The IRS's derivative treatment of variable prepaid forward sales.

• Author: Swindle, William R.

Wealthy clients frequently own an appreciated publicly traded stock that comprises a substantial portion of their investment portfolio. This situation often arises through an initial public offering, a corporate acquisition, an inheritance, or through executive compensation. Retention of a concentrated single stock position entails a significant amount of investment risk. Although a client can sell part or all of that stock and reinvest in a diversified portfolio, many clients will not want to pay the resulting capital gains tax. There are, however, a number of techniques that address the inherent risks with a concentrated stock position including puts, equity collars, exchange funds, loans, and charitable remainder trusts. In addition, a variable prepaid forward sale (VPFS) is a popular technique to monetize and diversify a concentrated position in a publicly traded stock.

Variable Prepaid Forward Sales

There is no single uniform structure for a VPFS, but the investor with the concentrated stock position enters into an agreement with a buyer (often referred to as a "counterparty") that is typically an investment bank or derivatives dealer. The investor agrees to deliver a variable number of shares of the publicly traded stock to the counterparty at the settlement or exchange date, which is generally three to five years after executing the VPFS documents. These documents consist of a stock purchase agreement, stock pledge agreement, and frequently a share lending agreement. When the documents are executed, the investor receives a nonrefundable cash payment equal to approximately 75 to 85 percent of the current fair market value of the stock. The investor is entitled to retain this cash payment in all events.

The investor also retains a share of the upside position if the stock price subsequently increases. This is reflected by a formula that adjusts the number of shares that the investor must deliver on the settlement date. For example, if the stock price subsequently increases, the investor will be required to deliver fewer shares than if the stock price decreases in value, and vice versa. Pursuant to a stock pledge agreement, the investor transfers into a pledge account the maximum number of shares that could be required to close out the VPFS on the settlement date. The investor often retains the right to close out the transaction on the settlement date with cash or other shares of the same issuer in lieu of the pledged shares.

There are a number of significant nontax benefits associated with a VPFS. First, the investor receives downside protection through the up-front cash payment. This nonrefundable payment allows the investor to monetize the concentrated stock position and then utilize that cash to diversify the investor's investment portfolio. Additionally, the investor retains a share of the upside position if the stock subsequently appreciates in value. Accordingly, the investor receives downside protection, retains a share of the upside position in the stock, and diversifies his or her investment portfolio.

Additionally, if properly structured, the appreciation in the concentrated stock position is not subject to federal income tax until the transaction is closed out years later on the settlement date. This allows immediate reinvestment of the entire cash payment without reduction for federal income taxes. The problem is that a VPFS can take many forms, and it is frequently unclear whether a particular structure qualifies for income tax deferral. There is very little statutory or case law directly addressing the income tax consequences of a VPFS, and all of the recent guidance comes from the Internal Revenue Service (IRS) in the form of rulings and other pronouncements, including a comprehensive coordinated issue paper released in 2008.

Revenue Ruling 2003-7

Based on the uncertainty surrounding the income tax consequences attendant to a VPFS, tax practitioners were relieved when the IRS issued Revenue Ruling 2003-7. (1) There, the taxpayer entered into a VPFS. The taxpayer received a cash payment and in exchange agreed to deliver to the counterparty a variable number of shares of the publicly traded stock, calculated by a predetermined formula. The higher the price of the stock on the settlement date, the fewer number of shares the taxpayer would be required to deliver, and vice versa. The minimum number of shares required to close out the transaction was 80 and the maximum was 100.

The taxpayer pledged 100 shares of stock to secure the counterparty's position. This constitutes the maximum number of shares deliverable under the sale agreement, which is customary in a VPFS. These shares were pledged by transfer to a third-party trustee. The taxpayer retained the right to vote and receive dividends with respect to the pledged shares. The taxpayer also retained the unrestricted legal right to deliver either the pledged shares, cash, or other shares of the same issuer to close out the VPFS on the settlement date. The taxpayer was not legally or economically compelled to deliver the pledged shares to discharge its obligations pursuant to the VPFS. Clearly, however, the taxpayer planned to deliver the pledged shares to the counterparty to close out the VPFS on the settlement date.

The IRS determined that the taxpayer did not sell the pledged shares pursuant to [section] 1001 of the Internal Revenue Code of 1986, as amended when entering into the VPFS and receiving the cash payment. (2) This ruling was based on a number of factors. First, the IRS noted that there was no restriction on the...