Rev. Rul. 2003-7 provides that variable prepaid futures contracts (VFPCs) represent “open transactions” that are not subject to tax until the contract is finally settled and do not represent constructive sales of the stock under IRC §1259.  The case of Estate of McKelvey v. Commissioner, 148 T.C. No. 13 looks at whether an extension of the VFPC represents either a taxable settlement of the contract or a constructive sale of the related shares under IRC §1259, a question not previously addressed by the Tax Court.

Under a variable prepaid forward contract, a taxpayer agrees to pledge a certain amount of stock in exchange for receiving a payment of cash.  The contract provides that, at a specified date in the future the taxpayer will deliver either a number of shares of stock (either from the original pledged group or other shares the taxpayer has) or a cash payment.  The number of shares to be delivered varies over a specified range of shares, based on the price of the stock on the date the transaction is closed.  The shares that are pledged represent the maximum number that may need to be delivered.  As well, the party pledging the shares would retain the right to close out the contract at any time before the final settlement date, either by transferring shares or cash.

Congress enacted IRC §1259 to deal with various transactions that had been used to defer gain on the sale of securities while still managing to reduce the taxpayer’s exposure to price changes in the underlying asset.  One of the types of transactions that would trigger immediate recognition was if a taxpayer entered into a futures or forward contract to deliver the same or substantially identical property. [IRC §1259(c)(1)(C)]

So, for instance, if a taxpayer received $200,000 today but agreed to deliver 500 shares of a corporation’s stock to the other party in a year, the taxpayer would be treated as selling the shares upon entry into the contract, even though legal title to the shares would not pass until the following year.  But a VFPC, as described above, does not meet the criteria found   

In Rev. Rul. 2003-7 the IRS ruled that such a VFPC was properly taxed under the “open transaction” doctrine.  To qualify for treatment as an open transaction, the arrangement must meet the following criteria:

• The taxpayer receives a fixed amount of cash,
• The taxpayer 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,
• The taxpayer pledges the maximum number of shares for which delivery could be required under the agreement,
• The taxpayer 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
• The taxpayer is not economically compelled to deliver the pledged shares

Under the open transaction doctrine, even though the taxpayer receives cash up front, no taxable gain or loss is recognized at that time.  Rather, the gain or loss is calculated when the taxpayer closes out the transaction, as only then can the taxpayer’s true basis be calculated since only then can it determined what exactly will be given to close out the transaction and the taxpayer’s basis in such property.

There was no question in this case that the taxpayer had entered into a VFPC which met all the requirements of Rev. Rul. 2003-7.  But as the originally scheduled settlement date approached, the taxpayer contacted the other parties to the transaction and negotiated, in exchange for paying a sum of cash, an extension of the contract, pushing the settlement date forward two years.

The IRS argued that the taxpayer had to recognize gain at the original due date of the initial VFPC.  The agency argued that, first, the modification created a taxable exchange of the old contract for a new one and, second, that the modification was, unlike the VFPC itself, was subject to the gain recognition rules found in IRC §1259 for being a constructive sale of the underlying securities that would have been required to be transferred at the date the contract was modified.

The Tax Court ruled that the modification did not result in a taxable exchange because, under IRC §1001, the section governing taxation of sales or exchanges, there must be a sale or exchange of property.  The Court found that the taxpayer did not possess any property at the time of the modification and thus could not have exchanged it.  The Court noted that at the date the contract was entered into the taxpayer did receive property (cash) but immediately afterward all that remained as far as the taxpayer was concerned was an obligation to deliver cash or securities to close out the contract.  That obligation did not represent property, thus there was nothing that could have been exchanged.

The Court also refused to accept the IRS’s view that somehow this transaction took a transaction that had been exempt from the constructive sale rules of IRC §1259 and suddenly triggered the application of that section.  While this provision clearly was meant to deal with specific situations where there was no sale or exchange technically under IRC §1001 and force gain to be recognized.  But the Tax Court did not find that the IRS had shown in what manner this transaction triggered this Section.

The taxpayer modified an existing contract and the Court found that any analysis under IRC §1259 referred back to the original arrangement, which the IRS conceded was not taxable under IRC §1259. 

As the opinion concludes:

Respondent’s argument that the extensions to the original VPFCs triggered constructive sales under section 1259 is predicated upon a finding that there was an exchange of the extended VPFCs for the original VPFCs under section 1001. As we concluded above, the open transaction treatment afforded to the original VPFCs continued when decedent extended the settlement and averaging dates, and there was no exchange of property under section 1001. Accordingly, because respondent concedes that the original VPFCs were properly afforded open transaction treatment under section 1001 — and because the open transaction treatment continued when decedent executed the extensions — there is no merit to respondent’s contention that the extended VPFCs should be viewed as separate and comprehensive financial instruments under section 1259.