Extensions of Variable Prepaid Forward Contracts Did Not Constitute a Sale of Property

(Parker Tax Publishing May 2017)

In an issue of first impression, the Tax Court held that a taxpayer's execution of variable prepaid forward contract (VPFC) extensions did not constitute sales or exchanges of property under Code Sec. 1001 and the open transaction treatment afforded to the original VPFCs continues until the transactions are closed by the future delivery of stock. The court also concluded that the taxpayer did not engage in constructive sales of stock under Code Sec. 1259. Est. of McKelvey v. Comm'r, 148 T.C. No. 13 (2017).

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 (original VPFCs) with two investment banks. Pursuant to the terms of the original VPFCs, the investment banks made prepaid cash payments to McKelvey, and he was obligated to deliver variable quantities of Monster stock to the investment banks on specified future settlement dates in 2008 (original settlement dates). McKelvey treated the execution of the original 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 consideration to the investment banks to extend the settlement dates until 2010 (VPFC extensions). The extensions provided that (1) McKelvey would pay additional consideration specifically for the extension of the settlement and/or averaging 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 execution of the VPFC extensions in 2008 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 disagreed, contending that no sale or exchange took place and, thus, no gain or loss should be recognized upon the extensions of the VPFCs. The Tax Court was asked to decide what tax consequences, if any, occurred when McKelvey extended the settlement and averaging dates of the original VPFCs in 2008.

Analysis

Before the Tax Court the IRS argued that the extensions to the original VPFCs resulted in taxable exchanges of the original VPFCs. According to the IRS, McKelvey possessed three valuable rights in the original VPFCs: (1) the right to the cash prepayments; (2) the right to determine how the VPFCs would be settled (i.e., whether with stock or in cash, and if stock, which specific shares); and (3) the right to substitute other collateral. The IRS also argued that the extensions to the original VPFCs resulted in constructive sales of the underlying shares of Monster stock pursuant to Code Sec. 1259. Under Code Sec. 1259, in the event there is a constructive sale of an appreciated financial position, a taxpayer must recognize gain as if that position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale.

McKelvey's estate argued that the extensions to the original VPFCs merely postponed the settlement and averaging dates of the contracts, did not trigger any tax consequences to McKelvey, and that the "open" transaction treatment provided by Rev. Rul. 2003-7 should continue until the contracts are settled by delivery of the Monster stock. Neither the court nor the two parties could find any cases addressing the tax consequences resulting from extensions to VPFCs. Thus, the issue was one of first impression for the Tax Court.

The Tax Court 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 afforded to the original VPFCs under Rev. Rul. 2003-7 should continue until the transactions are closed by the future delivery of stock.

In looking at the contractual provisions in the VPFC extensions, the court found that the provisions were not property rights but rather procedural mechanisms designed to facilitate McKelvey's delivery obligations. At the time he extended the original VPFCs, the court noted, McKelvey had only delivery obligations and not property rights in the contracts. These were purely liabilities, the court said. Thus, the court concluded that the VPFC extensions did not constitute exchanges of McKelvey's "property" in the original VPFCs under Code Sec. 1001.

The court also held that McKelvey did not engage in constructive sales of stock in 2008 pursuant to Code Sec. 1259. According to the court, because the IRS conceded that the original VPFCs were properly afforded open transaction treatment under Code Sec. 1001 and because the open transaction treatment continued when McKelvey executed the extensions there was no merit to the argument that the extended VPFCs should be viewed as separate and comprehensive financial instruments under Code Sec. 1259.

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 the rules relating to 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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