2nd Circuit overturns Tax Court ruling on constructive sale transaction

Tax Hot Topics newsletterThe 2nd Circuit Court of Appeals reversed the Tax Court’s decision in Estate of McKelvey, et. al. v. Commissioner (No. 17-2554), and remanded the case to determine the amount of gain to the taxpayer.

McKelvey was the founder of Monster Worldwide, Inc. (Monster) and held Monster stock with an unrealized gain. He entered into variable prepaid forward contracts (VPFC) with respect to some of his Monster shares. Pursuant to the VPFCs, McKelvey received a cash payment upfront from the counterparties, which was equal to a substantial portion of the value of the shares. In exchange for the cash payment, McKelvey was obligated to deliver Monster shares on specified settlement dates. The amount of such shares was contingent on the trading price of Monster shares. The VPFCs were intended to be treated as open transactions similar to Rev. Rul. 2003-7.

Prior to the settlement dates, McKelvey paid cash to the counterparties to extend the settlement of each VPFC for more than one year. At the time, McKelvey would have been required to deliver all of the underlying Monster shares unless the share price increased significantly.

The IRS contended that McKelvey should have short-term capital gain on the extension dates related to the VPFCs under Section 1001. The Tax Court concluded that Section 1001 did not apply because the VPFCs did not constitute property to McKelvey. The 2nd Circuit Court agreed that Section 1001 did not apply, but also analyzed the facts under Section 1234A and concluded that McKelvey realized short-term gain because his obligations under the initial VPFCs were terminated when the VPFCs were amended.

The IRS also claimed that McKelvey should have had long-term capital gain upon the extension of each VPFC pursuant to Section 1259(a), which provides that a taxpayer must recognize gain related to an “appreciated financial position” if such taxpayer enters into a “constructive sale” of such position. A constructive sale under Section 1259 includes a forward contract with respect to such appreciated financial position, which is a contract to deliver a substantially fixed amount of property at a substantially fixed price.

The IRS contended that the amount of Monster shares to be delivered was substantially fixed at the time of each extension, so Section 1259 should apply. An expert analysis cited by the court provided that there was an 85% to 87% probability that all of the Monster shares subject to the VPFC would be delivered upon the settlement. The 2nd Circuit Court agreed with the IRS that the taxpayer should have long-term gain resulting constructive sales of the Monster shares under Section 1259.

Josh Brady
Principal, Washington National Tax Office
T +1 202 521 1563

Jeff Borghino
Partner, Washington National Tax Office
T +1 202 521 1532

Bryan Keith
Managing Director, Washington National Tax Office
T +1 202 861 4116

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