On April 19, 2017, in a case of first impression, the Tax Court in Estate of Andrew J. McKelvey v. Commissioner held that the extension of two variable prepaid forward contracts held by decedent Andrew McKelvey did not give rise to taxable exchanges under Section 1001 or constructive sales under Section 1259. Consequently, the Tax Court rejected the IRS’s argument that McKelvey should have recognized over $200 million of capital gain upon the execution of the extensions in 2008.
In 2007, McKelvey, the founder and chief executive officer of Monster Worldwide, Inc. (“Monster”), entered into two variable prepaid forward contracts (“VPFCs”) with respect to his Monster stock. Under the VPFCs, the taxpayer received a fixed cash payment in 2007 in exchange for his obligation to deliver shares of Monster stock over several settlement dates in September 2008. The number of shares required to be delivered was determined based on the stock’s closing price on each settlement date or the average closing price on certain specified dates. As collateral, McKelvey pledged the maximum number of shares that could be required to be delivered. McKelvey could settle the VPFCs with the pledged shares, identical Monster shares, or an equivalent cash amount. In July 2008, McKelvey made a significant cash payment to extend the settlement dates of the VPFCs from September 2008 to January and February 2010. McKelvey died in November 2008.
Although the Internal Revenue Service (the “IRS”) agreed with the taxpayer that McKelvey did not have to recognize any gain or loss when the VPFCs were executed in 2007, the IRS argued that gain was triggered when the VPFCs were extended in 2008. The Tax Court rejected this argument, holding that the extension of the VPFCs did not constitute sales or exchanges of property under Section 1001 or constructive sales of stock under Section 1259.
The Tax Court agreed with the parties that when the VPFCs were executed in 2007 they qualified for “open transaction” treatment under Revenue Ruling 2003-7, 2003-1 C.B. 363. In Revenue Ruling 2003-7, the IRS ruled that a variable prepaid forward contract that met certain requirements (i) was an “open transaction” at the time it was executed and thus should not result in a sale or exchange under Section 1001 until future delivery of the shares, and (ii) did not cause a “constructive sale” of shares under Section 1259. The Tax Court explained that the rationale of Revenue Ruling 2003-7 is that a taxpayer entering into a variable prepaid forward contract does not know the identity or amount of property that will be delivered until the future settlement date arrives and delivery is made and, accordingly, gain or loss cannot appropriately be determined until such time.
The Tax Court then addressed the IRS’s arguments that the extension of the VPFCs in 2008 (i) resulted in taxable exchanges under Section 1001 of the original VPFCs for new VPFCs with extended terms, and (ii) constituted constructive sales of the pledged shares of Monster stock under Section 1259.
Section 1001—Sale or Exchange
Section 1001(c) provides that “the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis” of the property. Treas. Reg. § 1.1001-1(a) provides that where property is exchanged for other property (instead of cash), the exchange is not taxable under Section 1001 unless the exchanged properties differ “materially either in kind or extent.” The Tax Court interpreted these rules as requiring that the VPFC extensions satisfy two conditions to trigger gain or loss under Section 1001: (i) the original VPFCs must have constituted property to McKelvey at the time of the extensions, and (ii) the property must be exchanged for other property differing materially either in kind or extent.
The Tax Court held that the extensions of the VPFCs were not subject to Section 1001 because the VPFCs did not constitute “property” in McKelvey’s hands at the time of the extensions. When the VPFCs were extended in 2008, McKelvey had already received the cash prepayments to which he was entitled, and all that remained under the VPFCs were his obligations to deliver shares of Monster stock (or their cash equivalent) on specified future dates. Because an obligation is not property, the Tax Court concluded that the extensions could not constitute exchanges of property for purposes of Section 1001.
The Tax Court rejected the IRS’s argument that McKelvey’s rights to use the cash prepayments, determine how the VPFCs were settled, and substitute other collateral were valuable property rights in his possession at the time of the extensions. First, because the cash prepayments under the VPFCs were not loans that were required to be repaid, McKelvey’s ability to use the cash did not constitute a property right provided under the VPFCs. In addition, the provisions allowing McKelvey to choose settlement in stock or cash and to substitute collateral were not property rights, as they had no value that McKelvey could dispose of in an arm’s-length transaction, but simply were “procedural mechanisms designed to facilitate decedent’s delivery obligations.”
The Tax Court viewed its holding as consistent with the rationale behind open transaction treatment in Revenue Ruling 2003-7, which is that the uncertainty regarding the identity and amount of property to be delivered under a variable prepaid forward contract requires that gain or loss be determined at the time of delivery. Because the number of Monster shares that would be required to be delivered under the VPFCs was still uncertain after the VPFCs were extended, the Tax Court concluded that open transaction treatment continued to be appropriate.
Section 1259—Constructive Sale
The Tax Court also rejected the IRS’s argument that the extensions of the VPFCs constituted a constructive sale under Section 1259 of the Monster shares pledged as collateral under the VPFCs. As the IRS conceded, when the VPFCs were executed they met the requirements of Revenue Ruling 2003-7 and thus did not result in constructive sales under Section 1259. Accordingly, the argument that the extensions of the VPFCs triggered constructive sales was predicated on a finding that such extensions resulted in exchanges of the original VPFCs for new VPFCs that should be separately analyzed under Section 1259. Because the Tax Court concluded that the extensions did not result in an exchange of property and that open transaction continued after the extensions, the Tax Court held that there was no basis to analyze the extended VPFCs as separate instruments under Section 1259.