United States

Tax Court holds extension of prepaid forward contract not taxable


In 2007, the taxpayer in Estate of Andrew J. McKelvey v. Commissioner received over $193 million of cash from two banks under variable prepaid forward contracts. In exchange, the taxpayer agreed to settle each contract by transferring a variable number shares of stock to each bank in 2008 for no additional cash. The 2008 transaction would represent a taxable sale of the stock. In 2008, the taxpayer paid each bank to extend each contract term to 2010.

The Tax Court ruled that these 2008 extensions did not create taxable exchanges under section 1001. The court therefore rejected the IRS’ proposed assessment of about $41 million of additional tax for 2008.

Variable prepaid forward contracts

Unlike a regular forward contract, where both the subject property and the agreed-upon price are exchanged when the forward expires, a prepaid forward requires the buying party to make payment to the selling party at the inception of the contract. The variable nature of the contracts comes from the fact that the quantity of property (often corporate stock) to be delivered varies with its market value; terms are generally set so that the buyer receives an interest-like return on its initial payment, with the seller retaining some economic upside or downside. Some contracts, including the ones before the Tax Court in this case, also allow the seller to make a cash payment in lieu of actual delivery of shares, with that payment equal to the market value of the shares that would otherwise be deliverable.

Variable prepaid forward contracts structured like the one described in Rev. Rul. 2003-7 generally receive open transaction treatment—no gain or loss is recognized by the seller until shares are delivered to close the contract. This ruling means that variable prepaid forward contracts are often an attractive way to monetize appreciated assets while deferring tax related to that appreciation.

McKelvey case

In the instant case, the taxpayer had (while alive) entered into variable prepaid forward contracts to sell shares of Monster Worldwide, Inc. (which he founded) to two banks in September 2008. Consistent with Rev. Rul. 2003-7, the taxpayer recognized no gain or loss at the inception of the transaction. The taxpayer later paid a significant sum of money to the two banks to extend the settlement date of each contract to January 2010. The IRS asserted that this constituted a taxable exchange of one derivative contract for another.

Under the relevant tax law, there must be a sale or exchange of ‘property’ held by the taxpayer before any gain on the property is taxable. In analyzing the taxpayer’s position with respect to the variable prepaid forward contracts, the Tax Court held that it did not constitute property in the hands of the taxpayer. This conclusion was reached because the taxpayer did not have any rights with respect to the forwards that could be viewed as a property interest, merely obligations (since the taxpayer had already received the lump sum payment at the inception of the contract). Because of the lack of any substantive rights, the taxpayer did not have a property interest that could be subsequently exchanged for purposes of the tax law.

Separately, and in a brief part of the opinion, the Tax Court rejected the contention that the modification of the contract could be considered a constructive sale of the underlying Monster Worldwide, Inc. shares.

It remains to be seen whether the decision in McKelvey will have a far-reaching impact because it turned on the specific facts of the case. The court held that the taxpayer had no meaningful property rights at the time of the extension, only liabilities. This situation occurs rarely with respect to other derivatives, and as a result, taxpayers may be limited in their ability to rely on McKelvey to argue that an extension of a contract does not constitute a taxable event. In many other derivative contracts (such as swaps, regular forwards, etc.), both parties have both rights and obligations throughout the term of the derivative. In addition, this case only addressed the consequences of the modification to the selling party to the contract; the treatment of the modification to the buying banks was left unaddressed.


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