Wealthy clients sometimes have a lot of one particular stock in their investment portfolio. This can be risky because if the stock loses value, the client could lose a lot of money. To reduce this risk, clients can enter into a special agreement with a buyer, usually a big bank. The bank gives the client a cash payment now, and in a few years, the client must give the bank a variable number of shares of the stock. The client gets to keep the cash payment, no matter what happens to the stock. If the stock goes up in value, the client gets to keep some of the extra money. If the stock goes down in value, the client might have to give the bank more shares. The client can also choose to give the bank cash or other stocks instead of the original stock. A VPFS is a way for an investor to get some money now for their stock, without having to pay taxes on it right away. This lets the investor diversify their investments and protect themselves if the stock goes down. They still get a share of any future increase in the stock’s value. However, it can be tricky to know for sure if this setup qualifies for tax deferral. The IRS has given some guidance, but it’s still not completely clear. In a specific case, a taxpayer got a cash payment in exchange for agreeing to give a variable number of shares of stock later. The more the stock was worth later, the fewer shares they had to give. This ruling helped clarify how these types of arrangements might be treated for tax purposes. The taxpayer used 100 shares of stock as collateral for a financial agreement. The IRS determined that the taxpayer did not technically sell the shares and did not trigger any tax consequences. The IRS also found that the agreement did not count as a forward contract, which would have triggered tax consequences. The IRS said that a certain kind of financial transaction called a Variable Prepaid Forward Sale (VPFS) can defer income tax consequences until a later date. But many current VPFS transactions don’t qualify for this tax deferral because they don’t meet the specific rules set out by the IRS. In a specific case, the IRS ruled that a VPFS was taxable at the beginning of the transaction, not at the future settlement date, because it included a share lending arrangement. This means that the taxpayer had to pay taxes on the transaction right away. In this situation, the taxpayer pledged some shares to a trustee, who then lent them to someone else. The borrower of the shares can use them to minimize their risk in a deal, and they have all the rights of ownership over the shares while they have them. The IRS looked at a complex stock transaction where one party borrowed and sold the stocks that were supposed to be part of the deal. Even though the other party still had some rights to the stocks, the IRS said that those rights didn’t matter because the other party couldn’t get the stocks back. They also said that a tax rule that lets you delay paying taxes on certain stock deals didn’t apply here because the party gave up too much control over the stocks. And they said that a rule that lets you delay paying taxes because you can’t figure out the value of something didn’t apply either, because the value of the stocks was easy to figure out. The IRS issued a memo to clarify its stance on certain financial transactions that involve share lending agreements. The memo said that these transactions are taxable as a sale at the beginning of the deal, not at the end when it’s settled. This is different from a previous ruling that said the tax is due at the settlement date. The only difference between the two cases is the presence of a share lending agreement, which changed the IRS’s decision. The IRS looked at three agreements together as one transaction because they were all related to each other. In one case, the person who gave the shares as collateral still had rights to vote and get dividends. But in the other case, the person who borrowed the shares could sell them and take away those rights. This meant that the person who gave the shares as collateral could not easily get back the same shares. The IRS says that a specific type of financial arrangement called a Variable Prepaid Forward Sale (VPFS) with a share lending agreement is taxable from the beginning. This means that the person who enters into the agreement has to pay taxes on it right away, even if they haven’t sold the shares yet. The IRS says that the other party in the agreement gets most of the benefits and risks of owning the shares, so it’s like they’ve already bought them. This applies even if the person who entered into the agreement can still get some benefits from the shares. The IRS repeated this position in a guidance paper to make sure all IRS examiners apply the same rules. The IRS analyzed a situation where a taxpayer deposited shares into a pledge account for someone else’s benefit. The other party could sell, use, or dispose of the shares as they wanted. The IRS decided that this counted as a sale of the shares for tax purposes when the agreement was made. This decision was based on factors like who has control of the shares, who gets the profits, and who takes on the risk. The IRS says that if the other party can use the shares freely, it counts as a sale, even if they don’t actually do anything with them. The IRS says that in a certain situation, the taxpayer kept some rights to the shares they put up as collateral, so it was okay for them to defer taxes. But in a different situation, where the taxpayer didn’t have those rights, they couldn’t defer taxes. The IRS warns that if taxpayers don’t follow the rules, they might have to pay penalties. So, if you want to use this kind of structure to save on taxes, make sure you follow the rules. The IRS currently treats certain stock transactions as sales, even though they used to be taxed differently. Taxpayers who disagree may face penalties. Until this changes, it’s best to be careful when advising clients on these transactions. William R. Swindle, a tax expert, suggests caution and has a lot of experience in this area. This article is written by a member of the Tax Section, which is a group for lawyers who focus on tax law. The article expresses the author’s opinions and doesn’t necessarily represent the views of Wachovia Bank. The purpose of the Tax Section is to promote duty and service to the public, improve the justice system, and advance the study of law.
Source: https://www.floridabar.org/the-florida-bar-journal/the-irss-derivative-treatment-of-variable-prepaid-forward-sales/
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