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Variable Prepaid Forwards – Hedge At Your Own Risk…

At KYEstates, we’re happiest reporting on taxpayer victories, but if we have to report a loss, it mitigates our disappointment when the case is interesting. Anschutz v. Comm’r, 135 T.C. No. 5 (July 22, 2010), is that sort of case: an interesting taxpayer loss.  In this instance, a very expensive taxpayer loss (likely exceeding $21 million). (Out of professional courtesy, we hope the ruling is not also occasion for a correspondingly expensive claim under any legal opinions….).

Anschutz involved Anschutz Company and its sole shareholder Philip F. Anschutz, the well-known Los Angeles-based entrepreneur and natural resources investor. In the late ’90s, Mr. Anschutz needed to raise cash to fund his acquisitions of a number of professional sports venues and teams, including the Los Angeles Kings hockey team and the Staples Center in LA. Mr. Anschutz owned large equity positions in the Union Pacific railroad and Anadarko Petroleum. An investment bank, Donaldson Lufkin & Jenrette (DLJ) was only too happy to help Mr. Anschutz’s advisors consider a variable prepaid forward contract and stock lending agreement arrangement as a way to use these stock positions to raise the needed cash.

(A side note: DLJ is actually the “late DLJ”, having been absorbed into Credit Suisse First Boston in 2001.  For humorous investment banking nostalgia, see “Remember the Titans” at Leveraged Sellout.)

In 1999, Anschutz Company had made an election under Section 1362 to be taxed as an S corporation.  The Anschutz Corporation (TAC) was a qualified subchapter S subsidiary (“Q-sub”) of Anschutz Company.  TAC was the entity that entered into the transactions with DLJ in 2000 and 2001.  Because TAC was a Q-sub of Anschutz Company, the consequences of the income tax treatment of TAC’s transactions with DLJ directly affected Mr. Anschutz’s personal income tax return.

Before reviewing the structure of the transactions with DLJ, let’s consider the bigger picture, shall we?  Because the S-elections had been made in 1999, in 2000 and 2001 both TAC and its parent were within the 10-year built-in-gains period under Section 1374, an exception to the general pass-through rule for S corporation taxation. Section 1374(a) imposes a corporate-level tax on the net recognized built-in gain of an S corporation that has converted from C corporation to S corporation status. (The built-in gain is measured by the appreciation of any asset over its adjusted basis at the time the corporation converts from C corporation to S corporation status.)

TAC’s equity holdings had substantial built-in gains.  An outright sale of the equities would trigger these built-in gains.  A transaction promising to raise cash in relation to the equity positions without triggering a sale for income tax purposes (and thereby avoiding the undesirable double taxation of the built-in gains, once at the corporate level and then again at Mr. Anschutz’s level) would be very attractive.

That’s the sort of transaction DLJ was pitching.

Let’s consider how the transaction worked. It involved three classes of documents: a master stock purchase agreement (MPSA), prepaid variable forward contracts (PVFCs), and share lending agreements (SLAs) [Readers who enjoy playing Trivial Pursuit, if you thought of Patty Hearst when you saw “SLA” just now, you’re not alone]. The Tax Court explained PVFCs as follows:

A forward contract is an executory contract calling for the delivery of property at a future date in exchange for a payment at that time. A PVFC is a variation of a standard forward contract. In a typical PVFC, 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 PVFC 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. Typically 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.

For readers who do best with examples rather than descriptions, the Tax Court was happy to provide this example of a PVFC:

Consider a taxpayer holding 100 shares of Corporation X stock, trading at $10 per share. The taxpayer enters into a PVFC to deliver a number of shares in 1 year and receives a $1,000 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.

The Tax Court described SLAs as follows:

Share-lending agreements are often entered into by equity holders who have taken a long position with respect to a stock and plan on holding it for an extended period. The equity owner can agree to lend the stock to a counterparty, who can then use the borrowed shares to increase market liquidity and facilitate stock sales….The borrower will normally pledge cash collateral, and the lender will derive a profit lending the shares by retaining a portion of the interest earned by this cash collateral. At the end of the lending period, the counterparty will return the borrowed shares to the equity owner/lender.

So much for the general approach, right?  In this particular transaction, the PVFCs required DLJ to make an upfront payment to TAC equal to 75 percent of the fair market value of the shares subject to the PVFCs, which had durations between 10 and 11 years.  In addition, TAC was allowed to retain the first 50% of the appreciation in the shares subject to each PVFC during the PVFC term. The MPSA required TAC to pledge collateral in exchange for the upfront cash payment under the PVFC. The pledge agreements by which TAC carried out this obligation further required Wilmington Trust Company (which was acting as TAC’s collateral agent) to enter into SLAs with DLJ. TAC received a prepaid lending fee equal to 5% of the fair market value of the shares lent under the SLAs.  The SLAs allowed TAC to recall shares it had loaned to DLJ, but if TAC did so, it would have to return a pro rata portion of the prepaid lending fee.

Before entering into its transactions with TAC, DLJ had entered into short sales corresponding to the equity positions TAC was going to put into the PVFCs.  The Tax Court cogently noted that these “short sales in effect hedged DLJ’s risk on the forward contract, because the short sales protected DLJ from a decrease in stock value during the term of the PVFC….If the fair market value of stock subject to the PVFCs dropped over the course of the contract, the short sales would earn a profit; if the fair market value increased, the PVFCs would earn a profit.”

In the transactions, TAC received upfront payments under the PVFCs exceeding $350 million, and prepaid lending fees under the SLAs exceeding $23 million.

So, readers, those are facts and the stakes.

The taxpayers treated the PVFC portions of the MPSA as open transactions and not as closed sales of stock, and therefore reported no gain or loss from the stock transactions on S corporation or personal income tax returns. In its notice of deficiency, the IRS claimed that TAC had entered into closed sales of stock, and was liable for Section 1374 built-in gains tax in 2000 and 2001 by the amount that the sale proceeds exceeded TAC’s basis in the stock (which was, predictably, pretty darn low). The IRS also claimed that the amount of built-in gain (less the tax on that gain) should have flowed through to Mr. Anschutz’s personal income tax return, causing deficiencies on that return. The taxpayers petitioned.

The Tax Court summarized the government’s argument as follows:

Respondent argues that TAC’s transfers of stock during 2000 and 2001 should be treated as closed transactions for Federal tax purposes. His argument comprises three parts: (1) TAC transferred legal title and the benefits and burdens of ownership; (2) the SLAs are not true lending arrangements, but a way for TAC to deliver the shares of stock to DLJ; and (3) TAC transferred the shares to DLJ in exchange for an ascertainable amount of consideration equal to 100 percent of the fair market value of the stock.

The IRS argued that the consideration was 100% (rather than the 75% upfront PVFC amount plus the 5% lending fee, for a total of 80%), because TAC was entitled to retain 50% of the appreciation in the stock subject to the PVFCs during the term of the PVFCs, as well as any dividends, and that these rights could be valued as equity options.  The IRS claimed that along with DLJ’s fees for structuring the transaction, these options were worth the 20% difference between the 80% upfront receipts to TAC and the full fair market value of the stock.

The taxpayers argued that TAC executed two separate transactions, one by the PVFCs, and the other by the SLAs, and that the transactions were open, not closed, with the result that no sale had occurred.

The Tax Court didn’t agree:

We agree with respondent that the shares subject to the VPFCs and lent pursuant to the SLAs were sold for Federal income tax purposes. TAC transferred the benefits and burdens of ownership to DLJ in exchange for valuable consideration. Petitioners must recognize gain in an amount equal to the upfront cash payments received upon entering into the transactions.

TAC entered into an integrated transaction comprising two legs, one of which called for share lending. The transaction comprised PVFCs and SLAs. The two legs were clearly related and interdependent, and both were governed by the MSPA.

It probably wasn’t helpful for the taxpayers that, as the Tax Court noted, presentations by DLJ provided an overview of the transaction as a whole, and stated that DLJ would borrow shares from TAC pursuant to the SLAs to cover its initial short sale obligation.

The Tax Court explained its holding as follows:

If we analyze the MSPA as a whole, it is clear that TAC transferred the benefits and burdens of ownership, including: (1) Legal title to the shares; (2) all risk of loss; (3) a major portion of the opportunity for gain; (4) the right to vote the stock; and (5) possession of the stock….TAC transferred all risk of loss and most of the opportunity for gain with regard to the stock subject to the PVFCs and lent to DLJ. TAC received 75 percent of the cash value of the stock up front. Even if the stock value fell over the term of the PVFCs, TAC would not have to pay any of this amount back. DLJ could do with the lent stock whatever it wanted and in fact disposed of the stock almost immediately to close out its original short sales….Petitioners’ argument might hold true if the SLAs were separate and distinct from the PVFCs. However, the two are linked, and we cannot turn a blind eye to one aspect of the transaction in evaluating another.

The overall outcome for the taxpayer was bad.  But the loss wasn’t total: the IRS lost its argument that TAC had realized 100% of the fair market value of shares subject to the PVFCs. Instead, the Tax Court found that although:

certain portions of TAC’s contracts can be valued as equity options representing TAC’s entitlement to some appreciation in price and future dividends, whether petitioners will ever receive that value will not be determined until the contracts are settled….Accordingly, petitioners must recognize gain to the extent TAC received cash upfront payments in 2000 and 2001, which would include the 75-percent payment based upon the fair market value of shares and the 5-percent prepaid lending fee.

The IRS also claimed, in the alternative, that TAC had caused constructive sales of the stock at issue under Section 1259.  The Tax Court disagreed with this argument, because TAC had eliminated its risk of loss through the PVFCs, but not its opportunity for income or gain.  Unfortunately, this conceptual win for the taxpayer didn’t change the practical result, because the IRS had won its first argument.

Anschutz is a significant decision because it may affect strategies high net worth individuals commonly use to hedge concentrated stock positions or avoid built-in gains tax from S corporations converted from C status within the previous ten years.  Further, Anschutz undercuts the positive treatment of prepaid variable forward contracts in Rev. Rul. 2003-7.  Advisors helping clients evaluate prepaid variable forward arrangements should note Anschutz carefully. Beyond the case’s particular facts, it also shows the broader risk of related transactions explained and “marketed” as a whole later being treated in like manner by the Tax Court.  If this unified treatment would be undesirable, one lesson of Anschutz is to be very careful in the creation and distribution of written materials that would suggest that separate transactions are part of a unified overall plan.

As noted by Prof. Paul Caron’s TaxProfBlog, David Cay Johnston argued in this blistering Tax Notes opinion piece that the Anschutz decision can be read for the proposition that the variable prepaid forwards arrangement would have passed muster if only DLJ hadn’t obtained the shares it needed to sell short to hedge its exposure under the VPFCs from Mr. Anschutz via the SLAs – and had rather obtained the shares it needed to sell short in the open market, from someone else.  Sourcing the short sale shares from a third party would have increased fees on the transaction by $1m to $1.8m, but this would have been a rounding error on the deal and only slightly offset the income tax savings. Johnston suggests that the IRS may have won the battle in Anschutz while losing the war against variable prepaid forwards more generally, at a cost of over $35 billion to the fisc.

By comparison, as Jeffrey Skatoff noted, the Congressional Budget Office has estimated that estate and gift taxes will raise only $15.4 billion in 2010. The revenue effects of variable prepaid forwards are over twice that of the entire transfer tax system, and yet variable prepaid forwards produce negligible political theatre, Senate votes, or think tank articles. It’s a Lewis Carroll kind of moment out there, readers, where things are getting “curiouser and curiouser” as we move through 2010, the year when estate tax repeal actually happened.

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