Under Regs. Sec. 1.61-6(a), a taxpayer must include in gross income any gain realized on the sale or exchange of property, unless it is excluded by another provision. The specific rules for determining the amount of gain from a sale or exchange of property are contained in Sec. 1001; however, special Code provisions provide for sale or exchange treatment when Sec. 1001 does not apply (e.g., Sec. 1259). In a recent case, Estate of McKelvey,148 T.C. No. 13 (2017), the Tax Court determined whether Sec. 1001 and Sec. 1259 applied. This item summarizes the current law and discusses the facts and analysis inMcKelvey.
Andrew McKelvey was the founder and former CEO of Monster Worldwide Inc., known for its job-search website, Monster.com. As the founder of Monster, he held some Monster stock with a zero basis.
On Sept. 11, 2007, McKelvey entered into a variable prepaid forward contract with Bank of America (BofA) relating to 1,765,188 of his Monster shares. On that date, Monster stock closed at $32.91. Under the contract, McKelvey received $50,943,578 (i.e., approximately 88% of the value, based on the closing price, or $28.86 per share) upfront from BofA in exchange for agreeing to deliver a contingent amount of the underlying shares to BofA over the course of 10 settlement dates in September 2008.
The settlement dates were each allocated an average of 176,519 underlying shares. The number of underlying shares that McKelvey would be required to deliver on each settlement date was contingent on the closing price of Monster stock on that date. The terms of the contract specified that on each settlement date, McKelvey would be required to deliver:
1. If the price of Monster stock closed on that date at $30.461 (the floor) or less, all of the allocated underlying shares;
2. If the closing price of Monster stock on the settlement date was greater than the floor but less than or equal to $40.58 (the cap), a number of shares equal to the product of (a) 176,519 (or, on two settlement dates, 176,518) and (b) a fraction with a numerator of $30.461 and the denominator of the closing price on the settlement date; and
3. If the price of Monster stock closed higher than the cap, a number of shares equal to the product of (a) 176,519 (or 176,518) and (b) a fraction with a numerator of the floor price plus the closing price on the settlement date, minus the cap price, and a denominator of the closing price.
McKelvey could elect to deliver instead of the required shares an equivalent amount of cash. He also pledged 1,765,188 Monster shares to BofA to secure his obligations, but he could substitute other collateral with BofA's approval.
On July 24, 2008, less than two months before the settlement dates commenced, McKelvey paid BofA $3,477,950 to extend the settlement dates until February 2010 (i.e., approximately 17 months), with all other terms unchanged. On the date of the extension, Monster stock closed at $18.24; thus, McKelvey would have been required to deliver all of the underlying shares to BofA unless the share price appreciated significantly.
McKelvey also entered into a second contract under similar terms with another counterparty, which he similarly paid on July 15, 2008, to extend the settlement dates to January 2010.
The IRS determined a deficiency on McKelvey's tax return for his 2008 tax year. The Service argued that McKelvey should have recognized (1) short-term capital gain on the extension dates because the extensions resulted in taxable exchanges of the original contracts for the extended contracts under Sec. 1001 (with the gain being the number of shares pledged as collateral multiplied by the excess of the floor prices in the original contracts over the closing price of Monster stock on the extension date), and (2) long-term capital gain on the extension dates from a constructive sale of the underlying shares pursuant to Sec. 1259.
McKelvey died before the extended settlement dates, and nearly all of the underlying shares were transferred to the respective counterparties in 2009 following his death.
Sec. 1001(c) provides that the entire gain or loss on the sale or exchange of property is recognized, absent the application of any exceptions. Sec. 1001(a) provides that gain from such a sale or exchange is the excess of the amount realized over the adjusted basis (as provided in Sec. 1011), and loss is the excess of the adjusted basis over the amount realized.
Sec. 1001 applies only to a sale or other disposition of property. An exchange of property is not subject to Sec. 1001 unless the properties exchanged are materially different. See Regs. Sec. 1.1001-1(a)and Cottage Savings Association,499 U.S. 554 (1991).
The term "property" is defined as "any external thing over which the rights of possession, use, and enjoyment are exercised" (Black's Law Dictionary 1335-36 (9th ed. 2009)). Courts have also expounded on the meaning of property. For example, the Supreme Court in Craft, 535 U.S. 274, 278 (2002), stated, "a common idiom describes property as a 'bundle of sticks' — a collection of individual rights which, in certain combinations, constitute property. State law determines which sticks are in a person's bundle."
Constructive sales under Sec. 1259
Sec. 1259(a) provides that a taxpayer must recognize gain related to an "appreciated financial position" if the taxpayer enters into a "constructive sale" of the position. The taxpayer must recognize gain as if that position were sold, assigned, or otherwise terminated at its fair market value (FMV) on the date of the constructive sale (Sec. 1259(a)(1)).
An appreciated financial position generally includes any position with respect to stock, as long as there would be gain if the position was sold at its FMV (Sec. 1259(b)).
Subject to certain exceptions, the definition of a constructive sale in Sec. 1259(c) includes when a taxpayer (or a related party) enters into a forward contract to deliver the same or substantially identical property (Sec. 1259(c)(1)(C)).
Sec. 1259(d)(1) defines a forward contract as a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price. This definition of a forward contract was elaborated upon in the legislative history:
A forward contract results in a constructive sale of an appreciated financial position only if the forward contract provides for delivery of a substantially fixed amount of property and a substantially fixed price. Thus, a forward contract providing for delivery of an amount of property, such as shares of stock, that is subject to significant variation [emphasis added] under the contract terms does not result in a constructive sale. [S. Rep't No. 105-33, 105th Cong., 1st Sess. 125-126 (1997)]
Rev. Rul. 2003-7
The IRS has ruled that, under specific circumstances, a taxpayer should not be treated as selling stock under Sec. 1001, or having made a constructive sale under Sec. 1259, upon entering into a variable prepaid forward contract with respect to such stock.
In Rev. Rul. 2003-7, an individual (the shareholder) owned 100 shares in a corporation, Y, which was publicly traded. The shareholder's basis in the Y shares was less than $20 per share. On Sept. 15, 2002, the shareholder entered into a variable prepaid forward contract when Y shares had an FMV equal to $20 per share. Upon entering into the contract, the shareholder received an upfront cash payment from the counterparty in exchange for a contingent amount of the Y shares, to be determined by a formula on a future "exchange date."
The formula specified that the shareholder was required to deliver:
1. All of the Y shares if their price on the exchange date was less than $20;
2. An amount of Y shares with a value of $2,000 if their price on the exchange date was equal to or greater than $20 but less than or equal to $25; and
3. Only 80 shares if the Y share price on the exchange date was greater than $25.
The shareholder could deliver an equal amount of cash or other shares in lieu of Y shares.
The IRS ruled that the shareholder neither sold the stock under Sec. 1001 nor caused a constructive sale under Sec. 1259. The ruling concludes that there was not an event under Sec. 1001 because the shareholder retained rights related to the Y shares (i.e., voting rights and dividend rights), and the shareholder could retain the Y shares by delivering cash or other shares of equal value. Furthermore, notwithstanding that the shareholder had entered into the contract, the Service ruled that it was not a forward contract (as defined in Sec. 1259(d)(1)) that would cause a constructive sale under Sec. 1259 because the number of shares to be delivered under the contract was subject to "significant variation."
The Tax Court's opinion
The Tax Court first held that McKelvey did not incur short-term capital gain related to the contracts under Sec. 1001. In its analysis, the court focused on the fact that Sec. 1001 applied only when there was an exchange of property and concluded that the contracts did not constitute property to McKelvey. Because McKelvey had already received the upfront payments under the contracts, the court found that the contracts solely constituted obligations to McKelvey on the extension dates. The court did not view McKelvey to have any remaining property rights under the contracts on the extension dates.
The court further held that McKelvey did not incur long-term capital gain with respect to the underlying shares. It noted that in Rev. Rul. 2003-7, the IRS had "approved 'open' transaction treatment for [variable prepaid forward contracts] that meet certain criteria."
Both the IRS and the taxpayer agreed that the original contracts satisfied the requirements in Rev. Rul. 2003-7 and that McKelvey had no gain or loss in 2007. The court decided that the open transaction treatment under Rev. Rul. 2003-7 should continue to apply despite the extension of the settlement dates. It stated:
The rationale for affording open transaction treatment to [variable prepaid forward contracts] is the existence of uncertainty regarding the property to be delivered at settlement. . . . The [extensions] made only one change to the original [contracts]: The settlement and averaging dates were postponed. Thus, by only extending the settlement and averaging dates, the extensions did not clarify the uncertainty of which property [McKelvey] would ultimately deliver to settle the contracts.
Finally, the court held that the extensions did not result in a constructive sale of the underlying shares under Sec. 1259 because the extended contracts did not constitute separate financial instruments from the original contracts.
The court's opinions in McKelvey broach a number of interesting issues. First, the court concluded that the contracts did not constitute property to McKelvey because he had an obligation under the contracts only at the time of the extensions. However, the court acknowledged in a footnote that the extensions were valuable to McKelvey because he was willing to pay consideration for them. A sufficient change in the Monster stock price over the extension period would affect the amount of McKelvey's obligation but would enable him to retain some of the underlying shares even if he elected physical settlement. In addition, McKelvey had the right to cash-settle the contracts and retain the underlying shares if he so chose. Thus, the extended contracts arguably provided him some type of a property right.
Second, the court regarded the extended contracts as a continuation of the original contracts instead of new agreements that were materially different from the original contracts. As noted above, McKelvey had obligations under the original contracts in September 2008, but the obligations were extended to 2010 (specifically, February 2010 for the contract with BofA). By contrast, a deferral of an obligation under a debt instrument may be regarded as a new debt instrument for U.S. federal tax purposes (see Regs. Sec. 1.1001-3(e)(3)). Furthermore, the extension of the period covered by an option may be regarded as a different option (see Reily, 53 T.C. 8 (1969); General Counsel Memorandum (GCM) 35918; and GCM 38206).
Finally, the court did not consider Sec. 1234A at all. Sec. 1234A requires taxpayers to characterize gain or loss as capital if it relates to the termination of an obligation with respect to property that is (or would be) a capital asset in the hands of the taxpayer.
The court recognized that McKelvey had an obligation with respect to Monster stock, but the original obligation was apparently not considered to have been terminated in exchange for a new obligation. If the extended contracts were viewed to be materially different from the original contracts, it might be reasonable to infer that McKelvey terminated his obligations in September 2008 under the original contract in exchange for the extension payments and new obligations with settlement in 2010. Thus, under that theory, Sec. 1234A would seem to apply, so long as the underlying shares were considered capital assets in his hands.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.