A Very Pricey Forward Contract? Estate of McKelvey Says Think Twice Before Amending Your Variable Prepaid Forward Contract

From time to time, an extended deadline can be a big relief. In some cases, however, that extension comes at a price. For Monster.com founder Andrew McKelvey, the decision to extend two variable prepaid forward contracts (together, the "VPFCs") came at the steep price of recognizing $71 million of short-term capital gain. In Estate of McKelvey v. Commissioner, the Tax Court and Second Circuit demonstrated why start-up founders, early employees and investors should think carefully before seeking to extend or amend VPFCs or other similar arrangements. Properly structured, a VPFC can provide the seller with an attractive combination of upfront liquidity and income recognition deferral.

A Monster of a Deal

In September 2007, McKelvey entered into two VPFCs, one with Bank of America and the other with Morgan Stanley. The concept of each VPFC was the same. McKelvey would deliver shares of Monster.com stock (or a cash equivalent) to each bank on specified settlement dates in September 2008. The exact number of shares or cash McKelvey would transfer was contingent on Monster.com's stock price at the time of the settlement dates. In return, McKelvey would receive immediate up-front cash payments of nearly $200 million combined.

This is a popular VPFC arrangement that appears to have been designed to map onto the favorable guidance provided in Rev. Rul. 2003-7. More specifically, Rev. Rul. 2003-7 provides that:

A shareholder has neither sold stock currently nor caused a constructive sale of stock if shareholder receives a fixed amount of cash, 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, pledges the maximum number of shares for which delivery could be required under the agreement, retains an unrestricted legal right to substitute cash or other shares for the pledged shares, and is not economically compelled to deliver the pledged shares.

Put simply, this sort of transaction is treated as "open" rather than "closed" for federal income tax purposes. Under the open transaction doctrine, a taxpayer is not required to report income in situations where that income is speculative, or may never be received.¹ Further, at the time the agreement is entered into, it is not known whether the taxpayer will transfer any shares at all, so any income is speculative and the transaction remains open.

Unfortunately for McKelvey, 2008 was not a banner year for the stock market, and by July 2008, a share of Monster.com stock was worth roughly half of what it had been worth in September 2007. In the face of a less favorable outcome under his VPFCs as the settlement dates approached, McKelvey sought to amend their terms. In July 2008, McKelvey paid the banks a combined $11 million to extend the settlement dates for his VPFCs to early 2010, by which time the price of his stock would hopefully rebound. McKelvey did not alter his treatment of the VPFCs for tax purposes, and did not report the cash payments he received on his 2007 or 2008 returns.

Case Procedure

The IRS disagreed with McKelvey's decision to treat his VPFCs as open transactions following the amendments. The IRS argued that because McKelvey amended his original VPFCs, his situation was different. The IRS' position was that McKelvey effectively exchanged his original VPFCs for a new, second set of VPFCs. In the IRS' view, that "exchange" constituted both a sale or exchange of property under Internal Revenue Code ("IRC") section 1001 and a constructive sale under IRC section 1259. The IRS concluded that, as a result of amending the VPFCs, McKelvey recognized a significant amount of capital gain.

The Tax Court initially ruled in McKelvey's favor, but the Second Circuit disagreed. According to the appellate court, by amending each VPFC, the parties "changed the bets that the VPFCs represented," which constituted a "fundamental change" to the contract.² Under existing IRS precedent, a fundamental change in a contract could lead to a taxable gain event under IRC section 1001.³ The Second Circuit remanded the case to the Tax Court, which was tasked with determining whether McKelvey terminated his underlying obligations by amending the VPFCs. If McKelvey did terminate his underlying obligations, he would recognize capital gain under IRC section 1234A. Because IRC section 1234A determines whether an exchange of property qualifies as a short-term capital gain, IRC section 1001 would then be used to calculate that short-term capital gain.⁴

Legal Analysis

IRC section 1234A states that "gain or loss attributable to the cancellation, lapse, expiration, 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 or loss from the sale of a capital asset." The Tax Court found that, by paying to extend the settlement date for his VPFCs, McKelvey indeed terminated his underlying obligations and recognized capital gain under IRC section 1234A. The court based its decision on precedent dealing with tax treatment of options, stating, "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."⁵ Although VPFCs are not options, the court believed this rationale should apply to any open transaction with similar principles.

The court further noted that, in option contracts, the seller's obligations terminate when repurchasing an option from the holder.⁶ By treating the original VPFCs and amended VPFCs as two separate contracts, the court found that McKelvey (the seller) essentially repurchased his original VPFCs from the banks (the holders.) Applying this rationale, McKelvey had terminated his obligations.

McKelvey's estate argued that it was impossible to calculate gain at the time of the 2008 amendments because the VPFCs were still part of an open transaction. However, the court was not moved by the estate's arguments. Most notably, the court distinguished between whether the amendments replaced the prior agreements, or merely extended them. In the court's eyes, there was a difference between whether the parties extended their ongoing agreement (such as for a yearly option right), or replaced one agreement with another, as the Second Circuit found McKelvey did. The court also noted that the value of Monster.com stock was much lower than when the parties initially contracted. This goes to the Second Circuit's finding that McKelvey's amended contracts "changed the bets," and therefore caused a fundamental change.

Finally, the court found that it was actually possible to calculate gain in 2008. By terminating the first set of VPFCs, the parties also terminated all underlying uncertainty. The transferred cash and new obligations established by the amendments provided sufficient value and tax basis to calculate gain or loss, so McKelvey's initial VPFCs were not part of an open transaction. The Tax Court ultimately found that, because IRC section 1234A applied to McKelvey's amendments, McKelvey recognized $71 million of gain in 2008 under IRC section 1001.⁷

What Does This Mean for Founders and Early Employees?

VPFCs can be a useful tool for founders and early employees who are hoping to defer capital gain recognition on their shares. However, Estate of McKelvey shows that amending a VPFC can lead to the very outcome a shareholder specifically seeks to avoid through these contracts: early recognition of capital gain. These considerations are especially important for founders or early employees, who value such contracts for liquidity and likely have a basis of zero or near-zero.

Aside from a cautionary tale of VPFCs' potential volatility, Estate of McKelvey provides an interesting takeaway: the Tax Court finds that gain realization may depend on whether a VPFC is replaced or extended. Replacing one VPFC with another, as McKelvey did, is not a tax-efficient solution. However, if McKelvey had been able to extend his original VPFC, this entire debacle could have potentially been avoided.

For example, imagine that McKelvey and the banks negotiated into their original contract that each party maintained a one-time right to extend the settlement date. McKelvey's decision to extend the date would be less likely to constitute a "fundamental change" of the contract, because the parties agreed to those terms from the start. Negotiating this kind of term into a VPFC could offer both parties some protection against a worst-case scenario, while also avoiding early recognition for the shareholder.

However, the above approach requires proactivity. Those who agree to VPFCs with fixed settlement dates may later be forced to choose between a bad deal and a massive tax hit. Although each situation is unique, it seems prudent for founders and early employees who may wish to extend the term of their VPFC to bake such flexibility into the terms of their initial agreement.

Conclusion

The biggest takeaway from Estate of McKelvey is that founders and early employees entering into VPFCs or similar derivative agreements should negotiate the terms of these agreements carefully and thoughtfully. If there is a chance the deal will not work out in the seller's favor, that seller may not be able to amend the VPFC's terms without undesirable tax consequences. For more guidance on navigating these complicated issues, please contact Trent Tanzi, Daren Shaver, or another member of Hanson Bridgett's Tax group.

---

¹ Burnet v. Logan, 283 U.S. 404, 413 (1931).

² Estate of McKelvey v. Commissioner, 906 F.3d 26, 35 (2d Cir. 2018).

³ Rev. Rul. 90-109, 1990-2 C.B. at 192 ("A change in contractual terms effected through an option provided in the original contract is treated as an exchange under section 1001 if there is a sufficiently fundamental or material change that the substance of the original contract is altered through the exercise of the option.  Under such circumstances, the old contract is treated as if it were actually exchanged for a new one.")

⁴ The Second Circuit also remanded to the Tax Court to determine how much gain McKelvey recognized under IRC section 1259, but the Tax Court did not discuss this issue, as the parties stipulated to a number before trial.

⁵ Estate of McKelvey v. Commissioner, 161 T.C. No. 9 (2023), quoting Estate of McKelvey v. Commissioner, 906 F.3d 26, 35 (2d Cir. 2018); see also Rev. Rul. 78-182, 178-1 C.B. 265; Rev. Rul. 58-234, 1958-1 C.B. 279.

⁶ Laureys v. Commissioner, 92 T.C. 101, 102-104 (1989).

⁷ The court noted that IRC section 1001 only discusses "gain from the sale or other disposition of property," which is relevant because VPFCs are not property.  However, the underlying shares in the VPFCs are property.  The court decided that the nature of the underlying property controls, so IRC section 1001 also applies to VPFCs.