Exchange of Variable Contracts Results in $71 Million Short-Term Capital Gain

(Parker Tax Publishing November 2023)

On remand from the Second Circuit, the Tax Court held that when a taxpayer exchanged a set of variable prepaid forward contracts (VPFCs) for a second set of VPFCs, the first set of VPFCs was closed and the taxpayer's obligations with respect to that first set terminated for purposes of Code Sec. 1234A. As a result, the court found that the taxpayer realized over $71 million of short-term capital gain from the exchange of the VPFCs. Estate of McKelvey v. Comm'r, 161 T.C. No. 9 (2023).

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 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 under 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 exchange the first set of VPFCs for an amended set of VPFCs that had settlement dates in 2010. Treating the first set of VPFCs as remaining open after the exchanges, McKelvey did not report any gain or loss for 2008 with respect to those VFPCs as a result of the exchange. McKelvey died in 2008 after the execution of the VPFC extensions.

The IRS determined that the exchanges of the VPFCs constituted sales or exchanges of property under Code Sec. 1001, that the exchanges also resulted in constructive sales under Code Sec. 1259 of the Monster shares McKelvey used to collateralize the first set of VPFCs, and that, as a result, McKelvey should have reported gain from the transactions. 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.

In Estate of McKelvey v. Comm'r, 148 T.C. 312 (2017), the Tax Court held that McKelvey's treatment of the first set of VPFCs as remaining open after the exchanges was appropriate and that the exchanges constituted neither the sale nor the exchange of property under Code Sec. 1001 nor resulted in constructive sales of stock under Code Sec. 1259. Consequently, the Tax Court concluded that McKelvey did not have gain from the exchanges for 2008. However, in Estate of McKelvey v. IRS, 2018 PTC 324 (8th Cir. 2018), the Second Circuit reversed, determining that the exchanges of the VPFCs terminated the first set of VPFCs and resulted in the constructive sale of stock under Code Sec. 1259. The Second Circuit remanded for the Tax Court to determine whether the exchanges terminated McKelvey's underlying obligations with respect to the first set of VPFCs for purposes of Code Sec. 1234A and, if so, the amount of his gain from the termination. Under Code Sec. 1234A, gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.

McKelvey's estate argued that, since VPFCs are afforded open transaction treatment upon execution, the replacement of VPFCs requires equal treatment under the doctrine. Further, the estate contended that because the second set of VPFCs are open, any gain calculation from the exchanges is impossible at that time. The estate argued that, regardless of whether the Tax Court deemed them extensions or replacements, the gain amount, identity, and cost basis of the property to be delivered remained undetermined when the amendments were executed. The estate relied on two options-writing cases, Virginia Iron Coal & Coke Co. v. Comm'r, 37 B.T.A. 195 (1938), aff'd 99 F.2d 919 (4th Cir. 1938); and Hicks v. Comm'r, T.C. Memo. 1978-373. Each case evaluates written call options that were extended at or after expiration, and in each case the court held that gain or loss was not realized upon extension as uncertainty remained regarding what property would be delivered to the taxpayers' counterparties. In citing Virginia Iron and Hicks, the estate encouraged the Tax Court to ignore whether obligations are "continuing" or "replaced," proposing that such terms are merely irrelevant formalisms. Instead, per the estate, the court should focus exclusively on whether it is possible to determine the amount and character of any gain or loss. According to the estate, gain could not be calculated on the then-closed first set of VPFCs because gain could not yet be determined on the second set of VPFCs; uncertainty replaced with uncertainty does not close the transaction.

Analysis

The Tax Court found that when McKelvey executed the exchanges, he terminated the obligations under the first set of VPFCs. The court noted that McKelvey made payments to the investment banks and undertook obligations as part of the new contracts, in exchange for the termination of the prior contracts. He repurchased the options held by the investment banks, thereby executing closing transactions that terminated his obligations under the first set of contracts. McKelvey's obligations under the first set of VPFCs did not, in the court's view, relate forward to his separate obligations under the second set of VPFCs, and likewise the obligations under the second set of VPFCs did not relate back to his obligations under the first set. The court further found that McKelvey held obligations with respect to Monster shares, which are capital assets under Code Sec. 1221(a). As the exchanges resulted in the termination of those obligations, Code Sec. 1234A(1) applied to the exchanges. Therefore, any gain that McKelvey realized from the exchanges was treated as gain from the sale of a capital asset. Since McKelvey terminated the first set of VPFCs after holding them for less than one year, any gain that he realized from the exchange was short-term capital gain.

While the court agreed with the estate that it had to focus on whether the amount and character of any gain or loss was determinable, the court disagreed that doing so required it to act as though the Second Circuit's holding that the obligations were replaced was "irrelevant" and ultimately unnecessary. The court also found that the option contracts at issue in Virginia Iron and Hicks bore a few notable differences from the VPFCs at hand. First, those courts did not establish that the expiration and renewal of the option was a replacement of the option. The Tax Court, on the other hand, was operating under the established decision that McKelvey replaced the original set of VPFCs with a distinct second set. Second, the options in both Virginia Iron and Hicks concerned the rights to purchase defined plots of real property for a fixed amount set at the signing of each contract. The underlying real property did not vary in amount or price. The Tax Court found that the same could not be said of McKelvey's obligations. The VPFCs carried substantially different values depending on the length of time remaining on the contract and on the share price relative to the set strike price. The court observed that, with an eye toward those variables and the depressed value of the Monster shares at the time of extension, the Second Circuit agreed that the change in expiration dates fundamentally altered the bets that the VPFCs represented.

The court rejected the estate's argument that the VPFCs remained open through their replacement because the gain or loss McKelvey would realize from the second set of VPFCs could not be calculated at the time of replacement. The court found that the exchanges were a trade of McKelvey's obligations under the first set of VPFCs for his obligations under the second set, plus additional payments to the banks totaling $11 million. The termination of the first set of VPFCs, in the court's view, also terminated the uncertainty that existed with respect to the identity and the cost basis of the property to be delivered in exchange for the prepayment under those contracts. McKelvey satisfied the obligations from the first set of VPFCs by delivering a combination of cash and new obligations to which he was bound. The court found that together, the cash and the new obligations established a value and a tax basis sufficient to calculate any gain or loss derived from the first set of VPFCs. The court agreed with the estate that the second set of VPFCs, at the time of the exchange, existed as an open transaction; at the time of the exchange, it would have been impossible to calculate the gain from those VPFCs as McKelvey was still free to settle the transaction in cash or shares. However, the court said that it was not addressing McKelvey's possible gain from the second set of VPFCs. Instead, it merely needed their value at the time of the exchanges.

Finally, the court determined McKelvey's gain under Code Sec. 1001(a). McKelvey's amount realized was calculated by taking the prepayment amount he received and subtracting his basis in the transactions, which consisted of his payments to the VPFC holders and his outstanding liability as a result of the second set of VPFCs in the moment immediately following the exchanges. The court concluded that upon termination of the first set of VPFCs, McKelvey realized $71,668,034 in short-term capital gain for tax year 2008.

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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