Marital Problems, and a Failed Business Sale: Guess Which One The Wizard Solves?

CASE NUMBER 17—THE MILLER MARINA STORY USE: OF A SPECIAL TAXPAYER FAVORED DOCTRINE

When David Reed returned to his office at 100 Middle Street in Portland late Friday afternoon, July 9, 1982, he was presented with a stack of blue message slips from Marilyn, the office receptionist. She smiled and commented that the phone had been super busy that day.  David had been in Camden, Maine where he had two client appointments.  Camden in the summer is a wonderful experience for the tourists who come there, but a nightmare for business people trying to keep to a schedule.  Not even the dancing traffic cop at the corner of Route 1 (Main Street) and Front Street, which led to the waterfront, could make the congestion pleasant. 

Normally, David would have just gone straight home as it was near the end of his work day, but this Friday night he had a board meeting with a start-up pharmaceutical company.  They scheduled Friday meetings starting at 6:00 PM to accommodate the founder, a practicing physician.  After two years of these meetings every quarter David mentally vowed never to join a board again which had night meetings.  David was an early morning guy and extending his day to eight or nine o’clock at night was torture.

David looked through the blue slips as he walked to his office.  Marilyn had arranged them chronologically but David reshuffled them to put the important ones on top and the ones he could deal with on Monday on the bottom.  On top was a note from the office manager telling him to see her immediately. 

That was not good news, as it must mean he had added his time sheet up wrong or did not get his expense account in on time.  She was one tough lady and feared by all in the office.  This time it was OK. She just wanted to alert David that the time for the Sunday run had changed. Every Sunday a group got together to run 8 to 10 miles in training for one race or another. She loved leaving blue slips—some kind of perverse pleasure.

In 1982 it was a blue slip world as voice messaging or computer conversion of telephone messages to text had not yet arrived.

One slip was interesting.  It was from Professor Blackacre, one of David’s law school professors from his days at the University of Maine School of Law.  It was unusual as normally David only heard from the professor around the first of April when he was preparing his tax return.   He always had interesting questions and they often had to debate the professor’s desire to submit a scholarly memorandum with his tax return to support one position or another he was taking in his return. 

David usually won the debate by reminding the professor of David’s trip to the Andover, Massachusetts Internal Revenue Service Center where he viewed the processing of tax returns, including the initial delivery of bags and bags of envelopes holding tax returns; the emptying of the bags onto a conveyor system that opened the envelopes; and forwarded them to the first line of “reviewers”. 

While watching, David saw several irregular shaped envelopes ripped open such that the tax returns were damaged, making David wonder how these taxpayers ever got credit for filing. Later in the process a room full of seasonal employees (the director of the center said they had a 75% turnover rate from year to year) looked quickly at each return. If they found anything unusual that return was put into a box with other returns destined for a more thorough review and potential audit. 

Attached memorandums or other unexpected documents seemed to cause returns to be put into that box. They called the box a Bernoulli Box, named for the person who invented it. It was this story and the threat of an audit that persuaded the professor to refrain from submitting his memorandums of law, much to his displeasure.  To David’s knowledge he had never been audited.

The message from the professor just asked for a return call that David made.  The professor explained that he had a call earlier that day from a former student, Dean Smith, who was now practicing law in Rockland, Maine. Dean represented a couple that owned a large marina and boat brokerage business.  The couple sold their business to their daughter and son-in-law three months before in a transaction with a small down payment and a large 10-year note for the rest of the purchase price. They did make the down payment of $100,000 (5% of the purchase price of $2 million) but had not made any of the required monthly note payments. 

Apparently marital discord had resulted in a separation and the son-in-law leaving Maine to return to Florida where he had lived before.  The daughter was trying to run the marina but had lost most of her summer slip rentals due to damage from an early spring storm.  The son-in-law forgot to renew the insurance. Without the cash flow from the summer rentals she did not have enough money to pay all the bills let alone the mortgage payment.  Two days before she told her parents that they could take the business back, as she no longer wanted to be involved.   

The parents met with their lawyer, Dean Smith, who just shook his head knowing that this was a mess.  The parents had hoped to retire and have a nice income from the monthly note payments and the related lease of the real estate that would supplement their social security and distributions from an IRA account.   That dream had now evaporated.  Dean also knew that getting the son-in-law to sign needed documents to transfer title to the business back to the parents could be difficult.

The parents had sold the assets of the business so that their daughter and son-in-law would have a stepped up basis in all the equipment, docks, lifts, and special purpose storage buildings.  The incorporated business had made an S Corporation election when it was formed many years before and the parents at the advice of their accountant would use the installment sale method to report the income.  Luckily the corporation had retained the real estate, only executing a long-term lease with their daughter and son-in-law.

One of the first steps Dean took was to call the parents’ accountant to ask about the income tax ramifications of a failed sale.  Dean expected that there would be no ramifications as the deal had fallen through and the parents would again own the business. 

The accountant called back saying he had bad news.   The transaction had been fully consummated and for tax purposes the parents would have to report the sale and pay tax on most of it.  The personal property was subject to depreciation recapture that the installment sale provisions for a sale between related parties did not protect.  The inventory of boats that was sold was also not protected. The tax could be over $250,000.

It was right after that call that Dean called Professor Blackacre.  Dean wanted to make sure what he just heard from the accountant was correct and hoped the professor knew a tax person from whom a second opinion could be obtained.

All this was explained to David who worried that the accountant might be correct but certainly wanted to do his own research.  David had not experienced this fact pattern before but knew this would be a difficult one.  To buy some time and to make sure he had the facts correct he asked for the tax returns and financial statements for the business and a copy of the purchase and sale agreement and closing documents of the sale transaction.  Of course, he first said he would try to help and asked whom he should bill.

It took until the next Wednesday to receive the requested documentation (some were faxed and some were mailed). David reviewed all and saw that the documents mirrored Dean’s description of what had occurred. Before he got the material he researched the installment sale rules (principally Section 453 of the Internal Revenue Code).  His initial conclusion was unfavorable.  He remembered, however, one of the sayings he used with his colleagues and even his children; “ There is always a way. You just have to work hard and be smart enough to find it.”

Here his little saying seemed to be kicking him in the teeth as the statute was quite clear and for tax purposes a closed transaction is a closed transaction. 

Thursday night an idea came to him.  He remembered one of Professor Blackacre’s property law classes when they had a case involved a rescinded real estate sale.  The facts were not important but the word “rescission” was.  With a new angle to research David’s discovered the tax law Doctrine of Rescission.

                                         THE TAX LAW DOCTRINE OF RESCISSION

Neither the tax code nor the regulations provide an answer to what happens tax-wise to a failed transaction.  There is some case law on the subject and Revenue Ruling 80-58 provides some guidance.  It appears, however, that there is a limited window to free taxpayers from a very unjust result if they follow the rules.  There are two requirements: First, the initial transaction and subsequent reversal have to take place in the same tax year; Second, the parties to the original transaction have to be returned to the same position they had before the original transaction.

The use of this doctrine to unwind the sale of a business is tricky and the rescission agreement has to be carefully prepared.  Here it presented a window of opportunity as David explained to Professor Blackacre, Attorney Dean Smith, and the family accountant.  The accountant was especially pleased when David also told him that the original sale and subsequent rescission did not have to be reported on any tax return. 

The parents’ corporation returned the $100,000 and regained title to the business assets.  David never learned how the separated couple divided the $100,000 nor if they were ever divorced.  Such is the role of a professional giving a second opinion.

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David Hawkes (aka David Reed) is a tax, financial planning, family & small business consulting expert. He has worked with thousands of clients and saved them millions of dollars in taxes over the course of his career. David is also a former minority shareholder of the Boston Red Sox.