founder’s estate wins dispute over VPFC gain recognition

The contracts' extension was not a sale or exchange, and open-transaction treatment continued, the Tax Court holds.
By David Silversmith, CPA

The IRS argued that a taxpayer's extensions of variable prepaid forward contracts (VPFCs) constituted a sale or exchange of property and, thus, the taxpayer had to recognize gain in the year the extensions were executed. In a case of first impression, the Tax Court rejected this argument and stated that the taxpayer recognized gain only when the stock was delivered and the extended contracts were completed.

Facts: In 2007, Andrew J. McKelvey, the founder of the job-search website, entered into VPFCs with Bank of America and Morgan Stanley in which the firms gave him approximately $193 million immediately in exchange for delivery of shares of approximately a year later. Although a stated number of shares were pledged as collateral, the actual number of shares to be delivered was determined by a formula based on the closing price of Monster's publicly traded stock, relative to a floor price, on each of 10 settlement dates. Before the settlement dates, McKelvey entered into an agreement with the buyer banks giving them additional consideration in exchange for a two-year extension of the settlement dates. All other terms of each contract remained unchanged except for the 10 new settlement dates.

McKelvey died on Nov. 27, 2008. His estate continued the VPFCs with the two banks, settling them in 2009.

The IRS determined that McKelvey recognized a capital gain of nearly $201 million upon executing the extensions, and in 2014 the Service issued a notice of deficiency for 2008.

Issues: The issue before the Tax Court was whether McKelvey's execution of extensions to the VPFCs resulted in taxable dispositions of property that were subject to gain.

In a VPFC, a buyer pays the seller cash (discounted to present value) on the date the contract is executed. The seller is then obligated to pay the buyer shares of stock or their cash equivalent at a later date, when the seller recognizes the gain or loss on the completed contract. When VPFCs are first executed, they are given open-transaction treatment pursuant to Rev. Rul. 2003-7.

Rev. Rul. 2003-7 held that a shareholder "has neither sold stock currently nor caused a constructive sale of stock if Shareholder receives a fixed amount of cash, simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date, pledges the maximum number of shares for which delivery could be required under the agreement, retains an unrestricted legal right to substitute cash or other shares for the pledged shares, and is not economically compelled to deliver the pledged shares."

Under Sec. 1001, a gain is the excess of the amount realized over the adjusted basis, while a loss is the adjusted basis over the amount realized. Regs. Sec. 1.1001-1(a) states that exchanges are not taxable unless the properties "differ[] materially either in kind or in extent."

For the extension of the VPFCs to trigger a realized gain under Sec. 1001, the IRS had to prove that (1) the VPFCs constituted property at the time of the extension, and (2) the property was exchanged for other property differing materially either in kind or extent. The IRS claimed that McKelvey's original VPFCs were an integrated bundle of valuable investment and other contract rights, as well as obligations, that constituted property within the meaning of Sec. 1001. The IRS also argued that the execution of the extensions resulted in a constructive sale of the stock underlying the VPFCs under Sec. 1259.

McKelvey's estate argued that the VPFC constituted only obligations, not property. Thus, the open-transaction treatment of the VPFC under Rev. Rul. 2003-7 continued until the transactions were closed by the delivery of the stock.

Holding: The Tax Court held that the execution of the VPFC extensions did not constitute sales or exchanges of property under Sec. 1001, and the open-transaction treatment afforded to the original VPFCs under Rev. Rul. 2003-7 continued until the transactions were closed by the future delivery of stock.

The Tax Court agreed with the estate that the VPFCs constituted obligations, not property. The court found that after receiving the cash prepayments upon execution of the original VPFCs, McKelvey had no right to receive anything else and only had an obligation to deliver his shares of Monster stock or its cash equivalent in the future. In addition, contractual provisions allowing McKelvey to choose settlement with stock or in cash and to substitute collateral did not equate to property rights, the court said, but were "procedural mechanisms designed to facilitate" McKelvey's delivery obligations under the VPFCs. The extensions of the VPFCs did not change this fact, so there was no property exchanged that could give rise to a gain under Sec. 1001.

With regard to the continuation of open-transaction treatment, the Tax Court explained that the rationale for allowing open-transaction treatment for VPFCs under Rev. Proc. 2003-7 is that there is uncertainty about what property will be delivered at settlement. Because the extensions to McKelvey's VPFCs only postponed the settlement and averaging dates of the transactions and did not clarify the uncertainty regarding which property McKelvey would actually deliver to settle the VPFCs, the rationale for open-transaction treatment applied to the extended VPFCs.

Finally, the Tax Court found that the IRS's argument that the extensions to the original VPFCs triggered constructive sales under Sec. 1259 was "predicated upon a finding that there was an exchange of the extended VPFCs for the original VPFCs" under Sec. 1001. Because it concluded that the extended VPFCs were not "separate and comprehensive financial instruments" from the original VPFCs for purposes of Sec. 1259, the execution of the extensions was not an exchange of property that gave rise to a constructive sale of the stock underlying the VPFCs.

  • Estate of McKelvey, 148 T.C. No. 13 (2017)

—By David Silversmith, CPA, senior tax accountant at Fulvio & Associates LLP, New York City.

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