Government Argues to Second Circuit That Tax Court Made Monster Error

ESTATE OF ANDREW J. MCKELVEY, DECEASED;
BRADFORD G. PETERS, EXECUTOR
Petitioners-Appellees
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant

IN THE UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT

ON APPEAL FROM THE DECISION OF THE U.S. TAX COURT

OPENING BRIEF FOR THE APPELLANT
AND SPECIAL APPENDIX

DAVID A. HUBBERT
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG (202) 514-3361
JOAN I. OPPENHEIMER (202) 514-2954
CLINT A. CARPENTER (202) 514-4346
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

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TABLE OF CONTENTS

Table of contents

Table of authorities

Glossary

Statement of jurisdiction

Statement of the issues

Statement of the case

Summary of argument

Argument:

The decision of the Tax Court should be reversed because the modification of the VPFCs was a taxable event

Standard of review

Conclusion

Certificate of compliance

Special appendix

Certificate of service

TABLE OF AUTHORITIES

Cases

Anschutz Co. v. Commissioner, 664 F.3d 313 (10th Cir. 2011)

Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991)

Emery v. Commissioner, 166 F.2d 27 (2d Cir. 1948)

Foster v. United States, 329 F.2d 717 (2d Cir. 1964)

Gen. Elec. Co. v. Commissioner, 245 F.3d 149 (2d Cir. 2001)

Gluckman v. Commissioner, 545 F. App'x 59 (2d Cir. 2013)

Helvering v. Bruun, 309 U.S. 461 (1940)

Krumme v. WestPoint Stevens Inc., 238 F.3d 133 (2d Cir. 2000)

Pilgrim's Pride Corp. v. Commissioner, 779 F.3d 311 (5th Cir. 2015)

Progressive Corp. v. United States, 970 F.2d 188 (6th Cir. 1992)

Reily v. Commissioner, 53 T.C. 8 (1969)

Robinson v. Sheet Metal Workers' Nat'l Pension Fund, 515 F.3d 93 (2d Cir. 2008)

Skoros v. City of N.Y., 437 F.3d 1 (2d Cir. 2006)

Stavisky v. Commissioner, 34 T.C. 140 (1960)

Succession of Brown v. Commissioner, 56 T.C.M. (CCH) 1568 (1989)

United States ex rel. Keshner v. Nursing Pers. Home Care, 794 F.3d 232 (2d Cir. 2015)

United States v. Litvak, 808 F.3d 160 (2d Cir. 2015)

Vintero Corp. v. Corporacion Venezolana de Fomento, 675 F.2d 513 (2d Cir. 1982)

Welch v. Helvering, 290 U.S. 111 (1933)

Yee v. City of Escondido, 503 U.S. 519 (1992)

Statutes:

Internal Revenue Code (26 U.S.C.):

Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, § 507(a), 95 Stat. 172, 333

Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1003, 111 Stat. 788, 909–10

Rules:

Federal Rule of Appellate Procedure 13(a)(1)(A)

Local Rule 32.1(c)

Tax Court Rule 142(a)

Regulations:

Treasury Regulations (26 C.F.R.):

6 Williston on Contracts § 853 (3d ed. 1962)

Ashlea Ebeling, Monster Founder McKelvey's Estate Sidesteps Tax on $200 Million PPVF Capital Gain, May 18, 2017, https://www.forbes.com/sites/ashleaebeling/2017/05/18/monster-founder-mckelveys-estate-sidesteps-tax-on-200-million-ppvf-capital-gain/

David S. Miller et al., Tax Court Rules that Extensions of Variable Prepaid Forward Contracts Do Not Result in Taxable Exchanges, Tax Talks (Apr. 27, 2017), https://www.proskauertaxtalks.com/2017/04/tax-court-rules-that-extensions-of-variable-prepaid-forward-contracts-do-not-result-in-taxable-exchanges/

Ernst & Young LLP, Modification of variable prepaid forward contracts does not trigger gain realization, Tax Court holds, Tax News Update (Apr. 24, 2017), https://taxnews.ey.com/news/2017-0676-modification-of-variable-prepaid-forward-contracts-does-not-trigger-gain-realization-tax-court-holds

H.R. Rep. No. 97-201 (1981), reprinted in 1981-2 C.B. 352

James M. Peaslee, Modifications of Nondebt Financial Instruments as Deemed Exchanges, 95 Tax Notes 737 (Apr. 29, 2002)

John Kaufmann, Pontifications on McKelvey, 155 Tax Notes 1749 (June 19, 2017)

Mark Fichtenbaum & Robert Gordon, Estate of McKelvey v. Commissioner — Tax Planning Opportunity or a Trap for the Unwary?, 34 J. Tax'n Invs. 25 (Summer 2017)

Rev. Rul. 90-109, 1990-2 C.B. 191

Rev. Rul. 2003-7, 2003-1 C.B. 363

Robert W. Wood & Donald P. Board, Monster McKelvey Estate Tax Case and Litigation Finance, 156 Tax Notes 1299 (Sept. 4, 2017)

S. Rep. No. 97-144 (1981), reprinted in 1981-2 C.B. 412

T.D. 8675, 61 Fed. Reg. 32,926 (June 26, 1996)

GLOSSARY

Abbreviation	Definition
C.B.	Internal Revenue Cumulative Bulletin
I.R.C.	Internal Revenue Code (26 U.S.C.)
IRS	Internal Revenue Service
JA	Joint Appendix
SPA	Special Appendix
T.D.	Treasury Decision
Treas. Reg.	Treasury Regulations (26 C.F.R.)
VPFC	variable prepaid forward contract

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STATEMENT OF JURISDICTION

On August 14, 2014, the IRS issued a notice of deficiency to Bradford G. Peters, as the executor of the Estate of Andrew J. McKelvey, regarding taxpayer Andrew J. McKelvey's federal income tax liability for 2008. (JA 402.)¹ On November 10, 2014, taxpayer's estate and Peters, as executor, timely filed a petition in the Tax Court seeking a redetermination of the deficiency under § 6213(a) of the Internal Revenue Code of 1986, 26 U.S.C. (I.R.C. or the Code). (JA 4.) The Tax Court had jurisdiction under I.R.C. §§ 6214 and 7442.

On May 22, 2017, the Tax Court entered a decision for the estate, which disposed of all issues as to all parties. (SPA 38.) The Commissioner of Internal Revenue timely filed a notice of appeal on August 15, 2017. (JA 726); see I.R.C. § 7483; Fed. R. App. P. 13(a)(1)(A). This Court has jurisdiction under I.R.C. § 7482.

STATEMENT OF THE ISSUES

1. Whether taxpayer realized short-term capital gain upon the modification of his variable prepaid forward contracts with certain banks.

2. Whether taxpayer's entry into the modified contracts resulted in constructive sales of taxpayer's underlying shares of stock.

STATEMENT OF THE CASE

This case involves transactions whereby taxpayer sought to monetize his gains in appreciated stock, while seeking to avoid the substantial tax liability attendant upon a sale of the stock. To monetize those gains, taxpayer entered into two “variable prepaid forward contracts” (VPFCs) in 2007, which obligated him to deliver, in 2008, an amount of stock that would be determined based on the stock price on specified valuation dates. In exchange, taxpayer received prepayments in 2007 totaling $194 million, a sum of money over which he had complete dominion and control but on which neither he nor his estate ever paid income taxes.

Two months before taxpayer's delivery obligations were due, when he had substantial unrealized gains in the VPFCs, taxpayer paid his counterparties more than $11 million to extend the delivery and valuation dates of the VPFCs from September 2008 to early 2010. On his 2008 federal income tax return, taxpayer's estate did not report any income with respect to the modifications of the VPFCs.

The Commissioner determined that taxpayer, upon executing the modifications of the VPFCs in 2008, realized a capital gain of more than $200 million, consisting of (1) short-term capital gain from taxpayer's exchange of the original contracts for the modified contracts, and (2) long-term capital gain from the constructive sales of the number of shares of stock pledged under the VPFCs. But the Tax Court (Judge Robert P. Ruwe) disagreed, holding that the modification of the VPFCs did not result in a taxable disposition of property under I.R.C. § 1001 because, in the court's view, the VPFCs were not property to taxpayer at the time of the modifications. The Tax Court also rejected the Commissioner's constructive sale argument. The Tax Court's opinion is reported at 148 T.C. No. 13 (2017).

Because the parties stipulated to the factual record on which this case was decided (JA 201–04), the relevant facts are not in dispute. We summarize them below.

A. The original contracts

Andrew J. McKelvey (taxpayer) was the founder and chief executive officer of Monster Worldwide, Inc. (Monster), a company known for its website, monster.com, which helps inform persons seeking employment of job openings that match their skills and desired geographic location. (JA 208.) In September 2007, taxpayer entered into two VPFCs — one with Bank of America, N.A. and one with Morgan Stanley & Co. International plc (collectively, the banks). (JA 208–09, 218, 240.) Although the terms of the two VPFCs were not identical, the differences are generally immaterial, and we therefore treat the VPFCs collectively, except where otherwise noted.

Like stock options, futures, and forward contracts, a VPFC is type of financial instrument commonly known as a “derivative contract.” A standard forward contract is an executory contract in which a forward buyer agrees to purchase from a forward seller a fixed quantity of property at a fixed price, with both payment and delivery occurring at a specified future date. (SPA 12.) A VPFC is a variation of a standard forward contract, requiring the forward buyer to pay a forward price, discounted to present value, to the forward seller at the beginning of the contract, rather than at the date of contract maturity. (SPA 12–13.) In exchange for that cash prepayment, the forward seller must deliver to the forward buyer on a specified future date: (1) shares of stock that have been pledged as collateral at the inception of the contract; (2) identical shares of the stock that have not been pledged as collateral; or (3) an equivalent cash amount. (SPA 13.)

The number of shares (or cash equivalent) that the forward seller must deliver, however, is not fixed, but rather is determined by a formula that takes into account changes in the market price of the underlying stock over the contract duration. (Id.) The formula specifies both a floor price, which effectively guarantees the forward seller a minimum value for the shares involved in the agreement, as well as a cap price, which effectively places a ceiling on the forward seller's proceeds. (JA 157.)

VPFCs are often used by corporate insiders who own large equity positions in their own firms to raise cash and to hedge their risks, and they comprise an alternative to the open market sale of a large block of shares. (Id.) Like an open market sale, a VPFC provides the insider with immediate cash proceeds. (Id.) But unlike a sale, a properly structured VPFC allows the insider to defer recognition of capital gain because, under Revenue Ruling 2003-7, 2003-1 C.B. 363, a shareholder has not sold stock currently or caused a constructive sale of stock if he receives a fixed amount of cash and has simultaneously entered into an agreement that, inter alia, requires him to deliver on a future date a number of shares that varies depending on the value of the shares on the delivery date.

Under the VPFCs at issue here, taxpayer received cash prepayments from the banks totaling $194 million in September 2007. (JA 211, 213.) In exchange, taxpayer agreed to deliver to the banks between 5.4 million and 6.5 million shares of Monster stock (or their cash equivalent) one year later, in September 2008. (JA 75–77, 211–14.) Taxpayer secured that obligation by pledging 6.5 million shares of Monster stock that he owned (i.e., the maximum number he could be required to deliver), which at the time were worth approximately $217 million. (JA 196–97, 209, 212–14.)

Within the contractual range of 5.4 million to 6.5 million shares, the precise number of shares (or cash equivalent) that taxpayer would be required to deliver would depend on the stock market closing price of Monster shares on ten specified valuation dates in September 2008. (JA 160–63, 211–14.) Although the details varied slightly between the two VPFCs, essentially three different scenarios were contemplated (id.):

When taxpayer entered the Bank of America VPFC, which set a floor price of $30.461 per share, the closing price of Monster stock was $32.91. (JA 209, 211.) And when taxpayer entered the Morgan Stanley VPFC, which set a floor price of $30.894 per share, the closing price of Monster stock was $33.47. (JA 209, 213.) As of those dates, the probability that the share price would still exceed the VPFCs' floor prices one year later, on the September 2008 valuation dates, was between 52% and 54%. (JA 199.)

As it turned out, however, the price of Monster stock declined substantially during the life of the VPFCs and averaged only $17.727 on the September 2008 valuation dates. (JA 291.) Accordingly, if taxpayer's obligations under the original contracts had remained in effect until that time, then he would have been required to deliver the contractual maximum of 6.5 million shares, which were then worth approximately $115 million, or an equivalent amount of cash. (See JA 211–214.) But taxpayer avoided that result by modifying his obligations as follows.

B. The amended contracts

When taxpayer entered into the original contracts in September 2007, the total value of the 6.5 million shares he had pledged (i.e., the maximum number he could be obligated to deliver) was $217 million. (JA 196–97.) By July 2008, however, Monster stock had significantly declined in value, hovering around $18 per share on the NASDAQ (JA 290–291), barely half of each VPFC's respective floor price (JA 211, 213). So at that time, the total value of the pledged shares had declined by about $103 million. (JA 196–97.) As a result, in July 2008, taxpayer was only two months away from realizing a large taxable gain.

But that month, taxpayer paid the banks $11 million in exchange for their agreement to extend the valuation and settlement dates of the VPFCs for more than a year.² (JA 209, 214–15, 252–53, 255–56.) Thus, in July 2008, the contracts were amended to change the valuation and settlement dates from the original dates in September 2008 to new dates in January and February 2010. (Id.) The other terms and conditions of the contracts were unchanged. As of the dates of the July 2008 amendments, the probability that the share price would recover enough to exceed the floor price on the new valuation dates in January and February 2010 was between 12% and 15%. (JA 199.)

C. The Commissioner's determination of a tax deficiency

Taxpayer died on November 27, 2008. (JA 210.) His estate filed his 2008 federal income tax return, which reported no income with respect to the amendment of the VPFCs. (JA 299.)

In 2009, taxpayer's estate settled the amended contracts early by delivering 6.5 million shares to the banks. (JA 215–16.) On the dates of delivery, those 6.5 million shares were worth only about $88 million, the price of Monster stock having fallen even further since the contracts were amended. (JA 215–16, 293–94.) But even though the banks had paid taxpayer $194 million for those shares, his estate claimed a $3,000 loss from the stock sale on its 2009 tax return. (JA 46–47.) This loss apparently resulted from the estate's using a date-of-death basis for the shares, see I.R.C. § 1014, and from the decline in the Monster stock's value from the date of death to the settlement dates.³

The Commissioner determined a deficiency of more than $41 million in taxpayer's 2008 federal income tax based on his determination that taxpayer, upon executing the two VPFC extensions in 2008, realized a capital gain of more than $200 million. (JA 406–07.) This gain consisted of two separate components: (1) short-term capital gain resulting from taxpayer's exchange of the original contracts for the amended contracts, and (2) long-term capital gain resulting from constructive sales of the number of Monster shares pledged under the VPFCs. (JA 407.)⁴

To determine the value of the contracts and, thus, the amount of short-term capital gain that resulted from taxpayer's exchange of the original contracts for the amended contracts, the Commissioner relied on the analysis of his expert, Dr. Hendrik Bessembinder. Dr. Bessembinder explained that from the selling shareholder's perspective, a VPFC is economically identical to a combination of (1) a discount loan (which the seller repays with stock or cash on the VPFC's maturity date); (2) a long European “put” option with an exercise price equal to the floor price specified in the VPFC; and (3) a short European “call” option with an exercise price equal to the cap price specified in the VPFC.⁵ (JA 158, 166, 173–74.)

Accordingly, the value of a VPFC at a given point in time can be determined using standard valuation methods for debt and options. (JA 158, 167.) The Commissioner's expert valued the discount loans embedded in taxpayer's contracts with the banks by using U.S. Treasury interest rates, and he valued the embedded options by using the Black-Scholes option-pricing formula. (JA 174–75.) Under this formula, the premium on a stock option is determined by the following factors: (1) the market price of the underlying stock on the valuation date; (2) the risk-free interest rate on the valuation date; (3) the period between the purchase of the option and the option expiration; (4) the option strike price; (5) the volatility of the rate of change in the spot price of the underlying stock; and (6) the dividend yield. (JA 169.)

According to the expert, the extension of the VPFC maturity dates was economically identical to exchanging the existing VPFCs for new VPFCs with later maturity dates. (JA 180.) By virtue of the extensions, the existing discount loan obligation was, in effect, exchanged for a new discount loan obligation calling for the payment of the same dollar amount at a later date, and the existing put and call options were, in effect, exchanged for new options that were identical but for a later maturity date. (Id.)

D. The Tax Court proceedings

The estate commenced a Tax Court action. (JA 4.) On joint motion of the parties, the case was decided without trial based on stipulated facts, including the stipulated report of the Commissioner's expert regarding valuation. (JA 201–04.) The Commissioner argued that the 2008 VPFC modifications changed the fundamental substance of the contracts, resulting in a deemed exchange of the original contracts for the amended contracts on which taxpayer realized short-term capital gain under I.R.C. § 1001 on the appreciated value of the original contracts. (E.g., JA 565–77, 599–601.)

Section 1001(a) provides that “[t]he gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis. . . .” And Treas. Reg. § 1.1001-1(a) provides that a “disposition of property” includes an “exchange of property for other property differing materially either in kind or in extent.” The Commissioner also argued that taxpayer's entry into the amended contracts constituted a “constructive sale” under I.R.C. § 1259 of the number of Monster shares pledged under the VPFCs. (JA 611–25.)

The estate conceded that the extension of the VPFC maturity dates was economically identical to exchanging the original contracts for new contracts with later maturity dates. (JA 474.) But the estate argued that the VPFCs were not property to taxpayer at the time of the amendments because taxpayer then had only obligations under the VPFCs, and that, in any case, the modifications did not “fundamentally change” the terms of the VPFCs so that they can properly be treated as effecting an exchange of contracts. The estate also argued, however, that a conclusion that § 1001 is inapplicable does not end the inquiry. (JA 87 n.12; JA 690.) Rather, the proper “question for [the Tax] Court [was] whether the contract amendments . . . so fundamentally changed the essence of Mr. McKelvey's obligations that they should be treated as having been satisfied and replaced with new obligations.” (JA 694.)

The Tax Court held that § 1001 was inapplicable because at the time of the contract modifications, the VPFCs were not “property” under § 1001 with respect to taxpayer. (SPA 23.) The court reasoned that after taxpayer had received his cash prepayments from the banks, his lone right under the VPFCs was satisfied. Thereafter, taxpayer had only delivery obligations under the contracts, and obligations (the court held) are not property of the obligor. (SPA 22.)

Having decided the “property” issue in taxpayer's favor, the court added that its holding was consistent with the “open transaction” treatment afforded to sales of property under VPFCs satisfying the requirements of Revenue Ruling 2003-7, 2003-1 C.B. 363.⁶ (SPA 24.) The court reasoned that the extensions of the settlement and valuation dates did not clarify the uncertainty as to which property taxpayer would ultimately deliver to settle the contracts; he could use stock with a higher or lower basis than the stock pledged as collateral. The amount and character of the gain or loss taxpayer would realize on the forward sale, therefore, still remained uncertain. (SPA 30.)

Finally, the court rejected the Commissioner's argument that taxpayer's entry into the amended contracts was a constructive sale of appreciated stock under I.R.C. § 1259. Without reaching the substance of the Commissioner's argument, the Tax Court concluded that the Commissioner's contention that the amended contracts should be viewed as separate instruments under § 1259 lacked merit based on its earlier conclusions that there was not an exchange of the original contracts for the amended contracts, and that the open transaction treatment continued when taxpayer executed the extensions. (SPA 36.)

SUMMARY OF ARGUMENT

Taxpayer sold appreciated stock for $194 million in cash without paying a dime of federal income tax. The Commissioner determined a tax deficiency of over $41 million for 2008 resulting from taxpayer's exchange of the original contracts for the amended contracts and the constructive sale of approximately 6.5 million shares of taxpayer's Monster stock. The Tax Court's holding that no income tax liabilities resulted from these transactions is erroneous as a matter of law.

1. Taxpayer must recognize short-term capital gain on the appreciated value of the original contracts. Contrary to the Tax Court's opinion, the modification of the contracts to change the valuation dates is properly treated as a taxable exchange of property, i.e., of the original contracts for the amended contracts, under I.R.C. § 1001. Alternatively, it is properly treated as a taxable termination of taxpayer's original obligations (and replacement with amended obligations) resulting in the realization of gain under I.R.C. § 61 and § 1234A.

a. An “exchange of property for other property differing materially either in kind or in extent” is a taxable “disposition of property” under I.R.C. § 1001. Treas. Reg. § 1.1001-1(a). The Tax Court acknowledged that the VPFCs were property to taxpayer when he entered into them. But citing no authority, the Tax Court stated that the VPFCs must have been “property” to taxpayer based on rights existing at the time of the extensions and that the VPFCs failed to meet that test because taxpayer's rights under the VPFCs to payments totaling $194 million had already been satisfied.

That narrow approach to the question of “property” under § 1001 is unprecedented. The VPFCs imposed bilateral obligations to buy and sell stock at a future date, and our research has revealed no other case in which a court has ever held that a bilateral financial instrument ceased to be property to one party for purposes of § 1001 as soon as the other party has performed its obligations. The VPFCs were property to both parties at inception and should be treated as such until both parties have satisfied their obligations.

Moreover, extending the valuation dates of the VPFCs was a “fundamental or material change” resulting in a deemed exchange of the original contracts for the amended contracts. Rev. Rul. 90-109, 1990-2 C.B. 191, 192. The VPFCs were not just agreements to deliver Monster stock on certain future dates; they were “bets” on the value of Monster stock on those future dates. And by more than doubling the time to maturity, the extension of the VPFCs fundamentally changed those bets.

The economics of the extensions illustrate the fundamental nature of the change. To change the maturity dates of the VPFCs, the banks required additional consideration of $11 million from taxpayer. And just as stock options that differ only in their maturity dates are economically distinct contracts with different market values, so too are VPFCs that differ only in their maturity dates. Accordingly, the extension of the valuation dates was a “fundamental change” to the terms of the VPFCs and is therefore treated as a taxable exchange of the original contracts for the amended contracts under § 1001.

b. Alternatively, the extension of the valuation dates is properly treated as a taxable termination of taxpayer's obligations under the original contracts. Courts have long recognized that a taxpayer realizes gain upon relief from a liability, and I.R.C. §§ 61(a)(3) and 1234A establish that a termination of a taxpayer's obligations with respect to capital property results in taxable capital gain or loss.

The modification, or deemed termination, of taxpayer's original obligations is analogous to the extension of a call option. The owner and the writer of a call option may agree to extend the term of the option. This is a taxable event to the call writer under I.R.C. § 1234(b) (assuming the extension is material) because the statute and regulations treat the extension as a termination of the call writer's obligations under that option. Likewise, the extension of the valuation and settlement dates of the VPFCs is a deemed termination of taxpayer's obligations under the original contracts and results in taxable gain under §§ 61(a)(3) and 1234A. Thus, even if this Court were to agree with the Tax Court that the VPFCs were not property to taxpayer for purposes of § 1001, the extension of their valuation dates would still be a taxable event under §§ 61(a)(3) and 1234A because, in substance, it terminated taxpayer's original obligations thereunder and replaced them with fundamentally different obligations.

Although the Commissioner did not rely on § 1234A in the proceedings below, the issue whether taxpayer realized gain on a deemed termination of his obligations under the original contracts was placed squarely before the Tax Court by the estate itself, which argued that issue at length. Furthermore, the Commissioner properly presented to the Tax Court his argument that taxpayer's modification of the VPFCs resulted in the realization of short-term capital gain, and it is well settled that once a federal claim is property presented, an appellant can raise an argument in support of that claim that was not raised below. Accordingly, the Commissioner may rely on the termination of taxpayer's obligations in support of taxpayer's realization of short-term capital gain. Finally, this Court has frequently exercised its discretion to entertain new arguments on appeal where necessary to prevent injustice or where the argument presents a question of law and there is no need for additional fact-finding. Those conditions are satisfied here.

2. Taxpayer must also recognize long-term capital gain because, in the circumstances of this case, his entry into the amended contracts effected a constructive sale of 6.5 million shares of his appreciated Monster stock under I.R.C. § 1259. In general, a constructive sale under § 1259 occurs whenever a taxpayer holds an appreciated position and enters into a “forward contract” to deliver appreciated stock or certain other types of appreciated property. For purposes of § 1259, a “forward contract” is “a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.”

When taxpayer entered the amended contracts in July 2008, the price of Monster stock had plummeted to barely more than half of the respective floor prices. For example, on the day he entered into the amended Morgan Stanley contract, the NASDAQ closing price of Monster stock was only $17.28, while the contract's floor price was $30.894. At that point, the probability that the share price of Monster stock would recover enough to exceed either contract's floor price, even with the additional time provided by the extended valuation dates, was less than 15%. Therefore, the likelihood that the number of shares taxpayer would be required to deliver would vary at all from the contractual maximum was less than 15%. And the likelihood that the number of shares would vary “substantially” was necessarily even lower. Accordingly, the number of Monster shares to be delivered under the amended contracts was “substantially fixed” at the contractual maximum of 6.5 million shares, the amended contracts were therefore “forward contracts” for purposes of § 1259, and taxpayer's entry into those contracts constituted a constructive sale of 6.5 million shares of his Monster stock.

The decision of the Tax Court should be reversed and remanded for further proceedings to calculate the proper amount of the tax deficiency in this case.

ARGUMENT

The decision of the Tax Court should be reversed because the modification of the VPFCs was a taxable event

Standard of review

Where, as here, a decision of the Tax Court is based on a stipulated record, this Court's review is de novo. Gen. Elec. Co. v. Commissioner, 245 F.3d 149, 154 (2d Cir. 2001); Gluckman v. Commissioner, 545 F. App'x 59, 62 (2d Cir. 2013) (summary order); see also I.R.C. § 7482(a)(1) (providing that Tax Court decisions shall be reviewed on appeal “in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury”); Skoros v. City of N.Y., 437 F.3d 1, 13 (2d Cir. 2006) (“Where . . . a case is tried on a stipulated record, our review is de novo because the district court's rulings are necessarily conclusions of law or mixed fact and law.”); Robinson v. Sheet Metal Workers' Nat'l Pension Fund, 515 F.3d 93, 98 (2d Cir. 2008) (“Because the district court's judgment was based entirely on a stipulated record, our standard of review . . . is de novo.”).

Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that the determinations are erroneous. See, e.g., T.C. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

A. Introduction

Through the transactions in this case, taxpayer sold appreciated stock for cash prepayments totaling $194 million, a sum of money over which he had complete dominion and control, but on which he paid zero federal income tax. The Tax Court's opinion endorsing that scheme opens the door for any taxpayer with unrealized stock gains to monetize those gains during his or her lifetime by entering into a VPFC, while deferring indefinitely and, ultimately, avoiding taxation simply by extending the valuation and settlement dates, more than once, if necessary, until the taxpayer's death.⁷ Unsurprisingly, the federal tax laws do not countenance that result.

As we explain below, taxpayer's extension of the valuation dates of his VPFCs fundamentally changed the “bet” that those instruments represented on the future value of Monster stock, and it is therefore treated, for tax purposes, as a termination of the original contracts and replacement with the amended contracts. That has two tax consequences for taxpayer. First, taxpayer must recognize short-term capital gain on the value of the original contracts, which appreciated substantially between their inception and their deemed termination. And second, taxpayer must recognize long-term capital gain on the 6.5 million shares of Monster stock that he pledged (or an equal number of his other Monster shares) because, in the circumstances of this case, his entry into the amended contracts effected a constructive sale of those shares under I.R.C. § 1259.

B. Taxpayer realized short-term capital gain on the appreciated value of the VPFCs because the modifications, in substance, terminated the original contracts and replaced them with different contracts

At the time of the modifications, taxpayer had substantial unrealized gains in the VPFCs because of the drop in the price of Monster stock. Although the underlying sale of Monster stock remained an “open transaction,” taxpayer realized gains on the VPFCs when they were amended to extend the valuation dates because that fundamentally changed the “bet” those instruments represented on the future value of Monster stock on the valuation dates. Such a change required taxpayer to recognize short-term capital gain on the VPFCs under either of two legal theories. First, as the Commissioner argued in the Tax Court, the change in valuation dates is properly treated as a taxable exchange of property, i.e., of the original contracts for the amended contracts, under I.R.C. § 1001. Alternatively, it is properly treated as a taxable termination of taxpayer's original obligations (and replacement with amended obligations) resulting in the realization of gain under I.R.C. §§ 61 and 1234A.

In either case, the tax analysis and tax consequences are the same: taxpayer was required to recognize his short-term capital gain on the appreciated value of the VPFCs at the time of the modifications because the modifications materially altered the terms of the original contracts.

1. The Commissioner correctly treated the modification of the VPFCs as a taxable exchange of the original contracts for the amended contracts under I.R.C. § 1001

Section § 61(a)(3) of the Internal Revenue Code sets forth the general rule that “[g]ains derived from dealings in property” must be included in a taxpayer's gross income. Where such dealings involve a “sale or other disposition” of the property itself, the gain is generally determined and recognized under § 1001. I.R.C. § 1001(a)–(c). And under the regulations, the dispositions of property that are subject to § 1001 include an “exchange of property for other property differing materially either in kind or in extent.” Treas. Reg. § 1.1001-1(a); see also Cottage Savings Ass'n v. Commissioner, 499 U.S. 554, 556 (1991) (lender realized deductible loss when it exchanged its participation interests in one group of residential mortgage loans for another lender's interests in a different group of residential mortgage loans).

The Commissioner argued in the Tax Court that the modification of the VPFCs resulted in a deemed exchange of the original contracts for the amended contracts under § 1001, which required taxpayer to recognize his gain on the value of the original contracts. The Tax Court rejected this argument, reasoning that the VPFCs were not “property” to taxpayer for purposes of § 1001 because, at the time of the modifications, taxpayer held only obligations under the VPFCs. That was error, for the reasons we explain below.

a. The Tax Court erred in holding that the VPFCs were not “property” to taxpayer for purposes of § 1001

The Tax Court acknowledged that the VPFCs were property to taxpayer when he entered into them. (SPA 22.) But citing no authority, the court concluded that § 1001 could not apply to the modifications of the VPFCs unless taxpayer had property rights in the VPFCs that had not yet been satisfied at the time of the modifications. The court thus excluded from its analysis taxpayer's rights to the prepayments totaling $194 million.

That narrow approach to the question of “property” under § 1001 is unprecedented. The VPFCs imposed bilateral obligations to buy and sell stock at a future date. They were property to taxpayer because they entitled him to $194 million in exchange for his promise to deliver the specified amount of stock (or its cash equivalent). And they were property to the banks because they entitled the banks to the specified amount of stock (or its cash equivalent) in exchange for their payment of the $194 million. The mere fact that the VPFCs required the banks to perform their payment obligations before taxpayer performed his stock-delivery obligations is immaterial. Indeed, our research has revealed no other case in which a court has ever held that a bilateral financial instrument ceases to be property to one party for purposes of § 1001 as soon as the other party has performed its obligations.

The gain that the Commissioner seeks to tax under § 1001 is taxpayer's gain on the appreciated value of the contracts at the time of the modifications. And the Commissioner's position is that taxpayer realized that gain under § 1001 as a result of a deemed exchange of the original contracts for the amended contracts. Thus, for that exchange to constitute an exchange of “property,” it is the contracts that must be property. Accordingly, the “property” question under § 1001 is whether the contracts as a whole were property to taxpayer, which they clearly were because they entitled him to $194 million.

The regulation concerning modifications of debt instruments, Treas. Reg. § 1.1001-3, although not directly applicable here, illustrates that the question whether a thing is “property” for purposes of § 1001 does not turn on whether the taxpayer's property rights in the thing have already been satisfied at the time of disposition. Just as the Tax Court concluded that taxpayer had only obligations under the VPFCs at the time of the modifications, the issuer of a debt instrument, by definition, can likewise have only obligations when the instrument is modified. See Treas. Reg. §§ 1.1001-3(f)(5)(i), 1.1275-1(d). Thus, under the Tax Court's approach, a debt instrument could never be “property” — within the meaning of § 1001 — to the issuer at the time of modification.

But § 1.1001-3 makes clear that the question whether a debt instrument is “property” is not a question of rights versus obligations at the time of modification. Indeed, a debt instrument's status as “property” is not in question at all under the regulation. Although the issuer of a debt instrument necessarily has only obligations, the regulation holds that a “significant” modification “of a legal right or obligation of the issuer or a holder of a debt instrument” is a deemed exchange of “property” within the meaning of § 1001.⁸ Treas. Reg. § 1.1001-3(b), (c)(1)(i) (emphasis added).

The Tax Court's erroneous approach to the “property” question is not only inconsistent with the broad interpretation of “property” reflected in Treas. Reg. § 1.1001-3, but it also would produce inconsistent results for economically similar derivative financial instruments. For example, the tax treatment of a VPFC would differ from a standard forward contract with payment at the time of the settlement. And it would likewise produce inconsistent results between the parties to many financial instruments, either because, as here, one party satisfied its obligations first, or because, as often happens, the instrument changes from an asset to a liability as to one party, and vice versa as to the other party, based on changes in market prices. Cf. Stavisky v. Commissioner, 34 T.C. 140, 142 (1960) (“We . . . are not prepared to hold that a given transaction is or is not a sale or exchange from day to day depending on the vagaries of the securities market.”), aff'd, 291 F.2d 48 (2d Cir. 1961). As one commentator has argued:

Debt and other contractual rights are typically, in market value terms, a net asset of one party and a net liability of the other (although with executory contracts, which is which can switch over time). Based on the statute, it could be argued that § 1001 exchange principles should be applied only to the party holding the asset (the property owner). That approach clearly is not reflected in the law governing debt instruments [i.e., Treas. Reg. § 1.1001-3], however, and there seems to be no reason to follow a different, one-sided approach for other financial products. Thus, a contract modification that is a realization event for one party should be a realization event for the other.

James M. Peaslee, Modifications of Nondebt Financial Instruments as Deemed Exchanges, 95 Tax Notes 737, 755 (Apr. 29, 2002).

Here, the VPFCs were property to taxpayer when he entered into them and, viewed as a whole, when they were modified. And they were at all times property to the banks. That is more than enough to establish that the original contracts were “property” for purposes of determining whether the parties' exchange of those contracts for the amended contracts was a taxable event under § 1001. The rule invented by the Tax Court — that § 1001 cannot apply to the modification of a bilateral financial instrument unless, at that time, the taxpayer still had unsatisfied rights under the instrument — should be rejected.

b. The amended contracts were materially different from the original contracts

As discussed above, gain or loss realized “from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained.” Treas. Reg. § 1.1001-1(a). Thus, the “material difference” requirement is the legal standard for determining when an exchange of properties results in a realization event for purposes of I.R.C. § 1001. See Cottage Savings Ass'n, 499 U.S. at 560.

For non-debt instruments like the VPFCs, the standard is described in terms of “fundamental change.” As the estate correctly argued in the Tax Court: “a 'sufficiently fundamental or material change' to an original contract that results in 'a change in the fundamental substance of the original contract' will be considered an exchange of the original contract for the amended contract.” (JA 470 (quoting Rev. Rul. 90-109, 1990-2 C.B. 191, 192).)

In Revenue Ruling 90-109, the IRS held that changing the person insured under a life insurance contract (even though the contract expressly allowed such a change) was “a sufficiently fundamental or material change” because “the essence of a life insurance contract is the life that is insured under the contract.” 1990-2 C.B. at 192. Reasoning that such “a change in the fundamental substance of the original contract” is “substantively the same as an actual exchange of contracts,” the IRS held that the change “is treated as an exchange under section 1001,” i.e., “the old contract is treated as if it were actually exchanged for a new one.” Id. And subsequent administrative guidance endorsed “the application of the 'fundamental change' concept articulated in Rev. Rul. 90-109” to modifications of non-debt financial instruments generally. T.D. 8675, 61 Fed. Reg. 32,926, 32,927 (June 26, 1996).

Here, the modification of the VPFCs was just such a “fundamental change” because the time to maturity goes to the very essence of a derivative contract that is tied to the value of publicly traded stock on a certain date. The VPFCs were not just agreements to deliver Monster stock on certain future dates; they were “bets” on the value of Monster stock on those future dates. The higher the value of Monster stock on the valuation dates, the greater the amount of taxpayer's delivery obligation and the banks' return on their investments. The lower the stock value on the valuation dates, the lower the amount of taxpayer's obligation and the banks' return.

By extending the valuation dates, the parties fundamentally changed the bets that the VPFCs represented, from bets on the value of Monster stock in September 2008 to bets on the value of Monster stock in January and February 2010.⁹ Those changes are no less “fundamental” to the substance of the VPFCs than the change of the person insured under the life insurance contract at issue in Revenue Ruling 90-109, especially since, unlike the life insurance contract, the VPFCs did not specifically contemplate the changes at issue.

That the amended contracts were fundamentally different from the original contracts is illustrated by the economics of the extensions. Taxpayer paid the banks more than $11 million as consideration for those extensions. (JA 209, 214–15, 252–53, 255–56.) Indeed, the estate conceded “that the extensions of the VPFCs can be viewed as the economic equivalent of exchanging one set of contracts for new ones and that the extensions had economic value to Mr. McKelvey.” (JA 474.)

Treating the extension of the VPFCs' valuation dates as a “fundamental change” resulting in a deemed exchange of the original contracts for the amended contracts is also consistent with the usual treatment of extensions of option contracts. As any option trader knows, options that differ only in their maturity dates are nevertheless economically distinct contracts with different market values.¹⁰ (JA 169.) This is easily demonstrated by comparing prices of real-world options that are identical except for their maturity dates. For example, on September 11, 2007, when taxpayer entered the first of the VPFCs, a call option on Monster stock with a strike price of $35 could be had on the open market for $0.35 with a maturity date later that same month, $2.55 with a maturity date in January 2008, and $6.10 with a maturity date in January 2009. (JA 170.)

Thus, “[t]he authorities on modifications of options . . . indicate that the term of an option goes to the heart of the arrangement and accordingly a negotiated extension of the exercise date is almost invariably considered a § 1001 exchange.” Peaslee, supra, at 766. For example, Reily v. Commissioner, 53 T.C. 8 (1969), and Succession of Brown v. Commissioner, 56 T.C.M. (CCH) 1568 (1989), both involved situations in which the holders of options negotiated extensions of the options shortly before or at the time of expiration. And in both cases, the Tax Court recognized that a separately negotiated extension of the term of an option, paid for with separate consideration, is a new option contract for tax purposes. The courts reasoned that “[a]n option is a contract which gives the optionee a right to buy, sell, lease or the like within a certain period of time. This time factor or limitation in an option is of the essence. It goes to the very nature of an option.” Reily, 53 T.C. at 12 (emphasis added) (citing 6 Williston on Contracts § 853 (3d ed. 1962)); accord Succession of Brown, 56 T.C.M. (CCH) at 1572–73 (following Reily because “[t]he time limitation in an option is critical”).

Here, the time to maturity was equally essential to the nature of the VPFCs. The extension of the valuation dates more than doubled the time to maturity from September 2008 to January and February 2010, fundamentally changing the underlying bet. That is why the banks required consideration of more than $11 million for the modifications. (JA 180–82.)

In short, because the extensions of the valuation dates were a “fundamental change” to the terms of the VPFCs, they are treated as a taxable exchange of the original contracts for the amended contracts under § 1001. See, e.g., Emery v. Commissioner, 166 F.2d 27, 29–30 (2d Cir. 1948) (holding that exchange of bonds was a taxable exchange of property “for other property differing materially either in kind or in extent” under predecessor of § 1001 because “[t]hat the public considered the difference [between the old and new bonds] material is shown by the fact that the market value of the new bonds was higher than that of the old bonds which were still outstanding when the exchange was complete”; “a showing that the new bonds brought more in the market than the old is as good an indication as we can ask that they were something different”). As a result, taxpayer was required to recognize his short-term capital gain on the appreciated value of the original contracts.

c. The Tax Court's reliance on the “open transaction” doctrine was misplaced

Under the “open transaction” doctrine, a shareholder who enters into a properly structured VPFC generally does not recognize gain or loss on the underlying stock sale until the VPFC is settled. The IRS has ruled that a shareholder —

Rev. Rul. 2003-7, 2003-1 C.B. at 365. The shareholder recognizes gain or loss on the stock when the VPFC is settled, rather than when it is entered into, because he retains the right to substitute collateral until the settlement date and because it is impossible to know how many shares will be delivered until the settlement date.

But contrary to the Tax Court's opinion (SPA 24–34), these principles do not support its holding that taxpayer realized no taxable gain upon the modification of the VPFCs. The issue before the court was whether the modification of the VPFCs triggered realization of taxpayer's gain on the VPFCs themselves, but the court's “open transaction” analysis considered instead the realization of gain on the underlying stock. Although the court was correct that the modification of the VPFCs did not resolve the uncertainties as to how many shares would be delivered and at what price, that was never the issue. Instead, the gain to be recognized is the gain resulting from the increased value of the original contracts from their inception in 2007 to their modification in 2008, the amount of which is readily ascertainable.

Revenue Ruling 2003-7 addresses only the application of § 1001 to a VPFC's underlying stock-sale transaction; it does not address the application of § 1001 to a VPFC that is exchanged at a gain or loss before the stock sale closes, and it is therefore inapposite. Cf. Anschutz Co. v. Commissioner, 664 F.3d 313, 330 (10th Cir. 2011) (“The problem with petitioners' reliance on Revenue Ruling 2003-7 is that the transactions at issue in this case, considered as a whole, are different from the entirety of the transactions at issue in Revenue Ruling 2003-7.”). In relying on the open transaction doctrine, the Tax Court confused realization of gain on the exchange of the original contracts with realization of gain on the underlying sale of Monster stock.

2. Alternatively, the modification of the VPFCs is properly treated as a taxable termination of taxpayer's obligations under the original contracts

Even if this Court were to agree with the Tax Court that § 1001 does not apply, the modification of the VPFCs would still be a taxable event because, in substance, it terminated taxpayer's original obligations and replaced them with fundamentally different obligations. Indeed, the estate expressly conceded in the Tax Court that a termination of taxpayer's obligations under the VPFCs would be a taxable event. (See, e.g., JA 92 (acknowledging that taxpayer “could have realized gain or loss if he had terminated early all or part of his obligations under the VPFCs”); JA 690 (“WHETHER THE EXTENSIONS OF THE VPFCS RESULTED IN GAIN RECOGNITION TURNS ON WHETHER THEY CLOSED THE VPFCS OR OTHERWISE TERMINATED MR. MCKELVEY'S OBLIGATIONS.” (emphasis in original)).) That is because “it is settled that the realization of gain need not be in cash derived from the sale of an asset. Gain may occur as a result of exchange of property, payment of the taxpayer's indebtedness, relief from a liability, or other profit realized from the completion of a transaction.” Helvering v. Bruun, 309 U.S. 461, 469 (1940) (emphasis added; footnote omitted).

Like all taxable income, the gain that a taxpayer realizes upon “relief from a liability” (or “other profit realized from the completion of a transaction”) is included in the taxpayer's gross income under I.R.C. § 61(a). See, e.g., Bruun, 309 U.S. at 468–69 (applying § 22(a) of the Revenue Act of 1932, 47 Stat. 169, 178, which is a predecessor of the current I.R.C. § 61(a)). And where that gain is “derived from dealings in property,” it is defined as “gross income” in § 61(a)(3). Whether that income is then taxed as ordinary income or as capital gain is determined under § 1234A, which provides:

I.R.C. § 1234A(1). Taken together, these authorities establish that the termination of a taxpayer's obligations with respect to capital property is a taxable capital gain or loss to the taxpayer.

Here, the VPFCs were indisputably “dealings in property” within the meaning of I.R.C. § 61(a)(3), whether or not they were themselves property, because the VPFCs applied to taxpayer's Monster stock. And it is indisputable that taxpayer's Monster's stock was “property which [was] a capital asset in the hands of the taxpayer” and that the VPFCs imposed obligations on taxpayer “with respect to [that] property” (or its cash equivalent). I.R.C. § 1234A(1); see also Pilgrim's Pride Corp. v. Commissioner, 779 F.3d 311, 315 (5th Cir. 2015) (“By its plain terms, § 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets).”).

Thus, the only question is whether, in substance, the modification of the VPFCs terminated taxpayer's obligations under the original contracts. See id. at 317 (holding under § 1234A(1) that “[c]apital gain or loss results from the termination of contractual or derivative rights with respect to capital assets.”). For the reasons we explain below, it did. Accordingly, even if the modification did not result in a taxable exchange of “property” under § 1001, taxpayer nevertheless realized — and was required to recognize as income — capital gain on the termination of his obligations. See I.R.C. §§ 61(a)(3), 1234A. And because taxpayer held his obligations under the original contracts for less than one year, the capital gain resulting from their termination is taxed as short-term capital gain. See I.R.C. §§ 1222(1), 1234A.

a. The extension of the valuation dates terminated taxpayer's obligations under the original contracts and replaced them with fundamentally different obligations

As we have explained, supra pp. 34–40, a “fundamental change” to the terms of a non-debt financial instrument is deemed to terminate the original instrument and replace it with a new instrument. See T.D. 8675, 61 Fed. Reg. at 32,927; Rev. Rul. 90-109, 1990-2 C.B. at 192. And as we have shown, supra pp. 35–39, the extension of the VPFCs' valuation dates was just such a “fundamental change” because it went to the very essence of the contracts, changing them from a “bet” on the value of Monster stock on certain dates in September 2008 to a “bet” on the value of Monster stock on certain dates in early 2010. Accordingly, taxpayer is deemed to have exchanged the original contracts for the amended contracts, thereby terminating his obligations under the original contracts and replacing them with fundamentally different obligations.

To be sure, the administrative guidance that articulated the “fundamental change” rule arose in the context of § 1001, but that is only because (as we have explained, supra pp. 30–34) financial instruments and other contracts are generally treated as property for tax purposes and, thus, their exchange is generally an exchange of property under § 1001. The rationale for the rule, however, is in no way contingent on whether an instrument is property to the taxpayer; in either case, “a change in the fundamental substance of the original contract” is still “substantively the same as an actual exchange of contracts.” Rev. Rul. 90-109, 1990-2 C.B. at 192. And because a deemed exchange of a contract for a fundamentally different contract must necessarily be deemed to terminate the original contract, it is no less appropriate to rely on the “fundamental change” rule to determine whether there has been a deemed termination of obligations for purposes of § 1234A than a deemed exchange of property for purposes of § 1001.

Indeed, the estate itself argued below that the “question for this Court is whether the contract amendments . . . so fundamentally changed the essence of Mr. McKelvey's obligations that they should be treated as having been satisfied and replaced with new obligations.” (Doc 21 at 56 (emphasis added).) And even before the IRS articulated the “fundamental change” rule, courts had applied the same principle outside the context of § 1001. See Reily, 53 T.C. at 12–13 (holding that option “granted for a different period” and “for a new consideration” was not a mere extension of the prior option, but rather “was a new and different option,” for purposes of the long-term capital gain holding period); Succession of Brown, 56 T.C.M. (CCH) at 1572–73 (following Reily).

Moreover, treating the modification of the VPFCs as a deemed termination of taxpayer's original obligations, resulting in taxable capital gain under § 1234A, is consistent with the Code's treatment of call options under § 1234.¹¹ A call option is a type of derivative contract that is in many ways similar to a VPFC. For example, in a call option with respect to shares of stock, the buyer of the option pays the seller (or “writer”) of the option an upfront premium in exchange for the right, but not the obligation, to buy from the writer a specified number of shares for a fixed “strike” price by a certain date. Like a call writer, the short party to a VPFC receives cash in exchange for an obligation to deliver shares, and the value of VPFCs, like the value of call options, depends heavily on the volatility of the underlying stock and the length of time to maturity. Thus, as the Tax Court correctly noted, under the VPFCs, taxpayer “was similarly situated to the writer of a call option, as he received an upfront payment and maintained an obligation to deliver property at a future date.” (SPA 31.)

The Tax Court failed to appreciate, however, that the modification of taxpayer's obligation to deliver property under the VPFCs was analogous to “rolling forward” a call option, which is a taxable event to the option writer under I.R.C. § 1234(b). Just as taxpayer paid the banks a premium to extend the valuation and settlement dates of the VPFCs, writers of call options can, and often do, pay a premium to extend the maturation date of a call option. Commonly known as a “roll forward,” the writer first repurchases the call option from the holder and then immediately writes (i.e., sells) a new call option on the same property but with a longer term.

That is a taxable event to the call-writer because § 1234(b) and the regulations thereunder treat the writer's repurchase of the original call option as a termination of the writer's obligations under that option. Section 1234(b)(1) provides that the grantor of an option must recognize short-term capital gain or loss “from any closing transaction with respect to . . . an option in property.” Section 1234(b)(2)(A) then defines “closing transaction” as “any termination of the taxpayer's obligation under an option in property other than through the exercise or lapse of the option.” And under Treas. Reg. § 1.1234-3(b)(1)(i), “[r]epurchasing the [call] option from the holder” is identified as one such “closing transaction” because it “effectively terminate[s] [the grantor's] obligation under the option.”

Thus, extending a call option's maturation date requires the writer of the option to recognize gain or loss on the deemed termination of his original obligations. See I.R.C. § 1234(b); Treas. Reg. § 1.1234-3(b)(1). That gain or loss does not result from any disposition of the stock or other assets that are the subject of the option. Rather, it results from the decrease or increase in the value of the taxpayer's obligation since the time the option was sold. Because taxpayer here was similarly situated to the writer of a call option, and because the extension of a call option's maturation date is analogous to the extension of the valuation and settlement dates of the VPFCs, it is appropriate to treat the latter as a deemed termination of taxpayer's obligations for purposes of § 1234A. Kaufmann, supra, at 1751.

Treating the extension of the VPFCs' valuation dates as a taxable termination of taxpayer's obligations under the original contracts is also consistent with the purpose of § 1234A. Congress enacted § 1234A in 1981 to ensure that gains or losses from transactions that are economically equivalent to a sale or exchange of a capital asset receive similar tax treatment, i.e., as capital gains or losses.¹² H.R. Rep. No. 97-201, at 212 (1981), reprinted in 1981-2 C.B. 352, 480. Congress “believe[d] that the change in the sale or exchange rule [wa]s necessary to prevent tax-avoidance transactions designed to create fully-deductible losses on certain dispositions of capital assets, which if sold at a gain, would produce capital gains.” S. Rep. No. 97-144, at 170 (1981), reprinted in 1981-2 C.B. 412, 480. And as an example of the targeted problem, Congress highlighted “transactions involving cancellations of forward contracts.” Id.

In the transactions sanctioned by the Tax Court here, taxpayer effectively canceled two forward contracts by fundamentally changing their terms in a way that allowed him not only to further defer realization of his gains on a $194 million stock transaction, but also to avoid taxation of those gains entirely by virtue of the stepped-up basis upon his death. See I.R.C. § 1014(a), (b)(1). Treating the modification of those contracts as a deemed termination of taxpayer's obligations thereunder, resulting in taxable capital gain under § 1234A, is therefore fully consistent with § 1234A's purpose of preventing tax avoidance.

b. The question whether taxpayer realized gain on a termination of his obligations was squarely before the Tax Court and, in any event, may properly be considered by this Court

Because the Commissioner did not rely on § 1234A in the proceedings below, the estate will likely argue that we forfeited our alternative argument that the modification of the VPFCs resulted in a taxable termination of obligations. If this Court agrees with the Commissioner's argument under § 1001 that the modification of the VPFCs resulted in a taxable exchange of property, then the question of forfeiture is moot. But if the Court instead agrees with the Tax Court that § 1001 is inapplicable, then the Court can and should consider the Commissioner's alternative argument under § 1234A.

The issue whether taxpayer realized gain on a deemed termination of his obligations under the original contracts was placed squarely before the Tax Court by the estate itself. Indeed, the estate argued that “the only way that tax could be imposed in respect of those contracts would be if, by purchasing contract extensions, Mr. McKelvey either extinguished his obligations or so fundamentally altered them that they should be deemed extinguished.” (JA 641.) Of course, the estate also argued that the modification of the VPFCs did not result in a taxable exchange of property under § 1001, which was the only issue the Tax Court addressed. But as the estate conceded, that “does not answer the question, 'what is the proper tax analysis of whether the extension of time to satisfy his contractual obligations required Mr. McKelvey to recognize gain or loss?'” (JA 690.)

Thus, the estate's reply brief in the Tax Court contained the following argument heading: “II. THE PROPER ANALYSIS OF WHETHER THE EXTENSIONS OF THE VPFCS RESULTED IN GAIN RECOGNITION TURNS ON WHETHER THEY CLOSED THE VPFCS OR OTHERWISE TERMINATED MR. MCKELVEY'S OBLIGATIONS.” (Id. (emphasis in original).) The estate argued that the question whether the extensions “terminated Mr. McKelvey's obligations” depends, in turn, on “whether the contract amendments . . . so fundamentally changed the essence of Mr. McKelvey's obligations that they should be treated as having been satisfied and replaced with new obligations.” (JA 694 (emphasis added).)¹³

That is the very issue that the Commissioner is arguing here, and there can be no dispute that it was raised in the proceedings below by the party who bore the burden of persuasion. Moreover, while neither party relied on § 1234A, that statute establishes only that taxpayer's gain on the termination of his liabilities is taxed as capital gain, rather than ordinary income, and there has never been any dispute in this case that the gain taxpayer realized, if any, was capital gain. Accordingly, the Commissioner's alternative argument was not forfeited.

Furthermore, it is well settled that “[o]nce a federal claim is properly presented, a party can make any argument in support of that claim; parties are not limited to the precise arguments they raised below. Yee v. City of Escondido, 503 U.S. 519, 534 (1992); accord United States v. Litvak, 808 F.3d 160, 175 n.17 (2d Cir. 2015) (appellant “is not limited to the precise arguments he made before the District Court . . ., and may submit additional support for a proposition presented below”) (internal quotation marks and citations omitted); Vintero Corp. v. Corporacion Venezolana de Fomento, 675 F.2d 513, 515 (2d Cir. 1982) (“Arguments made on appeal need not be identical to those made below, however, if the elements of the claim were set forth and additional findings are not required.”).

There can be no question that the Commissioner properly presented to the Tax Court his argument that taxpayer's modification of the VPFCs resulted in the realization of short-term capital gain. Whether that was because the exchange of the original contracts was an exchange of property or because it terminated taxpayer's obligations thereunder, the claim, the ultimate issue, and the tax result are the same. Accordingly, the Commissioner may rely on either theory on appeal, whether or not he relied on it below.

Finally, even if the question whether the VPFC modifications resulted in a taxable termination of taxpayer's obligations under the original contracts is considered an entirely new issue raised for the first time on appeal, this Court can and should exercise its discretion to consider it. To be sure, appellate courts generally decline to consider issues raised by an appellant for the first time on appeal. But that general rule is “prudential, not jurisdictional,” and this Court has “exercised [its] discretion to entertain new arguments where necessary to avoid a manifest injustice or where the argument presents a question of law and there is no need for additional fact-finding.” United States ex rel. Keshner v. Nursing Pers. Home Care, 794 F.3d 232, 234 (2d Cir. 2015) (internal quotation marks omitted); accord Krumme v. WestPoint Stevens Inc., 238 F.3d 133, 142 (2d Cir. 2000).

The Commissioner's alternative argument under § 1234A presents just such a question of law, and the facts of this case are stipulated. Accordingly, the question whether taxpayer realized taxable capital gain on a deemed termination of his obligations under the original contracts falls within a recognized exception to the general prohibition of new issues on appeal. See, e.g., Foster v. United States, 329 F.2d 717, 718 (2d Cir. 1964) (noting that appellant's contentions on appeal in tax refund case were “wholly different from the points raised in the court below, but since only a question of law is involved, we will proceed to consider them.”); Krumme, 238 F.3d at 142 (considering new issue on appeal where “[t]he facts underlying the [new issue] have been fully set out during a decade of litigation” and the issue raised “is purely a question of law”).

Not only does the question whether taxpayer realized short-term capital gains from a deemed termination of his obligations under the original contracts present a pure issue of law, but it is in the interests of justice for this Court to consider this issue. The abusive scheme sanctioned by the Tax Court enabled taxpayer to avoid tax on short-term capital gains exceeding $80 million. The Tax Court's decision, if allowed to stand, will encourage any taxpayer with unrealized stock gains to monetize those gains by entering into a VPFC, while deferring realization indefinitely by continually rolling over the VPFC and, upon death, avoiding taxation entirely by virtue of the stepped-up basis of the underlying stock.¹⁴ Indeed, since the Tax Court's endorsement of taxpayer's scheme, tax professionals are watching this case closely to see whether the “enormous” and “almost too good to be true” implications of the Tax Court's “highly unexpected” decision withstand scrutiny, while “[m]ore than a few” are already “trying to work this new arrow into their quiver[s].” Fichtenbaum & Gordon, supra, at 25–26 (2017); Wood & Board, supra, at 1299; see generally Ebeling, supra; Kaufmann, supra; Miller et al., supra; Ernst & Young LLP, supra.

C. Taxpayer also realized long-term capital gain on the underlying stock because his entry into the amended contracts was a constructive sale of that stock under I.R.C. § 1259

Because the extension of the VPFCs' valuation dates resulted in a deemed exchange/termination of the original contracts, the amended contracts are treated as new contracts for tax purposes. In the circumstances of this case, taxpayer's entry into those amended contracts resulted in a “constructive sale” of the appreciated Monster shares pursuant to I.R.C. § 1259, on which he realized long-term capital gain.

In relevant part, § 1259 provides that a “constructive sale” occurs whenever a taxpayer (1) holds an “appreciated financial position” in stock or certain other types of property,¹⁵ and (2) “enters into a . . . forward contract to deliver the same or substantially identical property.” I.R.C. § 1259(b)(1), (c)(1)(C). Satisfying both of these elements results in a “constructive sale” of the “appreciated financial position,” on which the taxpayer “shall recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale.”¹⁶ I.R.C. § 1259(a)(1).

Here, the estate “readily acknowledge[d]” in the Tax Court “that both at the time of Mr. McKelvey's initial entry into the VPFCs and when the VPFCs were extended, all of his Monster shares were an appreciated financial position” within the meaning of § 1259(b). (JA 110.) Thus, the only question is whether taxpayer “enter[ed] into a . . . forward contract to deliver” any appreciated shares “or substantially identical property.” I.R.C. § 1259(c)(1)(C).

Critically, however, the term “forward contract” is defined more narrowly in § 1259 than in common usage. For purposes of § 1259, a “forward contract” is “a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.” I.R.C. § 1259(d)(1) (emphasis added). As a result, a prepaid forward contract in which the amount of shares to be delivered is not substantially fixed, like the original contracts in this case, is not a “forward contract” within the meaning of § 1259(d)(1). See Rev. Rul. 2003-7, 2003-1 C.B. at 365. And accordingly, the Commissioner does not contend that taxpayer's entry into the original contracts triggered a constructive sale of his appreciated Monster shares.

The amended contracts, however, are a different story. Under both the original and amended contracts, the number of shares to be delivered could vary only if, on the valuation dates, the share price exceeded the floor prices set by contracts. If the share price did not exceed the applicable floor price, then taxpayer was obligated to deliver the contractual maximum number of shares — i.e., the number of shares he pledged, which was approximately 6.5 million. When taxpayer entered the original contracts, the share price was above the floor prices (JA 159–60), and the chances that it would still exceed the floor prices on the original valuation dates were better than even (JA 199).

But when taxpayer entered the amended contracts in July 2008, the price of Monster stock had plummeted to barely more than half of the respective floor prices. On the day he entered the amended Morgan Stanley contract, the NASDAQ closing price of Monster stock was only $17.28, compared to that contract's floor price of $30.894. (JA 209, 213.) And the closing price when he entered the amended Bank of America contract a few days later was only $18.24, compared to that contract's floor price of $30.461. (JA 210, 211.) Moreover, on the dates of the amended contracts, the probability that the share price of Monster stock would recover enough to exceed the respective floor price on the extended valuation dates was less than 15%.¹⁷ (JA 199.)

Thus, when taxpayer entered the amended contracts, the likelihood that the number of shares he would be required to deliver would vary at all from the contractual maximum was less than 15%. (JA 182, 199.) And the likelihood that the number of shares would vary “substantially,” I.R.C. § 1259(d)(1), from the contractual maximum was necessarily even lower. For example, if the share price somehow defied the odds and closed at $31.00 on the extended valuation dates, then the floor prices would be exceeded, but the number of shares to be delivered would decrease by less than 50,000 shares, or less than 0.8%. (JA 190, 193.)

Because the probability of any substantial variation in the number of shares to be delivered was well below 15% when taxpayer entered the amended contracts, the number of Monster shares to be delivered thereunder was “substantially fixed” at the contractual maximum number of shares, and the amended contracts were therefore “forward contracts” under § 1259(d)(1). Consequently, under § 1259, taxpayer's entry into the amended contracts was a constructive sale of approximately 6.5 million shares of his Monster stock, on which taxpayer was required to recognize gain as if those shares had been sold at their fair market value on the dates of the amended contracts. Cf. Progressive Corp. v. United States, 970 F.2d 188, 193 (6th Cir. 1992) (concluding that the exercise of “in-the-money” call options, “that is, call options that are sold with a striking price below the market price of the underlying stock on the date that the option is written, . . . may be virtually guaranteed,” and remanding the issue to the district court to determine whether the call options written by the taxpayer “were so deep-in-the-money,” “i.e., so far below the market trading price on the day they were sold,” “as to be the equivalents of . . . contractual obligations to sell [the underlying stock]”).

CONCLUSION

The decision of the Tax Court should be reversed and remanded for further proceedings to compute the proper amount of taxpayer's tax deficiency.

Respectfully submitted,

DAVID A. HUBBERT
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG (202) 514-3361
JOAN I. OPPENHEIMER (202) 514-2954
CLINT A. CARPENTER (202) 514-4346
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

NOVEMBER 2017