Do you own a company and want to sell to de-risk your holdings but don’t want to pay tax now? And when you do sell, do you still want lower capital gains rates? That’s the most common goal for those considering tax planning.
Capital gains rates are lower than ordinary income rates. Tax planning focuses on getting lower capital gains rates when selling assets. This requires holding investments long-term before the sale. Tax deferral is also key–paying taxes later rather than sooner.
There are a number of tax planning options for this. Variable prepaid forward contracts (“VPFCs”) are one example. They target both benefits–deferral combined with lower capital gain tax rates.
The McKelvey v. Commissioner, Docket No. 26830-14 (Nov. 3, 2023) case provides an opportunity to consider VPFCs. The case is instructive as the taxpayer lost the tax deferral and capital gain rate benefit given that they changed the terms of the VPFCs. This same situation can arise in failed real estate deals.
Facts & Procedural History
The McKelvey case involved stock in a company the taxpayer founded. In 2007, the taxpayer entered into variable prepaid forward contracts (“VPFCs”) on the stock with two banks. The taxpayer received prepayments totaling over $193 million.
In 2008, before the original settlement dates, the taxpayer paid the banks to extend and modify the VPFCs, changing the valuation and settlement dates.
The large numbers drew the IRS’s attention. On audit by the IRS, the IRS determined this modification resulted in taxable deemed sales of the original VPFCs under Sectiosn 1234A and 1259. It asserted that the taxpayer owed more than $200 million in short-term and long-term capital gains.
Litigation ensued in the U.S. Tax Court, which initially found for the taxpayer. It concluded that he did not have income from the exchanges. The appeals court reversed and remanded the case to the U.S. Tax Court to determine the character of the gain.
About Prepaid Variable Forward Contracts
A VPFC is a contract between a shareholder and a counterparty, which is usually an investment bank. The VPFC allows a shareholder to monetize stock holdings while retaining upside exposure above a set price.
The shareholder receives an upfront cash prepayment in exchange for delivering a variable number of shares to the bank in the future. The shares delivered depend on the stock price at settlement versus the preset floor and cap prices in the contract.
Here are the steps in most VPFCs:
- Shareholders and counterparties negotiate and agree on key terms of the VPFC, including the number of shares, floor and cap prices, settlement dates, etc.
- Shareholder pledges their shares as collateral to secure their VPFC obligations.
- The counterparty makes an upfront cash prepayment to the shareholder, usually based on a discount on the current stock price.
- Shareholder agrees to deliver a variable number of shares or equivalent cash to the counterparty in the future on the settlement date(s).
- On settlement, if the stock price is above the cap, fewer shares are delivered. If below the floor, more shares are delivered.
- Shareholder retains upside exposure above the cap price. The counterparty’s risk is limited by the floor.
For income tax purposes, VPFCs are treated as open transactions when executed. Gain recognition is normally deferred until final settlement when the stock or cash equivalent is delivered. The character of any gain depends on the property ultimately used to settle the VPFC.
Termination Under Section 1234A
Section 1234A provides that gain or loss from terminating “an obligation with respect to property which is (or on acquisition would be) a capital asset” is treated as capital gain or loss from the sale of the underlying property.
The court in McKelvey held that modifying and extending the VPFCs terminated the original contract obligations. This triggered short-term capital gains treatment under Section 1234A on terminating the original VPFC obligations.
The court did not apply the open transaction doctrine. The open transaction doctrine defers gain recognition when the amount realized from a transaction cannot be reasonably ascertained. The court in McKelvey held this doctrine did not apply to defer gains on exchanging the VPFCs.
The court found the value of obligations and property exchanged in modifying the VPFCs could be determined. This allowed gain calculation despite the replacement VPFCs remaining open.
How to Calculate the Gain
Having decided that the exchange triggered income, the court then addressed how to calculate the gain.
The gain realized under Section 1234A equaled the prepaid amount received minus the taxpayer’s basis. Basis included the payments made to modify the VPFCs and the value of obligations under the replacement VPFCs after the exchange. The court outlined this methodology for calculating the gain:
The gain amount is determined under Section 1001 as:
Amount Realized – Adjusted Basis = Gain
The amount realized is the sum of any cash received plus the fair market value of property received in the exchange.
For the terminated VPFC, this equals:
- The upfront cash prepayment originally received by the taxpayer when entering into the VPFC
- Minus the amount paid by the taxpayer to the counterparty to modify and replace the VPFC
- Minus the fair market value of the taxpayer’s obligations under the new, replacement VPFC after the exchange
The taxpayer’s basis includes:
- Any payments made to modify the VPFC
- The value of obligations under the replacement VPFC after the modification
By subtracting the basis from the amount realized, the total gain on the VPFC termination can be calculated. This is the method for determining the amount of short-term capital gain when a VPFC is replaced with a new VPFC through fundamental modifications to the original contract terms.
This case establishes that exchanging VPFCs through modifications can trigger gain realization under Section 1234A, departing from normal deferred treatment. The case provides clarity on calculating gains when VPFCs are terminated and replaced. The case illustrates the nuances of VPFC taxation. Taxpayers must understand the deferral risks, accelerate gain possibilities, and the importance of character–particularly when modifying the VPFCs.