Founder’s Estate Wins Tax Court Decision on Decedent’s Variable Prepaid Forward Contracts

By: Jerald David August

Estate of Andrew J. McKelvey, Deceased, et al v. Commissioner,

148 T.C. No. 13, April 19, 2017

The decedent, Andrew J. McKelvey, was the founder and CEO of Monster Worldwide, Inc. (, a company known for its job placement website. Mr. Mc Kelvey died on November 27, 2008. The IRS issued a statutory notice of deficiency of approximately $41,257,00 in income tax for 2008. The only issue for the Court was whether modifications made in 2008 to the decedent’s variable prepaid forward contracts (VPFCs) resulted in taxable dispositions under §1001 or under §1259. The case was tried on joint motion (fully stipulated statements of facts) without trial pursuant to T.C. Rules 50(a) and 122(a). The Tax Court found for the Petitioner-estate.

Factual Background

The Decedent (McKelvey) entered into variable prepaid forward contracts (original VPFCs) with two investment banks in 2007 with respect to Bank of America, N.A. for 1,765,188 shares of Monster class B common stock owned by the Decedent [1]. Pursuant to the terms of the original VPFCs, the investment banks made prepaid cash payments to Decedent of $50.1M on September 14, 2007 with the Bank of America. Decedent was obligated to deliver variable quantities of stock to the investment banks on ten specified future settlement dates in September 2008 (original settlement dates).  The actual formula used was contained in the Court’s opinion. The actual number of Monster shares (or cash equivalent) required for delivery on each settlement date would vary according to the stock market closing price of Monster shares on each specific settlement date.  

On September 24, 2007, Decedent entered into a second VPFC this time for 4,762,000 shares of Monster common stock with Morgan Stanley & Co. Pursuant to the terms of this second VPFC McKelvey received a cash prepayment of $142.6M on September 27, 2007. In exchange, the decedent agreed to deliver to Morgan, Stanley on or about September 24, 2008, up to 4,762,000 shares of Monster common or the cash equivalent again in accordance with the average closing price of Monster stock on the specified settlement dates. The formula used was the same as that used with the Bank of American VPFC.

Decedent treated the execution of the original VPFCs as open transactions pursuant to Rev. Rul. 2003-7, 2003-1 C.B. 363, and did not report any gain or loss for 2007.  

In 2008, before the original settlement dates, Decedent paid consideration to both of the investment banks to extend the settlement dates until 2010 ( the VPFC extensions). Decedent did not report any gain or loss upon the execution of the VPFC extensions and continued to report using the open transaction treatment. Decedent died in 2008 after the execution of the VPFC extensions.  The estate did not report the gain in 2008 despite the modification extending the term of the agreement until 2010. It continued to rely on Rev. Rul. 2003-7, 2003-1 C.B. 363.

Service Issues Notice of Deficiency

Petitioner timely filed a Form 1040 for 2008 again not reporting any gain realization for either VPFC agreement. On August 14, 2014, Respondent issued a notice of deficiency to Petitioner for decedent's taxable year 2008. Respondent determined in the notice of deficiency that decedent, upon executing the extensions with Bank of American and Morgan Stanley, McKelvey realized capital gain of $200,886,619. Respondent's determined gain comprised: (1) decedent's realization of short-term capital gain of $88,096,811 from his exchange of the VPFC extensions for the original VPFCs and (2) decedent's realization of $112,789,808 of long-term capital gain from the constructive sales of Monster shares pledged under the VPFCs.  Respondent's determination of long-term capital gain is based on Decedent, as the founder of Monster, having zero basis in the Monster shares pledged as collateral to both Bank of America and Morgan Stanley.  Petitioner-estate timely filed a petition with the Court disputing Respondent's determinations in the notice of deficiency. It claimed that no taxes were due and owing for 2008.

Revenue Ruling 2003-7

The Tax Court began its analysis with delving into Rev. Rul. 2003-7, 2003-1 C.B. 363.  In Rev. Rul. 2003-7, supra, the Service analyzed the proper tax consequences associated with a VPFC on 5 technical grounds. The factual facts in the ruling involved whether a shareholder either sold stock currently or caused a constructive sale of stock under § 1259 where the shareholder (i) receives a fixed amount of cash, (ii) simultaneously enters into an agreement to deliver on a future date a number of shares of common stock that varies significantly depending on the value of the shares on the delivery date, (iii) pledges the maximum number of shares for which delivery could be required under the agreement, (iv) has the unrestricted legal right to deliver the pledged shares or to substitute cash or other shares for the pledged shares on the delivery date, and (v) is not economically compelled to deliver the pledged shares?  

The Service started with addressing the transfer of securities to a brokerage firm under a subordination agreement entered into to allow the brokerage firm to meet its net capital requirements under stock exchange rules. The owner of the marketable securities transferred legal title and actual possession of the securities to the brokerage firm under a subordination agreement which allowed the brokerage firm to sell the securities if necessary to meet claims of general creditors of the brokerage firm. The transferor, however, retained the right to receive dividends and the right to vote any stock. In addition, the transferor could reacquire the securities in the subordination account by substituting either cash or other securities of equivalent value.

In Miami National Bank v. Comm’r, 67 T.C. 793 (1977) the Tax Court held that that despite the right of the brokerage firm to sell the stock “loaned” so to speak to meet its legal obligations to creditors, the transferor remained the owner of the stock.  Accordingly, the Tax Court held that the transferor's subsequent sale of the stock in the subordination account was effective to permit the purchaser to be treated as the direct owner of the stock for purposes of the consolidated return ownership test.  The court gave significant weight to this right in holding that the creation of the subordination account did not cause the brokerage firm to become the owner of the stock in the subordination account.  Miami National Bank, supra, and other similar cases indicate that a transfer of actual possession of stock or securities and legal title may not itself be sufficient to constitute a transfer of beneficial ownership when the transferor retains the unrestricted right and ability to reacquire the securities.

Next, Rev. Rul. 2003-7, supra, analyzed short sales. In general, the courts have  similarly refused to recognize covering purchases as triggering a sale for federal income tax purposes due to the fact that until actual delivery, the taxpayer retains the unrestricted right to dispose of the covering shares. See, e.g. , Richardson v. Comm’r, 121 F.2d 1 (2d Cir.), cert. denied, 314 U.S. 684 (1941).

In a typical short sale, the taxpayer borrows stock or securities to effect the short sale strategy and is under an obligation to return identical stock or securities to the lender. In Richardson, supra, the taxpayer entered into various short sales effectuated with borrowed stock. In one case, the taxpayer purchased 7,100 shares of stock that were intended to be used to close out a short sale but were in fact delivered to close out a different sale. Despite the taxpayer's intent to use the purchased stock to close his earliest open short sale, the taxpayer was held not to have closed a short sale because the stock was not actually delivered to the stock lender. It is not until delivery when the covering transactions should be treated as closed for federal income tax purposes.

The Service noted a different outcome resulted in Hope v. Comm’r, 55 T.C. 1020 (1971), aff’d  471 F.2d 738, cert. den. 414 U.S. 824 (1973) where the Tax Court held that under the facts involved in a share lending type of arrangement with an investment bank to sell a large block of a stock on behalf of the “seller” that a sale had occurred despite the seller’s efforts to rescind the arrangement by filing suit in the subsequent year based on the investment bank’s failure to sell the stock at a price the seller wanted for his block of shares.

The Service also found that there was no constructive sale of an appreciated financial position under §1259(b) so as to recognize gain under §1259(a)(1). Under §1259(c)(1)(C) a taxpayer is treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person) enters into a futures or forward contract to deliver the same or substantially identical property. See §1259(d)(1)(“forward contract”).

Tax Court in Estate of McKelvey, supra, Agrees With Petitioner

In a fully reviewed decision, Judge Ruwe, in issuing the Court’s opinion found for the Petitioner. It held: (i) Decedent’s entering into the agreement extending the VPFC in 2008 until 2010 did not constitute sales or exchanges of property under §1001 and the open transaction treatment afforded the original VPFCs under Rev. Rul. 2003-7, supra, continues until the transactions are closed by the future delivery of stock; and (ii) Decedent did not tripwire the constructive sale rule for appreciated financial positions under §1259 in 2008.

The Tax Court, accepting the “open transaction” model developed in Rev. Rul. 2003-7 as “straightforward”, looked at the issue before it as “what tax consequences, if any, occurred when Decedent extended the settlement and averaging dates of the original VPFCs until 2010. Again, the government’s position on the extensions is that such resulted in taxable exchanges of the original VPFCs and also that the extensions resulted in constructive sales of the underlying Monster stock under §1259.

On the other hand the Estate argued that the extensions merely postponed the settlement and averaging dates of the contracts and permitted that the original VPFCs, as extended, to be allowed to continue to be reported as “open” transactions until the contracts were settled by delivery of Monster stock (or other consideration) in 2010. The Court considered this to be a case of first impression.

As to the Cottage Savings type argument that the Service was making under the regulations (Treas. Reg. §1.1001-1(a)), the Tax Court did not see that the VPFC contract extensions resulted in an “exchange of properties” that were “materially different either in kind or in extent”. In fact, the Court analyzed whether the contract rights reflected in the VPFCs were “property” for purposes of §1001. The Petitioner, in this regard, argued that the VPFCs were not property to the decedent when the extensions were executed and there could be no gain or loss resulting from the extension under §1001. The Decedent’s rights under the VPFCs, the Petitioner asserted, were only the right to receive prepayment required by each contract and that each VPFC was solely an obligation of the Decedent and not his “property”.

The Service countered under a “bundle of sticks” type argument in advancing its position that the extension was a taxable exchange of “property”. In particular, it argued that the original VPFCs were an integrated bundle of valuable investment and other contract rights, as well as obligations, and constituted property.  Such rights were subject to market forces and contained valuable investment and contractual rights (and obligations). The valuable rights in the original VPFCs were: (i) the right to the cash prepayments; (ii) the right to determine how the VPFCs would be settled, i.e., whether with stock or in cash, and if stock, which specific shares; and (iii) the right to substitute other collateral [2].  Respondent contends that, even if Decedent possessed primarily obligations, the original VPFCs still constituted property within the meaning of §1001.

The Tax Court rejected that the Decedent’s right to cash prepayments constituted a valuable property right. See Federal Home Loan Mortgage Corp. v. Comm’r, 121 T.C. 254 (2003). The reason for this was that there was not a loan or financing arrangement involved as in the Federal Home, supra, case which it felt the Service inappropriately relied upon on the basis that it was a case involving a financing used in a different context. While the Decedent received cash prepayments, once these prepayments were received in September 2007, decedent was left only with obligations to deliver the consideration set forth in the VPFCs, as extended, and had no further property rights with respect to the contracts. All Decedent had at that time were obligations that might increase or decrease in amount.

The right to settle the VPFCs with stock, cash and/or other collateral for the pledge shares similarly was not “property” for purposes of §1001 according to Jude Ruwe’s opinion. The settlement options did not equate into property rights. These provisions had no value that decedent could dispose of in an arms-length transaction for value. These contractual provisions were not property rights.

As noted above, the Court did not find the open transaction method espoused in Rev. Rul. 2003-7, supra, to be objectionable. The original VPFCs provided Decedent the ability to settle the contracts by delivering: (i) Monster shares pledged as collateral; (ii) other shares that were not pledged as collateral; or (iii) a cash equivalent. Decedent had not yet discharged his delivery obligations under the original VPFCs when he executed the extensions, and the original VPFCs were still open transactions. The extensions made only one change to the original VPFCs: the settlement and averaging dates were postponed. This extension, in the Court’s view, did not clarify the uncertainty of which property Decedent would ultimately deliver to settle the contracts. Decedent had the discretion to settle the VPFCs using stock with a higher or lower basis than the stock pledged as collateral. Because decedent's obligation to deliver a variable number of shares (or the cash equivalent) was continuing, it remained uncertain whether Decedent would realize a gain or loss upon discharge of his obligations, not to mention the characterization of such gain or loss. See Virginia Iron Coal & Coke Co. v. Comm’r, 37 B.TA. 195 (1938), aff’d 99 F.2d 919 (4th Cir. 1938), Federal Home Loan Mortgage Corp. v. Comm’r, supra. Note that with the Decedent’s death the “open transaction” model approach left basis to increase to date of death (or alternate valuation date) value. A large estate tax obligation while a step up in basis. Not bad, right?

On the constructive sale alternative theory advanced by the Service under §1259 the Court again found in favor of the Petitioner and that the extensions to the original did not constitute constructive sales under §1259 because the original VPFCs are the only contracts subject to evaluation. The Court further noted that the Service accepted the taxpayer’s reliance on Rev. Rul. 2003-7, supra. It felt that implicit in this acknowledge is that the original VPFCs did not trigger constructive sales under §1259 since they also required the future delivery of Monster stock subject to significant variation. The Court felt there was no merit to the IRS argument that the extended VPFCs should be viewed as separate and comprehensive financial instruments under §1259.

[1] In a typical VPFC, a securities owner (the forward seller) holding an appreciated equity position enters into a forward contract to sell a variable number of shares of that equity position. The purchaser prepays its obligation under the VPFC to purchase a variable number of shares on a future date. At the maturity date of the contract, the forward seller will settle the contract by delivering either: (1) shares of stock that had been pledged as collateral at inception of the contract; (2) identical shares of the stock; or (3) cash. In general, the number of shares or the amount of cash to be delivered at maturity is determined at or near the contract maturity date according to the market price of the stock at issue.

Consider a taxpayer who owns 100 shares of Corp. W stock, trading at $10 per share. The taxpayer enters into a VPFC to deliver a number of shares in 1 year and receives a $1,000 (per share) upfront cash payment. If the stock is trading at $10 or below, the taxpayer must deliver all 100 shares. If the stock is trading at $20, the taxpayer must deliver 50 shares or $1,000 cash. See Anschutz Co. v. Comm’r, 135 TC No. 5 (2010).

[2] As noted in fn. 15 of the Opinion, “Respondent attempts to disaggregate the VPFCs into three components: (1) a discount loan; (2) a long put option; and (3) a short call option. Although the economic value of a VPFC can be calculated by valuing these separate parts, respondent appears to argue that decedent had contract rights in each of these distinct components. We disagree. VPFCs are comprehensive financial products, and decedent did not have the ability to transact separately in discount loans or call and put options. See Chock Full O' Nuts Corp. v. United States, 453 F.2d 300, 305 [29 AFTR 2d 72-305] (2d Cir. 1971).”

"Disclaimer of Use and Reliance: The information contained in this blog is intended solely for informational purposes and the benefit of the readers of this blog. Accordingly, the information does not constitute the rendering of legal advice and may not be relied upon by the reader in addressing or otherwise taking a position on one or more specific tax issues or related legal matter for his or her own benefit or the for the benefit of a client or other person.” ©Jerald David August for Kostelanetz & Fink, LLP”

Part One "Federal District Court For The Southern District of New York Refuses to Dismiss Criminal Indictment Against U.K. Citizen-U.S. Resident For Failing to File U.S. Income Tax Returns and FBARS"