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Variable Prepaid Forward Contracts-A Monster Planning Idea

Variable prepaid forward contracts (VPFC) are used to diversify a concentrated position in a publicly traded stock, and defer tax on the sale.  Here is how they work: taxpayer (i) pledges the stock to a counterparty, (ii)  receives cash equal to a percentage of the fair market value of the stock (typically 75-85% of the stock), and (iii) agrees to transfer to the counterparty cash or a variable number of shares of the stock at expiration of the contract.  In Rev. Rul. 2003-7, http://www.unclefed.com/Tax-Bulls/2003/rr03-07.pdf, the IRS ruled that, since it was uncertain what the taxpayer would settle the contract with cash or a variable number of shares, the transaction could not be taxed until contract expiration based on the open transaction doctrine.  Thus the taxpayer has use of cash during the contract period, but is not taxed until the contract expires.

VPFCs got a big boost from the Tax Court in McKelvey v. Commissioner recently, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11187.   McKelvey involved a typical VPFC entered into by the founder of Monster Worldwide, Inc. in 2007.  The IRS did not challenge the original VPFC.  Instead what was at issue in McKelvey was whether an extension of the VPFC in 2008 was a taxable exchange.  More interesting is that taxpayer died shortly after entering into the extension, which resulted in a step up in the basis of the Monster stock.   Accordingly, since the stock had appreciated, income tax on the increase in the stock price would be permanently avoided.  The IRS argued that the extension was a taxable exchange of the original VPFCs for new ones under Code Section 1001.  The Tax Court disagreed holding that Code Section 1001 applies only to “property” and that the VPFCs were an “obligation” instead of property.   The implications of McKelvey are fascinating…indefinite extension of VPFCs until death to obtain basis step up.  The IRS has not yet indicated whether it will appeal.

VPFCs should be given consideration to someone with a concentrated stock position.  Care must be exercised in structuring the VPFC.  For example, coupling the VPFC with a lending transaction will cause the VPFC to be taxable, see Anschutz, http://www.ustaxcourt.gov/InOpHistoric/anschutz.TC.WPD.pdf.   And, of course, the transaction costs of a VPFC can be substantial.

About Grady Dickens

I created this blog to comment on items of current interest regarding trusts, estate planning, charitable planning and tax law, and share my knowledge and over thirty years of experience as an attorney practicing in Dallas, Texas.