Second chance sign
Have you ever dreamed of a second chance, the opportunity for a real overhaul? When it comes to taxes, you can change your tax returns, but that’s not the same as starting from scratch. If you sell your house but in six months you pay the money back and take the house back, have you already sold it? If you buy stock but the company reimburses you, are these two transactions or none? Getting back to square one may seem simple, but the tax system is rigid and rarely simple.
And the requirement to file an annual tax return means that, in most cases, each tax year stands on its own. Fortunately, the IRS recognizes that some transactions can be reversed and the tax effects can be ignored. But to claim that a deal never happened, you must meet two strict conditions: (1) Each party must return to their position before the transaction as if it never happened. Termination is not a unilateral agreement. (2) The rollback must take place in the same tax year as the transaction. The IRS covers this in Revenue Ruling 80-58.
It is this strict rule of timing that generally poses a problem. Let’s say you sell your house and the buyer claims the house is infected with mold. The dispute is unlikely to be resolved immediately. This often means a later tax year. For the IRS, each tax year must stand alone. Some taxpayers who do not follow the IRS’s strict same-year timing rule may argue that a reversal qualifies as long as the transaction is reversed before reporting it on their tax return.
Example: You sell your car to your brother-in-law for $25,000 in September 2011. He has some problems so returns the car to you in May 2012 and you pay the money back. Although your 2011 tax return was due on April 15, you received an extension and therefore have not yet filed your return when you take the car back. When you file your 2011 return in August 2012, can you treat this sale as never having occurred? The IRS says no, but some advisors could say yes.
The IRS is more liberal? Even the IRS could relax. In several rulings, the IRS has approved reversals even though one could argue that the parties are not exactly back to square one. For example, in IRS Private Letter Ruling 200952036, a partnership was transformed into a joint stock company, then converted into a limited liability company (SARL). The partners did not entirely return to square one. After all, when the smoke cleared, they were members of an LLC, not partners in a partnership. An LLC is not exactly the same as a partnership. Nonetheless, the IRS treated the transaction as voided and had no tax implications.
Caution. Any termination involves at least two parties. Even in the simple example of a car, what if your brother-in-law has already filed his 2011 tax return before the cancellation, perhaps even depreciating or writing off the car? In more complex transactions, there may be multiple parties. Even if you termination of loveit can be intimidating.