Tax News Update    Email this document    Print this document  

In Estate of McKelvey v. Commissioner, 148 T.C. No. 13, the Tax Court has held that extensions of the settlement dates of variable prepaid forward contracts (VPFCs) did not result in taxable exchanges under Section 1001, did not affect the open transaction treatment afforded to the VPFCs under Revenue Ruling 2003-7, and did not result in constructive sales under Section 1259.

Facts

In September 2007, Andrew McKelvey (McKelvey), the founder of job-search website Monster.com, entered into VPFCs with two separate investment banks, Bank of America and Morgan Stanley. Under the VPFCs, McKelvey received around $193 million cash upfront from the two banks. In return, McKelvey pledged to deliver to each bank a specified number of Monster.com shares, or the cash equivalent, on specified dates in September 2008. The actual number of shares to be delivered would vary under a formula based on the value of the stock at the time of delivery.

In July 2008, McKelvey paid consideration totaling approximately $11.7 million to the two banks to extend the VPFC settlement dates until early 2010. McKelvey died in November 2008. After his death, his estate settled the VPFCs in 2009.

In accordance with Revenue Ruling 2003-7, McKelvey recognized no gain from entering into the VPFCs in 2007. Likewise, his 2008 income tax return reported no gain as a result of the extension of the VPFCs. In 2014, however, the IRS issued notices of deficiency for McKelvey's 2008 tax year, asserting that McKelvey should have reported capital gains of approximately $88 million in 2008 as a result of the extensions of the VPFCs and an additional gain as a result of constructive sales of the Monster.com stock arising as a result of the extensions. The latter position was presumably based on the fact that, at the time of the extensions, the price of the Monster.com stock was only about half of what it had been in September 2007, so the VPFCs were substantially equivalent to short positions in a fixed number of Monster.com shares.

Opinion

Under Revenue Ruling 2003-7, the Tax Court explained, entering into certain VPFCs to deliver property qualifies for open transaction treatment, and does not, as a result, require the recognition of gain or loss on that property (here, the Monster Worldwide, Inc., stock) until the VPFC is settled. The IRS and McKelvey's estate agreed that the 2007 entry into the VPFCs, and corresponding receipt of cash by McKelvey, did not trigger gain. The primary issue for the Court, as a matter of first impression, was whether the 2008 extensions of the VPFCs triggered realization of gain for McKelvey.

Generally, under Section 1001(a), taxpayers must recognize gain or loss on the sale or exchange of property for other property that differs materially in kind or extent. Thus, the Court noted, for the extensions to trigger realization of gain or loss under Section 1001(a), among other requirements, the VPFCs must have been "property" to McKelvey at the time.

The Court cited several sources defining "property" to consist of certain rights. McKelvey's estate argued that the VPFCs were not property to the McKelvey at the time of the extensions because they encompassed only obligations to deliver stock (or the cash equivalent). The Court agreed that McKelvey had only obligations at the time of the extensions, and that no further rights remained to him in the VPFCs to constitute property after he received the funds from the VPFCs in 2007. The Court was not persuaded by the IRS's argument that McKelvey held rights to the prepayments, or rights as to how the VPFCs would be settled. Accordingly, because the VPFCs did not constitute "property" in the hands of McKelvey, the extension of the VPFCs in 2008 did not require the recognition of gain under Section 1001. The Court did not discuss the possibility that a modification of an obligation could be a taxable event to the obligor under general tax principles.

The Court added that the rationale of the "open transaction treatment" in Revenue Ruling 2003-7 supported its conclusion that no gain should be realized on the extension of the VPFCs. As when he entered the VPFCs, McKelvey could not have ascertained the amount of gain realized when the extensions were made. Computing realized gain would require knowing not just the amount realized (i.e., the cash prepayment), but also the adjusted basis, which would not be known until the time the VPFCs were settled.

The Court likewise dismissed the IRS argument that the extensions resulted in constructive sales under Section 1259 of the Monster.com shares pledged as collateral. The Court noted that the IRS conceded that the original VPFC transactions were afforded open transaction treatment under Section 1001, and the Court had already concluded that the same treatment continued at the time of the extensions. Accordingly, the Court stated that there was no merit to the IRS contention that the extended VPFCs should be viewed as "separate and comprehensive financial instruments under Section 1259."

Implications

The issue of whether a modification of a derivative contract providing only for obligations, not rights, triggers recognition of gain/loss arises frequently. For example, an investor might wish to extend the term or change the strike price of a written call or put option over stock. Many advisors have concluded that such changes could, if economically important enough, require the recognition of gain, or permit the recognition of loss. The Tax Court's opinion holds that Section 1001 does not apply to such a derivative, and that such modifications would therefore not require or permit any gain or loss to be recognized under Section 1001. Additionally, the opinion suggests that, as long as a VPFC or written option did not trigger a constructive sale under Section 1259 at the time the instrument was entered, any later modification of the instrument would not require a re-testing under Section 1259. Taxpayers who have written options outstanding or who are sellers under VPFCs and who are contemplating modifying those instruments therefore should consider the effect of the McKelvey decision on the tax consequences of that modification. For example, a taxpayer that has written an option that is about to lapse, resulting in the recognition of gain, might extend the term of the option in exchange for additional premium rather than allowing the existing option to lapse and writing a separate new option.

It would appear likely that the IRS will announce its nonacquiescence in this decision and will appeal the case to the Court of Appeals, likely the Second Circuit.

———————————————