information.

The late filing rules for some tax elections contain several well-justified features. First, the rules are hostile to attempts to use Misprediction of Service Challenge Hindsight. This hostility is warranted because the ability to use this type of hindsight could lead to less revenue collection than lawmakers intended, undermine fairness, and create problematic incentives for taxpayers. Second, as described above, the late filing rules applicable to some elections take a sensible approach to the concern that use of hindsight could lead to inconsistent reporting. Third, the late filing rules applicable to some elections contain a rebuttable presumption that takes a fairly reasonable approach to separating cases involving only Mistake of Tax Law Hindsight from cases that might also (or instead) involve Misprediction of Fact Hindsight. In particular, the Regulations deny late filing relief if “specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer,” unless the taxpayer provides “strong proof that the taxpayer’s decision to seek relief did not involve hindsight.” In broad strokes, this approach is sensible and consistent with the concern that, if facts have changed, the taxpayer may be in a position to benefit from Misprediction of Fact Hindsight.

Turning now to features of current law that merit revision, first, a few refinements might improve how lawmakers decide whether taxpayers are attempting to benefit from Misprediction of Fact Hindsight. In particular, even if no facts have changed since an election’s deadline, if there was potential for the facts to change in a way that would have made the election more or less advantageous, the Service ought to be wary. It is possible the taxpayer may have deliberately failed to make a seemingly beneficial election to preserve the option to either request late filing relief if no facts change or not request relief if facts change in a way that makes the election disadvantageous. Facts demonstrating, credibly, that the taxpayer was, indeed, unaware of the election or its effects by the time of filing could convince the Service that the taxpayer was not attempting to benefit from Misprediction of Fact Hindsight in this manner.

Along similar lines, in some issued letter rulings, the Service seems to conclude that a taxpayer is not attempting to benefit from Misprediction of Fact Hindsight because the taxpayer always intended to make a given election but merely failed to file it. While the rulings do not explicitly indicate why the Service concluded that the taxpayer had this long-standing intent, they do recite facts that, presumably, formed the basis for this conclusion. It may be worthwhile to raise a note of caution about accepting some of these facts as conclusive evidence of the taxpayer’s long-standing intent. To take one example, some letter rulings that grant late filing relief to file section 754 elections note that the partnership agreement provided for making the election. While many or all of the taxpayers who obtained relief may very well have been acting in good faith, it is possible that a taxpayer could include such a provision in a partnership agreement but fail to make the election in a timely manner to leave open the option of using Misprediction of Fact Hindsight. If, upon acquiring more information about the value of partnership assets, the taxpayer decides that filing the election is advantageous, she could request relief for late filing and point to the partnership agreement as evidence of long-standing intent to file the election. If, instead, the taxpayer learns that the election would be disadvantageous, she simply does not file the election and never alerts the Service to the existence of the provision in the partnership agreement.

As another example, some letter rulings that conclude that taxpayers always intended to make a given election seem to take the view that the long-standing intent is demonstrated by the fact that the taxpayer has reported tax consequences consistently with having made the election. While the taxpayers who obtained these particular rulings may have acted in good faith, an unscrupulous taxpayer could, theoretically, intentionally file a return consistent with an election that the taxpayer has not made to preserve the option to use Misprediction of Fact Hindsight. The unscrupulous taxpayer would then either seek relief to file the election late (claiming that the return demonstrates the taxpayer’s long-standing intent) or amend the return (claiming that the failure to file the election was an accurate reflection of intent and the return was filed in error). Because the taxpayer must disclose the earlier tax return to the Service by filing it, this gameplaying may be riskier for the taxpayer than the similar approach used by the taxpayer who plans to point to an undisclosed partnership agreement provision as evidence of their intent to file. Nevertheless, the possibility that a taxpayer has used this approach should not be ignored.

Another refinement to the existing rules that warrants consideration involves rethinking asymmetries in the tax law’s approach. In particular, for some elections like the section 83(b) election, the tax law takes an asymmetric approach. In some cases, revoking mistaken elections may be possible even when late filing is disallowed. This discrepancy does not seem to be well grounded. Taxpayers without access to sophisticated advice often fail to file any election. Such taxpayers might, in some cases, benefit from late filing relief but obtain no benefit from the ability to revoke elections.

Finally, some existing tax elections that affect many taxpayers who lack access to sophisticated advice take a restrictive approach to the use of hindsight. An analysis of underlying policy considerations may justify taking a more generous approach. For instance, lawmakers might provide married taxpayers more latitude to revisit their decision to file jointly.

Along similar lines, the dependent care FSA rules seem incongruous when considered in the general context of tax elections. The timing for making this election and the associated “use it or lose it” rules strictly limit the ability to use hindsight in this context. This is an election that affects many taxpayers, including those without access to sophisticated advice, a factor that may weigh against taking a restrictive approach to the use of hindsight. To some degree, concerns about trapping unwary taxpayers may be ameliorated by the fact that employers will provide employees with information about the election, but likely this is not a complete fix. An additional factor that may weigh in favor of taking a more generous approach is the fact that subjecting the dollar amount of contributions to a cap limits the amount of potential tax revenue loss even if taxpayers made better-informed decisions.

VI. Conclusion

In some cases, the tax law is hostile to taxpayers’ attempts to use hindsight, and, in some cases, tax law is more accommodating. An examination of underlying policy goals reveals that tax law ought to be more forgiving in some cases than others. Some features of existing law align with a consideration of underlying policy goals, but others do not, suggesting some features of current law that merit revision. For instance, refinements to the tax law’s existing approaches could, more reliably, ensure that the Service properly identifies the type of hindsight being used. In addition, in the case of some tax elections that affect taxpayers without access to sophisticated advice, tax law ought to be more forgiving.

The author would like to thank Yariv Brauner, Charlene Luke, Gil Rothenberg, the editors of The Tax Lawyer, and participants at the University of Florida Levin College of Law’s Tax Colloquium for their helpful comments and edits.  The author would also like to thank Jikai Cui for excellent research assistance. Support for this research was provided by the Office of the Vice Chancellor for Research and Graduate Education at the University of Wisconsin-Madison with funding from the Wisconsin Alumni Research Foundation. 

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