INSIGHT: Monster Founder McKelvey’s ‘VPFC’ Found to Be a ‘Forward Contract’

A federal appeals court recently decided that it was “virtually certain” that Andrew J. McKelvey, founder of Monster.com, would have had to deliver all of the shares he pledged under a variable prepaid forward contract—had he not died before the settlement date—resulting in taxable gain.

A variable prepaid forward contract (VPFC) is an agreement between a “short” party (usually the holder of a highly appreciated stock position) and a “long” party (usually a commercial bank or an investment bank). The technique is used to “monetize” the stock, yet defer (and perhaps even avoid) the tax that a “conventional” monetization of the stock would engender.

The long party agrees to pay the short party a sum of money equal to the value of the stock discounted to present value. In exchange, the shareholder agrees to deliver on a specified “settlement date” up to a maximum number of shares of stock, the exact number to be determined by the price of the shares on a specified valuation date. The number of shares to be delivered varies inversely with the performance of the stock.

The taxable gain issues arose because McKelvey, after executing two VPFCs, paid substantial sums of money to the long parties—Bank of America N.A. and Morgan Stanley & Co. Int’l plc—to obtain an extension of the settlement date and the valuation date. There were two precise issues: The first issue was whether the extensions resulted in a short-term capital gain. The second issue was whether the extension of the valuation date also resulted in a long-term capital gain.

Factual Background

McKelvey was the founder and principal shareholder of Monster Worldwide Inc. In 2007, McKelvey executed the VPFCs with Bank of America and Morgan Stanley.

Under the BOA contract, BOA agreed to pay McKelvey $50,943,578.31 on Sept. 14, 2007; he agreed to pledge 1,765,188 shares of Monster stock to secure his obligation; and he agreed to deliver to BOA up to 1,765,188 shares of Monster stock at settlement. The actual number of shares to be delivered on the 10 settlement dates would be determined in one of three ways, depending on the closing price of Monster stock on each of the 10 dates. The number of shares to be delivered would not exceed the total number of shares pledged as collateral. Under the BOA contract, McKelvey had the option to settle the contract with the “cash equivalent” no matter which of the three methods was applicable.

On July 24, 2008, two months before the 10 settlement dates, McKelvey paid BOA $3,477,949.92 to amend the BOA contract by extending the original settlement dates, which also served as valuation dates. No other terms of the 2007 BOA contract were changed. The Morgan Stanley agreement paralleled the BOA agreement, except that many more Monster shares were pledged as collateral therefor.

After McKelvey’s death in November 2008, his estate settled the amended BOA contract by delivering 1,757,016 Monster shares to BOA on May 8, 2009, and settled the amended Morgan Stanley contract by delivering 4,762,000 Monster shares to Morgan Stanley on August 5, 2009. The Estate obtained a stepped-up basis for the Monster shares so delivered. See tax code Section 1014(a)(1). Neither McKelvey nor the estate (thanks to the basis step-up) paid any income taxes with respect to the Monster shares.

Termination of Obligation

The Internal Revenue Service determined that McKelvey realized a capital gain when he executed the VPFC extensions. Second, the IRS asserted, McKelvey realized a long-term capital gain with respect to the “constructive sale” of the shares pledged as collateral for the VPFCs.

The U.S. Tax Court noted that the execution of the VPFCs did not result in recognition of any capital gains. The VPFCs, the court said, were “open transactions.” The IRS agreed, since the instant VPFCs conformed with the agency’s published guidelines, that the VPFCs did not give rise to capital gains when executed. See Revenue Ruling 2003-7.

The Tax Court ruled in favor of the taxpayer on all issues. See Daily Tax Report, Extension of Settlement Date of VPFC Not a Realization Event, 5/4/17. With respect to the claimed short-term capital gain, the court held that the extension of the contracts was not a taxable “disposition of property” under Section 1001 because the VPFCs were not “property” to the taxpayer at the time they were exchanged for the amended contracts. At the time the amended contracts were signed, McKelvey had received the cash prepayment due him under each VPFC and “had only obligations under the contracts—and obligations are not property—and therefore Sec. 1001 is inapplicable,” the Tax Court said.

With respect to the long-term capital gain, the Tax Court ruled that the amended contracts did not result in the constructive sale of the Monster shares under Section 1259 of the Code. The open transaction treatment under the VPFCs continued under the amended contracts which the court did not regard as “forward” contracts under Section 1259(d)(1).

The U.S. Court of Appeals for the Second Circuit agreed with the Tax Court that McKelvey did not incur a short-term capital gain on the basis of the IRS’s claim that replacement of the VPFCs with the amended contracts was an exchange of property. However, the IRS has an alternative claim which will probably, in the final analysis, carry the day.

“Gain attributable to the cancellation or other termination of a right or obligation with respect to property which is a capital asset in the hands of the taxpayer shall be treated as gain from the sale of a capital asset,” the appeals court said. See Section 1234A(1). See also Pilgrim’s Pride Corporation v. Commissioner. The parties differed, not surprisingly, on whether the amended contracts accomplished a termination of McKelvey’s obligations under the VPFCs. The appeals court agreed with the IRS that extension of the valuation dates resulted in amended contracts that replaced the original contracts. As the estate acknowledged in the Tax Court, a “sufficiently fundamental or material change to an original contract that results in a change in the fundamental substance of the original contract will be considered an exchange of the original contract for the amended contract.” See Rev. Rul. 90-109, dealing with a change in the insured party under an insurance contract.

The appeals court held that “extending the valuation dates was a fundamental change.” The court said, “the new valuation dates in the amended contracts resulted in new contracts just as new expiration dates for option contracts result in new option contracts.”

“Whether the replacement of the obligations in the original VPFCs with the obligations in what we hold are new contracts satisfies the criteria for a termination of obligations that gives rise to taxable income, presumably capital gain, and the amount of such gain are issues” that the appeals court left for determination in the first instance by the Tax Court in remand. The estate has to believe that the odds of the Tax Court finding a taxable termination of obligations, given the not so subtle preferences stated by the appeals court, are quite high, if not a certainty.

Forward Contracts

The IRS renewed the argument he made to the Tax Court—the execution of the 2008 contracts extending the valuation dates resulted in a constructive sale of the shares pledged as collateral, thus triggering the gain that had accrued with respect to those shares.

A constructive sale occurs when a taxpayer holds an “appreciated financial position” and enters into a “forward contract” to deliver the same or substantially identical property. Section 1259(c)(1)(C). A forward contract is defined as a contract to deliver a substantially fixed amount of property (including cash) at a substantially fixed price. McKelvey’s shares, it is undisputed, constitute an appreciated financial position.

The IRS’s legal contention was that the amount of Monster shares to be delivered at settlement of each amended contract was substantially fixed on the date when each such amended contract was executed. The agency’s rationale was that, because the closing price of Monster stock on that date had fallen so far below the “floor” price of each contract, there was only a remote chance that the price would recover and exceed the floor price by the valuation date. Cf. Rev. Rul. 2003-7, supra; a VPFC was not a forward contract. The IRS contended that, on the execution date of the amended contracts, it was virtually certain that, on the settlement date, McKelvey would have to deliver all of the pledged shares. This virtual certainty means that the amount of property to be delivered at settlement was substantially fixed within the meaning of Sec. 1259(d)(1) and therefore the pledged shares were constructively sold. To my surprise, the court bought into this argument.

There was a probability of 85.1 percent and 87.13 percent for the amended BOA and Morgan Stanley amended contracts, respectively, that the closing price would be below the floor price on the settlement date. Neither party, the court noted, cited a decision on the use of probability analysis to determine whether an amount has been “substantially fixed” for purposes of subsection 1259(d)(1). We are, the court said, “persuaded to accept probability analysis in this context.”

Tax laws, the court reminded us, are to be applied with an eye to economic realities. The economic reality pertinent to this case is not only the use of probability analysis in general but the use of the “widely accepted” Black-Scholes probability formula in particular. Using probability analysis to prevent “capital gain avoidance” in this case does not, thankfully, affect all amended VPFCs, but only those amended to become forward contracts where the number of shares to be delivered at settlement is substantially fixed because of a share price substantially below the floor price. We see, the court said, “no basis to conclude that the amount of shares to be delivered at settlement was not substantially fixed on the dates each contract was amended.” Constructive sales of the collateral shares therefore resulted.

The decision of the Tax Court was accordingly reversed, and the case was remanded for calculation of the amount of the long-term capital gain that resulted from the constructive sales of the pledged shares. The IRS has notched what has to be an unexpected, but no less decisive, victory. See Estate of McKelvey v. Commissioner, No. 17-2554, 2018 BL 348708 (2d Cir. 9/26/18).