Second Circuit Reverses Tax Court: Extensions of Variable Contracts Constituted Taxable Termination and Constructive Sale

(Parker Tax Publishing October 2018)

The Second Circuit reversed and remanded a Tax Court decision holding that the amendments of a taxpayer's two variable prepaid forward contracts (VPFCs) did not constitute sales or exchanges of property under Code Sec. 1001, were not terminations under Code Sec. 1234A, and were not constructive sales under Code Sec. 1259. Although the Second Circuit agreed with the Tax Court that no sale or exchange occurred, the court found that extending the valuation dates was a fundamental change giving rise to new contracts that could have resulted in taxable income, and found the VPFCs amended resulted in constructive sales of the collateralized shares because the amount of shares to be delivered at settlement was substantially fixed under Code Sec. 1259. Estate of McKelvey v. IRS, 2018 PTC 324 (2d Cir. 2018).

Background

Andrew McKelvey was the founder and chief executive officer of Monster Worldwide, Inc. (Monster), a company known for its website, monster.com. Monster.com helps inform job seekers of job openings that match their skills and desired geographic location.

In 2007, McKelvey entered into variable prepaid forward contracts (VPFCs) with two investment banks. The investment banks made prepaid cash payments to McKelvey in exchange for his obligation to deliver variable quantities of Monster stock to the banks on specified future settlement dates in 2008. McKelvey treated the VPFCs as open transactions pursuant to Rev. Rul. 2003-7, and did not report any gain or loss for 2007. In Rev. Rul. 2003-7, the IRS ruled that VPFCs that meet certain criteria are open transactions when executed and do not result in the recognition of gain or loss until the future delivery of property. In that ruling, the IRS concluded that a shareholder who entered into a VPFC secured by a pledge of stock neither caused a sale of stock under Code Sec. 1001 nor triggered a constructive sale under Code Sec. 1259.

In 2008, before the original settlement dates, McKelvey paid a total of approximately $11 million to the banks to extend the settlement dates until 2010. These extensions provided that (1) McKelvey would pay additional consideration specifically for the extension of the settlement dates, and (2) the terms of the original VPFCs remained in full force and effect. McKelvey did not report any gain or loss upon the execution of the VPFC extensions and continued the open transaction treatment. McKelvey died in 2008 after the execution of the VPFC extensions.

While agreeing that the original VPFCs were entitled to open transaction treatment under Code Sec. 1001, the IRS determined that the VPFC extensions constituted sales or exchanges of property under Code Sec. 1001, and thus McKelvey should have reported gain from the transactions for 2008. McKelvey's estate contended that no sale or exchange took place and, thus, no gain or loss should be recognized upon the extensions of the VPFCs. The estate took its case to the Tax Court.

The Tax Court agreed with the estate and held that McKelvey's execution of the VPFC extensions did not constitute sales or exchanges of property under Code Sec. 1001, and the open transaction treatment should continue until the transactions are closed by the future delivery of stock. Having determined that the VPFCs were not property on the date of the amended contracts, the Tax Court did not consider whether the amended contracts terminated the obligations of the original VPFCs under Code Sec. 1234A. The Tax Court also held that McKelvey did not engage in constructive sales of stock in 2008 under Code Sec. 1259. The IRS appealed to the Second Circuit.

Analysis

Under Code Sec. 1234A, capital gain or loss arises on the termination of a right with respect to property which is a capital asset in the taxpayer's hands. Code Sec. 1259 provides that when a taxpayer holding appreciated stock enters a forward contract to deliver the same or substantially identical property, a constructive sale occurs and the taxpayer must recognize gain as if that position were sold at its fair market value. Code Sec. 1259(d)(1) defines a forward contract as a contract to deliver a substantially fixed amount of property at a substantially fixed price.

On appeal, the IRS argued that a termination under Code Sec. 1234A occurred with execution of the amended contracts in 2008 because the new valuation dates fundamentally changed the VPFCs from betting on the value of Monster stock in September 2008 to betting on its value in January and February 2010. The IRS also contended that a constructive sale occurred because, on the date the amended contracts were executed, the share price of the stock pledged as collateral was so far below the floor price that McKelvey would almost certainly be required to deliver the maximum number of collateralized shares on the settlement date. As a result, the number of shares to be delivered was substantially fixed under Code Sec. 1259(d)(1), according to the IRS. The IRS's valuation expert applied a probability analysis using the Black-Scholes formula, which is widely used to price stock options, to determine that there was an 85 percent and 87 percent probability, respectively, that the closing price of the shares in the two VPFCs would be below the floor price on the settlement date.

The estate argued that if the extensions resulted in new contracts, there would be no constructive sale because the amended contracts would not constitute forward sales of a substantially fixed amount of property. According to the estate, the amount was not substantially fixed because the possibility of the Monster stock rebounding to above the floor price was not remote and because the contract terms did not fix the amount of shares to be delivered.

The Second Circuit agreed with the Tax Court that the replacement of the VPFCs with amended contracts was not an exchange of property under Code Sec. 1001. However, the Second Circuit found that the VPFC extensions were new contracts resulting in terminations under Code Sec. 1234A that resulted in constructive sales of the collateralized shares.

The Second Circuit agreed with the IRS that extending the stock valuation dates constituted a termination under Code Sec. 1234A because the extensions resulted in new contracts. The court noted that the new valuation dates were 16 and 17 months later than the original dates, respectively. The court also made an analogy to options, where new expiration dates result in new option contracts, and reasoned that the options market regards different expiration dates as constituting different option contracts. The court also inferred from the fact that McKelvey paid approximately $11 million to obtain the new valuation dates that he did not think he was making insignificant changes to the VPFCs.

The Second Circuit also held that the VPFC extensions resulted in constructive sales of the collateralized shares. The court based its conclusion on the IRS expert's probability analysis, which it found to show that the amount of shares to be delivered at settlement was substantially fixed on the dates on which each contract was amended. The court noted that applying probability analysis in this context was neither explicitly authorized nor prohibited by the Code or regulations. Nevertheless, the court accepted its use as a way of taking the economic realities of the transaction into consideration. In the court's view, virtually all stock transactions rest on perceptions of the probabilities of share price movement; such probabilities are an economic reality affecting such transactions, and the court saw no reason why they should not affect the tax consequences. The court also noted that the Black-Scholes formula is widely used to price stock options, so the pertinent economic reality was not only the use of probability analysis in general, but the use of that formula in particular.

The Second Circuit explained that, by repeatedly extending a VPFC, a taxpayer holding a large bloc of appreciated securities can receive a large up-front cash payment without incurring a capital gain. The court observed that the parties can repeat these extensions for the taxpayer's life, knowing that at the taxpayer's death the shares will have a stepped-up basis in the hands of the estate. The up-front payment will have been received without ever incurring capital gains tax that would have been due on a sale of the stock. In the court's view, the Code should not be readily construed to permit such a result.

The court rejected the estate's argument that the amount of shares was not substantially fixed. The court explained that the contract terms keyed the amount of deliverable shares to the closing prices on the settlement date, and noted that McKelvey had the option to settle with shares other than the collateralized shares by delivering property of equal value.

For a discussion of the rules for determining whether a sale of property has occurred for purposes of recognizing gain or loss under Code Sec. 1001, see Parker Tax ¶110,110. For a discussion of gains or losses on the termination of certain contracts under Code Sec. 1234A, see Parker Tax ¶116,130. For a discussion of constructive sales under Code Sec. 1259, see Parker Tax ¶116,140.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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