Menu
Tax Notes logo

McKelvey Estate Maintains Modifications Didn’t Result in Income

FEB. 27, 2018

Estate of Andrew J. McKelvey et al. v. Commissioner

DATED FEB. 27, 2018
DOCUMENT ATTRIBUTES

Estate of Andrew J. McKelvey et al. v. Commissioner

ESTATE OF ANDREW J. MCKELVEY,
DECEASED, BRADFORD G. PETERS, EXECUTOR,
Petitioner-Appellee,
v.

COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant.

United States Court of Appeals
for the
Second Circuit

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

BRIEF FOR THE PETITIONER-APPELLEE

MARK D. LANPHER (202) 508-8120
ROBERT A. RUDNICK (202) 508-8020
KRISTEN M. GARRY (202) 508-8186
SHEARMAN & STERLING LLP
401 9th Street, NW, Suite 800
Washington, DC 20004

Attorneys for Petitioner-Appellee


TABLE OF CONTENTS

TABLE OF CONTENTS

TABLE OF AUTHORITIES

STATEMENT OF ISSUES

STATEMENT OF THE CASE

I. Factual Background

II. Procedural History

SUMMARY OF THE ARGUMENT

ARGUMENT

I. The Tax Court Correctly Held that Mr. McKelvey Did Not Realize Short-Term Capital Gains upon the Extension of the VPFCs

A. The Extensions of the VPFCs Did Not Trigger Realization of Gain Because They Did Not Close and Complete Mr. McKelvey's Open Transactions

1. The VPFCs Were Open Transactions Consistent with Revenue Ruling 2003-7

2. The Extensions Did Not Resolve the Uncertainty that Precluded Realization of Gain or Loss in Connection with the VPFCs

3. The Extensions Did Not Result in a Deemed Exchange of Property or a Termination of Mr. McKelvey's Obligations

a. Section 1001 Is Inapplicable Because the VPFCs Were Not Property to Mr. McKelvey at the Extension Dates

b. Sections 61 and 1234A Would Only Apply if the Extensions Provided Relief from a Liability through a Termination of Mr. McKelvey's Obligations

c. Extending the Settlement Dates of the VPFCs Did Not Terminate or Lessen Mr. McKelvey's Obligations and Would Not Have Resulted in an Exchange of Property if the VPFCs Were His Property

B. The Commissioner's Suggestions of Abuse Are Specious

II. The Tax Court Correctly Found that the Extension of the VPFCs Did Not Result in Long-Term Capital Gain Recognition under Section 1259

A. The Extensions Did Not Trigger an Opportunity to Reevaluate the VPFCs for Purposes of Section 1259

B. Even if the VPFCs Were Reevaluated as New Contracts as of the Extension Dates, They Would Not Constitute Forward Sales of a Substantially Fixed Amount of Property Under Section 1259

CONCLUSION

CERTIFICATE OF COMPLIANCE

CERTIFICATE OF SERVICE

TABLE OF AUTHORITIES

Cases

Albany Car Wheel Co. v. Comm'r, 40 T.C. 831 (1963), aff'd, per curiam, 333 F.2d 653 (2d Cir. 1964)

Anschutz Co. v. Comm'r, 135 T.C. 78 (2010), aff'd, 664 F.3d 313 (10th Cir. 2011)

Beatty v. Comm'r, 46 T.C. 835 (1966) 

Bingham v. Comm'r, 27 B.T.A. 186 (1932)

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

City Bank Farmers Tr. Co. v. Hoey, 52 F. Supp. 665 (S.D.N.Y. 1942)aff'd, 138 F.2d 1023 (2d Cir. 1942)

Connecticut Nat'l Bank v. United States, 937 F.2d 90 (2d Cir. 1991)

Cottage Sav. Ass'n v. Comm'r, 499 U.S. 554 (1991)

Dunlap v. Comm'r, 670 F.2d 785 (8th Cir. 1982)

Emery v. Comm'r, 166 F.2d 27 (2d Cir. 1948)

Fed. Home Loan Mortg. Corp. (Freddie Mac) v. Comm'r, 125 T.C. 248 (2005)

Helvering v. San Joaquin Fruit & Inv. Co., 297 U.S. 496 (1936)

Hendricks v. Comm'r, 423 F.2d 485 (4th Cir. 1970)

Hicks v. Comm'r, T.C. Memo. 1978-373, 37 T.C.M. (CCH) 1540 (1978)

Motor Prods. Corp. v. Comm'r, 47 B.T.A. 983 (1942)

Olmsted Inc. Life Agency v. Comm'r, 35 T.C. 429 (1960), aff'd, 304 F.2d 16 (8th Cir. 1962)

Penn-Dixie Steel Corp. v. Comm'r, 69 T.C. 837 (1978)

Peterson's Estate v. Comm'r, 667 F.2d 675 (8th Cir. 1981)

Reily v. Comm'r, 53 T.C. 8 (1969)

Reinach v. Comm'r, 373 F.2d 900 (2d Cir. 1967)

Shafer v. United States, 204 F. Supp. 473 (S.D. Ohio 1962)

Slupinski v. First Unum Life Ins. Co., 554 F.3d 38 (2d Cir. 2009)

Stavisky v. Comm'r, 34 T.C. 140 (1960), aff'd, 291 F.2d 48 (2d Cir. 1961)

Succession of Brown v. Comm'r, T.C. Memo. 1989-133, 56 T.C.M. (CCH) 1568 (1989)

Virginia Iron Coal & Coke Co. v. Comm'r, 37 B.T.A. 195 (1938), aff'd, 99 F.2d 919 (4th Cir. 1938)

Wood v. Comm'r, T.C. Memo. 1985-517, 50 T.C.M. (CCH) 1232 (1985)

Statutes

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

§ 61

§ 61(a)

§ 1001

§ 1001(a)

§ 1014(a)

§ 1234

§ 1234(b)

§ 1234A

§ 1259

§ 1259(c)

§ 1259(d)

§ 1259(f)

Rulings

Rev. Rul. 70-452, 1970-2 C.B. 199

Rev. Rul. 73-160, 1973-1 C.B. 365

Rev. Rul. 73-524, 1973-2 C.B. 307

Rev. Rul. 77-374, 1977-2 C.B. 329

Rev. Rul. 78-255, 1978-1 C.B. 294

Rev. Rul. 84-121, 1984-2 C.B. 168

Rev. Rul. 85-23, 1985-1 C.B. 327

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

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

Rev. Rul. 2004-15, 2004-1 C.B. 515

Regulations

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

Treas. Reg. § 1.61-12(c)

Treas. Reg. § 1.1001-3(e)

Treas. Reg. § 1.1234-3(b)

Treas. Reg. § 1.1275-4(c)

Legislative Materials

S. Rep. No. 97-144 (1981)

S. Rep. No. 105-33 (1997)

Other Authorities

I.R.S. Chief Couns. Mem., 200515019 (Apr. 15, 2005)

I.R.S. Chief Couns. Mem., AM 2008-011 (Dec. 12, 2008)

2 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 40.8.1 (3d ed. 2000)

T.D. 8675, 1996–2 C.B. 60

U.S. DEP'T OF THE TREASURY, 2016-2017 PRIORITY GUIDANCE (Aug. 15, 2016)


STATEMENT OF ISSUES

1. Whether the Tax Court correctly held that Andrew McKelvey did not realize short-term capital gains when he and his counterparties extended the dates on which he was obligated to deliver a variable number of shares of stock or their cash equivalent under two variable prepaid forward contracts.

2. Whether the Tax Court correctly held that Andrew McKelvey did not constructively sell stock, requiring recognition of long-term capital gains, when he and his counterparties extended the dates on which he was obligated to deliver a variable number of shares of stock or their cash equivalent under two variable prepaid forward contracts.

STATEMENT OF THE CASE

The Tax Court correctly held that Mr. McKelvey did not realize or recognize any gains when he agreed with his counterparties to put off his obligations to deliver shares or cash in satisfaction of two variable prepaid forward contracts (“VPFCs”). There is no dispute that Mr. McKelvey did not realize gains when he entered into the VPFCs. Although Mr. McKelvey received upfront payments upon entering into the VPFCs, those payments would not result in realized gain or loss until Mr. McKelvey delivered property or cash in satisfaction of his resulting delivery obligations. There is also no dispute that, if Mr. McKelvey had originally entered into VPFCs of the length later agreed to with his counterparties, such longer-term VPFCs would not have been taxable at inception, and his estate (the “Estate”) would have been left in precisely the same position presented here. The only thing in dispute is whether the fact that Mr. McKelvey and his counterparties originally agreed to one set of settlement dates under the VPFCs and then later agreed to put those dates off by approximately 17 months changes this result. Put another way, the only thing in dispute is whether deferring Mr. McKelvey's obligations by 17 months triggered an independent realization or recognition of gain. It did not. When rhetoric and hyperbole are set aside, a straightforward application of both the law and common sense produces just one result: the Tax Court's decision should be affirmed.

I. Factual Background1

A VPFC is a transaction that provides a person with an upfront cash payment in return for the promise to deliver a variable amount of property (such as stock) or an equivalent amount in cash on a date in the future. (SPA 12-13.) Stockholders generally enter into VPFCs to hedge their risk that a stock's price will decline while retaining a portion of the future appreciation in the stock's price. (See JA 157-66.) A stockholder who enters into a VPFC does not commit to sell any particular amount of stock; VPFCs also allow stockholders to vote their shares throughout the term of a VPFC and to retain those shares at the conclusion of a VPFC by opting to settle in cash.

When a stockholder enters into a VPFC, it knows what consideration it will receive under the contract (an upfront payment of cash), but does not know what consideration it will eventually provide in exchange. Until the settlement date, the stockholder gives only its promise (secured by collateral) to deliver consideration in a form and amount that will not be determined until the settlement date. Thus, at the outset of a VPFC, the parties know the amount of the prepayment but do not know: (1) whether the stockholder will deliver stock or cash; (2) how much stock or cash will be delivered; or (3) the basis of any shares that will be delivered, in the event that the stockholder chooses to settle in stock. (See SPA 25-26.) Because knowledge of each of these components is needed to determine the amount and character of any gain or loss resulting from a VPFC, it is undisputed that no gain or loss is realized upon entry into a VPFC. See Rev. Rul. 2003-7, 2003-1 C.B. 363; (SPA 24-29.)

In September 2007, Andrew McKelvey entered into two VPFCs with respect to shares of Monster stock. (SPA 3-10; JA 208-13.) Under a VPFC with Bank of America, N.A. (“BofA”), Mr. McKelvey received $50,943,578.31 in exchange for a promise to deliver between 1,324,993 and 1,765,188 shares of Monster stock or their cash equivalent at the settlement date. (SPA 4; JA 211-13, 217-38.) Under a VPFC with Morgan Stanley & Co. International plc (“MSI”), Mr. McKelvey received $142,626,185.80 in exchange for a promise to deliver between 4,112,636 and 4,762,000 shares of Monster stock or their cash equivalent at the settlement date. (SPA 7; JA 213-14, 240-50.) The specific number of shares of stock, or cash equivalent, that Mr. McKelvey was required to deliver under each VPFC was to be determined by a formula based on the share price of Monster stock on or around the settlement date of each VPFC. (SPA 4, 7; JA 211-14, 218-50.) Mr. McKelvey was originally due to satisfy his delivery obligations under each VPFC in September 2008. Id.

In July 2008, in the midst of the financial crisis and after the price of Monster stock had declined by nearly 50%, Mr. McKelvey amended each VPFC to defer his delivery obligations by approximately 17 months, paying $3,477,949.92 to BofA and $8,190,640 to MSI as consideration. (SPA 6, 9; JA 214-15, 252-56.)2 The amendments did not change the formula that governed the number of shares Mr. McKelvey would be required to deliver, or any other terms in the contracts. After the extensions, Mr. McKelvey was still required to deliver between 1,324,993 and 1,765,188 shares of Monster stock or their cash equivalent under the BofA VPFC, and between 4,112,636 and 4,762,000 shares of Monster stock or their cash equivalent under the MSI VPFC. Only the dates on which the specific number of shares or cash equivalent was to be calculated and delivered were changed — from September 2008 to February 2010 in the case of the BofA VPFC, and from September 2008 to January 2010 in the case of the MSI VPFC. (SPA 6, 9, 19; JA 214-15, 252-56.)

Mr. McKelvey died on November 27, 2008. (SPA 3.)3 At the time of his death, Mr. McKelvey still had not settled his obligations under the VPFCs, and he owned over 9 million shares of Monster stock. (JA 152.) Accordingly, both Mr. McKelvey's obligations under the VPFCs and his shares of Monster stock passed on to the Estate, which settled the obligations under the VPFCs by delivering 1,757,016 shares to BofA in May 2009 and 4,762,000 shares to MSI in August 2009. (SPA 7, 10; JA 215-16.)

The Commissioner incorrectly states (without support from the record) that the Estate claimed a $3,000 loss from the settlement of the VPFCs. App. Br. 11-12. Although the Estate's income tax return is not in the record, the capital loss reported on such return derived from other property unrelated to the VPFCs or Monster stock. And while the Estate paid estate tax on the value of the Estate upon Mr. McKelvey's death (including any cash held from the $194 million prepayments or assets acquired with those prepayments), the Estate did not realize capital gains through the settlement of the VPFCs because it delivered shares with a stepped-up basis from when they passed to the Estate. See I.R.C. § 1014(a)4; Connecticut Nat'l Bank v. United States, 937 F.2d 90, 90 (2d Cir. 1991) (“[O]ne who acquires property from a decedent is entitled to use the property's fair market value on the decedent's date of death as a basis for valuing sales of the property made subsequent to the decedent's death.”). This was unquestionably correct, and the Commissioner is not challenging either the Estate's estate tax returns or its income tax returns.

II. Procedural History

The Commissioner issued a Notice of Deficiency (the “Notice”) with respect to Mr. McKelvey's 2008 tax return on August 14, 2014. (SPA 10; JA 21-50.) The Notice asserted that, by deferring the delivery dates set forth in his VPFCs, Mr. McKelvey had realized $88,096,811.03 of short-term capital gain and recognized $112,789,808.84 of long-term capital gain, which were not reflected on Mr. McKelvey's tax return. (SPA 10-11.) The Estate filed a petition in the United States Tax Court on November 10, 2014, challenging the Notice. (JA 4-19.)

In the Tax Court, the Commissioner made two primary arguments. First, the Commissioner argued that, as of the extension dates, the VPFCs were property that Mr. McKelvey exchanged for materially different property (i.e., the extended VPFCs), resulting in the realization of short-term capital gain pursuant to § 1001. (JA 554-611.) Second, the Commissioner argued that Mr. McKelvey's extended VPFCs constituted new contracts that, under § 1259, were constructive sales of the stock that Mr. McKelvey had pledged to secure his VPFC obligations, such that Mr. McKelvey recognized long-term capital gain. (JA 611-27.)

The Tax Court rejected each of the Commissioner's arguments.

First, the Tax Court held that Mr. McKelvey held no property rights in the VPFCs as of the extension dates and did not realize gain under § 1001. (SPA 18-23.) The court noted that, in an effort to demonstrate that the VPFCs constituted property of Mr. McKelvey as of the extension dates, the Commissioner had “attempt[ed] to disaggregate the VPFCs into three components: (1) a discount loan; (2) a long put option; and (3) a short call option,” but the court correctly held that “[a]though the economic value of a VPFC can be calculated by valuing these separate parts . . . VPFCs are comprehensive financial products and decedent did not have the ability to transact separately in discount loans or call and put options.” (SPA 21 n.15.) The court recognized that, after receiving the prepayments under the VPFCs, Mr. McKelvey had only obligations to deliver an undetermined number of shares or their cash equivalent to his counterparties, not property. (SPA 22-23.)

Second, the Tax Court explained why holding that the extensions did not result in a realization event under § 1001 was consistent with the “open transaction” doctrine: “decedent's extensions did not close the original transactions and the open transaction treatment afforded to the original VPFCs should continue until the VPFCs were settled by delivery of Monster stock on the extended settlement dates.” (SPA 29.) The Tax Court noted that Mr. McKelvey's situation could be analogized to those of option writers in cases such as Virginia Iron Coal & Coke Co. v. Comm'r, 37 B.T.A. 195, aff'd, 99 F.2d 919 (4th Cir. 1938), and Fed. Home Loan Mortg. Corp. (Freddie Mac) v. Comm'r, 125 T.C. 248 (2005), and held that “[b]ecause decedent's obligation to deliver a variable number of shares (or the cash equivalent) was continuing, it remained uncertain whether decedent would realize a gain or loss upon discharge of his obligations, not to mention the characterization of such gain or loss.” (SPA 30-33.)

Finally, the Tax Court rejected the Commissioner's argument that the extended VPFCs constituted constructive sales under § 1259 “because the original VPFCs are the only contracts subject to evaluation.” (SPA 35.) The court explained that “because [the Commissioner] concedes that the original VPFCs were properly afforded open transaction treatment under section 1001 — and because the open transaction treatment continued when decedent executed the extensions  there is no merit to [the Commissioner]'s contention that the extended VPFCs should be viewed as separate and comprehensive financial instruments under section 1259.” (SPA 36.)

Having lost each argument before the Tax Court, the Commissioner shifts theories on appeal in critical ways. The Commissioner reiterates his rejected “exchange of property” argument under § 1001, but also embraces a new alternative theory: that the extensions caused Mr. McKelvey to realize gain under §§ 61 and 1234A by relieving him of liabilities. Under either theory, the Commissioner argues that realization was triggered because the extensions “fundamentally changed” Mr. McKelvey's VPFCs. App. Br. 34-40. At the same time, notwithstanding the fact that there is a stipulated record, the Commissioner does not ask this Court to determine “the precise amount of taxpayer's gain and resulting tax deficiency,” App. Br. 12 n.4, that would purportedly result under either theory, but instead asks the court to remand the case to the Tax Court.

SUMMARY OF THE ARGUMENT

The Commissioner's brief sets forth an unprincipled, rhetorical attack on the Tax Court's well-reasoned decision. In place of grappling with the law, the Commissioner seemingly hopes that repeating that neither Mr. McKelvey nor the Estate paid income taxes on the $194 million Mr. McKelvey received as prepayments on the VPFCs will cause this Court to conclude that this result must be wrong. This result is the natural and inevitable consequence of two well-established principles of law: First, that entry into a VPFC does not result in realized gain or loss; and second, that when an individual taxpayer dies, the taxpayer's estate pays estate tax on the value of the estate (including, for example, any cash remaining from prepayments, or assets purchased therefrom) and receives a stepped-up tax basis in the estate's assets for purposes of determining income tax resulting from gain or loss realized when disposing of such assets. Because the Commissioner cannot dispute these principles, he has attempted to turn Mr. McKelvey's extension of his VPFCs into a realization event. He contends that the extensions caused Mr. McKelvey: (1) to realize short-term capital gains under § 1001 because they should be deemed an exchange of property for materially different property, or under §§ 61 and 1234A because they should be deemed a termination of Mr. McKelvey's delivery obligations under the VPFCs; and (2) to recognize long-term capital gains under § 1259. The Commissioner's arguments are divorced from precedent and without merit.

1. The extension of Mr. McKelvey's VPFCs did not cause him to realize short-term capital gains. When Mr. McKelvey entered into the VPFCs he did not realize gain or loss because the VPFCs were open transactions. Despite receiving approximately $194 million in prepayments upon entry into the VPFCs, Mr. McKelvey could not know whether this would constitute gain or loss, let alone the amount or character of any gain or loss, because Mr. McKelvey did not know (1) whether he would ultimately deliver Monster shares or cash in exchange for the prepayments, (2) how many Monster shares (or how much cash) he might deliver, or (3) in the event he delivered shares, what his cost basis would be in the shares he delivered. As the Tax Court recognized, the extension of the VPFCs did not resolve these issues. Accordingly, the extensions did not close Mr. McKelvey's transactions  the extensions continued the transactions. Mr. McKelvey continued to have the same obligations, and his counterparties continued to hold Mr. McKelvey's same promises, to deliver a variable number of Monster shares (or an equivalent amount of cash) in the future, which precluded the realization of gain or loss.

The Commissioner's contention that the extensions constituted taxable exchanges of property or the termination of obligations is incorrect. Mr. McKelvey did not have any property rights in the VPFCs he could have exchanged by virtue of the extensions. But even if he had, extending the VPFCs did not constitute a fundamental change to those contracts that would have triggered a taxable exchange. Mr. McKelvey continued to have precisely the same obligations both before and after the extensions — obligations to deliver a specific amount of cash or stock to be determined by reference to unchanged formulae. Thus, he did not change the fundamental substance of the contracts and was not relieved from any liability through the extensions. He would not be relieved from liability until he closed and completed his transactions.

2. The extension of Mr. McKelvey's VPFCs also did not cause him to recognize long-term capital gains. The Tax Court correctly held that there is no basis to conclude that the extensions turned Mr. McKelvey's continuing VPFC transactions into constructive sales of the underlying stock under § 1259. Contracts are evaluated to ascertain whether they constitute constructive sales under § 1259 only at inception, not as they appreciate or depreciate over time; because the extensions did not result in the deemed creation of new VPFCs, they do not provide a basis for reevaluation. But even if the VPFCs were reevaluated as of the extension dates, the VPFCs would not constitute constructive sales. The Commissioner acknowledges that when Mr. McKelvey entered into his VPFCs, he did not constructively sell the stock underlying the VPFCs because there was “significant variability” in the number of shares of stock he would be required to deliver. The exact same variability existed after Mr. McKelvey extended his VPFCs. While the likelihood that Mr. McKelvey would be required to deliver fewer than the maximum number of shares had diminished by the time he extended the VPFCs, there was still real and substantial uncertainty as to how many shares or cash he would in fact deliver, and that uncertainty was not diminished by the extensions in any way.

ARGUMENT

I. The Tax Court Correctly Held that Mr. McKelvey Did Not Realize Short-Term Capital Gains upon the Extension of the VPFCs

The Commissioner's brief repeatedly misstates the applicable law and glosses over the Tax Court's well-reasoned analysis in urging this Court to conclude that Mr. McKelvey realized short-term capital gain. Accordingly, set forth below, we both respond to the Commissioner's arguments and also explain why the Tax Court properly analyzed whether the extensions caused Mr. McKelvey to realize gain. In short, the only way Mr. McKelvey could have realized gains through modifying the VPFCs is if the modifications closed and completed his transactions by (1) resolving the uncertainty that had existed from the inception of the VPFCs, or (2) relieving Mr. McKelvey of all or part of his existing obligations. The extensions did neither.

A. The Extensions of the VPFCs Did Not Trigger Realization of Gain Because They Did Not Close and Complete Mr. McKelvey's Open Transactions

1. The VPFCs Were Open Transactions Consistent with Revenue Ruling 2003-7

While not in dispute, it is critical to understand why Mr. McKelvey did not realize gain when he entered into the VPFCs. As the Tax Court correctly recognized, this analysis informs why he also did not realize gain when the VPFCs were extended. (See SPA 24-34.)

In order to calculate the gain or loss realized from the sale or other disposition of property, a taxpayer must know both the amount realized and its adjusted basis in the property. See § 1001(a). That is, a taxpayer calculates gain or loss by taking the amount realized from a transaction and subtracting the taxpayer's adjusted basis in the property disposed of in the transaction. When either the amount realized or the adjusted basis in a given transaction is not known, gain or loss cannot be calculated, and the transaction must be treated as “open.”

The open transaction doctrine requires that the known component (e.g., the amount realized) be held in suspense and instructs that any gain or loss will not be realized until the missing component (e.g., the adjusted basis) is also known. See, e.g., Burnet v. Logan, 283 U.S. 404, 413 (1931) (holding that, where an amount realized could not be determined because property had no reasonably ascertainable fair market value, the “transaction was not a closed one”); Bingham v. Comm'r, 27 B.T.A. 186, 189 (1932) (“A short sale. . . leaves open the accounts of both the customer and the broker. No profit or loss exists until . . . the obligation of the short sale is discharged.”).

A short sale of a security is a classic example of an open transaction and helps to illustrate the doctrine. In a short sale of stock, the taxpayer borrows stock from a lender and sells it, thereby generating some amount realized from that sale. Because the stock sold was borrowed, a short seller is obligated to return replacement shares to the lender in order to “close” the short sale. Although the taxpayer knows the amount realized from the short sale immediately upon selling the borrowed stock, the transaction is nevertheless considered to be open, and no gain or loss is realized, until the taxpayer delivers the replacement shares to close the transaction because the taxpayer's basis in such replacement shares will determine the taxpayer's gain or loss. See, e.g., Hendricks v. Comm'r, 423 F.2d 485, 486 (4th Cir. 1970) (“The consistent position of the Commissioner has been that a short sale is not consummated or closed . . . until delivery of the shares to cover the short sale.”).

Another example of an open transaction is an option contract. The writer of a call option receives an upfront payment (“premium”) in exchange for agreeing to sell property in the future, at the discretion of the option holder. Although the option writer has unfettered ownership of the premium it receives, it cannot know whether the premium will become part of its amount realized from the sale of property (if the option holder chooses to exercise the option) or what its adjusted basis will be in the property delivered upon an exercise. Accordingly, no gain or loss is realized upon entry into an option. See Virginia Iron Coal & Coke Co., 37 B.T.A. at 198-99 (holding that the writer of an option that receives a cash premium does not include the premium in income until the option expires and the writer's obligation is extinguished); see also Freddie Mac, 125 T.C. at 260 (discussing tax treatment of options).

VPFCs are open transactions where the amount realized is known when the prepayment is received but the identity and adjusted basis of any property or amount of any cash to be delivered are unknown. See Rev. Rul. 2003-7, 2003-1 C.B. 363 (concluding that no gain or loss is realized upon a taxpayer's entry into a VPFC). Until settlement, it is unknown whether the taxpayer will deliver shares or cash, how many shares or how much cash will be delivered and, if the taxpayer delivers shares, what the taxpayer's basis in those shares will be. Indeed, a VPFC contains even more uncertainty than a short sale or option because the number of shares to be delivered under a VPFC (as well as whether shares, as opposed to cash, will be delivered) is unknown, whereas a short sale contemplates delivery of a fixed number of shares that have been borrowed from a lender and an option contemplates a fixed amount of property to be sold.

There is no dispute in this case that, when Mr. McKelvey entered into the VPFCs, they were open transactions. When Mr. McKelvey received his prepayments under the VPFCs, he did not realize gain or loss because, until he delivered either cash or stock to his counterparties, “it was impossible for either the taxpayer or the Commissioner to determine in [the years the payments were received] whether or not the payments would eventually represent income and how they should be reported.” Virginia Iron Coal & Coke Co., 37 B.T.A. at 198.

If Mr. McKelvey delivered Monster shares on the settlement date of a VPFC, the transaction would have been treated as a sale for tax purposes of the particular shares delivered (consummated on the settlement date). In that case, Mr. McKelvey's gain or loss would have been determined by comparing the amount realized (the prepayment) with Mr. McKelvey's basis in the particular shares delivered, and the short-term or long-term character of such gain or loss would have depended on Mr. McKelvey's holding period for those shares. For example, if Mr. McKelvey ultimately delivered zero-basis shares that he had held for years in satisfaction of his obligations, he would have realized long-term capital gains of approximately $194 million; but if Mr. McKelvey had gone into the market and acquired new shares to deliver in satisfaction of his delivery obligations, he could have realized short-term capital gain of a substantially lesser amount, or even a loss, depending on his cost for the specific shares delivered.

On the other hand, if Mr. McKelvey had decided to deliver cash on the settlement date of a VPFC (rather than shares), the transaction would have been treated as a termination of his obligation (and a simultaneous termination of the potential sale of stock), resulting in gain or loss on the VPFC itself. In that case, the amount of gain or loss would have been determined by comparing the prepayment with the amount of cash Mr. McKelvey paid to settle that obligation. If the value of Monster stock had gone up during the term of the VPFC, and Mr. McKelvey paid more than the prepayment amounts to get out of his obligations, he would have suffered a loss; by contrast, if the value of Monster stock had gone down during the term of the VPFC, and Mr. McKelvey paid less than the prepayment amounts to get out of his obligations, he would have realized a gain. Accordingly, while Mr. McKelvey's total amount realized of $194 million was fixed, it was unknown – even at the time of the extensions – whether he would realize gain or loss as a result of entering into the VPFCs or what the character of any gain or loss would be.

2. The Extensions Did Not Resolve the Uncertainty that Precluded Realization of Gain or Loss in Connection with the VPFCs

As the Tax Court correctly held, the VPFC extensions did not trigger the realization of gain because they did nothing to resolve the uncertainty inherent in the VPFCs from inception:

The rationale for affording open transaction treatment to VPFCs is the existence of uncertainty regarding the property to be delivered at settlement. . . . [B]y only extending the settlement and averaging dates, the extensions did not clarify the uncertainty of which property decedent would ultimately deliver to settle the contracts. Decedent had the discretion to settle the VPFCs using stock with a higher or lower basis than the stock pledged as collateral. Because decedent's obligation to deliver a variable number of shares (or the cash equivalent) was continuing, it remained uncertain whether decedent would realize a gain or loss upon discharge of his obligations, not to mention the characterization of such gain or loss.

(SPA 30.) Indeed, if the price of Monster stock had recovered above the floor price in the VPFCs and Mr. McKelvey had ultimately settled his obligations on the extended settlement dates for more than his $194 million prepayments, he could have realized a loss on the VPFC transactions.

Despite the Commissioner's suggestion to the contrary, the Tax Court's holding was entirely consistent with precedent  including with respect to the treatment of option extensions. As the Tax Court correctly explained, an extension of an option has long been held to continue, rather than close, the option transaction, precluding realization of gain or loss to the option writer. (SPA 32-33.) Virginia Iron Coal & Coke Co., 37 B.T.A. 195, is directly on point. Virginia Iron held that the writer of an option who received an upfront cash premium in exchange for granting an option would not include the premium in income until its obligation was extinguished, even when the option lapsed and was subsequently revived by the parties. 37 B.T.A. at 199. The taxpayer did not realize any gain upon the lapse and subsequent extension of the option because, as a result of the extension, the taxpayer still did not yet know whether the premium payments (1) would be included in its computation of gain or loss on the sale of the underlying property, in the event that the option were exercised, or (2) would be realized as gain in connection with the option itself, in the event the option obligation finally expired. See also Hicks v. Comm'r, 37 T.C.M. (CCH) 1540 (1978) (applying same reasoning to conclude that “payments for an option are not included in the grantor's income until the year in which the character of those payments can be determined”). The same rule applied by courts to options has been applied by the Commissioner when a short seller effectively extends a short sale by replacing its obligation to one stock lender with an obligation to another lender. In that situation, which may arise when an original lender demands that the short seller repay the stock loan, replacing the original obligation with a new obligation to a different lender does not close the short sale. See Rev. Rul. 2004-15, 2004-1 C.B. 515 (holding that a “short sale is not deemed to be consummated until the obligation of the seller created by the short sale is finally discharged” and that “[w]hen a taxpayer transfers borrowed property to satisfy its initial obligation under a short sale, the taxpayer's short sale obligation is not 'finally discharged.'”).

The Commissioner attempts to sidestep these precedents by separating the VPFCs from the potential underlying stock transactions in his analysis. App. Br. 40-41. According to the Commissioner, the Tax Court mistakenly analyzed “the underlying stock sale” rather than “the VPFCs themselves,” and, accordingly, “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.” App. Br. 40-41. The Commissioner is wrong. Until the VPFCs were settled with stock, there were no “underlying stock sales” for the Tax Court to analyze; there were only the VPFCs themselves, which, as explained above, would only become stock sales if Mr. McKelvey chose to settle them in stock. It thus defies logic for the Commissioner to argue that “[a]lthough the underlying sale of Monster stock remained an 'open transaction,' [Mr. McKelvey] realized gains on the VPFCs when they were amended to extend the valuation dates. . . .” App. Br. 27. Mr. McKelvey could not have realized gain from terminating (or exchanging) his VPFCs while leaving open his potential sale of stock. That is, the only way Mr. McKelvey could have realized gain or loss on the VPFCs themselves was if Mr. McKelvey eliminated the potential sale of Monster stock by eliminating his obligation to deliver Monster stock (or cash). The extensions did no such thing.5

3. The Extensions Did Not Result in a Deemed Exchange of Property or a Termination of Mr. McKelvey's Obligations

Essentially ignoring the open transaction doctrine, the Commissioner makes two primary arguments in support of his claim that the extensions caused Mr. McKelvey to realize short-term gains. First, he claims that the VPFCs were property that Mr. McKelvey should be deemed to have exchanged for materially different property (the extended VPFCs) by modifying their settlement dates. App. Br. 29-40. Second, he argues in the alternative that modifying the VPFCs terminated Mr. McKelvey's obligations and replaced them with new obligations, providing relief from liability. App. Br. 42-52. Both arguments are wrong. As set forth in more detail below, Mr. McKelvey cannot be deemed to have engaged in an exchange of property because the VPFCs constituted only obligations to him after receiving the prepayments. But even if he could be considered to have held property, the Commissioner's arguments would fail because the extensions did not constitute a fundamental change that could have triggered a deemed exchange of property and also did not serve to terminate (or even lessen) Mr. McKelvey's obligations. Both before and after the extensions, Mr. McKelvey remained obligated to deliver a number of shares (or cash equivalent) to be determined under the same formulae. Indeed, the Commissioner cites no authorities in which a court (or even the IRS itself) has held that an extension of time to settle a contractual obligation triggers realization of gain or loss, and many authorities have held precisely the opposite. Consistent with the open transaction doctrine discussed above, authorities repeatedly have concluded that an extension of time to satisfy an obligation does not close and complete a transaction or otherwise trigger the realization of gain or loss.

a. Section 1001 Is Inapplicable Because the VPFCs Were Not Property to Mr. McKelvey at the Extension Dates

The Tax Court correctly held that § 1001 is inapplicable because Mr. McKelvey's VPFC amendments occurred when the VPFCs were purely obligations to Mr. McKelvey, and not his property, and Mr. McKelvey thus had no property to exchange. (SPA 13-20.) Even the Commissioner's own expert recognized that after Mr. McKelvey had received his prepayments under the VPFCs, Mr. McKelvey retained only delivery obligations. (SPA 19-20; JA 155-99.)

The Commissioner now asserts that the Tax Court should have determined whether Mr. McKelvey had property to exchange by looking not to his position at the time of that alleged exchange, but instead by looking to his original position under the contracts at the time of execution (before he received any prepayments). App. Br. 29-34. The Commissioner did not advance this theory below, and he glaringly cites no authority for his new position. See App. Br. 30 (calling the Tax Court's approach “unprecedented” but providing as support only that “[his] 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”).6 As the Tax Court recognized, to the extent the Commissioner is now seeking to treat the extensions as “the sale or other disposition of property,” both the statutory language of § 1001 and logic compel that this question can only be answered by considering what Mr. McKelvey held at the time of those extensions. After all, once a party to a contract has received the performance it is owed under the contract (such as the right to receive prepayments), its right to receive that performance is discharged, and it can no longer transfer that contract right in exchange for other property.

The Commissioner relies on inapposite analogies to the treatment of debt instruments to contend that Mr. McKelvey should be seen as holding property as of the extension dates. See App. Br. 31-32. As the Commissioner acknowledges in a footnote, see App. Br. 32 n.8, because issuers of debt instruments do not hold property, they cannot realize gain or loss on debt modifications under § 1001. Instead, issuers can only realize income from the discharge of indebtedness under § 61(a)(12), a wholly separate statutory and regulatory scheme that reflects the fact that, although debt is not property to an issuer, changes to debt instruments which constitute a § 1001 exchange to the holder of debt may simultaneously discharge or lessen a liability of the issuer through the termination or reduction of an obligation. See Treas. Reg. § 1.61-12(c)(2) (explaining that a debtor does not realize gain but instead realizes income from the discharge of indebtedness if the debt is retired for a sum less than the adjusted issue price of the debt).

Finally, the Commissioner is wrong to rely on Stavisky v. Comm'r, 34 T.C. 140 (1960), aff'd, 291 F.2d 48 (2d Cir. 1961), to argue that the Tax Court erred by focusing on Mr. McKelvey's rights and obligations as of the extension dates. See App. Br. 32-33. Stavisky holds that a contract that provides a mix of economic rights and obligations to a taxpayer still constitutes property of the taxpayer when such rights have net negative value. See 34 T.C. at 142. As the Tax Court recognized, Stavisky does not hold that a contract continues to constitute property to a taxpayer when, as in Mr. McKelvey's situation, the taxpayer no longer possesses any potentially valuable rights under the contract whatsoever. Here, there was no possible way that Mr. McKelvey's VPFCs could come to have positive value, given that he had no property rights left under the VPFCs once his counterparties had provided him with his prepayments. At the time of the extensions, the VPFCs were purely obligations to Mr. McKelvey.

b. Sections 61 and 1234A Would Only Apply if the Extensions Provided Relief from a Liability through a Termination of Mr. McKelvey's Obligations

The Commissioner alternatively argues that Mr. McKelvey's extension of the VPFCs terminated his obligations, resulting in realized gain under §§ 61 and 1234A as “relief from a liability.” App. Br. 42-52. Section 61 provides that “gross income means all income from whatever source derived, including . . . [g]ains derived from dealings in property,” while § 1234A provides for the character of any gain or loss resulting from a “termination of a right or obligation . . . with respect to property which is . . . a capital asset in the hands of the taxpayer” by stating that it “shall be treated as a gain or loss from the sale of a capital asset.” Thus, § 1234A does not guide the determination of when gain or loss is realized, or otherwise provide any guidance as to when a contractual modification results in a “deemed termination of a taxpayer's obligations [under the modified contract].” App. Br. 52. It only guides the determination of the character of certain kinds of gain or loss that either § 61 or § 1001 may require a taxpayer to recognize, essentially ensuring that gains and losses realized from the termination of a taxpayer's interest in a derivative contract will have the same character as any gains or losses that would have been realized from the sale of the referenced property.7

Because the Commissioner did not rely on §§ 61 and 1234A in Tax Court, he spends a considerable portion of his brief urging this Court not to deem his arguments waived. See App. Br. 52-58. The Estate does not dispute that this Court may consider the Commissioner's new arguments, given that the Estate explained below why the extensions did not result in a termination of Mr. McKelvey's obligations. (JA 486-87, 694-702.) However, as set forth below, the Commissioner's arguments under §§ 61 and 1234A are just as meritless as his arguments under § 1001 because the extensions did not terminate, or even lessen, Mr. McKelvey's obligations. Mr. McKelvey was still required to deliver between 1,324,993 and 1,765,188 shares of Monster stock or their cash equivalent under the BofA VPFC, and between 4,112,636 and 4,762,000 shares of Monster stock or their cash equivalent under the MSI VPFC.

c. Extending the Settlement Dates of the VPFCs Did Not Terminate or Lessen Mr. McKelvey's Obligations and Would Not Have Resulted in an Exchange of Property if the VPFCs Were His Property

The Commissioner argues that the central threshold question to be addressed under either § 1001 or §§ 61 and 1234A is whether Mr. McKelvey's modifications to his VPFCs so “fundamentally changed” the essence of his obligations that he should be deemed to have terminated his obligations under his original VPFCs and replaced them with new ones.8 The Commissioner claims that “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.” App. Br. 35. The Commissioner is wrong. While the time to maturity impacts the value of any contract, all relevant precedent makes clear that modifying the time to maturity of a contract (including a derivative contract) does not constitute a fundamental change and does not result in the termination of an original obligation. Because the Commissioner glosses over nearly all of this precedent, we address it in depth below before turning to its application to this case.

Contractual parties frequently amend contracts without stopping to ask whether the amendments will trigger the realization of gain or loss in the contract. That common sense approach aligns with the law, as the general rule is that contractual modifications do not trigger the realization of gain or loss. See generally 2 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 40.8.1 (3d ed. 2000) (Contract Modifications). The IRS articulated the fundamental change doctrine as an exception to this general rule in Revenue Ruling 90-109. Rev. Rul. 90-109, 1990-2 C.B. 191.

In Revenue Ruling 90-109, the IRS ruled that a corporation's exercise of an option to change the insured party on a life insurance policy held by the corporation constituted a sale or disposition of the policy under § 1001. The IRS explained that changing the person whose life was insured under an insurance policy, even though effected through an option provided in the original contract, constituted an exchange under § 1001 of the original insurance policy for the modified insurance policy because there was a “sufficiently fundamental or material change that the substance of the original contract [wa]s altered through the exercise of the option.” Id. The IRS stated that the change modified the “fundamental substance of the original contract because the essence of a life insurance contract is the life that is insured under the contract.” Id.

The fundamental change test is intended to be neither a hair-trigger test nor a purely economic test. And it is entirely consistent with the Supreme Court's subsequent decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), holding that the exchange of one set of mortgage loans for an entirely different set of mortgage loans constituted an exchange of property for materially different property under § 1001 even though the two groups of loans were “economic substitutes.” See I.R.S. Chief Couns. Mem., 200515019 (Apr. 15, 2005) (discussing Beatty v. Comm'r, 46 T.C. 835 (1966), and Wood v. Comm'r, 50 T.C.M. (CCH) 1232 (1985), as well as Revenue Ruling 90-109 and Cottage Savings, and recognizing that altering one's rights under a contract, even where those rights “could be separately valued”, does not result in realization unless the alterations constitute “a sufficiently fundamental or material change”). Critically for present purposes, courts have repeatedly held that an extension or change in time for performance under a contract does not trigger realization of gain or loss, either through the sale or disposition of property or through the termination of an obligation.

For instance, in Olmsted Inc. Life Agency v. Comm'r, 304 F.2d 16 (8th Cir. 1962), aff'g, 35 T.C. 429 (1960), the Eighth Circuit held there was no sale or disposition under § 1001 when the taxpayer exchanged his contract rights to receive future “renewal commissions” for a 15-year annuity. In that case, the taxpayer served as a life insurance company's exclusive agent in Iowa pursuant to a contract that granted the taxpayer future renewal commissions arising from the business that he originated over the years. The taxpayer assigned his rights under the contract to the insurer and entered into a new contract with the insurer providing that, in lieu of paying renewal commissions as they accrued over time, the insurer would give the taxpayer a 15-year annuity providing for set monthly payments that approximated the amount the taxpayer would have received from future renewal commissions. The present value of the annuity was approximately 5 percent less than the present value of the renewal commissions owed to the taxpayer under the original contract. Olmsted Inc. Life Agency, 35 T.C. at 433. The IRS asserted that the exchange of contracts constituted a taxable “sale or other disposition” of the taxpayer's right to renewal commissions under the original contract such that the taxpayer would be required to treat the entire fair market value of the new contract as income in the year of the exchange. Both the Tax Court and the Eighth Circuit disagreed, holding that there was no taxable exchange because, even though the annuity's present value was different from the present value of the renewal commissions (by approximately 5 percent), the insurance company's obligation was “substantially the same” before and after the modification. Id. at 437. This same basic reasoning has been applied in the context of extending options, short sales, and debt instruments to hold that mere extensions do not trigger realization of gain or loss.

Options. As noted above, Virginia Iron Coal & Coke Co., 37 B.T.A. 195, and Hicks, 37 T.C.M. (CCH) 1540, both held that the writer of a call option did not realize gain upon the extension of an option. In each case, an option writer had received a premium for writing an option, the option had lapsed, and the writer and the option holder had agreed to extend the option for a longer period of time. Neither court concluded that the option writer should be treated as having exchanged one option for another or as having terminated the first option in favor of a new extended option. Instead, the courts held that the option writers did not realize gain when the option lapsed and was extended because the extension of the option prevented the writer from knowing what property, if any, it would deliver to satisfy its obligation under the option.

The Commissioner ignores these precedents (and the Tax Court's reasoning below), and attempts to rely instead on Reily v. Comm'r, 53 T.C. 8 (1969), Succession of Brown v. Comm'r, 56 T.C.M. (CCH) 1568 (1989), and commentary to claim “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.” App. Br. 38 (citation omitted). The Commissioner is wrong. Reily and Succession of Brown dealt only with whether holding periods for option holders (not writers) in options that they transferred to third parties included the period for which they held prior options; the prior options had expired on or about the day that the holders acquired the options that they later transferred. Those cases did not consider (and had no reason to consider) whether the holders had realized gain or loss when the prior options expired; nor did those cases consider whether an option holder realizes gain or loss when the original parties to an option agree to extend the contract for a longer period of time. On that issue, Virginia Iron and Hicks explicitly held that, at least with respect to an option writer (i.e., the obligor under the option), an extension of the option writer's obligation is not treated for tax purposes as though the option writer terminated one option and entered into a new one.

The Commissioner's reliance on § 1234 and the treatment of roll forwards of call options is particularly misguided. See App. Br. 49-51. The Commissioner claims that “the modification of [Mr. McKelvey]'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 § 1234(b).” App. Br. 49 (emphasis in original). Section 1234(b) provides no such thing. Instead, it specifies only that “gain or loss from any closing transaction” is treated as short-term capital gain, rather than as ordinary income. Meanwhile, § 1234(b) and Treas. Reg. § 1.1234-3(b)(1) define a “closing transaction” to mean a termination of the grantor's obligation under the option, and explain that “the grantor of a call may effectively terminate his obligation under the option [and thus engage in a “closing transaction”] by either (i) repurchasing the option from the holder or (ii) purchasing from an options exchange a call with terms identical to the original option granted and designating the purchase as a closing transaction.” Treas. Reg. § 1.1234-3(b)(1).

In the “roll forward” transactions described by Commissioner, an option writer repurchases a call option from a holder and then writes a new option. App. Br. 49. Of course a writer's repurchase of an option with cash is a closing transaction under Treas. Reg. § 1.1234-3(b)(1). And there is no reason that this treatment should differ if the writer also grants a new option to a different counterparty at the same time for a new cash premium. Particularly for exchange-listed options, where writers have no way of knowing who is on the other side of their trades, roll forward transactions must be accounted for as two separate transactions: a repurchase of the old option, and a grant of a new option.

But the § 1234 regulations cited by the Commissioner do not purport to address whether, if an option writer and the option holder agree to extend an option rather than repurchase it, the option writer must realize gain or loss. Indeed, by asking this Court to analogize the VPFC extensions to roll forwards of exchange-traded options, the Commissioner is describing a very different transaction. And while § 1234(b) is silent on whether the bilateral extension of an option results in realized gain or loss, both Virginia Iron and Hicks hold that it does not. See also Dunlap v. Comm'r, 670 F.2d 785 (8th Cir. 1982) (relying on Virginia Iron and Hicks to hold that an option holder did not realize a loss upon the expiration of each option in a series of 10 consecutive 1-year options).

The Commissioner's arguments with respect to the proper treatment of option extensions (and, by analogy, the VPFC extensions here) are also inconsistent with its prior position, in this very Court, recognizing that no gain or loss was realized where an option writer effectively extended an option obligation by replacing it with a short sale obligation. See Reinach v. Comm'r, 373 F.2d 900 (2d Cir. 1967). In Reinach, a taxpayer wrote call options on stock and later delivered the required stock by borrowing shares from his broker, effectively transforming his written call option into a short sale. The taxpayer did not report any gain or loss from the exercise of the option; instead, he determined that the transaction remained open (and the option premium he had received remained in suspense) until he closed the short sale. Although the dispute in Reinach concerned whether the loss realized by the taxpayer upon closing the short sale was a capital loss or an ordinary loss, the Commissioner “agree[d] that it was proper to consider an option and short sale a single transaction remaining open until the cover stock was acquired.” Reinach, 373 F.2d at 903.

Short Sales. As noted above, when a short seller borrows stock from a new lender and uses that borrowed stock to close its prior short sale, the transaction is treated as a continuation of the original short sale, rather than as a new short sale, and no gain or loss is realized. Such transactions can serve to extend a short sale if the original stock lender demands the return of its shares. Revenue Ruling 2004-15 recognized implicitly that replacing the obligation to one lender with an equivalent obligation to another lender does not result in any relief from liability that would trigger gain or loss under §§ 61 and 1234A. See Rev. Rul. 2004-15, 2004-1 C.B. 515.

Debt Extensions. Contractual modifications that merely serve to extend debt instruments also have been held not to trigger realization of gain or loss. See, e.g., Shafer v. United States, 204 F. Supp. 473, 476 (S.D. Ohio 1962) (“It is settled that an agreement extending the maturity dates [of] notes does not produce a sale or exchange upon which gain or loss must be recognized.” (citing Motor Prods. Corp. v. Comm'r, 47 B.T.A. 983 (1942)). Even where taxpayers have traded in old bonds for new bonds with myriad concessions, including extended terms, courts have held that no realization event occurred in instances where, on balance, the “obligation in the new bond does not differ either in kind or extent from that expressed in the old.” City Bank Farmers Tr. Co. v. Hoey, 52 F. Supp. 665, 666 (S.D.N.Y.), aff'd, 138 F.2d 1023 (2d Cir. 1942).

While the Commissioner relies on Emery v. Comm'r, 166 F.2d 27 (2d Cir. 1948), to stand for a contrary position, the changes in contractual terms at issue in Emery went far beyond mere extensions. In Emery, this Court considered whether an exchange of bonds triggered realization where “[t]he interest rate of the new bonds was substantially less after the call dates of the old bonds; the new bonds matured from one to twenty-three years earlier than the old bonds; and the period during which the city optionally might call in the bonds was shortened.” Emery v. Comm'r, 166 F.2d at 29. Under those circumstances, this Court found that the new bonds were “not merely new evidence of an old obligation,” Emery v. Comm'r, 166 F.2d at 30, but in no way suggested that a mere change in the maturity date or value of a bond would result in a “new” obligation for tax purposes. And well after Emery, the Commissioner continued to recognize that “the mere extension of the maturity of the notes . . . does not constitute in substance the exchange of the outstanding note for a new and materially different note, or a closed and completed transaction upon which gain or loss may be determined.” Rev. Rul. 73-160, 1973-1 C.B. 365.9

* * *

Applying these precedents, there is no basis to conclude that the extensions of Mr. McKelvey's obligations under the VPFCs terminated his obligations and replaced them with new, lesser obligations. And even if the VPFCs had constituted property to Mr. McKelvey that could have been exchanged as of the extension dates, the extensions would not have triggered a deemed exchange under § 1001.

Mr. McKelvey was left with the same obligations after his VPFC extensions that he had before the extensions, just like the option writers in Virginia Iron, Hicks, and Reinach, the short seller in Revenue Ruling 2004-15, and the debt issuers in cases like Shafer and City Bank Farmers Trust. Although these cases did not involve VPFCs, the same analysis should apply. While the extensions changed the dates on which Mr. McKelvey's obligations would be calculated and due, they did not change the essence of his obligations in any way, and certainly not in a way that relieved Mr. McKelvey of a liability. After his extensions, Mr. McKelvey was left with the same obligations to deliver a variable number of shares of Monster stock or cash, to be calculated based on unchanged contractual formulae. Indeed, for precisely the same reasons his VPFCs were still open, they had not been fundamentally changed, and his obligations had not been terminated.

The Commissioner's economic “analysis” of the extensions does not alter this result, or even support his contention that the extensions were fundamental. The Commissioner focuses on the fact that Mr. McKelvey paid approximately $11 million to extend his two VPFCs, see, e.g., App. Br. 37, but he never acknowledges that this was only approximately 5% of the value of the prepayments. In the context of VPFCs where the combined prepayment amount was $194 million, paying $11 million for extensions does not signal a fundamental change.10 See Olmsted Inc. Life Agency, 35 T.C. at 433 (holding that a contract modification did not result in a taxable exchange, even where it resulted in a change in expected value of 5%). It is not sufficient for the Commissioner to state that the extensions “more than doubled the time to maturity.” App. Br. 39. The extended VPFCs were still shorter (at 2.5 years) than the VPFC expressly treated as not taxable by the IRS in Revenue Ruling 2003-7. See Rev. Rul. 2003-7, 2003-1 C.B. 363 (holding that a VPFC with a three-year term was neither a current nor constructive sale of stock). And the analysis of the Commissioner's own expert makes clear that, because the extensions did not change the formulae in the VPFCs, the value of the extensions was essentially nothing more than the time value of delaying payment on the obligations. (See JA 180-81; 475-77.)

Rather than meaningfully address these facts, the Commissioner repeatedly argues the settlement dates were “of the essence” to the VPFCs because VPFCs can be viewed as “bets” on the value of a given stock on a future date. See, e.g., App. Br. 20, 26, 27, 36, 39, 45. Every forward contract can be viewed as a “bet” on the value of something on a future date — that is the nature of a forward contract. And every extension of the time to complete a taxpayer's obligations under a forward contract will carry a cost  that is the nature of the time value of money. But these truisms do not inform whether a taxpayer realizes gain or loss when the end date of a bet is changed. As set forth above, courts and the IRS repeatedly have held that the extension of time for one party to satisfy its obligations under a contract does not so fundamentally change the essence of a contract that it will be deemed terminated and replaced by a new contract for tax purposes, either in the case of contracts that constitute property or in the case of contracts that constitute obligations. Mr. McKelvey's extensions should be treated no differently.11

While one can contemplate changes to a VPFC that may be deemed fundamental or to terminate a taxpayer's obligations, such as changes to the referenced stock (which would be analogous to the change to the insured person evaluated in Revenue Ruling 90-109) or changes to the formula by which the number of shares to be delivered is calculated (which could result in a lessening of an obligation if it lowered the range of shares to be delivered), that is not this case. Here, the extensions left Mr. McKelvey with precisely the same obligations he had before the extensions, to be satisfied at a later date.

B. The Commissioner's Suggestions of Abuse Are Specious

This Court should not be swayed by the Commissioner's outlandish rhetoric. The Commissioner says the Tax Court “sanctioned” an “abusive scheme.” App. Br. 57. He then claims that [t]he 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.” App. Br. 57. Finally, the Commissioner quotes news articles and commentators in an effort to pressure, not persuade, this Court toward reversal. See App. Br. 58 (“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 more than a few are already trying to work this new arrow into their quivers.” (internal quotation marks and citations omitted) (alterations accepted)).

The Commissioner's claims lack analytical rigor and are divorced from reality. Affirming the Tax Court's well-reasoned decision will not result in some parade of tax avoidance; the only reason Mr. McKelvey was never required to pay income taxes on the $194 million he received in connection with the VPFCs is because he died. Death is not an “abusive scheme.” App. Br. 57. See Peterson's Estate v. Comm'r, 667 F.2d 675, 681-82 (8th Cir. 1981) (“[W]hile the death of a decedent can be a fortuitous event tax-wise, it is certainly hard to visualize death as a tax avoidance scheme.”) (quotation omitted). And Mr. McKelvey did not avoid taxes in death. The value of Mr. McKelvey's estate, including any remaining cash from the prepayments (or assets he had acquired using that cash), was subject to estate tax. This is precisely the regime Congress chose for the taxation of individuals and their estates at death, and it is also entirely consistent with how the IRS treats open short sales when a taxpayer dies. See Rev. Rul. 73-524, 1973-2 C.B. 307 (concluding that, when an individual dies with an open short sale, the decedent's estate receives a step-up in basis in shares held by the decedent on the date of death, and the short sale does not become a closed and completed transaction until the estate delivers the required shares).12

The Commissioner's sky-is-falling rhetoric also ignores the fact, to the extent the Commissioner believes the authorities set forth above should be altered, he can seek legislation or promulgate regulations doing just that. Such regulations could specify, for example, economic or non-economic thresholds for when a modification of a non-debt contract will trigger realization through a deemed exchange or termination.13 The IRS's failure to do so up until now provides no basis for this Court to reverse the Tax Court's decision.

II. The Tax Court Correctly Found that the Extension of the VPFCs Did Not Result in Long-Term Capital Gain Recognition under Section 1259

Section 1259(c) provides that a taxpayer will be treated as having made a “constructive sale” of an appreciated financial position if a taxpayer “enters into a futures or forward contract to deliver the same or substantially identical property.” For this purpose, § 1259(d)(1) defines a forward contract as “a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.” Section 1259(d)(1) (emphasis added). Accordingly, if each of Mr. McKelvey's VPFCs constituted a contract to deliver a substantially fixed amount of Monster stock, he would have been treated as having constructively sold that amount of stock upon entering into the VPFCs, resulting in long-term capital gains.

The Commissioner recognizes that Mr. McKelvey's VPFCs were not contracts to deliver a substantially fixed amount of property within the meaning of § 1259 at inception. Under the terms of the BofA VPFC, Mr. McKelvey was required to deliver anywhere from 1,324,993 to 1,765,188 shares of Monster stock or their cash equivalent; in the case of the MSI VPFC, he was required to deliver anywhere from 4,112,636 to 4,762,000 shares of Monster Stock or their cash equivalent. Nevertheless, the Commissioner argues that Mr. McKelvey's VPFCs should be reevaluated as of their extension date and further argues that this significant variability should no longer be respected because the price of Monster stock had dropped from the inception of the VPFCs, making it more likely that Mr. McKelvey would ultimately deliver the maximum number of shares required. The Commissioner is wrong on both fronts.

A. The Extensions Did Not Trigger an Opportunity to Reevaluate the VPFCs for Purposes of Section 1259

The constructive sale rules under § 1259 are applied when a taxpayer enters into a contract. See § 1259(c)(1)(C) (“A taxpayer shall be treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person) . . . enters into a futures or forward contract to deliver the same or substantially identical property.”); S. Rep. No. 105-33, at 124 (1997) (“Whether any part of the constructive sale definition is met by one or more appreciated financial positions and offsetting transactions generally will be determined as of the date the last of such positions or transactions is entered into.”). Accordingly, the Commissioner's contention that this Court should reevaluate the amended VPFCs as potential forward contracts within the meaning of § 1259 is entirely contingent on his argument that “the extension of the VPFCs' valuation dates resulted in a deemed exchange/termination of the original contracts” for fundamentally different “amended contracts [that] are treated as new contracts for tax purposes.” App. Br. 58-59.

For the reasons set forth in Section I above, Mr. McKelvey did not enter into new contracts at the time of the extensions — he modified and kept open his existing contracts. As the Tax Court rightly found, “the original VPFCs are the only contracts subject to evaluation,” (SPA 35), and the Commissioner's constructive sale argument fails as a matter of law.

B. Even if the VPFCs Were Reevaluated as New Contracts as of the Extension Dates, They Would Not Constitute Forward Sales of a Substantially Fixed Amount of Property Under Section 1259

As noted above, § 1259(d)(1) defines a forward contract as “a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.” Meanwhile, the legislative history of § 1259 states that a forward contract providing for the delivery of “an amount of property, such as shares of stock, that is subject to significant variation under the contract terms does not result in a constructive sale.” S. Rep. No. 105-33, at 125-26 (1997) (emphasis added). Thus, a VPFC that provides a minimal variation in the number of shares to be delivered (e.g., between 99 and 100) likely would constitute a forward contract for a substantially fixed amount of property under § 1259, even if there was complete uncertainty as to whether, in fact, 99 shares would be due or 100 shares would be due. However, a VPFC that provides a broader variation in the number of shares to be delivered (e.g., between 80 and 100) would not constitute a forward contract for a substantially fixed amount of property, even if there was a high likelihood that 100 shares would be delivered, so long as the possibility that fewer would be delivered was real and not illusory. See Rev. Rul. 2003-7, 2003-1 C.B. 363.

The Commissioner contends that, because of the drop in share price of Monster stock as of the extension dates, the likelihood that Mr. McKelvey would be required to deliver fewer than 6.5 million shares of Monster stock in satisfaction of his extended VPFCs was approximately 15% in the case of the BofA VPFC and approximately 13% in the case of the MSI VPFC. Accordingly, he contends that the contract was for a substantially fixed amount of property. See App. Br. 62-63. The Commissioner does not explain at what point he contends these VPFCs turned into contracts for a substantially fixed amount of property or why the variation in the contract terms should not be respected. Nor does he explain why it is appropriate, for purposes of applying § 1259, to rely on his expert's financial estimate that there was an approximately 13-15% probability that Monster, which had seen its price drop in half in the previous 10 months but had also reached highs far higher than the cap price under the VPFCs in then-recent years, would rebound above the floor prices by the extended settlement dates of the VPFCs. Instead, as he does in arguing that the extensions constituted a fundamental change, he asks this Court to apply an unspecified economic test to draw lines that neither Treasury nor the IRS has ever seen fit to draw.

By focusing on the estimated likelihood that the extended VPFCs would result in Mr. McKelvey delivering fewer than the maximum number of shares rather than the terms of the contract, the Commissioner misreads § 1259. In issuing Revenue Ruling 2003-7, the IRS considered only the degree of variability expressly provided under the terms of the VPFC to determine whether it constituted a constructive sale:

According to the Agreement, delivery of a number of shares, which may vary between 80 and 100 shares, depends on the fair market value of the stock on the Exchange Date. Because this variation in the number of shares that may be delivered under the Agreement is a significant variation, the Agreement is not a contract to deliver a substantially fixed amount of property for purposes of § 1259(d)(1). As a result, the Agreement does not meet the definition of a forward contract under § 1259(d)(1) and does not cause a constructive sale under § 1259(c)(1)(C).

Rev. Rul. 2003-7, 2003-1 C.B. 363. Similarly, in Anschutz Co. v. Comm'r, 135 T.C. 78, 113 (2010), aff'd, 664 F.3d 313 (10th Cir. 2011), the Tax Court evaluated whether a VPFC constituted a constructive sale as follows:

TAC's stock transactions were not forward contract constructive sales because they were not forward contracts as defined in section 1259(d)(1) — they did not provide for delivery of a substantially fixed amount of property for a substantially fixed price. Section 1259 does not define the term 'substantial', and the Secretary has not issued regulations providing any additional guidance. TAC's ultimate delivery obligation may vary by as much as 33.3 percent; this is in excess of the variance in Rev. Rul. 2003-7, supra. TAC may ultimately deliver between 6,025,261 and 9,037,903 shares of stock to settle the [VPFCs]. We find this variance in TAC's delivery obligation to be substantial. TAC did not cause a constructive sale under section 1259(c)(1)(C).

Anschutz Co., 135 T.C. at 113.

Focusing only on the terms of variance under the terms of the contract is consistent with the structure and history of § 1259. In enacting § 1259, Congress specified four categories of transactions that were constructive sales based on criteria that could be applied by taxpayers and the Commissioner without economic analysis, including a forward contract for the delivery of a substantially fixed amount of property for a substantially fixed price. Congress also directed Treasury to promulgate regulations to determine other transactions that should constitute constructive sales based upon economic analysis. See § 1259(f) (“The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section.”); see S. Rep. No. 105-33, at 126-27 (describing economic factors to be taken into account in issuing regulations on “collar” and “in-the-money option” transactions, such as “the spread between the put and call prices, the period of the transaction, and the extent to which the taxpayer retains the right to periodic payments on the appreciated financial position (e.g., the dividends on collared stock),” and “the yield and volatility of the stock and the period and other terms of the option”). Despite Congress's mandate, in the twenty years since § 1259 was enacted, Treasury has promulgated no such regulations.

The Commissioner does not dispute that the VPFCs, as originally structured, contained sufficient variability under the terms of the contract to render them open transactions under Revenue Ruling 2003-7, rather than forward contracts for a “substantially fixed amount of property,” because Mr. McKelvey was going to be required to deliver anywhere from 5,437,269 to 6,527,188 Monster shares in aggregate. While the likelihood that Mr. McKelvey ultimately would be required to deliver fewer than 6,527,188 shares had declined by the time of the extension date, the range of possible outcomes was unchanged. And where the proper tax treatment depends on a future event which may or may not occur, such as the existence of significant variability in the precise amount of Mr. McKelvey's future delivery obligation, the possibility of that event occurring should not be disregarded so long as it is real, or non-remote. See, e.g., Penn-Dixie Steel Corp. v. Comm'r, 69 T.C. 837, 843-44 (1978) (holding that even though it was unlikely that an option would not be exercised, the form of the transaction should not be disregarded because the possibility was non-remote). Here, the chance that Monster stock would rebound to above the floor price of the VPFCs before the extended expiration was certainly not remote. Even accepting that there was only an approximately 13-15% likelihood based on Black-Scholes modeling, that possibility must be respected. See, e.g., Freddie Mac, 125 T.C. at 266 (treating mortgage purchase contracts as options even though the option holders exercised their delivery option approximately 99 percent of the time); Rev. Rul. 70-452, 1970-2 C.B. 199 (“Any possibility in excess of 5 percent that the contingency will occur . . . is not considered so remote as to be negligible. . . .”); Rev. Rul. 85-23, 1985-1 C.B. 327 (following Rev. Rul. 70-452); Rev. Rul. 78-255, 1978-1 C.B. 294 (same); Rev. Rul. 77-374, 1977-2 C.B. 329 (same).

CONCLUSION

The decision of the Tax Court should be affirmed.

Respectfully submitted,

Mark D. Lanpher
Robert A. Rudnick
Kristen M. Garry
SHEARMAN & STERLING LLP
401 9th Street, NW
Washington, DC 20004
Telephone: (202) 508-8120
Mark.lanpher@shearman.com

Attorneys for Petitioner-Appellee

Dated: February 27, 2018

FOOTNOTES

1The parties stipulated to the factual record on which this case was decided. (JA 201-04.) However, in his brief on appeal, the Commissioner takes substantial liberties in characterizing the facts and even references facts he acknowledges are not in the record. See, e.g., App. Br. 10 n.2, 57-58. As discussed further below, the Commissioner's suggestions of an “abusive scheme” are specious, and his attempt to reframe the facts to imply that one existed is a transparent attempt to influence this Court with factors other than the record and the law.

2The Commissioner claims that, as a result of the decline in the share price of Monster stock, “in July 2008, [Mr. McKelvey] was only two months away from realizing a large taxable gain.” App. Br. 10. This assertion presumes without support both that the share price of Monster stock was going to remain depressed through the maturity date of the VPFCs and also that Mr. McKelvey was going to settle his VPFCs with cash or low-basis stock. Moreover, the Commissioner obscures the non-tax consequences of the extensions. Had Mr. McKelvey not extended the VPFCs, he would have been required to deliver a very substantial number of shares, or the cash equivalent, within two months. Extending the settlement dates allowed him to put off the obligation while retaining the potential upside from a recovery in the price of his shares of the company he had founded.

3The Commissioner cites a series of articles to note that Mr. McKelvey had been fighting pancreatic cancer at the time. See App. Br. 10 n.2. That fact has no relevance to this appeal, which presents purely legal questions, and the Commissioner did not seek to make it part of the factual record. See Slupinski v. First Unum Life Ins. Co., 554 F.3d 38, 56 (2d Cir. 2009) (“[F]acts that are not in the record are not properly brought to our attention, and we do not consider them.”).

4Unless otherwise indicated, all section references herein are to the Internal Revenue Code of 1986, as amended (26 U.S.C.), and “Treas. Reg. § ” refers to the Treasury regulations promulgated thereunder (26 C.F.R.).

5Appellant further suggests that the open transaction doctrine did not apply to the extensions of the VPFCs because the VPFCs could be valued at the time of extension. See, e.g., App. Br. 40-41. Appellant is once again incorrect. Of course, the VPFCs could be valued at the time of extension (as they could at all times), but that valuation did not establish the identity or basis of what Mr. McKelvey would deliver in satisfaction of his obligations.

6The Commissioner ignores the precedent presented by the Estate to the Tax Court demonstrating that the IRS has repeatedly determined that a taxpayer having only obligations under a contract does not hold property on which gain or loss can be realized, even where there had been an earlier receipt of cash pursuant to the contract. (See JA 465-67; 686-88.)

7For these reasons, the Commissioner is wrong to assert that “[t]reating 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.” App. Br. 50. As the Commissioner himself acknowledges, § 1234A was enacted to combat a specific form of tax avoidance that allowed a taxpayer to elect capital or ordinary treatment for gain or loss realized from the sale or termination of a taxpayer's interest in a derivative contract. See App. Br. 51 (citing S. Rep. No. 97-144, at 170 (1981), reprinted in 1981-2 C.B. 412, 480, which states that enacting § 1234A was necessary “to prevent tax-avoidance transactions designed to create fully-deductible ordinary losses on certain dispositions of capital assets, which if sold at a gain, would produce capital gains.”). The issues presented in this case involve nothing of the sort. In this case, as the Commissioner later acknowledges, “there has never been any dispute . . . that the gain taxpayer realized, if any, was capital gain.” App. Br. 54. Instead, the dispute centers on whether the VPFC extensions triggered the realization of gain, a question as to which § 1234A provides no guidance.

8We are unaware of any precedent that has applied a “fundamental change” analysis to evaluate whether an obligation has been terminated. See App. Br. 46 (acknowledging that the “fundamental change” concept arose in the context of § 1001 but arguing that the same test should be applied “to determine whether there has been a deemed termination of obligations. . . .”). It is far from certain that the same test should apply, in the absence of a statutory provision, to determine whether a taxpayer has realized income under § 61 from relief from a liability. However, as discussed further below, under any articulation of the relevant test, it is evident that Mr. McKelvey was left with the same obligations after the extensions — they had not been fundamentally changed, terminated, or lessened.

9Since the debt cases cited above were decided, Treasury has promulgated specific regulations to govern when the modification of debt instruments constitutes a realization event, including when they will result in cancellation of indebtedness income to a debt issuer. Those regulations do not suggest that every debt extension will result in realization; to the contrary, they create specific safe harbors regarding when debt extensions are deemed immaterial for tax purposes. See Treas. Reg. § 1.1001-3(e)(3)(ii). However, in doing so, Treasury explained that:

[T]he rules for modifications of debt instruments would not necessarily work well or be appropriate in determining whether modifications of other instruments result in exchanges under section 1001. For equity instruments in particular, the IRS and Treasury believe that the application of certain rules in these regulations would be inappropriate. Similarly, for contracts that are not debt instruments, the final regulations do not limit or otherwise affect the application of the “fundamental change” concept articulated in Rev. Rul. 90-109 (1990-2 C.B. 191) . . .

T.D. 8675, 1996–2 C.B. 60. Thus, for equity instruments such as VPFCs, there is still no regulatory guidance as to what types of contractual modifications would trigger the realization of gain or loss.

10Moreover, the Commissioner's focus on the $11 million is itself misguided, as this does not represent the economic value of the extensions — it reflects the amount Mr. McKelvey paid. The Commissioner's own expert calculated that the extensions only changed the “value” of Mr. McKelvey's VPFCs (i.e., the expected cost of fulfilling Mr. McKelvey's obligations) by approximately $4 million in aggregate, or 2% of the prepayments. (See JA 181.)

11The Commissioner's rhetorical suggestion that the VPFCs should be viewed as “bets” is ironic given the IRS's approach to gambling gains and losses. The “fluctuating wins and losses” of a gambler are disregarded “until the taxpayer redeems her tokens and can definitively calculate the amount above or below basis (the wager) realized.” I.R.S. Chief Couns. Mem. AM 2008-011 (Dec. 12, 2008). Thus, even if one were to embrace the Commissioner's analogy of VPFCs to a bet, by extending his delivery obligations Mr. McKelvey did not redeem his tokens — he let them ride.

12In asking this Court to ignore this regime, the Commissioner does not ask this Court to embrace the gain calculations in the Notice, the amended gain calculations the Commissioner later asserted in his Tax Court briefing, or any other particular calculation of gain. See App. Br. 12 n.4.; (JA 513, 603-04) (reflecting the Commissioner's revised determinations as presented to the Tax Court). While the Commissioner provides no explanation for this decision, even a cursory examination of how one would be required to calculate short-term gains if the Commissioner were to prevail under either of his theories helps reveal the flaws in the Commissioner's approach.

Under § 1001, the Commissioner argues that Mr. McKelvey realized short-term gain when he exchanged the “original VPFCs” for the “extended VPFCs”. In his Tax Court briefing, the Commissioner argued that this “gain” could be ascertained by looking to the value of the “extended VPFCs,” because Mr. McKelvey's basis in the “original VPFCs” that he purportedly exchanged in order to receive the “extended VPFCs” was zero. (JA 603-09.) But this is nonsensical, given that according to the Commissioner's own expert, the extended VPFCs had negative value to Mr. McKelvey. (JA 161-63.) To force the values to be positive, notwithstanding his expert's own analysis, the Commissioner claimed that the “extended VPFCs” purportedly received as part of the “exchange” should be valued taking into account the pre-payments that had been received long before that “exchange”.

Under §§ 61 and 1234A, the Commissioner fares no better. Under the Commissioner's theory, that Mr. McKelvey replaced his “original obligations” with “new obligations,” those new liabilities must represent the basis the Commissioner believes Mr. McKelvey paid to terminate his “original obligations.” Even if that were correct, the “new obligations” were still contingent. Issuing a contingent liability cannot establish a taxpayer's basis because, even though the liability may be valued when issued, the actual cost of satisfying it is unknown until the contingency is resolved. See Albany Car Wheel Co. v. Comm'r, 40 T.C. 831 (1963), aff'd, per curiam, 333 F.2d 653 (2d Cir. 1964) (holding that the taxpayer could not increase its cost basis in purchased assets by the value of a contingent liability incurred in connection with the purchase); see also Treas. Reg. § 1.1275-4(c)(7), Ex.1 (explaining that where land is purchased with a contingent debt obligation, the contingent portion is only taken into account for purposes of the buyer's basis when it is paid). The contingency prevented Mr. McKelvey from knowing whether he would have gain or loss both when he entered into the VPFCs and after the extensions.

These flaws simply highlight that holding that Mr. McKelvey's extensions triggered realization before the ultimate settlement of the potential underlying stock sales would create severely distortive results. Indeed, if Mr. McKelvey ultimately settled his VPFCs in stock (as happened here) but the earlier extensions had constituted realization events, the character of his gain would have been improperly transformed from a gain on the eventual sale of stock into gain on the contracts. More than 80 years ago, the Supreme Court established that gain or loss may not be recognized on a contract to acquire property when the contract is settled by acquisition of the property; value in the contract must be accounted for as gain or loss in the property being acquired. See Helvering v. San Joaquin Fruit & Inv. Co., 297 U.S. 496 (1936) (rejecting taxpayer's contention that it should be treated as if, upon the exercise of an option, it exchanged both the option contract and the exercise price for the purchased property); see also Rev. Rul. 84-121, 1984-2 C.B. 168 (noting that the Service's treatment of stock options is consistent with the holding of San Joaquin Fruit). The same principle must apply here. The extension of Mr. McKelvey's VPFCs cannot have resulted in gain or loss on the contracts so long as the contracts remained in effect and the gain or loss on the potential sale of Monster stock remained to be determined.

13Indeed, after the Estate filed its Petition in this case, the Commissioner expressed an intention to issue “[r]egulations under § 1001 on the modification of nondebt financial instruments,” see U.S. DEP'T OF THE TREASURY, 2016-2017 PRIORITY GUIDANCE (Aug. 15, 2016) at *11, through which he could presumably attempt to alter the result required by existing law.

END FOOTNOTES

DOCUMENT ATTRIBUTES
Copy RID