IRS starting to challenge popular tax deferral technique.

• Author: Rubinger, Jeffrey L.
• Position: Variable prepaid forward contracts

A recent article in Forbes magazine refers to it as a "tax trick" and a "kinky forward" contract. (1) In particular, the article describes a transaction entered into in January 1998 by Bobby Stevenson, CEO of Ciber, Inc., in which he received $82 million in cash up front from Merrill Lynch in exchange for his agreement to deliver a certain number of his Ciber shares by Feb. 1, 2001. It was supposed to be a great deal for Stevenson, whose stock has fallen more than 80 percent since he received the cash, as he locked in the gain in his Ciber shares before the stock market crashed in March 2000, but would not be subject to tax on this gain until he delivered the shares in 2001. The IRS, however, is now claiming that Stevenson owes taxes on the $82 million gain dating back to the 1998 taxable year. (2) The transaction described in the article is commonly referred to as a variable prepaid forward contract (VPFC).

In general, a VPFC is a privately negotiated agreement between an individual taxpayer who owns shares of appreciated stock and a counterparty (i.e., a commercial or investment bank). The individual receives an up-front cash payment from the bank equal to the present value of the forward delivery price in exchange for the obligation to deliver to the bank a variable number of shares of the underlying stock on the contract's maturity date. Typically, these contracts are entered into by individuals who have a concentrated stock position in their own company and are still bullish on the company, but want to generate liquidity so they can diversify their portfolio without triggering a current income tax liability on the appreciation in the shares.

Given that the number of shares ultimately required to be delivered on the maturity of the VPFC will depend upon the value of the underlying stock at that time, it is generally thought a VPFC does not constitute a "forward contract" under [section] 1259(d)(1) (3) (i.e., a contract to deliver a substantially fixed amount of property for a substantially fixed price), and thus, does not give rise to a constructive sale of the underlying shares of stock under [section] 1259. Recently, however, as indicated by several field service advisories (4) (FSAs) (and the Stevenson case), the IRS is starting to challenge these types of transactions. (5) For example, in FSA 200111011, the IRS determined under common law principles that taxpayers sold shares of appreciated stock when' they entered into a derivative product that is similar economically to a VPFC because, among other things, the taxpayers did not have the option to cash-settle the contract. Similarly, in both FSA 200131015 and FSA 200150012, the IRS stated that a derivative product that is also similar economically to a VPFC could be analyzed as a cash-settled collar in addition to a prepaid forward contract. As such, it may not be sufficient, in order to avoid constructive sale treatment, to simply rely on the fact that a VPFC does not satisfy the specific definition of a forward contract.

Economics of a VPFC

The economics of a VPFC can best be illustrated by way of an example. Assume individual taxpayer Aidan is the chief executive officer of Oliver, Inc., a company that went public a little more than one year ago. Aidan currently owns 400,000 shares of Oliver, Inc. stock with a cost basis of $5 per share. The shares of Oliver, Inc. are presently trading at $100 a share. Consequently, the market value of Aidan's interest in Oliver, Inc. is worth $40 million, an amount which represents approximately 25 percent of his net worth.

While Aidan still believes in Oliver, Inc. and, therefore, does not want to sell his shares, he recognizes this position represents too high a percentage of his net worth. Moreover, Aidan wants to generate liquidity so he can invest in other stocks and diversify his portfolio, but he does not want to currently pay tax on the $38 million of built-in gain in the Oliver, Inc. shares.

Accordingly, Aidan enters into a five-year VPFC with Big Bank, a large commercial bank, involving 200,000 of his 400,000 shares of Oliver, Inc. (6) The contract is structured with a minimum share value of $100 per share (i.e., 100 percent of the current market value of the Oliver, Inc. shares) and a maximum share value of $120 per share (i.e., 120 percent of the current market value of the Oliver, Inc. shares). Aidan will keep 25 percent of any appreciation beyond the $120 per share. At the inception of the contract, Big Bank will pay to Aidan 75 percent of the current market value of the Oliver, Inc. shares involved in the transaction (i.e., $15 million), an amount which represents the present value of $20 million discounted back five years from the contract's maturity date. (7) The difference between the $20 million current market value of the Oliver, Inc. shares involved in the transaction and the $15 million up-front payment from Big Bank represents the cost of entering into the transaction (i.e., the implied financing cost).

As security for his obligation to deliver a certain number of his Oliver, Inc. shares to Big Bank on the contract's maturity date, Aidan is required to pledge his shares of Oliver, Inc. stock to Big Bank as collateral. When the contract matures, Aidan has the option to either "physically settle" the contract (i.e., deliver a certain number of the Oliver, Inc. shares to Big Bank) or "cash settle" the contract (i.e., deliver the cash equivalent of a certain number of Oliver, Inc. shares to Big Bank).

By entering into the VPFC, Aidan has in effect agreed to sell a certain number of his Oliver, Inc...