Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Revisionist History: Retroactive Federal Tax Planning
David H. Schnabel*
* Partner in the Tax Department of Debevoise & Plimpton LLP; Macalester College, B.A., 1988; New York University School of Law, J.D., 1992; New York University, LL.M., 1993.
This Article discusses three contexts in which taxpayers sometimes seek to alter the federal tax treatment of a transaction or event by changing what is considered to have occurred in the past. This can occur, for example, when a taxpayer sells property for cash, or incorporates a partnership under section 351, but later rescinds the transaction and claims that the transaction should be disregarded for federal tax purposes. While the rescission doctrine clearly allows a completed transaction to be unwound as a state law matter and disregarded for tax purposes in certain cases, current law is not clear as to how far the doctrine extends in disregarding a transaction for tax purposes or what exactly a taxpayer must establish in order to invoke the doctrine.
Retroactive tax planning can also arise when the tax consequences of a transaction or event turn on the taxpayer’s rights or obligations under state law and the taxpayer petitions a local court either to interpret or to reform those rights or obligations. Thus, for example, if the amount of estate tax is dependent upon whether the decedent was the owner of certain property, the decedent’s estate may (in the face of a Service audit or court proceeding) seek a state court ruling as to those rights or obligations and cite the state court ruling as authoritative on the state law issue. Alternatively, if the tax consequences resulting from a divorce decree do not reflect what was intended, the taxpayer may seek to amend the court decree in a manner that is retroactive for both state law purposes and federal tax purposes. While the law in this area is much less forgiving, it is quite clear that (1) state court interpretations of a taxpayer’s state law rights and obligations are generally entitled to proper regard in a subsequent federal tax proceeding; (2) in limited cases state court interpretations are controlling for tax purposes; and (3) state courts may, in very limited circumstances, correct a prior judicial decree with retroactive tax effect.
In addition, retroactive tax planning now routinely occurs by filing a “check-the-box” election relating to the classification of an entity for federal income tax purposes. Although it is quite clear that the resulting liquidation and incorporation can be afforded tax free treatment under sections 332 or 351, it is not entirely clear whether certain aspects of sections 332, 351, and 357 ( i.e., business purpose, intent, and solvency) should be tested as of the date the election is filed or as of the date the election is effective. Moreover, while the check-the-box rules generally limit retroactivity by providing that an election can be effective for no more than 75 days prior to the date the election is filed, the regulations apparently apply a different rule in certain limited cases involving foreign entities. Specifically, if an election becomes effective prior to the date a foreign eligible entity is “relevant” (within the narrow definition set forth in Regulation section 301.7701-3(d)(1)), the elected classification will apparently apply retroactively to the date the entity was first formed. “Apparently” is used here because the regulations are not entirely clear on this point, and it is somewhat surprising that the Service would permit the original classification of an entity to be determined years after it was formed and had begun operations.This Article is divided into three parts: Part I discusses the rescission doctrine, Part II considers the impact of a state court decree that interprets or reforms an agreement (or prior judicial decree), and Part III covers a variety of retroactivity issues under the check-the-box rules.